Insurance policies typically include a cooperation clause, which requires the insured to cooperate with the insurer in the defense of a covered claim. Insurers routinely use this clause as a sword against their insureds by arguing that some alleged failure by the insured violates the clause and voids valuable coverage.

The Pennsylvania Supreme Court put a tight lid on that strategy in a ruling decided July 21. In Babcock & Wilcox Co. v. American Nuclear Insurers et al., No. 2 WAP 2014 (July 21, 2015), the court held that the company’s insurers could not avoid coverage for an $80 million class action settlement of radiation exposure claims to which the insurers had not consented.

The insurers had agreed to defend the insureds against the class-action claims, but challenged coverage to certain aspects of the underlying claims, and defended subject to a reservation of rights. When Babcock & Wilcox had an opportunity to settle the class action, the insurers refused, and sent the insured a letter reserving their right to disclaim coverage because the insured pressed the insurers to settle the underlying claims. The insurers contended that these settlement demands breached the duty to cooperate in the policy. In contrast, Babcock & Wilcox, arguably in the best position to evaluate settlement, contended that the settlement offers were reasonable, and without the insurers’ consent, settled the class action claims for a total of $80 million, well below the $320 million in available coverage.

After the settlement, the insurers refused to reimburse Babcock & Wilcox for the settlement, again citing the cooperation clause. The insurers claimed that they had the absolute right to control settlement, and that they did not have a duty to fund the settlement unless Babcock & Wilcox could show that the insurers acted in bad faith by refusing to settle the claims. The insured argued that it need only prove that the settlement was fair and reasonable because the insured was seeking coverage within the policy limits.

The Pennsylvania Supreme Court rejected the insurers’ bad faith standard and instead applied a fair and reasonable standard. If the settlement was fair and reasonable – and settled a covered claim— the insurer must pay the amount of the settlement when the insurer is defending the claim subject to a reservation of rights and has refused to consent to a settlement. Determination of “fair and reasonable” requires consideration of the settlement terms, the strength of the insured’s defense against the underlying claims, and where there is any evidence of fraud or collusion by the insured. Because a jury had already determined the settlement was fair and reasonable, the court required the insurers to reimburse Babcock & Wilcox for the $80 million settlement.

Notably, courts (including Pennsylvania courts) often apply a bad-faith standard to insureds’ claims for settlements and verdicts above policy limits. Thus, when an insurer refuses to settle a claim within policy limits, and that claim is ultimately a covered claim, and the insured is exposed to a verdict or settlement above policy limits, courts require the insurer to pay the full amount of the settlement even though more than the policy limits, if the insured can show that the insurer acted in bad faith. In this case, the insurers attempted to use that higher bad-faith standard for settlements above policy limits to a settlement below policy limits. The Pennsylvania Supreme Court was not persuaded, and recognized the difference between the two situations.

Insureds should take note when presented with settlement opportunities. If an insurer is defending under a reservation of rights but refuses to settle a covered claim, the insured may be able to settle the claim over the insurer’s objection without forfeiting coverage under the cooperation clause. Insureds should check the governing state law if faced with such a situation, and should be prepared to document the fairness and reasonableness of any settlement within policy limits.