The United States Court of Appeals for the Fourth Circuit, applying North Carolina law, held that a liability insurer may properly withdraw from the defense of its policyholder after obtaining a judicial declaration of no coverage, despite the policyholder’s pending appeal, provided the insurer offers to continue defending if the policyholder wins a stay of the trial court’s decision. Auto-Owners Ins. Co. v. Potter et al., Nos. 06-1231, 06-1298, 2007 U.S. App. LEXIS 16832 (4th Cir. July 13, 2007). The Court also confirmed that an insurer need not reimburse its policyholder for a settlement that the insurer did not authorize.
The policyholder, a utilities provider, sought coverage under its commercial general liability contract for suits alleging that it had supplied contaminated water to its customers. Its insurer, Auto-Owners Insurance, offered a defense under a reservation of rights and filed suit seeking a declaration of rights under the policy. The federal district court ruled that the insurer owed no defense. The policyholder appealed, and the insurer notified the policyholder that it would be withdrawing its defense based on the ruling of the trial court unless the policyholder sought and received a stay of the trial court’s decision. No stay was sought, and the insurer terminated its defense.
Shortly thereafter, the policyholder settled the underlying claim for $6 million and a transfer of all its rights against the insurer to the underlying claimant. The insurer refused to approve the settlement, contending that it was unreasonable, and instead offered to settle for $150,000, the value placed on the case by the policyholder’s defense counsel. The policyholder declined.
On appeal of the declaratory judgment, the Fourth Circuit vacated the district court’s ruling of no coverage. On remand, the district court held that the insurer did indeed owe a defense, but that the insurer’s prior withdrawal of defense was justified given the court’s earlier finding of no coverage. The court also ruled that because the insurer did not approve the settlement, the policyholder had breached a condition in its policy and the insurer was not obligated to pay the settlement amount accordingly.
The claimant, standing in the shoes of the policyholder, appealed.
The Appellate Court Decision
On appeal of the remand decision, the Fourth Circuit noted that, under North Carolina law, an insurer may withdraw a defense if it finds before trial that the insurance contract does not provide coverage. If, however, an insurer withdraws defense without justification, it may waive certain coverage defenses. Furthermore, under North Carolina law, withdrawal based on an honest (but mistaken) belief that no coverage is owed does not amount to a justifiable excuse.
In this context, the Fourth Circuit rejected the claimant’s argument that the insurer’s withdrawal was unjustified. In reaching its conclusion, the court observed that only three jurisdictions— Wisconsin, Michigan and the Eighth Circuit—have found that an insurer must bear the risk on an appeal and continue to defend, even if a lower court has found that no coverage is owed. The court also pointed out that the claimants had failed to seek a stay from the trial court, and that the insurer had explicitly offered to continue to defend the claim if the stay had been sought and received.
Instead, the court sided with the insurer, noting that the insurer had defended up until the moment that it received the ruling from the district court. This, the court noted, “adhered to the spirit of public policy requiring defense of injured persons.” The court also opined that it would have been relatively easy for the policyholder to seek a stay, and that such stays were routinely granted when there were monetary issues involved. Finally, the court ruled that it would shift the balance too much in favor of policyholders to require an insurer to wait until all possible avenues of appeal have been exhausted before withdrawing a defense.
The court also rejected the claimant’s argument that the insurer must pay for the settlement even though the insurer had not approved it. Because the insurer had justification for withdrawing the defense, it had not waived any policy provisions and could still rely on the clause preventing the policyholder from entering into a settlement without approval. The contract explicitly stated that a settlement reached without approval was “at [the policyholder’s] own cost,” therefore the insurer had no obligation to pay.
This decision is favorable for liability insurers in North Carolina, as it relieves them of the burden of providing a defense pending the appeal of decisions finding no coverage. The case does suggest, however, that a prudent insurer should not withdraw its defense where the coverage decision has been stayed or until the insurer has allowed the policyholder the opportunity to seek such a stay. Additionally, it reaffirms that courts in North Carolina will enforce the voluntary payment provisions within standard liability insurance contracts.