A Deeper Dive into Nautilus: Differentiating Insurer Efforts to Recover Defense Costs and Assessing Recoupment in the Wake of the ALI Restatement

• Pages: 57-96
• Date: 01 January 2022
• Published date: 01 January 2022
• Author: Jeffrey W. Stempel
• Subject Matter: Derecho Público y Administrativo

57

*Doris S. & Theodore B. Lee Professor of Law, William S. Boyd School of Law, University

of Nevada Las Vegas. Thanks to Bill Boyd, John Buchanan, Jay Feinman, Chris French,

Sara Gordon, Dan Hamilton, Yong Han, Helmut Heiss, Bob Jerry, Erik Knutsen, the late

Doris Lee and Ted Lee, Randy Maniloff, David McClure, Ann McGinley, colleagues in the

American College of Coverage Counsel and the Project Group for the Principles of Reinsur-

ance Law (PRICL), and the ALI Restatement of the Law of Liability Insurance process.

Opinions expressed herein are of course my own and should not be attributed to any persons

cited or thanked. © 2021 Jeffrey W. Stempel.

A DEEPER DIVE INTO NAUT ILUS: DIFFERENTIATING

INSURER EFFORTS TO RECOVER DEFENSE COSTS

AND ASSESSING RECOUPMENT IN THE WAKE OF

THE ALI R ESTATEMENT

Jeffrey W. Stempel*

I. Introduction: The Recoupment Controversy ...............................58

A. Acceptance and Rejection of RLLI §21 ................................ 62

II. Differentiating Recoupment Scenarios .........................................64

A. Policy Provisions on Recoupment .......................................... 64

B. A Finding of No Duty to Defend Any Claims Against

the Policyholder ......................................................................66

C. An Action Against the Policyholder Presenting a Mix

of Covered andUncovered Claims ........................................67

D. A More Sophisticated Scorecard ............................................ 68

E. Recoupment Barred by Insurer Action or Inaction ...............69

III. The Clouded Waters and Conflicting Analyses of Nautilus .........69

IV. Conclusion: The Potentially Limited Voyage of Nautilus ............95

Tort Trial & Insurance Practice Law Journal, Winter 2022 (57:1)58

I. INTRODUCTION: THE RECOUPMENT CONTROVERSY

Promulgation of the American Law Institute’s Restatement of the Law,

Liability Insurance (RLLI)1 was marked by more pronounced controversy

than that usually attending Restatements.2 Among the provisions attract-

ing criticism from insurers was RLLI §21, which states: “Unless otherwise

stated in the insurance policy or otherwise agreed to by the insured, an

insurer may not obtain recoupment of defense costs from the insured, even

when it is subsequently determined that the insurer did not have a duty to

defend or pay defense costs.”3

Because the typical general liability insurance policy does not provide

for insurer recoupment of defense expenditures in connection with claims

eventually deemed outside potential coverage,4 this provision effectively

means that insurers using standard forms are precluded from seeking reim-

bursement of defense costs under the RLLI approach.5 Insurers of course

are free to include such language in the policies that they draft but have

consistently declined to do so despite being well aware of the issue.

Although the black letter of §21 leaves some room for argument, the

Comments and Reporters’ Note to the Section make clear that an insurer

1. A L I, R   L, L I (2019)

[hereinafter RLLI].

2. See Jeffrey W. Stempel, Hard Battles over Soft Law: The Troubling Implications of Insurance

Industry Attacks on the American Law Institute Restatement of the Law of Liability Insurance, 69

C. S. L. R. 605 (2021) (chronicling RLLI project and insurer opposition to particular

provisions regarded as unduly pro-policyholder). Notwithstanding the controversy surround-

ing portions of the RLLI, it should be emphasized that many portions of the fifty-section

RLLI were uncontroversial and that the Institute rejected most insurer motions to alter con-

tested versions of the document, approving the final RLLI by an overwhelming majority vote.

Equally important is that support for the final version of the RLLI was enhanced or solidified

by the revisions made in response to insurer concerns.

3. RLLI, supra note 1, §21 (emphasis omitted).

4. See, e.g., Insurance Services Office (ISO), Commercial General Liability Coverage Form

CG 00 01 04 13 (2012). In addition to promising to defend “suits,” the standard CGL policy

promises to provide “supplementary payments,” including “all” defense costs in actions the

insurer chooses to defend, a typically overlooked provision discussed infra notes 105–06 and

accompanying text.

