Under What Circumstances Can Insurer Recover Defense Costs?
The insurer's duty to defend is exceedingly broad, but the duty is not interminable. As long as there are allegations of covered claims the duty includes an obligation to defend allegations not covered by the insurance policy. Professional liability policies—the Errors & Omissions (E&O) and analogous Directors and Officers (D&O) policies—permit the insurer to "clawback" defense costs if a judicial finding is made that the alleged acts are excluded from coverage or are otherwise not covered. The insurer's success depends upon the wording of the policy, a finding by a court and the insurer's explicit reservation of rights letter explaining its coverage position including that it would seek recoupment of defense costs if coverage were found inapplicable or excluded.
The Duty to Defend
The insurer must provide a defense to the action if the complaint, liberally construed, sets forth any claim which can reasonably be said to fall within the coverage provided by the insurance policy, or if the carrier has actual knowledge of facts which tend to establish the reasonable possibility of coverage. In New York, insurers may not look beyond the "four corners of the complaint" to avoid the obligation to defend. Even if extensive facts suggest the claim may ultimately prove meritless or outside the policy's coverage the insurer must initially provide a defense.
Only when the insurer can establish that there is no possible factual or legal basis to indemnify the insured, either because no reading of the policy language encompasses the loss at issue or the alleged act is excluded from coverage, will the insurer be relieved of its obligation to defend. Once the insurer commences a defense it should continue to defend until a court finds it has no coverage obligation, or a jury issues a finding concerning the alleged misconduct that shows the loss to be one that is excluded or outside the boundaries of coverage.
An insurer is obligated to pay or advance defense costs as they are incurred, "subject to recoupment in the event it is ultimately determined no coverage was afforded[.]"1 Language allowing the insurer to recoup defense costs may appear in either the E&O or the D&O policies. In addition, if a policy is properly rescinded the insurer may be able to recover defense costs.
The First Department in Certain Underwriters at Lloyd's London v. Lacker Lovell-Taylor recently reaffirmed the principle that recovery of the defense costs will be permitted if the policy language provides for the recovery of defense costs and the insurer has explicitly reserved its rights to seek reimbursement of defense costs once there is a finding of no coverage.2
An insurer who notifies the insured of the policy rescission may refuse to pay defense costs. The insurer, however, remains obligated to defend its insured until a court finds the rescission is proper. It may then be entitled to clawback the defense costs.
Interestingly, a 2012 decision in the Southern District of New York, XL Specialty Ins. v. Level Global Investors, drew a distinction between rescission and other types of insurance coverage disputes when it considered an insurer's obligation to advance defense costs. There, the insured sought an injunction requiring advancement of defense costs by its professional liability insurer.3 The insurer claimed it had no obligation to defend or indemnify, relying on policy exclusions.
While recognizing the "irreparable harm" component was satisfied by the insured's "need to access additional legal costs," the court disagreed that New York law compelled the advancement of defense costs if the coverage was excluded by policy language. The court explained that "[m]andating advancement while even dubious assertions of coverage are resolved would invite abuse" and ultimately "would only serve to drive up the costs of insurance[.]"4
Rescission of the Policy
Proper rescission occurs when the insurer returns the premium paid and the insurer is able to establish that but for a misrepresentation that was so material the insurer would not have issued the policy had it known the truth.
Section 3105 of New York's McKinney's Insurance Law "Representation by the Insured" governs the insurer's right to rescind a policy. Section 3105 (1) defines "representation" as: "a statement as to past or present fact, made to the insurer by, or by the authority of, the applicant for insurance or the prospective insured, at or before the making of the insurance contract as an inducement to the making thereof."
The insurer must return the paid premium when it notifies the insured of the rescission and should be prepared to litigate the validity of the rescission. If the insured wins, the insurer may be responsible for the costs in the litigation concerning rescission as well as in the underlying action.
The insurer may recover the defense costs expended on behalf of the offending party if the rescission is successful. Rescission without court approval does not provide retroactive effect for recovery of defense costs.
Unique Terms in Policies
The ability of an insurer to void the insurer's contract based on a material misrepresentation may be limited by a severability clause. The policy in issue in the seminal case Federal Ins. v. Kozlowski5 (Tyco) contained a severability clause so that misrepresentative statements made by one director or officer did not apply to the interpretation of the application concerning another. In the Tyco case the insurer also relied on financial statements not attached to the application to bolster its misrepresentation claim. The court held the information was insufficient to prove the officer in issue had the specific knowledge required to rise to the level of "a false representation, and the facts misrepresented are those facts which make the representation false."6
Another severability clause relates to certain policy exclusions, including the personal profit and fraud exclusions. Both severability clauses preclude the carrier from imputing to an insured person any facts or knowledge of other insured persons "to determine if coverage is available." Only after the issue is resolved will there be an apportionment of legal fees for covered and uncovered claims.