Earlier this year, the Washington Supreme Court issued a 5-4 decision addressing an insurer’s ability to reserve the right to seek reimbursement of costs paid in defending claims that are ultimately determined to not be covered.  This was an issue of first impression in Washington.  In National Surety Corp. v. Immunex Corp., 176 Wn.2d 872, 297 P.3d 688 (2013), the Court found that the insurer defending under a “reservation of rights” may not seek to recover defense costs of the insured, even if a court determines the underlying claims are not covered under the applicable insurance policy.

National Surety issued various excess liability and umbrella policies to Immunex from 1998-2002.  In 2001, Immunex reported to National Surety that it was under investigation by state and federal authorities.  Later that year, several entities sued Immunex for the conduct that was the subject of the investigation.  Immunex tendered its defense on those suits to National Surety on October 2006.

In March 2008, National Surety issued a reservation of rights letter to Immunex indicating that it did not believe the claims were covered, but that its coverage investigation was continuing.  Further, National Surety agreed to defend Immunex, and pay all reasonable costs from the date of tender, until there was a declaration that the claims were not covered.  National Surety also reserved the right to seek reimbursement of any defense costs in the event there was a declaration that the claims were not covered under the policies.

National Surety filed a suit seeking a declaration of no coverage the same month it issued the reservation of rights letter.  In April 2009, the trial court issued a declaration that the claims were not covered under the policy.  The trial court also determined that National Surety was obligated for Immunex’s defense costs prior to the declaration, but that its liability for defense costs could be mitigated if it were able to establish that it was prejudiced by Immunex’s late tender.  The Court of Appeals affirmed the trial court.

The Court framed the first question to be addressed as “[W]hether an insurer may recover defense costs incurred under a reservation of rights in the event a court ultimately determines no duty to defend is owed.”  In answering that question, the Court began with a detailed overview of Washington law on the duty to defend.  It stated that “[a]n insurer’s broad duty to defend against colorable claims tendered by an insured, particularly when the insurer elects to defend under a reservation of rights, is central to our decision.”  The Court concluded its analysis by rejecting the argument of the insurance company and dissent that the insured is unjustly enriched when the insurer defends under a reservation of rights but is unable to recover the costs expended when a court ultimately determines there was no coverage for the underlying claims.  In particular, the Court found that the insurer benefits under that scenario “[b]y insuring itself against potentially disastrous findings of breach, bad faith, waiver, and coverage by estoppel.”

After concluding there was no unjust enrichment conferred upon the insured, the Court surveyed the decisions of other jurisdictions on the issue.  The Court ultimately sided with the minority of jurisdictions in concluding that those decisions disallowing reimbursement of defense costs is most consistent with Washington law regarding the duty to defend. The Court refused to adopt the insurer’s “all reward, no risk” proposition.

An important passage of the opinion comes in footnote 2 where the Court acknowledges the potential conflict between its decision and a passage from the Court of Appeals’ opinion in Holly Mountain Resources, Ltd. v. Westport Ins. Co., 130 Wn.App. 635, 652 n.8, 104 P.3d 725 (2005).  There, the Court of Appeals posited that “[a] reservation of rights is a means by which the insurer conditionally defends its insured, subject to potential reimbursement by the insured upon later discovery that there was no duty to defend.” Id.  The Court expressly disaffirmed that language from Holly Mountain, agreeing with the state’s leading insurance treatise that the language was “erroneous” and “wholly inconsistent” with the teachings of Tank v. State Farm Fire & Cas. Ins. Co., 105 Wn.2d 381, 715 P.2d 1133 (1986).  See Thomas V. Harris, Washington Insurance Law, sec. 17.01, at 17-1, 17-2 (3d ed. 2010).

The second question addressed by the Court was whether the insurer’s duty to defend may be excused due to the insured’s untimely tender of the claims to the insurer.  On that issue, the Court found that under Washington law the insured may recover pre-tender defense fees and costs except where the late tender prejudiced the insurer.  The insurer is required, however, to establish that the late notice “actually and substantially prejudiced its interests before performance of [the insurer’s] duties will be excused.”  The Court remanded this issue to the trial court for additional consideration.

This case will likely have a lasting impact on an insurer’s duty to defend under a reservation of rights and will likely result in additional litigation concerning the scope of the decision.  We will follow-up with any additional updates on the case.