The Expanding Ability of an Insurer to Recoup Costs Expended for Uncovered Claims

Insurers are routinely presented with complaints filed against their insureds where some of the complaint’s allegations do not fall within the coverage provided by an insured’s insurance policy.

Nevertheless, insurers are often required to provide a full defense to their insureds because the complaints contain some allegations that are arguably covered by an insured’s policy.

Of note, an Illinois Appellate Court recently issued an opinion that upholds an insurer’s right to recover defense costs when it explicitly reserves the right to recoup costs expended for uncovered claims. See, General Agents Ins. Co. of America, Inc. v. Midwest Sporting Goods Co., et al, 2004 WL 1440666 (Ill. App. 1st Dist. June 28, 2004).

In General Agents, the City of Chicago sued Midwest Sporting Goods (“Midwest”) alleging that Midwest created a public nuisance by selling guns to individuals who later resold the guns to gang members. Midwest tendered the defense of the lawsuit to its insurer, General Agents Insurance Company of America, Inc. (“General”). General denied coverage and filed a declaratory judgment action claiming that it had no duty to defend or indemnify.

During the pendency of the declaratory judgment action, General agreed to provide a defense to Midwest under a reservation of rights. General and Midwest agreed that Midwest could retain independent counsel, but General reserved its right to recoup defense costs for uncovered claims.

The trial court granted summary judgment in favor of General, declaring that General did not have a duty to defend, and the Illinois Appellate Court affirmed. Subsequently, General sought to recoup the approximately $40,000 it paid in defense costs. The trial court again held in favor of General and ordered Midwest to reimburse General for all defense costs paid on its behalf.

On appeal, Midwest argued that the terms of the insurance contract did not grant General a right to recoup defense costs. Midwest further argued that General could not recover the defense costs under a theory of unjust enrichment because the relationship between them was governed by a contract. The Illinois Appellate Court rejected Midwest’s arguments and held that General could recover payments made for non-covered claims because, at the time it accepted the defense payments, the insured had been fully advised by the insurer of its plans to do so.

The appellate court relied on the Illinois Supreme Court’s decision in City of Chicago v. McKechney, 205 Ill. 372 (1903), which involved a dispute over a construction contract. In McKechney, the city agreed to pay for the construction of a tunnel. The builder encountered difficulties in the construction, and demanded increased payments from the city. When the city failed to make payments at the increased rate, the builder sued for breach of contract. The city denied liability and entered into a new “accommodation” agreement, in which the city agreed to pay the higher rate, while reserving its right to recover any amounts that were later determined by the court to be overpayments.

The Illinois Supreme Court held that the “accommodation” agreement effectively reserved the city’s rights under the original contract and did not obligate the city to pay more than the original contract price. Similarly, the General Agents court reasoned that General and Midwest had reached an accommodation agreement concerning the expenditure of defense costs.

The court also relied on the Supreme Court of California’s landmark decision Buss v. Superior Court, 939 P.2d 766, (1997). In Buss, an insured tendered the defense of a multiple claim lawsuit to its insurer. The insurer accepted the defense after finding potential coverage for one of the causes of action, but reserved its right to deny coverage and recover defense costs paid for the defense of claims not covered by the policy. The Buss Court held that the insurer was entitled to reimbursement because it had properly preserved the right to recover the defense costs paid to defend claims not covered by the policy.

The court reasoned that since the insurer did not have a duty to defend claims that were not potentially covered and the insured did not pay premiums for uncovered claims, the insurer did not bargain to bear those costs and, therefore, had a right of reimbursement.

Midwest argued that Buss and its progeny provide the insurer with too much leverage and place the insured in the difficult position of trying to determine whether to contest or settle the underlying suit without having all of the facts of its insurance coverage in place. The Illinois Appellate Court rejected this argument and observed that if the insured refused to accept the defense provided under the insurer’s conditions, it “could force [the insurer] to choose either to defend without a right of reimbursement, or deny a defense and risk losing all policy defenses if a court found it in breach of the insurance contract.”

The court also noted that the insurer’s offer of a defense subject to a reservation of rights to recover the defense costs did not place the insured in a worse position than it would have been without the offer. Specifically, if General had not paid defense costs, the insured would still not know who would ultimately be responsible for the defense costs, “it would just not have had use of [the insurer’s] money while the parties litigated the claim”. Accordingly, the First District affirmed the trial court’s judgment.

General Agents is the first time an Illinois Appellate Court has explicitly allowed an insurer to recover defense costs paid for non-covered claims by reserving its right to recoup defense costs. The General Agents decision adds another important right and option for insurers – provide a defense under a reservation of rights, while reserving the right to recoup defense costs for non-covered claims. However, the decision makes clear that an insurer must explicitly reserve its right in this regard.

Many insurers employ the common practice of reserving rights to recover defense costs expended for uncovered claims. Given the General Agents decision, this practice appears to be a sound one. In the end, this decision provides some fairness to the insured-insurer relationship. An insured should not be entitled to obtain a defense for claims that are clearly not covered by the policy.

Concurrently, insureds should be entitled to a defense of all claims until there is a judicial determination of no coverage. The question that exists is whether insurers will continue to push for decisions such as Buss and General Agents to provide a clear direction on these issues.

Andrew S. Boris is a partner in the Chicago office of Tressler Soderstrom Maloney & Priess. His practice is focused on litigation and arbitration of insurance coverage and reinsurance matters throughout the country, including general coverage, directors and officer’s liability, professional liability, environmental, and asbestos cases. Questions and responses to this article are welcome at aboris@tsmp.com The Tip of the Month runs each month on claimsguides.com.