Defense Costs Presumed Reasonable if Insurer Breaches Duty to Defend

The United States Court of Appeals for the Seventh Circuit has held that, under Indiana law, when a liability insurer breaches its duty to defend, the defense costs that the insured incurs in the underlying matter are presumed to be reasonable and necessary. Therefore, the burden shifts to the insurer to prove that the fees are unnecessary or unreasonable to avoid liability for them. USA Gymnastics v. Liberty Ins. Underwriters, Inc., __ F.4th __, 2022 WL 3365082 (7th Cir. May 17, 2022). The insurer may defeat this presumption only under limited “special circumstances.”

An athletic association purchased a claims-made directors and officers liability insurance policy that provided coverage for lawsuits against and investigations of the insured. After misconduct by one of the persons affiliated with the athletic association, it faced numerous lawsuits and investigations, which it contended were covered under the D&O policy. The D&O insurer denied coverage. The athletic association sued the D&O insurer for breach of the duty to defend and won. It then sought coverage for the amounts it had incurred in defense costs. The D&O insurer disputed the amount of the fees that it owed, arguing that the fees were not reasonable and necessary. The trial court determined that, because the D&O insurer had wrongfully denied coverage, the insured was entitled to a presumption that the fees were reasonable and necessary.

On appeal, the United States Court of Appeals for the Seventh Circuit affirmed and clarified the contours of the presumption. It held that, absent limited “special circumstances,” a policyholder who is denied coverage under a liability policy has no reasonable expectation of reimbursement and is thus incentivized to keep its legal spend low. Thus, the fees are “market tested” and do not require rigorous judicial review to determine whether they were reasonably and necessarily incurred. However, in the event that the policyholder lacks an adequate incentive to keep the bills low—for example, because defense counsel agrees that it will only seek further reimbursement from the policyholder’s insurers—the presumption does not apply. The court also held that the proper method to assess whether fees are reasonable and necessary is to employ a “total value” approach, which is consistent with Indiana Rules of Professional Conduct 1.5.