A Pennsylvania intermediate appellate court recently prescribed new rules relative to the defense of insureds under a reservation of rights. In Babcock & Wilcox Company, et al. v. American Nuclear Insurers, et al., 2013 PA Super. 174, 2013 PA Super. LEXIS 1630, the Superior Court of Pennsylvania held that when an insurer tenders a defense subject to a reservation, an insured now has the option of rejecting the insurer’s tender, funding its own defense, and settling the case without the insurer’s consent. Should coverage later be found, the insured may recover from the insurer the costs of defense and settlement to the extent those costs are deemed fair, reasonable and non-collusive. A copy of the Pennsylvania Superior Court’s decision is available here. The concurrence and dissent are available here.

The decision arises out of a class action lawsuit filed by individuals who allegedly sustained bodily injury and property damage caused by radiation emanating from a nuclear fuels plant operated by Babcock & Wilcox Company (“B&W”). B&W’s insurer, American Nuclear Insurers (“ANI”), agreed to defend B&W subject to a reservation of rights. B&W settled the class claims over ANI’s objections for approximately $80 million and then sought indemnity from ANI for the settlement amount and prejudgment interest.

In a subsequent declaratory judgment action, the trial court determined that B&W was entitled to indemnity from ANI, notwithstanding the violation of the consent to settle clause in the policy, provided that the settlement was “fair and reasonable.” A jury thereafter found that the settlement was fair and reasonable, and the court entered a judgment in favor of B&W.

On appeal, the Superior Court focused on the standard applicable to an insurer’s tender of a defense under a reservation of rights. Adopting the approach espoused by the Florida Court of Appeal in Taylor v. Safeco Insurance Co., 361 So.2d 743 (Fla. Ct. App. 1978), the Superior Court held that, when an insurer offers a defense subject to a reservation, the insured may now choose either of two options: (1) it may accept the defense, thereby remaining bound to the terms of the consent to settlement provision of the underlying policy and granting full control of the litigation to the insurer; or (2) it may decline the insurer’s tender of a defense and furnish its own defense, including the option of settling the underlying claim under terms it believes best. Under this latter option, should subsequent litigation establish coverage, the insured may recover its defense and settlement costs if they are fair, reasonable and non-collusive. According to the court, the Taylor approach “best balances the interests of insurer and insured, and better honors the binding nature of the insurance contract.” The court then remanded the case to the trial court to determine if B&W expressly rejected ANI’s defense and, if not, whether ANI’s refusal to consent to the $80 million settlement constituted bad faith. It remains to be seen whether this decision will be appealed to the Pennsylvania Supreme Court.

The B&W ruling may have an impact on the decision-making process of both policyholders and insurers in the context of a reservation of rights letter. While an individual or smaller commercial insured is likely to continue to accept an insurer’s defense subject to a reservation of rights, a larger, deep-pocketed commercial insured may have the wherewithal and means to strike out on its own and pursue coverage litigation. This may cause an insurer to reconsider defending under a reservation of rights if it does not believe its coverage defenses will ultimately prevail.