Litigation is expensive and the cost of pursuing your rights in court are all too frequently pyrrhic. Consider the plight of an employee who is forced to sue his or her insurance company because it refuses to pay for certain medical costs due to a dispute over whether hospital procedures are covered by its insurance policy. After a long and time-consuming legal battle, even if the employee ultimately wins, the attorney fees incurred along the way may equal or even dwarf the recovery.

The same can be said of a contractor who is forced to sue its insurance carrier because it refuses to defend and indemnify the contractor against water damage claims that arose during a construction project. While the contractor contends the water damage was a covered “occurrence” under its comprehensive general liability policy, the carrier disagrees and litigation ensues to determine what is (and is not) covered. At the end of the day, even if the contractor prevails, the contractor will never be made whole and in retrospect, perhaps the contractor’s dollars would have been better spent trying to settle directly with the building owner rather than fighting it out with its insurance carrier.

Life is not always fair, but it ought to be, particularly in the case where an insurance company wrongfully refuses to honor the insurance policies it issues. Except in the rare case where the insurance company’s failure to insure constitutes a clear case of bad faith, in New York, carriers benefit from the existence of the “American Rule.”1 It provides that absent a statute, agreement or court rule permitting an award of attorney fees, a successful litigant may not recover its own attorney fees as damages even when the litigant prevails at trial.

In the United States, unlike England, attorney fees are largely seen as a non-recoverable cost of doing business. As a result, a policyholder who sues its carrier and wins still loses because the policyholder is out-of-pocket for all of its attorney’s fees. While arguments exist, pro and con, regarding the fairness and utility of the American Rule, its wholesale application to policyholders’ lawsuits against their insurance carriers stacks the deck against the policy holder and bestows an unnecessary gift to the insurance industry.

A 1979 case from New York’s highest court, known as Mighty Midgets,2 purports to create an exception to the American Rule, but, practically speaking, it does not. This so-called exception permits a policyholder to recover attorney fees when it “has been cast in a defensive posture by the legal steps an insurer takes in an effort to free itself from its policy obligations.” The court observed that a policyholder having to defend an insurance coverage lawsuit filed by its own carrier has been placed in a “defensive posture.”

Unfortunately, however, in the same breath, the court also declared that a policyholder who sues as a plaintiff “has taken the offensive” and cannot be seen as having been cast in a defensive posture. Therefore, strategy-wise, it makes no sense for an insurance company to throw the first punch by filing a lawsuit because if its insured wins, the carrier will be required to pay for its insured’s attorney fees.

Clearly, from the carrier’s perspective, the better strategy is to “sit tight” when a coverage dispute arises. If the policyholder elects not to pursue the issue and file suit, it’s a win for the carrier. When the insured hires an attorney to file a lawsuit, worse-case scenario from the carriers’ perspective, it will end up having to pay for what its policy requires, but not the attorney fees its policyholder incurred to file and prosecute its lawsuit.

This is nonsensical. As a federal court noted in 2004, New York seems to provide “a perverse incentive for the insurer to refuse to defend in the underlying suit, thereby leaving it up to the insured to bring a declaratory action seeking coverage.”3

As a New York state court astutely noted early last year, “[t]here is the potential that insurers might shrink from their defense obligations under their policies and categorically deny their insureds’ tenders of defense in an effort to reduce their financial exposure, without risk of incurring any additional liabilities or expenses associated with issuing and maintaining policies.”4

Clearly, cost-benefit wise, there is no upside for an insurance carrier to initiate litigation to resolve bona fide insurance coverage disputes in good faith.

Carriers assert that the “American Rule” is even-handed because its application also prevents them from recovering attorney fees when they prevail in coverage disputes with policyholders. This point is well-taken, but it disregards the chilling effect the current law has on individuals with no alternative except to sue their insurance company to honor its policy, but who lacked the financial wherewithal to hire an attorney to do so. Since insurance policies are considered “contracts of adhesion” (i.e., they are always drafted by the party with superior bargaining position, to wit, the carriers), the courts construe any ambiguity in the policy’s language against the carrier.

The spirit behind this rule of construction supports the notion that no matter who initiates an insurance coverage lawsuit, if the policyholder wins, he or she should be put back in the position they would have been had the carrier initially honored its policy. To address the carriers’ point that any possible award of attorney fees in coverage lawsuits should cut both ways, the court can act as a gatekeeper to determine whether the policyholder initiated its lawsuit in good faith. If the policyholder did, even if the insurance company prevails, it would not be awarded attorney fees.

However, if the court determined that the policyholder’s lawsuit lacked sufficient merit, then the policyholder would be required to reimburse the carrier for its reasonable attorney fees.

New York is accurately seen as a progressive state, but it lags behind on this important consumer issue. Approximately 27 other states, including New Jersey and states generally seen as conservative (i.e., South Carolina, Tennessee, Texas and West Virginia), permit successful policyholders to an award of attorney fees in insurance coverage lawsuits.5

These states recognize that an insurance company which improperly refuses to defend its insured should bear the consequences of its wrongful conduct. This means not only being required to pay benefits to the insured for the covered loss or to defend and possibly indemnify its policyholder from third-party claims. It also means having to reimburse its insured for the legal expenses that arose because the carrier refused to do what it should have done from the start.

As one judge aptly noted, until the New York Legislature takes action, the courts are constrained to “interpret the law as it currently stands.”6 This begs the question: Who among our politicians will recognize this inherent unfairness in the law and sponsor legislation to protect policyholders?

Neal Eiseman is a partner with Goetz Fitzpatrick in New York.

Endnotes:

1. Baker v. Health Management Systems, Inc., 98 N.Y.2d 80, 745 N.Y.S.2d 741, 772 N.E.2d 1099 (2002).

2. Mighty Midgets v. Centennial Insurance Company, 47 N.Y.2d 12, 416 N.Y.S.2d 559, 389 N.E.2d 1080 (1979).

3. Folksamerica Reinsurance Company v. Republic Insurance Company, 2004 WL 2423539 (S.D.N.Y. 2004).

4. Estee Lauder v. OneBeacon Insurance Group, LLC, 918 N.Y.S.2d 825, 31 Misc.3d 379 (New York Co. 2011).

5. See 87 A.L.R.3d 429, “Insured’s right to recover attorneys’ fees incurred in declaratory judgment action to determine existence of coverage under liability policy” (2011).

6. Estee Lauder v. OneBeacon Insurance Group, supra, at 393.