Allocating Defense Costs

April 10, 2002

by Mary E. McCutcheon

Five years ago, the initial headlines describing Buss v. Superior Court, 16 Cal. 4th 35 (1997), characterized the Supreme Court's decision as a stunning victory for insurers. They read "Supreme Court Grants Insurers' Right to Reimbursement" or "Insurers Win Allocation Fight." Insurance companies cheered. Policyholders sang the blues. But then, everybody sat down and read the opinion. Insurance companies' cheers turned to shivers of trepidation, and policyholders' groans turned to murmurs of excited anticipation.

In fact, the Buss decision did not have the doomsday effect that policyholders feared. After the cheering and groaning stopped, people actually read the decision and learned that as a practical matter, Buss often has little or no impact on the insurer's duty to defend.

True, Buss holds that an insurer who is called upon to defend a "mixed" action (one involving both potentially covered and clearly noncovered claims) ultimately need not defend the noncovered claims. Policyholders had argued that, because an insurance policy obligates the insurer to defend any "suit" seeking potentially covered damages, the insurer must defend a "mixed" action in its entirety—even if doing so meant paying defense costs clearly allocable only to noncovered claims. While Justice Kennard adopted this reasoning in her dissent, the majority disagreed, finding that an insurance company has no duty to defend claims in a mixed action which have no potential for coverage. (In other words, the insurer can "allocate" defense costs between covered and noncovered claims.) Policyholders had also argued that, if an insurer has a right to allocate defense costs between covered and noncovered claims, it can do so only if the allocation is supported by "undeniable evidence." The Court rejected this argument as well, finding that while the insurer bears the burden of proof in establishing its right to allocation, it need do so only by a preponderance of the evidence.

But the good news for insurers ends there. The Court reaffirmed and expanded several basic principles concerning the duty to defend. The duty to defend extends to claims that are "merely potentially" covered, not just claims that are "actually covered," even if such claims are intermixed with clearly noncovered claims. The insurer can seek reimbursement only for defense costs "solely" attributable to claims "that are not even potentially covered." If the duty to defend is extinguished, "it is extinguished only prospectively, and not retroactively: before, the insurer had a duty to defend; after, it does not have a duty to defend further." And, an insurer cannot reserve a right to reimbursement for defense costs as to claims that are "at least potentially covered."

The Court also took a lot of the sting out of its pro-insurer holdings by clarifying when an insurer can attempt to allocate fees. If an insurer is called upon to defend a "mixed" action, it must pay for all defense costs as incurred. It can only seek reimbursement of defense costs allocable to noncovered claims at the end of the case. As the Court stated:

To defend meaningfully, the insurer must defend immediately. [Citation omitted] To defend immediately, it must defend entirely. It cannot parse the claims, dividing those that are at least potentially covered from those that are not.

These few sentences confer an enormous advantage upon policyholders. Previously, insurers often unilaterally allocated defense costs in "mixed" actions as bills were submitted, arbitrarily determining which defense costs benefited noncovered claims. Now, according to Buss, an insurer must pay all defense costs for a "mixed" action as they are incurred. It can only resolve issues of allocation, and thus reimbursement, at the end of the case.

While the right to reimbursement may loom like a dark cloud on the horizon for an insured embroiled in the defense of a "mixed" action, the Buss opinion renders that threat more potential than real. As a practical matter, many reimbursement issues may be negotiated out at the time the "mixed" action is settled. Indeed, the Court's decision assumes that the right to reimbursement will be very difficult to establish, and that insurers will pursue it only "in apparently exceptional cases," where defense costs "are clear and substantial," and where the insured has assets to satisfy a reimbursement claim. If defense counsel has developed the appropriate defense strategy, it may be extremely difficult for an insurer to satisfy its burden of proof on the issue of reimbursement, even under a preponderance of the evidence standard.

Furthermore, Buss raises as many questions as it answers: (1) what, if any, reservation of rights is necessary to preserve an insurer's right to reimbursement; (2) what guidelines can an insurer impose on defense counsel in an effort to maximize the chances for reimbursement; and (3) what burden of proof must be met by an insurer who has breached its duty to defend a "mixed" action? But clues to these answers lie within the opinion, and point favorably towards insureds. The Court points out in footnote 27 that "Through reservation, the insurer avoids waiver." Its statement that an insurer cannot "parse the claims" supports an argument that an insurer cannot impose billing guidelines which force defense counsel to pave the way for the insurer's reimbursement action. And on the whole, the Court views the Court of Appeal decision (which held that a breaching insurer should be held to a higher standard of proof than an insurer which has conscientiously discharged its obligations) favorably, suggesting it would agree with the Court of Appeal on that point as well.

Policyholders should take heart, study the Buss decision carefully, and remain calm in the face of insurers' demands for reimbursement for defense costs in "mixed" actions.