Introduction

The measure of damage that a policyholder may recover from a liability insurer for failure to defend includes the costs of defense, the cost of settlement, the costs of mitigating loss, emotional distress and prejudgment interest. For a breach of the covenant of good faith and fair dealing, the policyholder may also recover loss of business, attorneys fees incurred to recovery policy benefits, and punitive damage.

The Policyholder May Recovery For an Insurer’s Failure to Defend

The insurer must compensate the policyholder, not independent counsel. The contract that the insurer has breached is the insurance policy to which the policyholder is a party, but independent counsel is not. “Cumis counsel . . . represents the insured, not the insurer.”[1] Thus, the insurer owes the policyholder, who in turn owes independent counsel. In order to remain independent, Cumis counsel should not enter into any direct financial relationship with the insurer without informed written consent.[2]

Measure of Damage for Breach of the Duty to Defend

Breach of Contract

The measure of damage for breach of contract is all foreseeable detriment proximately caused by the breach, plus simple interest at the rate of 10% per annum. “For the breach of an obligation arising from contract, the measure of damages . . . is the amount which will compensate the party aggrieved for all the detriment proximately caused thereby, or which, in the ordinary course of things, would be likely to result therefrom.”[3] These measures may include the costs of defense, the cost of settlement, the cost of an adverse judgement, consequential damages, emotional distress, and prejudgment interest.

Costs of Defense

An insurer that breaches its duty to defend is “liable for all costs and attorneys’ fees expended by [its insured] for this purpose.”[4] The insurer becomes liable for defense costs incurred by the policyholder allocable to claims not even potentially covered under the policy.[5] The policyholder may also recover the costs of financing the defense.[6] “Where an insured mounts a defense at the insured’s own expense following the insurer’s refusal to defend, the usual contract damages are the costs of the defense.”[7] “[T]he courts have held that, by its refusal to participate, the recalcitrant [insurer] waives the right to challenge the reasonableness of defense costs.”[8] “An indemnity against . . . liability, expressly, or in other equivalent terms, embraces the costs of defense against such . . . liability incurred in good faith, and in the exercise of a reasonable discretion.”[9] “[W]here the insured is thus compelled to conduct his own defense, it is uniformly held that he may recover the expenses of litigation, including costs and attorneys’ fees, from the insurer. . . .”[10] “Having defaulted such agreement the company is manifestly bound to reimburse its insured for the full amount of any obligation reasonably incurred by him. It will not be allowed to defeat or whittle down its obligation. . . . Sustaining such a theory would not only tend to discourage busy attorneys from rendering adequate services for needy clients but would tend also to encourage insurance companies to similar disavowals of responsibility with everything to gain and nothing to lose. If there be uncertainty as to the nature or extent of the services reasonably to be rendered by counsel engaged by the insured, that uncertainty must be resolved against defendant insurer…. ‘[The] wrongdoer shall bear the risk of the uncertainty which his own wrong has created.’”[11]

Civil Code § 2860(c) Limitation

“An insurer usually provides a defense to its insured by hiring competent defense counsel, who represents the interests of both the insurer and the insured. In some cases, . . . there is a conflict of interest or a potential conflict of interest between the insurer and the insured. Usually, these conflicts involve the insured trying to obtain coverage and the insurer trying to avoid it. When this happens, defense counsel may not be permitted to represent both the insurer and the insured. The insurer may be required to provide the insured, at the insurer’s expense, with independent counsel (i.e., Cumis counsel), who then controls the litigation.”[12] Civil Code § 2860 applies only if the insurer has a duty to defend and a disqualifying conflict of interest exists.[13] A defaulting insurer may not invoke the protections of the statute.[14] An insurer that belatedly provides a defense may not invoke § 2860 retroactively.[15]

