As a matter of public policy, Pennsylvania (like a number of other states) prohibits insuring against punitive damages. But what happens if an insurer refuses to settle a case against a policyholder within policy limits and the policyholder then sustains an award of punitive damages? That was the question decided by the Third Circuit in Wolfe v. Allstate Property & Casualty Insurance Co.

Wolfe was injured after being rear-ended by Allstate insured Karl Zierle. Before learning how intoxicated Zierle really was, Wolfe demanded $25,000 to settle his claim, which was within the $50,000 policy limit. Allstate countered at $1,200. Wolfe brought suit, after which he learned through discovery about Zierle’s intoxication level and amended his complaint to seek punitive damages. Neither party budged further during mediation, so the case went to trial.

The jury awarded Wolfe $15,000 in compensatory damages and $50,000 in punitive damages. Allstate immediately paid the compensatory damages, but refused to pay the punitive damages, invoking Pennsylvania’s policy against insuring punitive damages and the corresponding exclusion in Zierle’s insurance policy. Zierle then assigned his rights against Allstate to Wolfe in exchange for Wolfe’s agreement not to enforce the punitive judgment against him.

Standing in Ziele’s shoes, Wolfe sued Allstate for breach of contract and statutory bad faith. Allstate moved for summary judgment, contending that because punitive damages are not insurable, it had no duty to consider Zierle’s exposure to punitive damages when determining whether to settle the case. Allstate moved in the alternative to exclude evidence of the $50,000 punitive award. The district court denied both motions, and the case went to trial. The jury found that Allstate breached the insurance policy and committed statutory bad faith. It awarded no compensatory damages and $50,000 in punitive damages.

The Third Circuit vacated the judgment and remanded for a new trial. Applying Erie, the court “predict[ed]” that “the Pennsylvania Supreme Court would conclude that, in an action by an insured against his insurer for bad faith, the insured may not collect as compensatory damages the punitive damages awarded against it in the underlying lawsuit.” That being so, “the punitive damages award was not relevant in the later suit and should not have been admitted.”

The Third Circuit deemed this prediction to be “a logical extension of Pennsylvania’s policy regarding the uninsurability of punitive damages.” In so holding, the court rejected the Eighth Circuit’s holding (under Arkansas law) that even if they are not insurable in the first instance, punitive damages “are part of the consequential damages flowing from [an insurer’s] alleged bad faith and negligence in handling [the insured’s] insurance claims.”

The Third Circuit made plain that “an insurer has no duty to consider the potential for the jury to return a verdict for punitive damages when it is negotiating a settlement of the case. To impose that duty would be tantamount to making the insurer responsible for those damages, which * * * is against public policy.”

The upshot for insurers in cases governed by Pennsylvania law is that, so long as the insurer advises the insured that punitive damages are uninsurable, the insurer need only consider the compensatory exposure in determining whether to settle a third-party claim against its insured. To be sure, the Pennsylvania courts could ultimately choose to part company with the Third Circuit on this issue of Pennsylvania law, but it could hardly constitute bad faith for an insurer to rely on Wolfe in the mean time.