The Pennsylvania Superior Court has adopted a new paradigm for determining whether a policyholder can require its insurer to fund a settlement made without the insurer’s consent when the insurer has reserved the right to deny coverage.

Under the rule, announced in Babcock & Wilcox Co. v. American Nuclear Insurers, when an insurer defends but reserves the right to deny coverage, the policyholder has two options. The policyholder may: (1) accept the insurer’s defense, in which circumstance the policyholder may not settle without the insurer’s consent, or (2) reject the insurer’s defense so that it can control the defense (with a corresponding responsibility to pay defense costs) and control settlement decisions. The option allowing policyholders to reject an insurer’s defense is new to Pennsylvania law. And in providing this option, the court also introduced a new, less stringent standard for determining when an insurer must fund a settlement made without its consent.

Under the new option, if the insurer is later found to owe coverage, the policyholder may recover its defense and settlement costs, as long as these costs are fair, reasonable and not the product of collusion. However, as before, if the policyholder accepts the defense under reservation of rights, the insurer retains the right to control the defense and settlement decisions. If the policyholder then settles without the insurer’s consent, the insurer will not be required to fund the settlement unless the policyholder can demonstrate the insurer acted in bad faith in withholding consent.

With this decision, Pennsylvania joins other states that have adopted similar rules to balance the competing interests of policyholders and insurers. In doing so, the new rule broadens a policyholder’s rights under an insurance policy by providing a choice where none previously existed and adopting new governing standards, and therefore, will likely change the dynamic between insurers and policyholders where a defense is provided subject to a reservation of rights. While further review of this case by the Pennsylvania Supreme Court may be down the road, insurers must be aware of the Superior Court’s ruling in circumstances when they are providing a defense subject to reservation of rights.