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A Liability Insurer's Duty to Settle

When an insurance carrier defends its insured in a third-party lawsuit under a reservation of rights, a number of conflicts may arise between them. One possibility is when the plaintiff in the underlying liability lawsuit seeks damages exceeding policy limits, but makes a settlement offer equal to or less than those limits. Believing that the settlement offer is too high or that facts will be established undermining coverage, the carrier may have an incentive to decline the settlement and proceed to trial. The insured, on the other hand, may prefer to avoid a trial.
      The insurance carrier in this circumstance may face a difficult choice: If it accepts the settlement offer and it is later determined that there was no coverage for the claim, it risks having to seek reimbursement of the settlement payment from its insured-who may or may not have the financial means to repay it. But if the carrier rejects the offer and the claimant hits against its insured, the carrier could be liable not only for a judgment exceeding policy limits but also for additional damages its insured has sustained.
      In fact, it is this very conflict that gives rise to the duty to settle. (See 14 Couch on Insurance 3d, § 203:13 at p. 20321: "The basis for the insurer's duty to settle within policy limits is the insurer's exclusive control over settlement negotiations, plus the inevitable conflict between the insurer's interest to pay as little as possible and the insured's interest not to suffer an excess judgment.")
      "Reasonable" Offers and Acceptance
      Though the exact formulation of an insurer's duty varies among the states, the California Supreme Court has directed that the only possible consideration is "whether, in light of the victim's injuries and the probable liability of the insured, the ultimate judgment is likely to exceed the amount of the settlement offer." (Johansen v. California State Auto. Ass'n Inter-Ins. Bureau, 15 Cal. 3d 9 at 16 (1975).)
      In making this determination, the court noted that the insurer's decision-making process should not be swayed by: the limits imposed by the policy, a desire to reduce the amount of future settlements, or a belief that the policy does not provide coverage.
      According to a recent appellate decision, this rule does not impose an unfair burden on insurance carriers. The reasoning is that if an insurer rejects a settlement offer on the ground that there is no coverage, and its position is later vindicated, it will have no liability for the damages flowing from such refusal. To mitigate the possible consequences, an insurer may reserve its right to dispute coverage but then accept the settlement offer to protect its insured against exposure to an excess judgment. Such action would preclude any claim of bad faith against the insurer if coverage is later established; and the insurer would have a remedy if its coverage position is ultimately vindicated. (Archdale v. American Int'l Specialty Lines Ins. Co., 154 Cal. App. 4th 449 (2007).)
      When a carrier has spurned an offer within policy limits, and a verdict is rendered in excess of that offer, the liability carrier will face a claim for the breach of implied covenant of good faith and fair dealing. In California, such a claim will give rise to both contract and tort damages.
      A key peril that a liability insurer then faces is that once it declines the claimant's "reasonable" offer, neither its belated payment of policy limits nor its belated acceptance of the claimant's settlement offer will discharge its bad faith liability. Thus, in Archdale, the carrier, which had declined the claimant's policy-limits demand, defended against the insured's bad faith action on the ground that it had complied with its express policy obligations by providing a defense to the insured and by eventually paying policy limits. The court rejected that contention, holding that because the source of a liability insurer's duty to settle arises from an implied covenant of good faith and fair dealing, the insured could still maintain a bad faith action against the insurer. (154 Cal. App. 4th at 465.)
      The carrier's subsequent acceptance of the claimant's demand does not undermine the insured's claim. As the court noted in Critz v. Farmers Insurance Group: "Rejection of an initial settlement offer is frequently regarded as a preliminary bargaining tactic, not as a breakoff of negotiations. ... Even if the insurer attempts to resume negotiations by a belated offer of the policy limit, that action does not necessarily relieve it of the onus of an earlier bad faith rejection." (230 Cal. App. 2d at 79798 (1964).)
      Risks of Declining Coverage
In the classic coverage-refusal case, the carrier is deemed to be acting "at its own risk." (Comunale v. Traders & Gen. Ins. Co., 50 Cal. 2d 654 at 660 (1958).) Having failed to accept a reasonable settlement offer from the claimant on the ground that the claim against its insured was not covered, the insurer will be at risk for any excess judgment-and possibly additional damages-if it is later determined that the insurer's coverage determination was incorrect.
      This is potentially dangerous from the carrier's perspective.
