Why Subrogation Allows Insurers to Earn Money After Paying a Claim

Adapted from Zalma on Insurance Claims Part 107 Second Edition: A Comprehensive Review of the law and Practicalities of Property, Casualty and Liability Insurance Claims now available  here.

The equitable doctrine of subrogation places the subrogee in the precise position of the one whose rights are subrogated.[1] Subrogation is the remedy called into existence for the purpose of enabling a party secondarily liable, but who has paid the debt, to reap the benefit of any securities which the creditor may hold against the principal debtor, and by the use of which the party paying may thus be made whole.[2]

In an insurance situation the insurance company, after it pays a loss to its insured, obtains by equity or contract, the right to an assignment from its insureds, up to the amount paid, of the insured’s rights against third parties responsible for the loss. Texas law, like every other jurisdiction, recognizes three sources of subrogation rights: equitable, contractual, and statutory.[3]

Every claim investigated by a professional claims person requires a thorough investigation of subrogation possibilities. The insurance claims person who ignores the possibility of subrogation is completing only half of a thorough investigation. The remedy arises from tort, contract or equitable remedies available to the insured as the result of a loss that, after an insurer pays, must be assigned to the insurer.

In 1748, the House of Lords in England decided in Randall v. Cochran, that an insurer for an English ship that was taken by the Spanish was permitted to bring suit in the name of its insured against the administrators of a public prize fund, collected by the British government from the sale of captured Spanish ships. The Lord Chancellor, quoted in an article by John J. O’Brien, said:

The plaintiffs had the plainest equity that could be. The person originally sustaining the loss was the owner; but after satisfaction made to him, the insurer … the assured stands as trustee for the insurer, in proportion for what he paid.[4]

The earliest master of insurance law in England was Lord Mansfield, who addressed subrogation in a case called Mason v. Sainsbury in 1782. Rioters had ransacked Mason’s house and his insurance company paid the claim. At the time there was a Riot Act of 1714 that provided a means to recover damages against the local administrative district. The insurance company pursued a recovery action against the administrator in the name of its insured and collected the benefits.

Traditionally, an insurer that pays its insured’s claim is entitled to recover the payment from the third party who caused the insured’s covered loss. This concept is called subrogation, and can arise by contract, statute, or equitable principle.[5] As early as 1888, the US Supreme Court found that equitable subrogation was a well-recognized doctrine.[6] The Supreme Court stated the historical rule that:

The Equitable assignee of a chose in action has the right to go into a court of equity to have his interest therein established; and when so established he will have the right to complete relief in the same action by decree of specific performance of the contract.

Regardless the Supreme Court found that the insurer acted as a volunteer and ruled against its right of subrogation.

The US Supreme Court stated the basic rule of subrogation as follows:

Hence it has often been ruled that an insurer, who has paid a loss, may use the name of the assured in an action to obtain redress from the carrier whose failure of duty caused the loss. Hall & Long v. Railroad Companies,13 Wall. 367, 369 … But it is equally well settled that the right, by way of subrogation, of an insurer, upon paying for a total loss of the goods insured, to recover over against the carrier, is only that right which the assured has, and that accordingly when a bill of lading provides that the carrier, when liable for the loss, shall have the full benefit of any insurance that may have been effected upon the goods, this provision is valid, as between the carrier and the shipper; and that, therefore, such provision limits the right of subrogation of the insurer, upon paying the shipper the loss, to recover over against the carrier. Phoenix Ins. Co. v. Erie & Western Transportation Co.,117 U.S. 312; St. Louis, Iron Mountain; Railway v. Commercial Union Insurance Co., 139 U.S. 223.[7]

Generally, to protect its subrogation rights, an insurer may seek intervention in the insured’s lawsuit against the legally responsible party or may wait to seek the funds from its insured who is required to hold, in trust, any funds it recovered from the tortfeasor or by contract to reimburse the insurer. The purpose of subrogation is to prevent the insured from obtaining a double recovery (and thus being unjustly enriched) and to place the responsibility for paying the loss on the party who caused the loss.

