You are a contractor. A claim has been asserted against you. You tender the defense to your general liability carrier. The most common response is that the insurer will assume the defense under a reservation of rights. That reservation always means that the insurer may later dispute whether the policy covers the claim and if there is no coverage, the insurer is not obligated to pay any damages awarded to the claimant. The insurer may also, though, reserve its right to recoup defense costs that it paid, if it is determined at a later time that it did not owe a duty to defend. It is this second, less common reservation that is the subject of this article.
Commercial General Liability policies provide two broad forms of protection for insureds: (1) the promise to pay damages awarded for covered claims and (2) the promise to provide a defense to claims which, if valid, would be covered by the policy. The duty to defend is broader than the duty to pay damages for covered claims because it may apply even if the claims are baseless and result in no liability. Indeed, in Ohio and most other places, “an insurer’s duty to defend attaches when the allegations in the complaint state a claim that is ‘potentially or arguably’ within the scope of the policy’s coverage regardless of the ultimate outcome of the case.” City of Willoughby Hills v. Cincinnati Ins. Co. 9 Ohio St. 3d 177, 179 (1984) (emphasis added). Thus insureds reasonably assume that their insurer will defend them, at the insurer’s cost, against a wide range of claims, whether or not valid. For this reason, an insurer’s reservation of a right to recoup defense expenses is very significant.
Although the Ohio Supreme Court has not ruled on the enforceability of a reservation of the right to recoup, the United States Court of Appeals for the Sixth Circuit has predicted that Ohio would enforce such a reservation. The basis is that if the insurer notifies the insured of its reservation of the right to recoup and the insured does not object, an implied contract arises between the insurer and the insured. In other words, by silently accepting the defense supplied by the insurer in the face of its notification that it reserves the right to recoup defense costs, the insured has entered a binding agreement to reimburse the insurer if it is later found that the insurer never owed a duty to defend in the first place. United National Ins. Co. v. SST Fitness Corp. 309 F.3d 914 (6th Cir. 2002).
Why is this important? Costs of defense may be very substantial and the contractor might receive a bill for a five or six-figure number—a very unpleasant surprise. Even worse, when the insurer takes on the defense, it chooses counsel—so the insured may find itself, in the end, paying for defense counsel selected and largely controlled by the insurer, without the insured ever having had the opportunity to manage or approve the counsel’s strategy, billing rates, or resulting expenses.
What should you do? The Sixth Circuit says the insured has three options when faced with an insurer’s provision of a defense with a reservation of the right to recoup its costs: “(1) decline the offer, pay for the defense, and seek to recover on the policy; (2) decline the offer and file a declaratory judgment action; or (3) accept the offer subject to the reservation of rights.” Each of these has significant drawbacks. The insured would obviously like a defense, without the right of the insurer to recoup.
There is at least one other possibility that an insured could consider. Since the basis of the insurer’s right to recoup is its unilateral announcement of that right and the insured’s alleged agreement when it accepts the defense, the insured could consider objecting in writing to the reservation. The potential upside to objecting is that if the insurer nonetheless provides the defense, the insured will have the argument that there is no implied contract of recoupment. That’s preferable to not having the argument. The potential downside to objecting is that the insurer refuses to provide the defense. That refusal might be worth testing, though, since one of the reasons insurers tend to provide a defense in close cases is to avoid a bad faith claim for refusing to do so.
In other words, under this suggestion, the insured contractor continues to demand a defense as something it is entitled to under the policy and refuses to accept the additional new condition—which is not contained in the policy—that the insurer is trying to impose with its reservation of rights letter.
Your insurance policy is a valuable asset, but is complicated both in itself and in how courts interpret it. You should seek counsel before making any decisions in cases involving an insurer’s reservation of a right to recoup defense costs.