Subrogation in professional liability policies: the ‘made whole doctrine
Subrogation is an equitable principle by which one party substitutes for another party, and assumes the rights of that substituted party. In the context of an insurance relationship, subrogation takes place when an insurer ‘steps in the shoes of its insured in order to pursue recovery from third parties that are legally responsible to the insured for a loss.(1) Developed in the English equity courts, an insurer’s subrogation right and its many permutations focus on the balance of fairness between insurer and its insured. As these equity courts pre-dated the birth of quasi-contracts, the modern concept of equitable subrogation – an insurer’s right to be reimbursed for payments made to the insured – can arise in favour of insurers even without a contractual or statutory mandate.(2) Similarly, an insured’s defences and alternatives to subrogation can arise from equitable principles outside of the contractual wording.(3)
Subrogation was a natural result of indemnity: insurers paid out losses to their insureds and thereafter sought reimbursement of these funds from the responsible tortfeasor.(4) Insurers were in better positions to find and litigate the third-party claim, and insured parties were less likely to be unjustly enriched in ‘double recovery’ by directly recovering from a tortfeasor and also receiving insurance proceeds.(5) However, courts soon began to find that having a blanket right of subrogation did not create a proper balance of the equities. This was especially true in the area of personal insurance contracts (e.g., life, death, health, and injury), where it may be difficult to determine the value of the ‘loss’ or difficult to decide whether the insured was therefore unjustly enriched or not quite ‘made whole’.(6) Subrogation and its many defenses became a blurred line between balancing the traditional equitable principles governing the insurance relationship and freedom of contract.(7)
The modern-day professional lines liability contract is also a natural result of indemnity, wherein the parties attempt to strike a balance between equitable considerations and freedom of contract.(8) However, a liability contract is a different creature from most other lines of insurance.(9) Coverage is triggered when a claim is brought by a third party against the insured and, unlike personal lines and even property insurance, professional liability insurers have no expectation of recovery except under limited circumstances. Instead, insurers seek to reflect their risk of loss through, and have increased risks compensated by, the insured’s respective premium. Professional lines policies have become a sophisticated field of pricing, underwriting and procurement based on the ebbs and flows of several industries.(10) However, professional lines policies may contain subrogation clauses and reimbursement clauses that do not properly reflect the sophistication and unique nature of such an insurance relationship.
Professional lines insurers are governed by the same subrogation case law developed in the context of personal lines and pure-loss indemnification contracts.(11) Many of these cases focus on the ‘made whole doctrine, which simply states that in the event that a recovery for the insured does not meet or exceed its amount of cognisable loss, courts will determine whether the insured was ‘made whole’ before allowing an insurer to seek reimbursement of any amounts it paid out in connection with the claim.(12) Interpretation of this doctrine has spurred thousands of litigations, and has created stark lines among different states as to:
• what makes an insured whole;
• what forms of recovery belong to either the insured or the insurer; and
• what impact contract language has in such determination.(13)
This update tackles the states’ split on which party has the superior interest in subrogation and reimbursement. By detailing the jurisprudence of states on polar ends of the split and focusing on the most internally contentious state for subrogation, California, it aims to emphasise the need for professional liability insurers to be proactive in understanding their rights in subrogation. It is important to know what the policy form provides with respect to subrogation rights and priority of recovery. Will ambiguous language blur an insurer’s subrogation rights and allow for unpredictable results in equity? Similarly, it is essential to know what courts and state insurance codes mandate regarding priority in the jurisdiction where the insured’s claim arises or where the choice of law clause dictates. To this end, how does the applicable jurisdiction characterise self-insured retentions and attorney’s fees in the context of recovery and subrogation? After addressing these issues, this update works practically with policy excerpts to determine the best practices for insurance carriers and insured parties.
