Who pays the legal bills when a court finds an insurance company has no duty to defend?

When you purchase insurance, like homeowner’s insurance or auto insurance, one of the things you’re buying is access to a lawyer paid for by your insurance company to defend you if you ever screw up and hurt someone else. This benefit is frequently referred to as the insurance company’s “duty to defend.” Sometimes, however, insurance companies try to wriggle out of this duty by trying to find reasons why you are not covered for what happened.

When faced with a lawsuit against its policyholders, insurance companies have three options:

  1. Hire a lawyer and pay the lawyer to represent the policyholder until the claim is resolved;
  2. Refuse to provide a lawyer and tell the policyholder it has no duty to defend and won’t cover the loss; or
  3. In close calls where it isn’t clear there’s no coverage, provide a lawyer under what’s called a “reservation of rights,” which puts the policyholder on notice that the insurance company thinks there might not be coverage and why. The insurance company then starts a separate proceeding to ask the court for a ruling there is no duty to defend.

Obviously, the first option is best, and there’s no problem if the insurance company does this. The second option is a dangerous one for insurance companies because it carries heavy penalties — if the insurance company is wrong and a court finds it did have a duty to defend, the insurance company is on the hook for all the harm the denial of coverage caused, including attorney fees, business losses, emotional distress at having been abandoned by your insurance company, etc. These damages are often significant because of the ripple effect caused by being abandoned by your insurance company (paying for your own lawyer, which affects personal and business finances, which can lead to people losing homes or businesses, which can lead to psychological or physical health problems, which can lead to more money problems, etc.).

Because option two is such a bad option, Washington courts have encouraged insurance companies that have questions about coverage to use the third option. This gives the policyholder a lawyer in the underlying injury action, while at the same time providing the insurance company with a venue to argue why it shouldn’t have the duty to defend the policyholder and protection from a later bad faith suit arguing the insurance company mishandled the claim (though the policyholder has to hire a lawyer at his/her own expense to argue why the insurance company is obligated to provide coverage). If insurance companies provide a lawyer in the underlying lawsuit while a court is deciding whether there is coverage, then everyone’s interests are (in theory) protected.

But the question occasionally arises, who pays the policyholder’s lawyer up to the point when the court finds no duty to defend? Division I of the Washington Court of Appeals answered that question last week in National Surety v. Immunex. There, the court held that National Surety was still on the hook for the fees of the lawyers who represented its policyholder, Immunex Corporation, up to the point the court found there was no duty to defend. National Surety did not have to pay fees beyond that finding. The court reasoned that by providing a defense under a reservation of rights, National Surety incurred a very important benefit, namely, protection from a later lawsuit alleging it mishandled the claim. As such, paying for the lawyer for the policyholder was a proper price for this benefit. The court further noted that there was no provision in the insurance policy giving the insurance company the right to recoup those attorneys fees from the policyholder, and National Surety’s attempts to add a right to recoupment into the reservation of rights letter was improper.

While this case gives important protection to insureds, the implication is that insurance companies can write a right to recoup such defense costs into the policy. Such an addition would be problematic and harm the insured in a couple of ways. First, as discussed above, it ignores the benefit insurance companies incur when they defend under a reservation of rights and would in essence force the policyholders to pay for something that benefits the insurance company. Second, it would force policyholders to pay for legal fees incurred at the direction of the insurance company but were usually never ok’d by the insured. Most of these types of insurance policies give the right to control the defense of the lawsuit to the insurance companies, meaning the policyholder has no say in what happens and what the lawyers do. In other words, the insurance company tells the lawyer what to do up until the court says it has no duty to defend, and then the policyholder has to pay for everything the lawyers did, even if he/she disagrees with the tactics taken by the lawyers as directed by the insurance company.

Hopefully the courts will have a chance to rule on whether recoupment provisions in insurance policies are appropriate.

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