Upon indemnifying a policyholder for a loss, an insurergenerally has the right to recoup its loss by pursuing recoveryfrom other entities or individuals who may be responsible for thepolicyholder's damages in the first place.

Subrogation rights vary across jurisdictions and can haveserious consequences both for the policyholder and the insurer.Disputes often arise, such as the circumstances under which theinsurer may subrogate and for how much, particularly where thepolicyholder has not been fully compensated for its losses.

Generally, an insurer's subrogation rights are limited torecovering no more than what it paid to its policyholder. However,there is a disagreement among jurisdictions as to whether theinsurer can recover in subrogation before the policyholder is “madewhole.”

For example, if the insurer disputes part of the insured's claimand only partially compensates the policyholder, some jurisdictionssubordinate the insurer's subrogation rights and require that thepolicyholder be made whole before the insurer can recover. Thisissue can become complicated depending on the circumstances, suchas whether the applicable policy covers all or part of a claim, andin situations where the policyholder purchased inadequate limits tocover the loss or claim.

A majority of courts have agreed that an insurer may not recoverin subrogation unless the policyholder is fully compensated for itslosses. The courts reason that the insurer should bear the risk ofloss, because the policyholder paid the insurer to assume thatrisk.

Conversely, a minority of jurisdictions adhere to the“insurer-whole” rule, whereby the insurer is made whole first outof a recovery from a responsible third-party up to the amount paidby the insurer to the policyholder. These courts reason that thepolicyholder chose the policy limits, and if the insurercompensates the policyholder in accordance with its obligationsunder the policy, the insurer should be permitted to subrogate forthat amount. This situation is sometimes referred to as “partialsubrogation,” which occurs when both the insurer and thepolicyholder possess an interest in the subrogation claim.[See Winkelmann v. Excelsior Ins. Co., 650N.E.2d 841, 844 (N.Y. 1995).]

Some courts have devised variations of these methods, such as apro rata allocation in accordance with the percentage of theoriginal loss paid to the policyholder. [See Culver v. Insurance Co. of NorthAmerica, 559 A.2d 400, 404 (N.J. 1989).] Therefore, it iscritical to understand which state's “made whole” laws will applyto a particular loss.

Related: 5 subrogation recovery tips

It's possible to avoid subrogation by clear terms dictatedin an insurance contract. (Photo: iStock)

Made-whole doctrine may be modified by contract

Notwithstanding the laws of a particular jurisdiction,subrogation rights can be modified by contract. The majority ofjurisdictions that have addressed this issue enforce expressexclusions of the made-whole doctrine, and have determined that aninsurance policy can grant subrogation rights to an insurer, evenwhere the policyholder has not been completely indemnified.

Thus, the parties can circumvent subrogation by the clear andunambiguous terms of a contract. In most circumstances the partiesare free to negotiate the terms of the policy; therefore, amajority of courts will generally enforce a policy's subrogationclause. [See Fortis Benefits v. Cantu, 234 S.W.3d 642, 649(Tex. 2007).]

Policyholders and insurers alike should be aware of theapplicable policy language. In order to repudiate the presumptionthat a policyholder is to be made whole before an insurer'ssubrogation rights arise, parties must use clear, specific languagein the insurance policy.

Courts have reached opposite conclusions as to whetherboilerplate language allowing an insurer to subrogate “in the eventof any payment” under the policy is sufficient to overrideapplication of the made whole doctrine. [See Fireman's Fund Ins. Co. v. TD Banknorth Ins.Agency, 644 F.3d 166, 170-71 (2d Cir. 2011).]

Has the policyholder was made whole?

A critical issue that must be resolved is whether thepolicyholder has, in fact, been made whole.

When a case is resolved by settlement, there are likely to bequestions as to whether the insured has been fully compensated. Forexample, the issue of whether a policyholder can assert that it hasnot been made whole until it has been compensated for itsattorney's fees is often disputed. Most jurisdictions follow the“common fund doctrine” — an equitable principle which states that“[t]o allow the others to obtain full benefit from the plaintiff'sefforts without contributing equally to the litigation expenseswould be to enrich the others unjustly at the plaintiff's expense.”[Mills v. Electric Auto-Lite Co., 396U.S. 375, 392 (1970).]