State court split on subrogation: ‘made whole’ doctrine
Subrogation’s most famous permutation, the made whole doctrine, is also an equitable principle that was formed outside of the concepts of contract and quasi-contract. This doctrine arose as a result of insured parties and insurers settling with, or reaching judgments against, third parties for amounts less than what the insured’s loss or damages were estimated to be.(14) A majority of courts were concerned that insurers and insureds would evenly split settlement amounts, while still leaving the insured harmed from the action.(15) While most jurisdictions have sought to define the parameters of what makes an insured whole, there are drastic differences in state courts’ preferences between insurer and insured rights. An insurer must therefore understand the governing jurisdiction for an insured’s claims when assessing the strength of its own subrogation clause. Even when analyzing the governing contract, courts are known to depart from the concept of contractual subrogation when faced with a vague or superficial subrogation clause, and instead instill their own concept of equitable subrogation.(16)
The majority of states follow the made whole or ‘insured whole’ doctrine, which holds that an insured must be fully compensated for its loss from the proceeds of a settlement or judgment before the insurer may share in the proceeds of the recovery.(17) Even within this majority, courts have used divergent reasoning to arrive at the same conclusion. For example, Wisconsin follows the rationale that an insurer assumes the risk of loss by accepting the insured’s premium despite the subrogation provisions in the standard policy language; the insurer therefore implicitly agrees to follow the made whole doctrine.(18) The Alabama courts’ reasoning takes a step further, holding that it is the insurer’s burden to prove that the insured has been fully compensated before asserting its subrogation claims against the insured.(19) Similarly, Montana states that an insurance contract needs specific terms giving the insurer the right of first indemnity to negate the presumption of the insured whole or made whole doctrine.(20) Although reasonings may vary among states, the courts in these states have agreed that ambiguous or general subrogation clauses shall be interpreted in light of the balance of equities. Standard or boilerplate policy language will be interpreted in light of the balance of equities in the majority of states, and will likely favour an insured party.
Even in the minority of states that are called ‘insurer whole’, courts base their reasoning on freedom of contract, and will not rely solely on equitable considerations to protect insurers’ rights. Instead, states such as Ohio have decided their cases based on the existence of disclaimers and plain meaning of contracts that give the insurer priority of right.(21) Other states have focused on refuting the reasoning of insured whole states. For example, Texas has rejected the reasoning used by states like Wisconsin and Alabama, instead holding that the burden of proving whether an insured has been made whole is on the moving party.(22) Texas touts freedom of contract further, arguing that boilerplate language, so long as it purports to entitle the insurer to subrogation out of the first money received by the insured, can summarily overcome the made whole doctrine. (23) However, even in this minority of states, few hold that insurers have priority of reimbursement as a general rule. (24) In the balance of equitable considerations, these states most highly value the language of the contract and the line of insurance.(25)
California: prudence in underwriting
California case law epitomizes this balance between equitable and contractual subrogation, and the importance of underwriting clear policy clauses with regard to recovery, reimbursement, and subrogation. Of import to professional liability insurers that predominantly write loss and defense policies, California has also addressed the question of which funds are available for subrogation and a determination of whether an insured has been made whole (i.e., self-insured retentions, attorney fees).
California courts generally assume that parties to the insurance contract have agreed to the made whole doctrine, but have carved out exceptions where the parties have agreed to a specific subrogation clause and the insurer actively participates in the third-party action.(26) California courts have approved of the contractual waiver of the made whole doctrine when contractual provisions state that the insurer shall have rights of subrogation regardless of whether the total amounts of recovery by the insured are less than its actual loss.(27) Therefore, California courts favour specific and clear subrogation clauses which allude to the made whole doctrine.
21st Century Ins Co v Superior Court, a personal injury case, has had broad implications for several insurance lines, especially in the context of classifying the recoverability of attorney fees. The 21st Century court reviewed the priority of recovery when an insured was not made whole, and both the insurer and insured expended money towards the insured’s attorney fees.(28) The court ruled that California’s assumption of the made whole doctrine did not cover liability for attorney fees, which were subject to a separate equitable apportionment rule of pro rata sharing.(29) California courts have followed this reasoning, also stating that an insurer that does not participate in the third-party action must pay a pro-rata share of the insured’s attorney fees and costs when it seeks reimbursement from the insured.(30) California courts developed these limited exceptions to the made whole doctrine to discourage absentee insurers, which do not assist the insured in its action against a tortfeasor, from enjoying the fruits of the insured’s labor.
