Insurers often provide their policyholders a defense pursuant to the duty to defend even though they disagree that the policy covers the underlying claims at issue. (This is not an act of unilateral generosity. Insurers have a duty to defend even claims that may be covered.) If a court later determines that there is no coverage for the claims, emboldened insurers often demand repayment of the defense costs the insurer paid prior to the coverage determination.

Over the last decade, several state high courts—including those in Illinois, Pennsylvania and Washington—have rejected insurers' efforts to recover their defense outlay in the absence of express contractual language requiring repayment. In a late January ruling that closely tracked these states' analysis, the U.S. District Court for the Eastern District of New York, while noting that New York state courts have not provided "clear guidance" on the issue, denied an insurer's attempt to recover prior defense costs. The federal court predicted that, if it were presented with the issue, New York's highest court, the Court of Appeals, would join this "recent trend toward courts rejecting claims for recoupment."

In General Star Indemnity Co. v. Driven Sports, Inc., the parties disputed whether claims concerning the advertising of "Craze," an energy supplement marketed and sold by the policyholder, fell within a coverage exclusion. The insurer provided a defense for the underlying actions pursuant to a unilateral reservation of rights, and sought a declaration that no coverage was available under the policy.

The court found that the exclusion applied, relieving the insurer of its duty to indemnify and duty to defend going forward, but denied the insurer's request for recoupment of the defense costs it had already paid.

There was no agreement that permitted the insurer to recoup its costs. The policy required the insurer to pay all expenses incurred in defense of the suit until it was determined that no coverage was available, without referring to recoupment. And the policyholder had refused the insurer's specific request to agree to repay defense costs if the claims at issue were determined later not to be covered.

The court found that, absent a contractual basis to require repayment, permitting an insurer to recover prior defense costs on a quasi-contractual theory such as unjust enrichment runs counter to the "well-established doctrine under New York law of imposing an 'exceedingly broad' duty to defend on insurers" whenever claims may be covered. The court also found that such a ruling would collide with the rule that a policy is interpreted to align with the "reasonable expectations of the average insured."

The Eastern District and the state supreme courts that have adopted this view have articulated several reasons not to allow an insurer to recoup prior defense costs without express authorization, including that:

  • The insurer properly bears the risk when it omits recoupment language from its policy, because it could have made issuance of the policy contingent on including such language;
  • To give effect to an insurer's unilateral reservation of rights requiring the insured to repay defense costs if there is later a finding of no coverage permits the insurer to impose after-the-fact conditions to coverage to which the parties did not agree; and
  • If courts were to order a policyholder to repay defense costs in the absence of express language, a policyholder facing a claim for which coverage is not 100% certain might simply choose to forego the protection it purchased and may well be entitled to receive, rather than risk a potentially crippling repayment burden in the future.

In light of Driven Sports and the different states' decisions from which it draws, policyholders may find it helpful to determine which rule(s) apply under the law of the state(s) that govern their policies. Policyholders may also wish to review their policies to determine whether the duty to defend is limited by any express recoupment language, while policyholders facing ongoing claims may wish to review any proposed or operative reservation of rights to identify any recoupment language the insurer may have attempted to impose.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.