Congratulations, your cracker-jack defense team just won the underlying case. They also just lost your insurance coverage and you now must repay millions of dollars of defense costs. Seem odd? Not according to the Second Circuit in Petroterminal de Panama, S.A. v. Houston Cas. Co., No. 15-2941-cv (2d Cir., Sept. 8, 2016).

In Petroterminal, Panama-based Petroterminal de Panama was sued by Castor Oil for losses resulting from an oil spill. Petroterminal tendered the Castor suit under its primary marine liability and excess bumbershoot policies. Petroterminal then successfully defended the lawsuit.

Neither insurance policy contained a “duty to defend,” but both policies provided for indemnification of defense costs. Both policies also contained potentially applicable exclusions. In light of the policy language, the Petroterminal and the insurers agreed to an advancement of defense costs, subject to an agreement that Petroterminal would repay those amounts if it were unsuccessful in any later coverage action.

In subsequent coverage litigation, the district court found the policies’ exclusions applied to bar coverage for the Castor suit. The court based its finding on Petroterminal’s successful underlying defense, where Petroterminal showed that the alleged losses were not due to Petroterminal’s negligence, but rather the Panamanian government’s “attachment” of 5.4 million barrels of Castor’s oil. Consequently, the district court found that Petroterminal would be required to reimburse its insurers for the advanced defense costs.

On appeal, the Second Circuit affirmed, explaining that even without the parties’ agreement to reimburse defense costs, the recognized distinction between “duty to defend” policies and “duty to reimburse” policies would lead to the same conclusion, since in the case of the latter, “. . . New York law generally requires . . . advancement . . . , though such fees are subject to recoupment by the insurer if it is ultimately found that no coverage exists.”

The dilemma facing Petroterminal – win the case but lose coverage – is not at all uncommon. Every day, policyholders and defense counsel grapple with the decision to settle or litigate. Often, that decision is made based only the probabilities of success. But, deeper consideration is required. For instance, had Petroterminal settled the Castor litigation without obtaining a factual finding as to the cause of Castor’s losses, that settlement would have been covered, as would all of Petroterminal’s defense costs – a far-greater victory of sorts. Petroterminal is a reminder, therefore, of the significant impact a seemingly strong defense strategy can have on the availability of insurance coverage and, thus, the company’s ultimate financial outcome. While a strong defense is good; a strategy that includes early and frequent communication between defense teams and coverage counsel is better, and will help to ensure that the company’s broader interests and financial objective are achieved.