California’s departure from the jurisprudence of a number of states also implicates insurers’ rights in their deductible or self-insured retention clauses. Conceivably, an insured could argue that it has not been made whole until the insurer reimburses the amount that the insured paid to satisfy its self-insured retention. In California, the recoverability of an insured’s self-insured retention hinges on whether the self-insured retention can be characterized as insurance. States that consider self-insured retention as insurance deem the insured as the primary insurer, and all other insurers become excess to the insured’s self-insured retention obligations.(31) California courts have determined that self-insured retention is equivalent to a primary layer of insurance, and the primary insurer is, therefore, an excess carrier with no duty to indemnify until the self-insured retention is exhausted.(32) Conversely, Washington courts have ruled that self-insured retention is not insurance, relying on the definition of ‘insurance’ used in the Washington Insurance Code and Washington common law. (33)
This somewhat semantic distinction is actually quite significant for the purposes of subrogation. If an insured’s self-insured retention is deemed to be a primary policy, then an insured is responsible for all reasonable costs until it exhausts this primary limit. Therefore, courts are not as willing to allow an insured to recover the proceeds of the self-insured retentions before reimbursing insurers for payments made for loss and defense.
Other states have followed similar lines of reasoning as the California courts, stating that the applicability of retentions and deductibles to the made whole doctrine is based on an assessment of the risk allocation between the insurer and insured. Recently in Fireman’s Fund Ins Co v TD Banknorth Ins Agency, Inc the Connecticut Supreme Court decided that deductibles are not subject to the made whole doctrine.(34) In so deciding, the court emphasized the persuasiveness in the characterization of deductibles and retentions as primary layers of insurance. The court further reasoned that allowing the insurer to be out of pocket for even one dollar before the insured satisfies its deductible would create an unbargained-for exchange.(35) Insurers calculate their premiums based on the risk attributed to first-dollar loss over deductibles. To allow insureds to have priority of recovery for their deductibles would force the insurer to cover the risk without properly offsetting it with increased premium rates.(36)
Several state courts have enumerated a number of equitable considerations and characterizations of an insured’s retention with regard to the subrogation that are instructive to professional lines insurers. Insurers should determine:
• how their jurisdiction characterizes the self-insured retention;
• whether their retention clause adequately characterizes the self-insured retention as the primary limit; and
• their jurisdiction’s policy considerations for risk allocation.
Relevant policy provisions and strengthening insurers’ rights
As exhibited by this cross-section of the state split on subrogation, courts do not necessarily limit themselves to the specific subrogation provisions of the insurance contract. Courts reviewing a policy with limited or vague subrogation language will likely not be swayed from the made whole majority reasoning. Understandably, it may seem impractical to insert made whole language in subrogation clauses when such a scenario rarely occurs. Further, ‘subrogation’ as a term has come to cover not only the right of insurers to bring a third-party action but also an insurer’s right to reimbursement or offset from its insured.(37) Therefore, an insurer may better protect its rights by clearly defining several policy provisions.
Subrogation and reimbursement
Lawyers’ professional liability insurance policies vary in wording for subrogation and reimbursement. Some clearly delineate the insurer’s rights in the event of payment under the policy:
“In the event of any payment under this policy, the Company shall be subrogated to all the Insured’s rights of recovery… and the insured shall… do whatever else is necessary to secure such rights. The insured shall do nothing after any loss to prejudice such rights.”
To this end, some policies clearly spell out the insurer’s right of reimbursement separate from the subrogation language:
“While the Company has no duty to do so, if the Company pays damages or claims expenses within the amount of the applicable deductible or in excess of the applicable limit of liability all the insureds shall be jointly and severally liable to the Company for such amounts… Failure to pay any amount indicated may lead to policy cancellation.”
Practically, such wording in these clauses creates in the insurer a strong right of recovery, whether or not within the rubric of subrogation. While not dispositive, the combination of clauses can indicate that the balance was struck between the parties when the parties agreed to these policy provisions.
Contrastingly, some policies are written with such narrow subrogation clauses so as not only to limit the insurer’s right of recovery in subrogation but also to create ambiguity as to the insurer’s reimbursement right separate from subrogation:
“No rights of subrogation shall accrue hereunder against any past or present partner, shareholder, officer or director, or EMPLOYEE of the FIRM unless such person shall have committed active and deliberate fraud or dishonesty with actual fraudulent or dishonest purpose and intent to relate to matters which are the subject of a CLAIM hereunder.”