Multiple Insurer Limitation

Where one insurer provides a defense, the policyholder has no action against another insurer which fails to defend. “‘The fact that several insurance policies may cover the same risk does not increase the insured’s right to recover for the loss, or give the insured the right to recover more than once. Rather, the insured’s right of recovery is restricted to the actual amount of the loss. Hence, where there are several policies of insurance on the same risk and the insured has recovered the full amount of its loss from one or more, but not all, of the insurance carriers, the insured has no further rights against the insurers who have not contributed to its recovery. Similarly, the liability of the remaining insurers to the insured ceases, even if they have done nothing to indemnify or defend the insured.’”[16]

Belated Defense Is No Cure

An insurer that wrongfully fails to defend but later makes “a belated offer to pay the costs of defense may mitigate damages but will not cure the initial breach of duty.”[17]

A Breaching Insurer May Not Allocate

While a performing insurer may seek reimbursement of defense costs allocable to claims that were never even potentially covered,[18] a breaching insurer may not. “ By repudiating its duty to defend and providing no defense, [the insurer] has nothing from which to seek reimbursement. Buss does not support [the insurer’s] theory that the State should contribute to attorney’s fees. To the contrary, it unequivocally holds that the insurer’s duty is to defend the action in its entirety”[19] Where “the insurer has breached its duty to defend, it is the insured that must carry the burden of proof on the existence and amount of the … expenses, which are then presumed to be reasonable and necessary as defense costs, and it is the insurer that must carry the burden of proof that they are in fact unreasonable or unnecessary.”[20]

Costs of Settlement

An insurer which fails to defend must reimburse the policyholder for “all sums reasonably paid to the injured party . . . pursuant to a . . . reasonable settlement negotiated by the insured.”[21] A reasonable non-collusive settlement raises a rebuttable presumption that the policyholder is legally liable to the plaintiff for the full amount of the damages specified.[22]

Settlement Is Presumed Reasonable

“In a [coverage] action against the insurer for reimbursement based on a breach of its contractual duty to defend the action, a reasonable settlement made by the insured to terminate the underlying claim against him may be used as presumptive evidence of the insured’s liability on the underlying claim, and the amount of such liability.”[23]

To give rise to this presumption, the plaintiff must show that “(1) the insurer wrongfully failed or refused to provide coverage or defense, (2) the insured entered into a settlement of the litigation which was (3) reasonable in the sense that it reflected an informed and good faith effort by the insured to resolve the claim.”[24] “[T]he insurer cannot escape liability for that judgment simply because it was not necessarily based on a theory within the coverage of the policy.”[25]

The burden is on the insurer to show that the settlement was the product of fraud or collusion.[26]

Good Faith Limitation

Civil Code 2778(5) provides: “If, after request, the person indemnifying neglects to defend the person indemnified, a recovery against the latter suffered by him in good faith, is conclusive in his favor against the former.”

Collusion Limitation

A settlement “should only bind an insurer under circumstances which protect against the potential for fraud and collusion.”[27] The presumption that a settlement is reasonable shifts the burden of proof to the insurer to prove that the settlement was for an amount in excess of the policyholder’s actual liability or was the product of fraud or collusion.[28]

Non-covered Claims Limitation

That portion of the settlement that is clearly allocated to non-covered claims are not recoverable from a defaulting insurer. The policyholder may not recover “damages awarded in the underlying action against the insured were not within the coverage of the policy.”[29] Coverage issues must be determined in subsequent litigation to which the insurer is a party.[30]

Policy Limit

“Where there is no opportunity to compromise the claim and the only wrongful act of the insurer is the refusal to defend, the liability of the insurer is ordinarily limited to the amount of the policy plus attorneys’ fees and costs.”[31] “No California case holds the insurer to liability for the amount of the judgment exceeding the policy limit where its only wrong is breach of the duty to defend.”[32] “When, in addition to refusing to defend, the insurer also rejects a reasonable settlement offer within policy limits, it may become obligated to pay more than its policy limits.”[33]

