Excess Insurer May Recover Defense Costs from Primary Insurers

June 30, 2012 | Insurance Coverage

Valero Refining Company contracted with Encompass Power Services to design, engineer, and construct a co-generation facility. After a fire caused significant damage, Valero sought over $40 million in damages from Encompass.

A federal district court held that Encompass’ three primary insurers had to split the costs initially spent by one of them defending Encompass against Valero’s claims. The district court also held, however, that Encompass’ excess insurer could not recover from the three primary insurers any of the defense costs it had paid for Encompass’ defense even though it paid for the defense when the primary insurers should have done so, and even though the excess policy contained a subrogation clause. In the district’s court’s view, the excess insurer was barred from recovering its costs under an “empty shoes” theory because Encompass had assigned its rights against its primary insurers to Valero and the excess insurer therefore could not assert Encompass’ right to recover defense costs.

The excess insurer appealed to the U.S. Court of Appeals for the Fifth Circuit, arguing that the district court had erroneously denied recovery of its defense costs from the primary insurers. The circuit court decided that the excess insurer should have been able to recover its defense costs based on contractual subrogation.

As the circuit court explained, the three primary carriers refused to defend Encompass. The excess insurer “stepped in” to take over the defense and incurred significant defense costs. The excess insurer, the circuit court declared, thus bore the costs of a defense to which Encompass was entitled from the primary carriers. Under the terms of the subrogation clause in its policy, the excess insurer was entitled to reimbursement from the insurers who should have borne the costs that it paid, the Fifth Circuit ruled.

The circuit court concluded by rejecting the “empty shoes” argument, observing that an original creditor’s shoes will be “empty” any time a third party makes a payment on its behalf and then seeks to recover under the fiction that the debt still exists to that creditor; this is “not determinative” of the payor’s ability to recover under subrogation. [Continental Cas. Co. v. North American Capacity Ins. Co., No. 10-20262 (5th Cir. May 30, 2012).]

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