InfoCentral: Commercial General Liability (CGL) Defense Costs for Uncovered Claims
It's been more than five years since the Texas Supreme Court ruled in the case of Lloyd's vs Frank's Casing that insurers could not seek reimbursement from their insureds for amounts spent to defend claims that aren't covered by the policy.
The decision was a victory for policyholders in general, but the Court left one door open to insurers. The court stated that an insurer has an option to include a reimbursement right in the policy itself. This option could come in a policy form or endorsement that specifically provides for reimbursement of the insurer's defense costs by the insured when the insurer defends the insured and pays defense costs but later determines that none of the claims are covered by the policy.
At least one insurer took the hint and has begun to add such a provision to its policies.
A Texas agency received a proposal for its E&O policy renewal that included such an endorsement. The endorsement reads as follows
Changes - Defense Costs
If we initially defend an insured or pay for an insured’s defense but later determine that none of the claims, for which we provide a defense or defense costs, are covered under this insurance, we have the right to reimbursement for the defense costs we have incurred.
The right to reimbursement under this provision will only apply to the costs we have incurred after we notify you in writing that there may not be coverage and that we are reserving our rights to terminate the defense or the payment of defense costs and to seek reimbursement for defense costs.
Here is a scenario describing how this endorsement might work to serve its ugly purpose to the detriment (and potential financial ruin) of an unsuspecting policyholder.
The insured receives a lawsuit and reports the claim to the insurance company. The insurance company reviews the allegations of the lawsuit, compares them to the coverage provided by the policy and believes that none of the allegations are covered. The company sends a reservation of rights letter to the insured, stating its belief that none of the allegations are covered but agreeing to begin defending the lawsuit pending a final decision on the coverage issues. In the letter, the company notifies the insured that it will seek reimbursement of incurred defense costs if it is determined that none of the allegations are covered by the policy. As it begins to hire attorneys to answer the lawsuit and investigate the claim, the company files a separate lawsuit against the insured -- called a declaratory action - to ask the court to determine the coverage issue. If this court ultimately decides in favor of the company - and this could take months if not years, including probable appeals to higher courts - the insurance company will tender a bill to the insured for the amounts it spent in defending the underlying lawsuit. Now the insured is faced not only with the prospect of taking over its own defense and possibly settling the claim on its own, but it must also write the insurance company a check to reimburse the defense costs spent up to that point.
Many insureds won't be able to handle the double whammy and will seek other solutions, like bankruptcy and/or suing their insurance agent for selling them a policy that included such an onerous provision.