      First, the threshold for liability is extremely low. To be liable for the excess judgment, the carrier need only to have been "incorrect" in connection with its evaluation of coverage. (See Johansen, 15 Cal. 3d at 16, fns. 4 and 5.) No finding of bad faith, unreasonableness, or other culpable conduct is necessary.
      Second, the insured or its assignee will be able to recover not simply the amount of the excess judgment but "the full amount which will compensate the insured for all the detriment" caused by the insurer's conduct. (Comunale, 50 Cal. 2d at 660.) And when the carrier's coverage declination is found to have been made in bad faith, the insured is entitled to recover tort damages, including punitives.
      Third, if an insurer denies coverage, the insured's contractual obligation to notify the insurer of developments in the pending liability lawsuit ceases, and the insured is relieved of the obligation to inform the insurance company of the service of summons or the date of trial. (Samson v. Transamerica Ins. Co., 30 Cal. 3d 220 (1981).) The insured is then free to strike the best deal it can with the claimant, and that deal will normally be binding on the carrier in any subsequent bad faith action on the magnitude of the insured's liability. (See Pruyn v. Agricultural Ins. Co., 36 Cal. App. 4th 500 (1995); Armstrong World Indus. v. Aetna Cas. & Sur. Co., 45 Cal. App. 4th 1 (1996).)
      For these reasons, it is not surprising that a carrier that declines coverage, and thereafter spurns a settlement offer, is deemed to be "gambling with the insured's money." (See Crisci v. Security Ins. Co., 66 Cal. 2d 425 at 431 (1967).) And because the consequences of guessing wrong on coverage are so onerous, a carrier that has declined to cover its insured in a liability lawsuit is wise to consider contributing to a settlement to mitigate its risk of a subsequent bad faith suit.
      Carrier Reimbursements
      An insurer seeking to avoid the "coverage refusal" scenario might wish to accept a policy-limits demand from the claimant and then, after the underlying lawsuit is resolved, seek to recoup the settlement amount from its insured.
      But not all states allow this. (See Texas Ass'n of Counties Cty. Gov. Risk Assessment Pool v. Matagorda, 52 S.W.3d 128 (2000); Mt. Airy Ins. Co. v. Doe Law Firm, 668 So. 2d 534 (1995).) However, in Blue Ridge Insurance Company v. Jacobsen (25 Cal. 4th 489 (2001)), the California Supreme Court held that an insurer defending its insured under a reservation of rights may settle with the claimant over its insured's objections. The insurer may then seek recoupment of the settlement payment from its insured following a determination that there was no coverage.
      In Blue Ridge, the court conditioned the insurer's right to pursue recovery of the settlement payment from its insured on a timely and express reservation of rights, an express notification to the insured that the insurer intended to accept the claimant's settlement offer, and an express offer to the insured that it may assume its own defense arising from the parties' dispute about whether to accept the settlement offer.
      From the carrier's standpoint, this scenario has the advantage of insulating it from potential bad faith claims that could be asserted by its insured if the underlying lawsuit went to trial and an excess judgment were rendered. But such protection comes at a cost: The insurer bears the economic risk that its insured may be incapable of reimbursing it for the settlement payment that the insurer has advanced. However, this serves the societal interest of transferring the risk of nonpayment from the injured party to the insurer. (Blue Ridge, 25 Cal. 4th at 503.)
      Splitting the Settlement
      In a case involving both covered and noncovered claims, a carrier's duty to settle does not extend to the noncovered portions of the injured party's claim. (Camelot by the Bay Condo. Owners' Ass'n, Inc. v. Scottsdale Ins. Co., 27 Cal. App. 4th 33 (1994).) The "reasonableness" of the carrier's settlement offer is measured by the insured's potential exposure in respect to the covered, as opposed to the noncovered, claims. (Zieman Mfg. Co. v. St. Paul Fire & Marine Ins. Co., 724 F.2d 1343 (9th Cir. 1983).)
      A carrier therefore does not breach its duties to its insured by requesting that the insured contribute to a settlement when there is a bona fide dispute about the extent of the carrier's obligations. (Croskey, et al., CALIFORNIA PRACTICE GUIDE: INSURANCE LITIGATION (Rutter Group 2006) ;§ 12:449 at p. 12B-65.)
