Why it matters: An insured may settle a claim without the insurer's consent where the insurer is defending the claim subject to a reservation of rights, and may recover the settlement amount from the insurer, provided that coverage is found to exist and the deal is fair, reasonable, and was made without collusion, the Supreme Court of Pennsylvania recently held. This case dates back to 1994, when a group of plaintiffs filed a class action against two nuclear facilities, alleging that they suffered bodily injury and property damage because of emissions from the facilities. The liability insurer of the facilities defended the suit under a reservation of rights, but refused to consent to any settlement offers. Nevertheless, the policyholders settled the lawsuit for $80 million, and requested reimbursement from the insurer. Invoking a provision prohibiting the insured from assuming obligations without the insurer's consent, the carrier refused to cover the settlement. The trial court ordered the insurer to pay for the settlement, but an appellate court reversed. The state's highest court reversed again, concluding that "if an insurer breaches its duty to settle while defending subject to a reservation of rights and the insured then accepts a reasonable settlement offer [within the policy limits], the insured need only demonstrate that the insurer breached its duty by failing to consent to a settlement that is fair [and] reasonable." This standard allows policyholders to be reimbursed for otherwise covered settlements, even if the insurer does not consent, without having to establish the insurer acted in bad faith.

Detailed discussion: Babcock & Wilcox Company and Atlantic Richfield Company (collectively, BW/ARCO) were named in a federal class action lawsuit brought by plaintiffs claiming to have suffered bodily injury and property damage caused by emissions from nuclear energy facilities operated by BW/ARCO. Insurers American Nuclear Insurers and Mutual Atomic Energy Liability Underwriters (collectively, ANI) agreed to defend BW/ARCO under a reservation of rights.

The class grew to more than 500 plaintiffs, and in 1998 the court conducted a jury trial of eight test cases. Jurors awarded a verdict totaling in excess of $36 million, or about $4.5 million per plaintiff. Due to evidentiary issues, however, the court ordered a new trial.

Concurrently, ANI filed a declaratory judgment action in state court seeking an order that it owed no duty to defend. The trial court held that the insureds were entitled to separate counsel, which was affirmed on appeal.

Before a second trial could take place in the underlying class action, BW/ARCO settled the case. ANI refused to consent to any settlement offers, believing that the case had a strong likelihood of a defense verdict, given the federal court's grant of a new trial on evidentiary issues and a lack of medical support for the plaintiffs' claims. Despite ANI's refusal to consent, BW/ARCO settled the case for $80 million, which was substantially less than the policy limits of $320 million.

BW/ARCO then sought reimbursement from ANI in state court. ANI refused to cover the settlement, citing a standard consent to settlement clause requiring the policyholder to cooperate with the insurer and obtain consent prior to reaching a settlement:

"The insured shall cooperate with the companies, and upon the companies' request, attend hearings and trials and assist in making settlements, securing and giving evidence, obtaining the attendance of witnesses and in the conduct of any legal proceedings in connection with the subject matter of this insurance. The insured shall not, except at his own cost, make any payments, assume any obligations or incur any expense."

Pointing to Cowden v. Aetna Cas. Co., a 1957 case from the Pennsylvania Supreme Court, ANI argued that state law requires an insurer to pay for the settlement only if it acted in bad faith in refusing to settle and that the policyholder had not established that ANI acted in bad faith. BW/ARCO countered that ANI should indemnify them because the claim otherwise was covered and the settlement was fair, reasonable, and entered in good faith, pointing to a line of cases originating with United Services Auto. Assoc. v. Morris from the Arizona Supreme Court. The trial court agreed with BW/ARCO, applying the Morris standard and ordering ANI to indemnify BW/ARCO in light of the jury's determination that the settlement was "fair and reasonable."

ANI appealed. Emphasizing that insurance policies are contracts at heart, the intermediate appellate court reversed, opining that the language of the policy trumped any public policy arguments. The appellate panel chose to adopt a different approach from a Florida federal court decision in Taylor v. Safeco Insurance Co. The so-called "Taylor/Insured's Choice Test" requires a policyholder to accept the insurer's defense and full control of the litigation (with protection in the form of a bad faith action), or decline it and shoulder the financial responsibility itself.

BW/ARCO then appealed. The Pennsylvania Supreme Court accepted the case to address the question: "Does a policyholder forfeit its right to insurance coverage by settling an underlying and covered claim without its insurer's consent, where the insurer is defending subject to a reservation of rights to disclaim coverage, the settlement is at arm's length, is fair and is reasonable, and the insurer has failed to offer any amounts in settlement?" The court then answered the question in the negative, rejecting the Taylor standard articulated by the appellate panel and adopting a variation on the Morris test.

ANI argued that it acted in good faith in refusing to accept the settlement in the underlying litigation, based on its belief in a strong defense to the case, as well as concern that other plaintiffs would file copycat lawsuits. The insurer also reiterated the importance of respecting the policy's terms requiring consent prior to settlement, arguing that the Cowden standard had worked in Pennsylvania for 60 years. Adopting the Morris standard, ANI cautioned, also would lead to protracted litigation regarding whether a settlement is fair and reasonable.

But the Supreme Court was not persuaded. It reviewed the Morris decision (which has been adopted by other jurisdictions, including Alaska, Indiana, Maine, and Wyoming) and found that other courts have adopted slightly modified versions, such as Iowa and Minnesota. Considering prior case law in Pennsylvania, including Cowden, as well as the line of cases following Morris, "we adopt a variation on the Morris fair and reasonable standard limited to those cases where an insured accepts a settlement offer after an insurer breaches its duty by refusing the fair and reasonable settlement while maintaining its reservation of rights and, thus, subjects an insured to potential responsibility for the judgment in a case where the policy is ultimately deemed to cover the relevant claims," the court wrote. "Like our sister states, we observe that a determination of whether the settlement is fair and reasonable necessarily entails consideration of the terms of the settlement, the strength of the insured's defense against the asserted claims, and whether there is any evidence of fraud or collusion on the part of the insured."

"[I]f an insurer breaches its duty to settle while defending subject to a reservation of rights and the insured accepts a reasonable settlement offer, the insured need only demonstrate that the insurer breached its duty by failing to consent to a settlement that is fair, reasonable, and non-collusive … rather than demonstrating bad faith by the insurer, as the damages sought are subject to the policy limits to which the insurer originally contracted," the court concluded. Accordingly, the Supreme Court reversed the appellate panel and reinstated the judgment of the trial court.

To read the opinion in The Babcock & Wilcox Company v. American Nuclear Insurers, click here.