When an insurer provides a defense to a policyholder subject to a reservation of its rights to dispute coverage, who controls the terms of a settlement of the underlying claims?

An appellate court in Pennsylvania recently weighed in on this question, giving policyholders two options: (1) reject the insurer’s defense due to the reservation of rights, front its own defense costs, and then sue for reimbursement, all while controlling the defense and settlement; or (2) accept the defense and give the insurer total control over the defense and settlement, subject only to review for potential breach of fiduciary duty.

The not uncommon scenario arose when Babcock & Wilcox Company and B&W Nuclear Environmental Services faced hundreds of personal injury lawsuits alleging exposure to radiation. B&W turned to American Nuclear Insurers and Mutual Atomic Energy Liability Underwriters for coverage. Although the insurers provided a defense, they did so while also filing a declaratory judgment seeking to limit or avoid their coverage obligations.

Acting independently of its insurers, B&W reached an $80 million settlement with the plaintiffs, which also included prejudgment interest of more than $15 million. The insurers objected to the settlement. A trial court ordered the insurers to cover the settlement after a jury found that the settlement was “fair, reasonable, and non-collusive.”

The appellate court recognized that when an insurer reserves the right to deny coverage, the parties’ interests may diverge. When an insurer reserves its rights subject to a duty to defend, “the interests of the insurer and the insured may be antagonistic: If an insurer is exposed only to liability up to the limit of its policy, and any settlement would be at or near that level, then even a modest chance of obtaining a defense verdict might be sufficient in a self-interest cost-benefit analysis to convince an insurer to litigate despite the prospect of a verdict in excess of the policy limits,” the court explained.

The court announced a rule for navigating that situation, diverging from what it saw as the majority rule (permitting the insured to reject a defense offered under a reservation of rights, forcing the insurer either to defend unconditionally or to refuse to defend at its peril) as well as one minority rule (allowing insurers to retain full authority under a consent to settlement provision with the imposition of a heightened good faith requirement).

The court adopted a version of another minority approach, following cases from Florida and Missouri (which also were similar to, with variations, cases in Colorado, Kentucky, New Jersey and South Dakota). Under this approach, the insured has “the option to decline a defense tendered subject to a reservation of rights,” but the insurer retains the “right to control the defense when it is accepted by the insured.” “By granting the insured a basis upon which to eliminate the risk of a conflict of interest at the outset of a claim, it does not consign the insured solely to the protection of our strictly-construed bad faith standard. At the same time, our approach protects an insurer’s right to control litigation when it provides a defense,” the court said.

Whoever then defends the suit “retain[s] the unqualified prerogative to proceed in the way that it determines is best.” The court noted that policyholders will remain protected as insurers continue to be bound by their fiduciary obligation to represent the insured’s interests and have the good faith obligation to settle cases when appropriate.

Because the trial court applied a different standard, the appellate court vacated the prior ruling and instructed the trial court to apply this new standard.

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

Why it matters: The standard adopted by the Pennsylvania appellate court attempts to reconcile the competing interests of insureds and insurers in cases where an insurer provides a defense only subject to a reservation of rights. Courts across the nation have adopted very different rules for this situation, so policyholders and insurers alike must be mindful of the governing law. In Pennsylvania and other jurisdictions with similar rules, insureds must carefully assess their interests and risks before making the election required by the Babcock & Wilcox decision. Of course, if the insured cannot afford to front its own defense, this standard leaves them with little choice; larger companies will have the opportunity to be more strategic.