The right to subrogation is not new in South Dakota. A half century ago, the South Dakota Supreme Court stated: “It is a well settled rule of law that an insurer is entitled to subrogation, either by contract or in equity for the amount of the indemnity paid.” [Parker v. Hardy, 73 S.D. 247, 248, 41 N.W.2d 555, 556 (1950)]. Though frequently repeated, that sentence is seldom parsed. Subrogation can arise out of two sources. First, the parties can agree to create a contractual right of subrogation. This is commonly done in insurance policies. In addition, equity can require the creation of subrogation based upon the circumstances, even without a contractual obligation. [Met Life Auto and Home Ins. Co. v. Lester, 719 N.W.2d 385, 2006 SD 62 (S.D., 2006)]

In applying the made whole doctrine to preclude the insurer from accessing funds for which it was competing with its own insured, the Wisconsin Supreme Court stated that, under Wisconsin law, the test of wholeness depends upon whether the insured has been completely compensated for all the elements of damages, not merely those damages for which the insurer has indemnified the insured. [Dufour v. Progressive Classic Ins. Co., 370 Wis.2d 313, 881 N.W.2d 678 (Wis., 2016)]

The “made-whole” rule is a common law exception to an insurer’s subrogation right.[8] As applied in California, the rule generally precludes an insurer from recovering any third party funds unless and until the insured has been made whole for the loss. The applicability of the doctrine generally depends on whether the insured has been completely compensated for all the elements of damages, not merely those for which the insurer has indemnified the insured.[9]

In many jurisdictions, including California, courts hold that parties may avoid the made-whole exception by contract. California courts have recognized that the made-whole exception does not apply if the insurer participated in prosecuting the claim against the third party.[10]

A separate and independent limitation on the subrogation and reimbursement right provides that an insurer’s reimbursement from its insured is subject to the insurer bearing a pro rata portion of the insured’s attorney fees and costs incurred to obtain the recovery from the third party.[11]

A transfer of rights provision in a general liability insurance policy, which gave insurer subrogation rights, did not abrogate the “made whole doctrine,” and therefore an insured had priority to receive any indemnification payment from third-party before insurer, where the transfer of rights provision only allowed insurer to recover payments it had actually made, indemnification payment to insured was not enough to satisfy insured’s self-insured retention obligation, such that insurer had yet to provide payment, and provision did not address the priority of reimbursement nor did it expressly abrogate the made whole doctrine. [Intervest Const. of Jax, Inc. v. General Fidelity Ins. Co, Supreme Court of Florida, 133 So.3d 494, 39 Fla.L. Weekly S75 (2014)]

Pennsylvania law requires that a party suffering damages be made whole before an insurer is entitled to subrogation. As noted by all parties and set forth below, Pennsylvania has applied the “made whole” doctrine repeatedly, and thus there is no dispute in this case that the doctrine applies, generally, as part of Pennsylvania common law. [Jones v. Nationwide Prop. & Cas. Ins. Co., 32 A.3d 1261 (Pa., 2011)]

The made whole doctrine is but one consideration in determining whether an insurer is entitled to subrogation. The made whole doctrine is not applicable in all situations, and thus the test of “wholeness” is not the sole criterion for determining whether an insurer may pursue its subrogation interest. Stated otherwise, an insurer is not always precluded from retaining funds obtained as subrogation for payments the insurer previously made simply because the insured has not been fully compensated for the loss. Rather, the specific facts and equities dictate whether the made whole doctrine will apply to prevent an insurer from retaining funds received for its subrogation claim. The made whole doctrine does not apply to preclude an insurer from retaining funds obtained in subrogation even though the insured has not recovered all of his bodily injury damages flowing from the accident. [Dufour v. Progressive Classic Ins. Co., Supreme Court of Wisconsin, 881 N.W. 2d 678, 2016 WI 59 (2016)]

In several jurisdictions adopting the made-whole rule, the courts have stated or assumed that attorney fees and costs should be deducted from the total recovery in determining whether the insured was made whole.[12] Several other jurisdictions have specifically held that attorney fees and costs to obtain the third party recovery should not be deducted from the insured’s total recovery for purposes of the made-whole rule calculation.[13]

The California Court of Appeal, with no decisions to guide it, found as a matter of first impression:

[w]e conclude that in determining whether an insured has been made whole, the amount of the insured’s total recovery should not be reduced by the attorney fees and expenses incurred by the insured to obtain the recovery from a third party tortfeasor.[14]

Because attorneys’ fees are not recoverable in a tort action, the fees paid by an insured have no effect on determining if he or she was made whole. It is well established in California and in most states that an insurer has the right to enforce a subrogation and reimbursement contractual provision to require an insured to repay the insurer in the event of a recovery for the covered loss from a third party. It is not the purpose of the made-whole exception to eliminate this right merely because it would appear fair to do so. Rather, the applicability of the made-whole rule depends on whether the insured has received an amount that is equivalent to all the damages to which he or she is entitled under California law. Where the insured reports that he or she has received that full recovery, there is no valid basis for precluding an insurer from reimbursement after the insured has twice recovered for the same loss.