While the language clearly creates a limited subrogation right for the insurer, without other well-defined sections (e.g., retention, reimbursement, conditions precedent to coverage) the clause can lead to ambiguity. This language is typical to many policies and an insured may actively seek this language. As the only mention of recovery is found in this limited subrogation clause, an insured may rightfully interpret this limited language to mean that any windfall belongs to the insured, in the absence of the referenced fraud or dishonesty. At the very least, this clause is a vestigial clause mimicking the fraud and dishonesty exclusion present in most every professional liability policy. To an extreme, this clause could be read to limit severely insurers’ rights to recovery.
After consulting the characterization of the self-insured retention in an applicable jurisdiction, an insurer should examine whether the policy’s retention language is properly excluded from a made whole determination. Most policies utilize the ‘excess’ language in characterizing the self-insured retention, yet may not properly address the question of reimbursing an insured for its self-insured retention:
“It shall be a condition precedent to an INSURED’s right to be indemnified under this Policy in respect of any CLAIM made against such INSURED including reasonable costs, charges, and expenses incurred in connection therewith, that the INSUREDS pay, as the case may be, reasonable costs, charges and expenses and/or amounts due on the CLAIM as they become due up to the amount of the RETENTION.”
While the language does indeed provide satisfaction of the retention as a condition precedent to the insurer’s obligation for indemnification, it is conceivable for an insured to argue that once it satisfies this condition, it has a priority of right to recover its self-insured retention. A change in wording may allow insurers to delineate the recoverability of the self-insured retention proactively:
“The obligation of the Underwriter to pay Loss, including Defense Expenses, in connection with any claim will only be in excess of the Retention… the amount of which must be borne by the Insureds at their own expense. The Underwriter will have no obligation whatsoever, either to the Insureds or any other person or entity, to pay all or any portion of the retention amount on behalf of any Insured. The Underwriter will, however, at its sole discretion, have the right and option to do so, in which event the Insureds will repay the Underwriters any amounts so paid.”
By characterizing the self-insured retention in terms of the insurer’s obligation, the parties may better understand the insurer’s obligation and the insured’s mandate to repay any such reimbursement.
The line between contractual and equitable subrogation has become blurred to the point that often insurers and insureds cannot freely contract out of the made whole doctrine. Overly specific subrogation languages may place insurers at a competitive disadvantage with the market, while boilerplate language treats subrogation as a vestige of a past age. While ‘made whole’ is the presumptive norm in most states, insurers should be proactive in learning the law of the jurisdiction controlling their insured’s claims, assess the practical implications of their subrogation clauses and related policy wording, and properly value their relevant policy clauses. Similarly, an insured can better realise its own rights in case of reimbursement and enumerate these rights through contract.
The lawyer professional liability market is on the tail end of what has been among the softest markets for risk and premium rates. With the anticipation of entering a harder market where premium rates may better reflect the risk of loss in a policy, insurers should not undervalue any one clause in their liability policies. If an insurer prefers the standard form of boilerplate subrogation language, it should realize that other insurers have been adopting more protective and practical language, or may be rewarded with better premium rates for their less protective subrogation clauses. Professional liability insurance policies are different creatures from the personal, property, and casualty lines policies that have been used to develop the case law on subrogation. Professional liability insureds are sophisticated consumers in their market and insurers can better quantify the risk of loss for these insureds. Subrogation clauses and related terms of the professional lines policy should likewise reflect the sophistication of this unique insurance relationship.
(1) “Subrogation v Contribution: What’s in a Name?” 30 The Brief 44, 45.
(2) The “Made Whole” Doctrine in all 50 States, Matthiesen, Wickert & Lehrer, SC, available athttp://webcache.googleusercontent.com/search?q=cache:4E_qJHFAS_sJ:www.mwl-law.com/wp-content/uploads/2013/03/made-whole-doctrine-in-all-50-states.pdf+&cd=1&hl=en&ct=clnk&gl=us.
(3) Insured, Insured and Priority in Recovery Proceeds – Who Gets What and When?, available atwww.cozen.com/subrogation/resources/publications/deductive-reimbursement–insurer,-insured-and-priority-in-recovery-proceeds—who-gets-what-and-when-subrogation-and-recovery-theories-of-liability.