Cost of Judgment

An insurer’s wrongful failure to defend may render it liable on a judgment for which the insurer would have had no duty to indemnify. “Otherwise, an insurance carrier could refuse to defend its insured on the slightest provocation and then resort to hindsight for justification.”[34] “It is no defense that the ultimate judgment against the insured is not rendered on a theory within the coverage of the policy.”[35] The policyholder need not prove that the judgment would have been smaller, or would not have occurred, but for the insurer’s wrongful failure to defend: “Such a theory . . . would impose upon the insured the impossible burden of proving the extent of the loss caused by the insurer’s breach.”[36] The rationale for this rule prevents the insurer from relying on hindsight to justify its failure to defend. A judgment raises a conclusive presumption[37] that the policyholder is legally liable to the plaintiff for the full amount of the damages together with “all material findings of fact essential to the judgment.”[38] “[T]he law is well settled that, where one is bound either by law or agreement to protect another from liability, he is bound by the result of a litigation to which such other is a party, provided he had notice of the suit and an opportunity to control and manage it.”[39]

The extent to which a defaulting insurer is bound by a judgment may depend on several variables. “An insurer that has been notified of an action and refuses to defend on the ground that the alleged claim is not within the policy coverage is bound by a judgment in the action . . . as to all material findings of fact essential to the judgment of liability of the insured. The insurer is not bound, however, as to issues not necessarily adjudicated in the prior action and can still present any defenses not inconsistent with the judgment against the insured.”[40] Some reported cases have reduced “the amount of the judgment recovered by the insured against the insurer on the ground that some of the damages awarded in the underlying action against the insured were not within the coverage of the policy.”[41] A defaulting insurer may be liable to pay an otherwise non-covered judgment “whenever the trial in the underlying action involved a theory of recovery within the coverage of the policy and it was not clear whether the jury’s verdict was based upon that theory.”[42]

A default judgment may be the “expectable result” of the insurer’s breach of that duty.[43] An insurer which fails to defend may be liability for judgments rendered after uncontested trials and default prove-up proceedings.[44]

Consequential Damage

Under a contract measure of damages, the policyholder is entitled to recover only amounts due under the policy plus any other “consequential” damages foreseeable when the contract was entered into.[45]

Lost Profits

When a policyholder that closed its business, “lost profits would be available even when the implied covenant of good faith and fair dealing sounds only in contract, so long as the lost profits were among the natural and direct consequences of the breach.”[46]

Impaired Credit

A policyholder may recover under the tort measure for damage to his or her business or impaired credit proximately resulting from the insurer’s wrongful refusal to defend a covered claim against the insured.[47] If the insurer’s ‘bad faith’ proximately causes plaintiff to borrow money, the costs of such borrowing are recoverable as compensatory damages.[48]

Cost of Mitigation

Because the policyholder has an obligation to mitigate damages, the policyholder may recover the reasonable costs of doing mitigation including legal fees and costs the insured incurs or expends in obtaining substitute counsel in the underlying action.[49]

Value of Relinquished Claim

Where the policyholder was required to dismiss its counterclaim to effectuate the settlement, the insurer may be held liable for the value of the relinquished counterclaim.[50]

Emotional Distress

Under the contract measure, emotional distress may be recoverable as consequential damages flowing from a substantial economic loss: “Whenever the terms of a contract relate to matters which concern directly the comfort, happiness or personal welfare of one of the parties . . . he may recover damages for physical suffering . . . caused by its breach. . . . A liability insurance policy is such a contract.”[51]

Prejudgment Interest

The measure of damages for the insurer’s breach includes the amount due under the contract, plus interest.[52] “Every person who is entitled to recover damages certain, or capable of being made certain by calculation, and the right to recover which is vested in him upon a particular day, is entitled also to recover interest thereon from that day.”[53] The statutory requirement that benefits be “certain or capable of being made certain by computation” is generally liberally construed to permit recovery of prejudgment interest.[54] A prejudgment interest award is intended to make plaintiff whole “for the accrual of wealth which could have been produced during the period of loss.”[55] The policyholder is entitled to recover interest at 10% per annum for breach of a contract entered into after 1985.[56]