An insurer’s right to subrogation is limited, however, by the recognition that an insured is entitled to be fully compensated for his or her damages. Known as the “made whole doctrine,” explained in Montana that when the insured has sustained a loss in excess of the reimbursement by the insurer, the insured is entitled to be made whole for his entire loss and any costs of recovery, including attorney’s fees, before the insurer can assert its right of legal subrogation against the insured or the tortfeasor. [Van Orden v. United Services Auto, Supreme Court of Montana, 374 Mont. 62, 318 P.3d 1042, 2014 MT 45 (2014)]

The Supreme Court of Connecticut was asked by the United States Court of Appeals for the Second Circuit whether the make whole doctrine is recognized as the default rule under Connecticut law; and, if so, does the make whole doctrine apply to insurance policy deductibles under Connecticut law? It answered the questions from the Second Circuit in Fireman’s Fund Ins., Co. v. TD Banknorth Insurance Agency, Inc., SC 18796 (Conn. 07/30/2013).

The facts summarized by the court were:

In 2005 Haynes construction company [Haynes] began work on a housing development and retained TD Baknorth as its agent to arrange insurance. TD Banknorth procured a [b]uilder’s [r]isk insurance policy from peerless insurance company [peerless] and an [i]nland [m]arine insurance policy from Hartford insurance company [Hartford]. in February 2006, a fire destroyed a house being built on lot 14 of the Haynes development. Peerless denied coverage of the loss because lot 14 was not listed in its [b]uilder’s [r]isk policy—an error of omission by TD Banknorth. Haynes thereupon claimed against TD Banknorth for its negligent omission of lot 14. TD Banknorth had purchased [e]rrors [and] [o]missions coverage [(errors and omissions contract) from] Fireman’s Fund….

Fireman’s Fund undertook to pay on TD Banknorth’s behalf any sums TD Banknorth became ‘legally obligated to pay as damages because of a negligent act, error or omission in the performance of [TD Banknorth’s] professional services.’ the [errors and omissions] [c]ontract had a deductible of $150,000 per claim. TD Banknorth gave timely notice of the loss to Fireman’s Fund. In July 2006, TD Banknorth and Fireman’s Fund settled with Haynes for $354,000. of that, TD Banknorth contributed $150,000 (its single claim deductible) and fireman’s fund contributed the $204,000 remainder.

In the settlement, Haynes assigned its rights against peerless and Hartford to Fireman’s Fund and TD Banknorth collectively. TD Banknorth—and Fireman’s Fund as subrogee— then proceeded against peerless and Hartford for the $354,000. in the ensuing settlement, peerless paid $88,000 and Hartford paid [$120,000] in exchange for complete releases. TD Banknorth and Fireman’s Fund ‘reserve[d] all rights that they may have against each other relating to the allocation of the [settlement funds] held in escrow.’ the $208, 000 was deposited in an escrow account.

Fireman’s Fund sued TD Banknorth in the United States District Court for the District of Connecticut, seeking a declaratory judgment that it was entitled to all of the escrow funds. Fireman’s Fund claimed $10,000 in defense costs (incurred on TD Banknorth’s behalf) in addition to the $204,000 it had paid Haynes: a total of $214,000. TD Banknorth counterclaimed for a declaratory judgment that, under Connecticut’s make whole doctrine, it was entitled to recover its $150,000 deductible from the escrow funds.

The object of legal or equitable subrogation is the prevention of injustice. It is designed to promote and to accomplish justice, and is the mode that equity adopts to compel the ultimate payment of a debt by one who, in justice, equity, and good conscience, should pay it. Subrogation further promotes equity by preventing an insured from receiving more than full indemnification as a result of recovering from both the wrongdoer and the insurer for the same loss, which would unjustly enrich the insured.

When the amount recoverable from the responsible third party is insufficient to satisfy both the total loss sustained by the insured and the amount the insurer pays on the claim, however, this principle may lead to inequitable results. The make whole doctrine addresses this concern by restricting the enforcement of an insurer’s subrogation rights until after the insured has been fully compensated for injuries, that is made whole.

When the insured’s recovery from both the insurer and the tortfeasor is less than or equal to its loss the insurer forfeits its right to subrogation.