(4) “The “Made Whole” Doctrine: Unraveling the Enigma Wrapped in the Mystery of Insurance Subrogation”, Parker, John, 70 Mo L Rev 723, 729 (2005).
(5) Supra note 2.
(6) Supra note 4 at 733, citing Am Pioneer Life Ins Co v Rogers, 753 S W2d 530, 532-33 (Ark 1988).
(7) Supra note 2.
(8) Supra note 4 at 735.
(9) See id at 731.
(10) See An Insider’s Look at Lawyers Professional Liability Insurance, available atwww.dominioninsurance.com/?view_id=2212697&page=main.
(11) Supra note 4 at 735.
(12) Supra note 3.
(13) Supra note 2.
(14) The Insurer/Insured Relationship in Subrogation, Peter M Papasavas of Cozen & O’Connor, available at www.cozen.com/subrogation/resources/publications/the-insurer-insured-relationship-in-subrogation-subrogation-and-recovery—articles-and-papers.
(15) See id.
(16) See id.
(17) Supra note 14 (citing the adoption of the made whole doctrine in Alabama, Arkansas, Colorado, Connecticut, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Massachusetts, Michigan, Minnesota, Mississippi, Montana, Nebraska, New Jersey, New York, North Carolina, Oklahoma, Rhode Island, South Carolina, Tennessee, Texas, Utah, Vermont, Washington, West Virginia and Wisconsin).
(18) See Garrity v Rural Mutual Insurance Co, 77 Wis 2d 537, 253 N.W.2d 512 (1977). See also Shelter Insurance Companies v Frolich (498 NW 2d 74 (Neb 1993) (reasoning that the insurer accepts premiums for the coverage provided, and is obligated to pay claims regardless of the insured’s negligence or the liability of any third party). See generally 3 Con Ins LJ 105, 113.
(19) See Complete Health, Inc v White, 638 So 2d 784 (Ala1994).
(20) See Skauge v Mountain States Telephone & Telegraph Co (citation omitted).
(21) See Peterson v Ohio Farmer Ins Co, 191 NE 2d 157 (Ohio 1963).
(22) See Veazey v Allstate Texas Lloyds, 2007 WL 29239 (ND Tex 2007).
(23) See Fortis Benefits v Cantu, 234 SW 3d 642 (Tex 2007).
(24) See supra note 14 (citing the adoption of the insurer whole doctrine in Idaho, Ohio, Virginia, Wyoming and under certain circumstances, California).
(25) See Peterson v Ohio Farmers Insurance Co (holding that the express policy provisions stating that the insured “assign all rights of recovery” would be without meaning if the insurer were not accorded priority as to the fund received from the third-party tortfeasor. See Ervin v Garner (holding that an insured is not entitled to be made whole first from the proceeds of the recovery if the insured refuses cooperation and assistance from the insurer).
(26) 21st Century Ins Co v Superior Court of San Diego County (2009) 4th Cal 4th 511. See also Progressive West Ins Co v Superior Court (2005) 135 Cal App 4th 263. See also Sapiano v Williamsburg Nat Ins Co (1994) 28 Cal App 4th 533, 536.
(27) Progressive West at 274-275 (approving of the language in Samura v Kaiser Foundation Health Plan, Inc, 17 Cal App 4th 1284, 1289-1290 (1st Dist 1993).
(28) 21st Century at 515.
(30) Progressive West at 276.
(31) Forecast Homes, Inc v Steadfast Ins Co, 181 Cal App 4th 1466, 1474 (2010). See also Fireman’s Fund Ins Co v TD Banknorth Ins Agency, Inc 2013 Conn LEXIS 259.
(32) Forecast Homes at 1474.
(33) Bordeaux, Inc v Am Safety Ins Co, 145 Wash App 687, 695-96 (2008).
(34) Fireman’s Fund at [*35].
(35) Id at [*19] citing Jones v Nationwide Property & Casualty Ins Co, 613 PA 291, 2334-36 (2011).
(36) See id at [*32], citing Averill v Farmers Ins Co of Washington, 155 Wn App 10-6, 111-15 (2010).
(37) 21st Century at 519.