A recent California Supreme Court decision, 21st Century Insurance Co. v. Superior Court (Quintana), S154790 (Aug. 24, 2009), clarifies the rules governing an insurer’s right to reimbursement for payments to its insured, after the insured obtains a recovery from the responsible third party.  The Court held that while the insured has right to be “made whole” before the insurer can assert its reimbursement rights, the made whole rule only applies to the insured’s non-covered damages, not his attorney’s fees.  While the decision is favorable to insurers, it only applies to auto insurers seeking to recover small payments made pursuant to the standard “med-pay” coverage in their policies.  See id. at n. 1.  By circumscribing its holding so narrowly the Court may be signaling that, in other contexts, it would reach a different result.

“When an insurance company pays out a claim on a first-party insurance policy to its insured, the insurance company is subrogated to the rights of its insured against any tortfeasor who is liable to the insured for the insured’s damages.”  Progressive West Ins. Co. v. Sup. Ct., 135 Cal. App. 4th 263, 272 (2005).  Virtually all first-party (and most third-party) insurance policies contain a subrogation or reimbursement provision.  When the insurer pays a claim, these provisions entitle the insurer carrier to recoup its payments from a responsible third party.

In cases involving property damage claims, the insurer may pay the insured’s claim and proceed directly against the third party tortfeasor.  Alternatively, if the insured has brought an action against the responsible third party (for example, to recover uninsured losses), the insurer may intervene in that lawsuit.  See Hodge v. Kirkpatrick, 130 Cal. App. 4th 540, 551 (2005).  However, personal injury claims are non-assignable in California.  Therefore, an insurer may not recover a bodily injury or medical insurance payment directly from the tortfeasor.  Rather, the insurer must wait for the insured to obtain a recovery from the responsible third party, then request reimbursement out of that recovery.  See Progressive West, 135 Cal. App. 4th at 272.

In either context, California recognizes the common law “made whole” rule:

The general rule is that an insurer that pays a portion of the debt owed to the insured is not entitled to subrogation for that portion of the debt until the debt is fully discharged.  In other words, the entire debt must be paid.  Until the creditor has been made whole for its loss, the subrogee may not enforce its claim based on its rights of subrogation.

Sapiano v. Williamsburg, 28 Cal. App. 4th 533, 536 (1994), quoting2 Cal. Ins. Law & Prac. (1988 rev.) § 35.11[4][b].  Under this rule, an insurer may not obtain a subrogation recovery before its insured is fully compensated for both insured and uninsured losses.  Id.; see also Progressive West, 135 Cal. App. 4th at 274.

In 21st Century, the insured (Quintana) was injured in a car accident.  Pursuant to the no-fault “med-pay” coverage provision in Quintana’s auto insurance policy, 21st Century paid her the full $1,000 policy benefit.  Quintana then instituted a personal injury action against the responsible third party.  In that action, she incurred attorney’s fees and costs of $2,106.50 and settled her claim for $6,000.  Quintana acknowledged that the $6,000 payment fully compensated her for her total damages (both insured and uninsured).

21st Century then sought reimbursement of its $1,000 med-pay payment out of Quintana’s recovery.  Quintana contended that 21st Century was not entitled to any such reimbursement, because she had not been made whole – after deducting the $2,106.50 in legal expenses, her $7,000 total recovery ($6,000 from the third party tortfeasor, $1,000 from 21st Century) did not fully compensate Quintana for the $6,000 in damages that she sustained.

21st Century conceded that its reimbursement claim should be reduced, in consideration of the legal expenses incurred by the insured.  However, 21st Century contended that any such off-set was governed the “common fund doctrine”: “One who expends attorneys’ fees in winning a suit that creates a fund from which others derive benefits, may require those passive beneficiaries to bear a far share of litigation costs.”  Quinn v. State of Cal., 15 Cal. 3d 162, 167 (1975).  Under the common fund rule, a party who benefits from another party’s efforts to obtain a recovery must bear a pro rata share of the litigation costs.  Thus, under 21st Century’s view, it was entitled to reimbursement in the amount of $600 – the $1,000 med-pay benefit, less its pro rata share of Quintana’s litigation costs ($400).

The California Supreme Court agreed with 21st Century.  However, the rationale underlying its decision is tied to the unique nature of med-pay coverage in auto insurance policies.  First, as personal injury claims are non-assignable, a med-pay insurer cannot proceed on its own behalf against the third party tortfeasor, nor can it intervene in the insured’s personal injury lawsuit.  Therefore, the Court reasoned, the insurer cannot voluntarily elect to bear its own litigation costs in order to seek reimbursement.

Second, med-pay insurance is a no-fault coverage which “pays the insured’s reasonable and necessary medical expenses incurred due to an accident up to a relatively low dollar limit, in exchange for relatively low premiums.”  As such, the med-pay insurers “have no financial incentive to participate [in litigation against the third-party tortfeasor], given the likelihood that the attorney fees would exceed the amount of reimbursement sought.”  The Court further reasoned that, because the insurer’s maximum potential would rarely exceed a few thousand dollars, “plaintiffs’ attorneys may not want insurers to intervene in lawsuits, as the insurers’ litigation goals of reimbursement may conflict with the plaintiffs’ interest in recovery for losses beyond the low med-pay amount.”

The Supreme Court also rejected an argument which the Southern District of California, considering the same issue, had found persuasive: “If either the policyholder or the [insurer] must to some extent go unpaid because the policyholder has recovered less than her total loss, the loss should be borne by the insurer for that is the risk the insured has paid it to assume.”  Chong v. State Farm Mut. Auto. Ins. Co., 428 F.Supp.2d 1136, 1145 (S.D. Cal. 2006), internal quotes and citation omitted.  The Court again pointed to the unique nature of med-pay coverage – low premiums, in exchange for a small policy benefit – to avoid application of this principle:

Although this reasoning may hold true in certain insurance situations, in the context of med-pay insurance the insured has not contracted for the insurer to assume any risk beyond the insured’s medical payments.  Quintana’s lower premiums provide her only with medical payments in the event of an accident.  …Quintana has not paid 21st Century to assume the risk of paying attorney fees for uninsured losses on her behalf.

(Emphasis added.)

Clearly, the Supreme Court was not willing to extend its reasoning to any other type of insurer subrogation claim.  Indeed, a footnote in Justice Werdergar’s concurring opinion pointedly notes: “I address only the circumstances (as here) of an insurer that is, for public policy reasons, precluded from independently proceeding against the tortfeasor under subrogation, and not whether an insurer who could so proceed, but instead voluntarily elects to await reimbursement, should be placed in the same position under reimbursement as well as under subrogation.”  For most California policyholders, it therefore remains an open question whether the “made-whole” rule applies to their total out-of-pocket losses, including both uninsured damages and litigation costs.  By circumscribing its 21st Century decision so narrowly, the Court may be signaling that, in other contexts, the insured’s right to be “made whole” includes its right to recover litigation costs.