5. Pursuant to RLLI § 21, an insurer with a duty to defend may not be reimbursed for

defense costs related to claims not potentially covered unless the policy has express language

to that effect or an express agreement exists in that regard. This is the RLLI’s attempt to deal

with what is frequently referred to as the “Buss” issue, so named after a famous California

Supreme Court case. See Buss v. Superior Ct., 939 P.2d 766 (Cal. 1997). Since that decision,

several significant courts (most prominently Pennsylvania and Illinois—General Agents Insur-

ance Co. of America v. Midwest Sporting Goods Co., 828 N.E.2d 1092, 1102–03 (Ill 2005), and

American & Foreign Insurance Co. v. Jerry’s Sport Center, Inc., 2 A.3d 526, 546 (Pa. 2010))—have

rejected Buss and denied recoupment, at least for standard language CGL policies. See also

R M  ., G L I C: K I  E

S ch. 7 (5th ed. 2020) [hereinafter K I]. Chapter 7 of Key Issues provides a discus-

sion of the history and development of the issue as well as a state-by-state scorecard. Insurers

have opposed RLLI §21 and argued in favor of the Buss approach.

59A Deeper Dive into Nautilus

cannot create a right of recoupment that is not in the policy simply by

agreeing to defend pursuant to a reservation of rights that includes a pur-

ported right to seek recoupment6 as does case law rejecting recoupment.7

In reaction to the draft form of §21, insurers cried foul and attacked

the RLLI provision.8 These attacks were consistent with the arguments

advanced by insurers for “recoupment” (the commonly used shorthand ref-

erence for an insurer obtaining repayment from the policyholder for the

insurer’s cost of providing a defense of claim ultimately found not to trig-

ger the duty to defend a claim or action) for decades, which have been met

with considerable but mixed success.9 The majority of courts considering

6. RLLI, cmt. a, provides:

[B]ecause [§21] is merely a default, if it turns out that the recoupment rule would

be relatively easy to administer or that the costs justify the expense, insurers can

incorporate an express right to recoupment in their policies. Second, situating the

right to recoupment in the insurance policy carries significant advantages; it puts

the legal basis of the insurer’s entitlement beyond dispute, and it specifies the con-

tours of that entitlement in advance of a dispute, making it easier to evaluate for

all parties concerned. Third, a default rule of no recoupment places the burden of

contracting around the rule on the party best able to do so.

Against this background, an insurer’s choice not to insert a recoupment provision

in the policy acquires contractual significance. At a minimum, it suggests that the

hardship created by the lack of a right of recoupment is not as substantial as might

appear in retrospect, when an insurer has defended a specific legal action that it

was not obligated to defend. Moreover, recognizing that the insurer is making

the choice not to insert a recoupment provision in the policy brings the default

rule followed in this Section within the principle disfavoring the use of unjust en-

richment when the parties are in a position to address the issues by contract. See

Restatement Third, Restitution and Unjust Enrichment §2, Comment c. The is-

sue of the right to recoup the costs of defending a noncovered legal action is a

known uncertainty that the insurer can address in the liability insurance contract,

as is frequently the case in Directors’ and Officers’ Liability Insurance policies.

In addition, a default no-recoupment rule better informs insurance regulators of

the coverage that the insurer intends to provide under the policy form, facilitating

informed administrative review of insurers’ intent to seek recoupment, and, once

the form permitting recoupment is approved, better informs insurance purchasers

of the more limited defense coverage provided by the policy.

7. See, e.g., Texas Ass’n of Counties Cnty. Gov’t Risk Mgmt. Pool v. Matagorda Country,

52 S.W.3d 128, 131 (Tex. 2000) (noting “a unilateral reservation-of-rights letter cannot create

rights not contained in the insurance policy”) (citing Shoshone First Bank v. Pac. Employ-

ers Ins. Co., 2 P.3d 510, 515–16 (Wyo. 2000) (both cases cited in RLLI , supra note 1, §21,

Reporter’s Note a).

8. See Hard Battles, supra note 2, at 658–62 (noting insurer-affiliated comments submitted

to ALI during the RLLI process criticizing draft RLLI provisions, including what became

§21).

9. See, e.g., Morgan, Lewis & Bockius, L.L.P. v. Hanover Ins. Co., 929 F. Supp. 764 (D.N.J.

1996) (supporting recoupment of insurer defense expenditures); Lowenthal v. Security Ins.

Co of Hartford, 436 A.2d 493 (Md. 1981) (same); see also Okada v. MGIC Indem. Corp.,

823 F.2d 276 (9th Cir. 1987) (approving recoupment in the context of a Directors & Offi-

cers liability insurance policy that expressly contained a provision permitting recoupment);

SL Indus., Inc. v.Am. Motorists Ins. Co., 607 A.2d 1255 (N.J. 1992) (permitting apportion-

ment of insurer defense obligations by covered and uncovered claims); Jeanne H. Unger,