The Supreme Court concluded that the equitable considerations supporting the make whole doctrine are inapplicable to deductibles. If the Supreme Court decided otherwise, as TD Banknorth urged, it would effectively disturb the contractual agreement into which TD Banknorth and Fireman’s Fund entered, thereby creating a windfall for TD Banknorth for a loss that it did not see fit to insure against in the first instance when it contracted for lower premium payments in exchange for a deductible.

The answer to the certified question of whether the make whole doctrine is the default rule under Connecticut law was: yes.

The answer to the certified question of whether the make whole doctrine applies to insurance policy deductibles under Connecticut law was: no.

[1].       Wimer v. Pa. Emp. Benefit Trust Fund, 939 A.2d 843, 853 (Pa. 2007); Chow v. Rosen, 812 A.2d 587, 590 (Pa. 2002); Pennsylvania Mfrs.’ Ass’n Ins. Co. v. Wolfe, 626 A.2d 522, 525 (Pa. 1993); see also Paxton Nat’l Ins. Co. v. Brickajlik, 522 A.2d 531, 532 (Pa. 1987).

[2].       Ario v. Reliance Insurance Co., 602 Pa. 490, 980 A.2d 588, No. 3 MAP 2008 (Pa. 10/05/2009).

[3].       Fortis Benefits v. Cantu, 243 S.W.3d 642, 648-49 (Tex. 2007).

[4].       John J. O’Brien, J.D., CLU, CPCU, “The Origins of Subrogation,” Property/Casualty Insurance, January/February 2005, see www.subrogation.net/Home.aspx.

[5].       Hodge v. Kirkpatrick Development, Inc. (2005) 130 Cal.App.4th 540, 548 (Hodge); Sapiano v. Williamsburg Nat. Ins. Co. (1994) 28 Cal. App.4th 533, 537-538 & fn. 1 (Sapiano); Travelers Indem. Co. v. Ingebretsen (1974) 38 Cal.App.3d 858, 864.).

[6].       Aetna Life Insurance Company v. Middleport, SCT.40059; 124 U.S. 534, 31 L.Ed. 537, 8 S.Ct. 625 (1888).

[7].       Wager v. Providence Insurance Company v. Morse., 1893. SCT. 40365; 150 U.S. 99, 37 L. Ed. 1013, 14 S. Ct. 55 (1993).

[8].       Barnes v. Independent Auto. Dealers of California (9th Cir. 1995) 64 F.3d 1389, 1394.

[9].       Chase v. National Indemnity Co. (1954) 129 Cal. App.2d 853, 861.

[10].      Travelers Indem. Co. v. Ingebretsen, supra, 38 Cal. App.3d at p. 866; see Progressive West, supra, 135 Cal. App.4th at p. 273.

[11].      Progressive West, supra, 135 Cal.App.4th at pp. 275-276; Lee v. State Farm Mut. Auto. Ins. Co., supra, 57 Cal. App.3d at p. 467; Hartford Accident & Indemnity Co. v. Gropman (1984) 163 Cal. App.3d Supp. 33, 3 8-40.

[12].      Skauge v. Mountain States Tel. & Tel. Co. (Mont. 1977) 565 P.2d 628, 632; Nationwide Mutual Insurance Co. v. Butler (Pa. 1983) 28 Pa. D. & C.3d 627, 629; Central National Insurance Group v. Hotte (Fla. App. 1975) 312 So.2d 235, 237; Washtenaw Mutual Fire Insurance Co. v. Budd (Mich. 1919) 175 N.W. 231, 232; St. Paul Fire and Marine Insurance Company v. W.P. Rose Supply Company (N.C. 1973) 198 S.E.2d 482, 485; Gibbs M. Smith, Inc. v. U.S. Fidelity (Utah 1997) 949 P.2d 337, 345-346.

[13].      Peterson v. Safeco Ins. Co. (Wash. App. 1999) 976 P.2d 632, 635-636; CNA Ins. Cos. v. Johnson Galleries (Ala. 1994) 639 So.2d 1355, 1357.

[14].      Allstate Insurance Co. v. Superior Court of San Diego County, 60 Cal. Rptr.3d 782, 151 Cal. App.4th 1512 (Cal. App. Dist.4 06/14/2007).

Read about this, the ten volumes of Zalma on Insurance Claims, and other insurance books by Barry Zalma at http://zalma.com/blog

Adapted from Zalma on Insurance Claims Part 107 Second Edition: A Comprehensive Review of the law and Practicalities of Property, Casualty and Liability Insurance Claims now available  here.