      The difficulty here for a carrier is that by suggesting that its insured contribute to an overall settlement, it is walking the razor's edge: On the one hand, from the perspective of the insurer, the reasonableness of any settlement offer made by the claimant will be measured against the magnitude of the covered, as opposed to noncovered, claims. On the other hand, any effort by the carrier to "coerce" the insured to contribute to a settlement might be invoked later by the insured as evidence of the carrier's bad faith. (See J.B. Aguerre, Inc. v. American Guar. & Liab. Ins. Co., 59 Cal. App. 4th 6 (1997).)
      An insured pressured by its carrier to partially fund a settlement has an important resource. According to the California Supreme Court, when faced with the insurer's unreasonable refusal to pay a settlement demand within policy limits, "the insured may recover the amount of payment from the insurer in an action for bad faith failure to settle." (Hamilton v. Maryland Cas. Co., 27 Cal. 4th 718 at 731 (2002).)
      Insureds Settling Directly
      As discussed above, an insured whose carrier does not provide a defense is free to settle with the claimant, without notice to or consent by its carrier. (National Steel Corp. v. Golden Eagle Ins. Co., 121 F.3d 496 (9th Cir. 1997).) If it is later determined that the carrier improperly denied coverage for the claim, then it will be exposed to a potential bad faith claim.
      The rules are different, however, when the carrier defends its insured. Then, the general rule is that a carrier, even under a reservation of rights, has the ability to control settlement. The insured is ordinarily not entitled to unilaterally conclude a settlement with the claimant without breaching the "no voluntary payments" provision of the policy. (Sargent v. Johnson, 551 F.2d 221 (8th Cir. 1977).) However, not all courts agree with this principle. (See United Servs. Auto. Ass'n v. Morris, 154 Ariz. 113 (1987); Miller v. Shugart, 316 N.W.2d 729 (Minn. 1982).)
      Difficult questions often arise when an insurer defending under a reservation of rights offers a settlement to the claimant that its insured deems inadequate. This conflict may be particularly acute if the policy has "burning limits"-where defense costs reduce the amount of coverage available to pay a settlement or judgment. In such an instance, the insured has a strong economic incentive to have the carrier settle with the claimant early in the litigation. By contrast, the carrier's incentive may be to continue to defend through trial, especially if coverage is in doubt and facts may be established at trial undermining coverage.
      Though the existence of such a conflict may require that the insured be represented in the litigation by so-called Cumis counsel (codified in Cal. Civ. Code § 2860), the carrier need not relinquish control over settlement even in these circumstances. (See Rose v. Royal Ins. Co., 2 Cal. App. 4th 709 (1991).) An insured may therefore be motivated to settle on its own with the claimant, without its carrier's participation.
      But this course can be a risky choice if the insured wishes to later seek reimbursement from its carrier. Because the insured's breach of the policy's no-voluntary-payments provision will usually lead to a loss of coverage, it must establish in any subsequent bad faith lawsuit that the carrier committed an antecedent breach by failing to satisfy its duty to settle. (Gribaldo, Jacobs, Jones & Assoc. v. Agrippina Versicherunges A. G., 3 Cal. 3d 434 (1970); Hyatt Corp. v. Occidental Fire & Cas. Co., 801 S.W.2d 382 (1990).)
      The insured will argue that the carrier's breach of its duty to settle excused its own compliance with the policy's no-voluntary-payments provision. Thus, some courts hold that when the insurer has refused, either negligently or in bad faith, to effect a reasonable settlement, the insured may make a settlement on its own initiative, then sue the insurer to recover the amount expended, notwithstanding the policy provision that no action shall be against the insurer. (COUCH ON INSURANCE 3d, 203:13 at pp. 20370.)
      In Hamilton, however, the court held that an insured's settlement with a claimant would not be binding on the insurer in the subsequent bad faith action. In that case, the carrier had been defending its insured under a reservation of rights. After the carrier rejected the claimant's settlement offer, the insured and the claimant reached a settlement on a "no personal liability" basis without the carrier's participation or consent. The state Supreme Court held that in these circumstances the settlement would not be binding on the carrier, and no bad faith suit against the carrier would lie. (27 Cal. 4th at 730.)
      Peter S. Selvin is a partner in the Los Angeles office of Loeb & Loeb, where he concentrates on commercial litigation.
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