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Insurers, dealing with claims, seldom consult the policy wording and almost never, until after a claim is resolved, consider the subrogation and salvage provision. Those provisions provide an insurer with rights that effect the handling of a claim and can destroy any right the insured has to indemnity under the policy.

A standard subrogation and salvage provision provides:

TRANSFER OF RIGHTS OF RECOVERY AGAINST OTHERS TO US

If any person or organization to or for whom we make payment under this Coverage Part has rights to recover damages from another, those rights are transferred to us to the extent of any payment. That person or organization must do everything necessary to secure our rights and must do nothing after loss to impair them….[1]

This is an assignment of rights from the insured to the insurer. Thus, if a negligently driven automobile strikes an insured’s building the rights of the insured against the driver of the automobile is transferred to the insurer up to the amount paid by the insurer. This is an important right that can only be waived by the insured under certain limited circumstances authorized by the insurer.

The inclusion in the policy of subrogation and salvage conditions, like that quoted above, dealing with the prospective right of subrogation is evidence of the economic facts of life in the insurance industry. The fixing of reserves and the actuarial process by which premiums are calculated take into account the probabilities of a projected percentage of recoveries from third party tortfeasors against whom the insurer will obtain from its insureds, by the right of subrogation. Either in aid of this right or because of it, the law in many jurisdictions is that an insured who gives a release to one responsible for damaging property of the insured, thereby cutting off the insurer's right of subrogation against the tortfeasor, loses his right of action against the insurer under the policy. [2]

As the California Supreme Court stated in Gruenberg v. Aetna Ins. Co., 9 Cal. 3d 566, 108 Cal. Rptr. 480, 510 P.2d 1032 that:

[t]he duty of good faith and fair dealing on the part of defendant insurance companies is an absolute one. . . . [The] nonperformance by one party of its contractual duties cannot excuse a breach of the duty of good faith and fair dealing by the other party while the contract between them is in effect and not rescinded.

Faced with this sweeping and portentous pronouncement from the California Supreme Court on the force and dignity of the covenant of good faith and fair dealing there should be no difficulty in construing the scope of the impact of the covenant to apply alike upon the insured as well as the insurer and that a breach thereof by the insured would lead to the same legal consequences as any other common or unremarkable breach of contract. Thus it should be in every claim. Given every insurer’s expectation of the opportunities to subrogate in the event of payment of a loss caused by the negligence of a third party, it is a breach of the insured's implied covenant of good faith and fair dealing for any insured to frustrate that expectation by contracting away such opportunity before the loss occurred without first receiving the permission of the insurer.

Every claim, therefore, where the insured has a right to collect from a tortfeasor, under a contract or in any other way, the insurer must:

1. Examine the policy to determine if the policy authorizes a waiver of the insurer’s right of subrogation;
2. Determine if the insured waived subrogation in an approved method; 
3. Whether the insured collected anything from the tortfeasor, under a contract or in any other manner for the same loss that is the subject of the claim; or
4. If the policy does not authorize a waiver of subrogation or other rights of recovery.

In a 2006 decision of the Virginia Supreme Court, recovery of relief funds from the US Government acted to deprive an insured of its right to indemnity from its insurer. This decision can effect the way insurers handle catastrophe claims where insureds receive grants of money from the Federal Emergency Management Agency (FEMA) after a natural disaster.

For example, the basic homeowners policy provides:

F.                  Subrogation
An “insured” may waive in writing before a loss all rights of recovery against any person. If not waived, we may require an assignment of rights of recovery for a loss to the extent that payment is made by us.

If an assignment is sought, an “insured” must sign and deliver all related papers and cooperate with us.[3]

Since there is no reason for an insured to waive, before a loss, its rights to grants from FEMA or a charity like the Salvation Army or the Red Cross, it appears that a homeowners insurer may have a right to an assignment of the rights of its insured to FEMA or charitable grants so that the insured does not profit from the disaster. The homeowners policy has no apportionment language with regard to such grants and usually FEMA or the charities will not give grants if they know insurance exists. The terms of the grant and the terms of the insurance policy should control.

In most disasters FEMA and/or the Red Cross will arrange for housing and food for the victims.  If those victims also have a homeowners policy with coverage for additional living expenses it would be improper and a payment in excess of indemnity if those insureds recovered additional living expenses from their insurers without providing an offset for the money received from FEMA since the insured would not have actually incurred a loss.

The most draconian approach to the concept of a set-off as a result of a right of subrogation or salvage resulted from claims after the September 11, 2001 attacks on the United States. As a result of the attack US Airways was prevented by government order from flying into or out of Reagan International Airport. As a result it made claim to its insurers for business lost as a result of the governmental action, an insured against peril.

Pursuant to an act of Congress[4] US Airways received approximately $310 million from the federal government.

Section 24 of the Policy, entitled "Salvage and Recoveries," states in relevant part that "[a]ll salvages, recoveries, and payments, excluding proceeds from subrogation and underlying insurance recovered or received prior to a loss settlement under this policy shall reduce the loss accordingly."[5] (Emphasis added)

This clause is clearer than that in the homeowners policy since it specifically states that recovery from others reduces the amount of loss. The Virginia Supreme Court, without a need to discuss the mutual obligation of insurers and insureds to deal fairly and in good faith with each other, found that by its plain language, the Stabilization Act was designed to "compensate air carriers" like US Airways for both "direct losses" as a result of "any Federal ground stop order" and "incremental losses" as a "direct result of" the September 11, 2001, terrorist attacks. The Supreme Court concluded:

Assuming without deciding that US Airways was covered by the Policy for the business interruption losses suffered as a result of the FAA order and the MWAA order, Section 24 of the Policy clearly requires the proceeds received by US Airways pursuant to the Stabilization Act [act] to reduce US Airways' claimed losses against PMA under the Policy. The $310 million received far exceeds the $58 million in claimed losses and far exceeds the $2.5 million potential liability of PMA under the Policy. US Airways conceded during oral argument that if Section 24 of the Policy barred its recovery then remand would be unnecessary.

Accordingly, we will reverse the judgment of the trial court and we will enter final judgment in favor of PMA.

The Virginia Supreme Court refused to accept the airline’s argument that the Federal Act was not designed to reduce insurance proceeds. In so doing, the Supreme Court recognized that the true purpose of insurance is to provide indemnity, that is, put the insured back in the place the insured was before the loss. If the airline was able to recover from the US Government’s largess more than its loss and then recover the loss from its insurers it would have profited from the disaster.

Insurers must recognize that the covenant of good faith and fair dealing is a two way street and that the insured owes as much an obligation to deal fairly with its insurer as the insurer is required to deal with the insured.  When dealing with a disaster, therefore, claims people must always obtain the following information:

• Did the insured apply for assistance from FEMA or any charitable organization?
• Did the insured obtain any assistance from any source other than its insurer?
• If so, how much?
• If so, for what purpose?
• If not, is the claim still pending with FEMA or any other source?
• Did the insured waive the insurer’s right of subrogation or salvage before the disaster?
• Did the insured waive the insurer’s right of subrogation or salvage after the loss or disaster?

If evidence establishes that assistance in the form of grants (where there is no requirement to repay) the insurer’s rights should be reserved or the insured should be asked to sign a non-waiver agreement. The question should then be presented to competent local insurance coverage counsel for advice on whether the insured has breached the covenant of good faith and fair dealing or if the insurer is entitled to an off-set or reduction in the amount of claim presented.