New York Appellate Court Rules That Liability Insurer’s Right to Recoup Defense Costs Must Be Defined by Policy
A recent decision of New York’s Appellate Division, Second Department, demonstrates why liability insurance policies should expressly define the circumstances under which the insurer may recoup its costs defending the insured: where a policy is silent on recoupment, courts disagree over whether a reservation of rights letter can effectively fill the gap. In conflict with rulings from the First Department and other courts, a unanimous panel in the Second Department held in American Western Home Insurance Co. v. Gjonaj Realty & Management Co., 192 A.D.3d 28 (2d Dep’t 2020), that a reservation of rights letter is not sufficient to secure the insurer’s right to recoupment where that right is not expressly granted by the policy.
American Western Home Insurance Company (“American”) insured Gjonaj Realty & Management Company and 28-47 Webb Avenue Associates, LLC under a CGL policy. In 2010, during the policy period, an individual fell from a ladder on the insureds’ premises. While the individual filed a personal injury suit against American in 2011, the insureds did not notify American until October 2014. In 2015, American agreed to defend and indemnify the insureds in the personal injury suit, but reserved its right to deny coverage if future developments established that the insureds’ late notice prejudiced American. In May 2017, American concluded that the late notice had caused it prejudice and sent the insureds a letter denying coverage and reserving its right to recoup the defense costs it had incurred. While continuing its defense in the personal injury suit, American commenced an action in New York Supreme Court seeking a declaration that American had no duty to defend or indemnify the insureds in the personal injury suit and that American was entitled to recoup its defense costs in that suit since the date of the letter that purported to reserve its right to recoupment. In February 2018, Supreme Court granted American the declaratory relief it sought, and the insureds appealed to the Appellate Division, Second Department.
The Second Department affirmed the Supreme Court’s ruling that, due to the prejudice caused by the late notice, American owed neither a duty to defend nor to indemnify the insureds. However, the Second Department reversed the Supreme Court’s ruling on the recoupment of defense costs. The Second Department held that, under New York law, American was not entitled to recoup any of its defense costs, notwithstanding American’s purported reservation of rights. The crux of the Court’s reasoning was that the underlying insurance policy did not expressly grant American any right to recoup defense costs, and American’s “unilateral reservation of rights letter” could not reserve rights that had never existed:
[A]warding an insurer its defense costs when the insurer issues a reservation of rights letter for the same despite the lack of any language in the policy at issue permitting the insurer to recover the costs of defending claims that are later determined not covered by the policy flies in the face of basic contract principles and allows an insurer to impose a condition on its defense that was not bargained for[.]
The Court also emphasized the well-established doctrine that the duty to defend is broader than the duty to indemnify, and noted that the doctrine could be “eroded” if, upon establishing that it owes no duty to indemnify, an insurer was entitled, by default, to recoup the costs it incurred carrying out its duty to defend.
The Court acknowledged that its analysis conflicts with other authority. First, it expressly disagreed with two out-of-state cases—United National Insurance Co. v. SST Fitness Corp., 309 F.3d 914 (6th Cir. 2002) and Knapp v. Commonwealth Land Title Insurance Co., 932 F. Supp. 1169 (D. Minn. 1996)—which held that a new, implied contract is created when an insurer purports to reserve a right to recoup defense costs and the insured continues to accept the insurer’s payments for the defense. The Court also expressly “declined to follow” a “handful” of cases applying New York law that, as the Second Department described them, “allowed defense costs to be recouped where such a reservation of rights letter has been sent.” Among those cases are two decisions of the First Department—one affirming an award of defense costs to an insurer that had “reserved its right to seek reimbursement of its defense costs in the event of a finding of no coverage,” Certain Underwriters at Lloyd’s London Subscribing to Policy No. SYN-1000263 v. Lacher & Lovell-Taylor, P.C., 112 A.D.3d 434 (1st Dep’t 2013), and another holding that an insurer had a viable claim for recoupment “[a]s [the insurer] reserved its rights to recoup expenses it incurred that are not covered by the policies,” American Home Assurance Co. v. Port Authority of New York, 166 A.D.3d 464 (1st Dep’t 2018).
However, the Second Department’s decision in American Western Home is in line with recent decisions from the Eastern District of New York that also reached the conclusion that, under New York law, an insurer cannot use a reservation of rights letter to recoup defense costs where no such right exists under the insurance policy itself. See, e.g., Crescent Beach Club LLC v. Indian Harbor Ins. Co., 468 F. Supp. 3d 515, 554 (E.D.N.Y. 2020); Century Sur. Co. v. Vas & Sons Corp., 2018 WL 4804656, at *6 (E.D.N.Y. Sept. 30, 2018).
In light of the conflicting authority over an insurer’s right to recoupment under New York law—including an apparent split between the First and Second Departments—New York insurers and insureds should expressly agree on whether, and under what circumstances, the insurer may recoup its defense costs. Parties to an insurance policy—particularly the insurer—should also keep in mind that, while reservation of rights letters are often necessary to reserve contractual rights that indisputably exist, they are generally insufficient to create ones that do not.