The reasoning behind this principle is that where an insurerthat did not participate in the policyholder's litigation against aresponsible tortfeasor but benefitted from the results of thatlitigation, the insurer should share in the costs of thelitigation. Most courts require the insurer to pay a reasonableshare of fees and costs, often a percentage based on the amountsrecovered by the insured and insurer respectively, or a percentageof the amount recovered by the insurer, similar to a contingencyfee.

A minority of jurisdictions do not follow the common funddoctrine, and permit the insurer to recover without compensatingthe policyholder for its attorney's fees. However, as with mostequitable principles, the parties can nullify the common funddoctrine in writing.

Related: Are you getting the most out ofsubrogation?

Some courts require policyholders to be made whole for alldamages, not just those covered by an insurer. (Photo:iStock)

How to address deductibles

A policyholder's deductible presents another barrier indetermining whether the insured has been made whole. Somejurisdictions deem a policyholder's deductible to be an exceptionto the made whole doctrine, and permit the insurer to subrogatebefore the policyholder recovers its deductible. [See Fireman's Fund Ins. Co. v. TD Banknorth Ins. AgencyInc., 309 Conn. 449, 468 (Conn. 2013).]

These courts reason that the insurer and the policyholderentered into a contractual relationship whereby the policyholderagreed to a lower premium payment in exchange for a deductible.Thus, requiring the policyholder to be made whole beforesubrogation would create a windfall for the policyholder for a lossthat the policyholder did not insure against when it agreed to thedeductible.

Other states use different methods to allocate the cost of thedeductible. For example, Pennsylvania has enacted regulationsrequiring the policyholder and insurer to share the cost of thedeductible proportionally in a subrogation action. [31 Pa. Code § 146.8(c).]

Settlement agreements

If the policyholder reaches a settlement with a responsiblethird-party without obtaining the insurer's consent, an issue mayarise as to whether the settlement presumes that that policyholderhas been made whole. This is especially pressing in the situationwhere the insurer's subrogation rights are eliminated by thepolicyholder's release of the third-party. Generally, however, asettlement alone does not carry with it a presumption that thepolicyholder has been made whole, nor does it operate to preventthe policyholder from proving that it still has uncompensatedlosses.

Some courts require the policyholder to be made whole for allelements of damages, and not just those damages paid by theinsurer. The “double recovery” rule allows the insurer to bereimbursed only from that portion of a recovery which represents adouble recovery for the policyholder. However, in 2013, in anEmployee Retirement Income Security Act case, the Supreme Courtfound that, as with the made whole doctrine, the parties mayabrogate the “double recovery” rule by contract. [US Airways, Inc. v. McCutchen, 133 S. Ct.1537, 1541 (2013).]

Other jurisdictions have determined that recovery from a thirdparty is divisible, and where the policyholder has been fullycompensated for its losses that are covered by the policy, theprinciples behind the made whole rule have been satisfied. Thesejurisdictions reason that to hold otherwise would authorize thepolicyholder to be unjustly enriched by requiring the insurer toinsure against losses which it had not agreed to.

As a result, where the policyholder successfully recovers from aresponsible third-party, it is the policyholder's responsibility toallocate the recovery between compensation for damages that arecovered by the policy and damages that are not covered.

The majority view is that a policyholder is entitled to be “madewhole” before an insurer may recover from third-parties insubrogation. However, some jurisdictions that have adopted themajority view may resolve related issues differently. Policyholdersand insurers alike must be aware of the applicable policy languageand the laws in the applicable jurisdiction, not only when payingon a claim and contemplating subrogation, but also when pursuingsubrogation and agreeing to settle third-party claims.

Matthew D. Stockwell is counsel with Pillsbury WinthropShaw Pittman LLP in New York. Email him at [email protected].