Why it matters: Insurers must proceed with caution when they become aware that a settlement within policy limits is possible, because a failure to settle may constitute bad faith. And a rejected demand within the policy limits is not required to establish a bad faith failure to settle claim against an insurer, a California federal court judge recently concluded. The case involved a real estate company sued for rescission of a home sale. The parties engaged in settlement talks and the insured learned that it could make a deal for less than the limits of its policy with the insurer. However, the insurer made settlement offers below the amount requested by the underlying plaintiff and filed a declaratory action while the settlement negotiations were ongoing seeking to rescind the policy. The policyholder responded with a counterclaim for bad faith failure to settle. Ruling on the insurer's motion to dismiss, the court said a policyholder is not required to demonstrate that a demand was made within the policy limits in order to establish bad faith. Instead, an insured must simply allege some "circumstance demonstrating the insurer knew that settlement within policy limits could feasibly be negotiated," the judge wrote.

Detailed discussion: A married couple purchased a home from Willis Allen Real Estate. Not long after, a landslide caused a significant portion of their new backyard to slide into an adjacent canyon. The couple filed suit against multiple defendants, including Willis Allen, the real estate company, seeking rescission of the house purchase and recovery of home repair costs.

Willis Allen tendered defense of the suit to Aspen Specialty Insurance Company. Initially, the insurer agreed to defend and Willis Allen began settlement negotiations with the married couple. However, while the negotiations were still ongoing, Aspen filed a declaratory judgment action against Willis Allen seeking rescission of the policy, arguing that it had misrepresented material facts when it purchased the policy.

Willis Allen fought back, filing a counterclaim for breach of contract and bad faith failure to settle the underlying lawsuit by ignoring Willis Allen's liability exposure and refusing to give policy limits settlement authority.

Aspen moved to dismiss the counterclaim, arguing that the bad faith failure to settle the claim failed as a matter of law because Willis Allen did not allege that the married couple had made a policy limits demand or otherwise indicated they would settle within policy limits. According to Aspen, this meant it had no duty to settle and only a duty to negotiate, which it did by making settlement offers, albeit too low.

Willis Allen disagreed. Counsel kept the insurer abreast of its settlement efforts throughout the process, the policyholder told the court, and requested authority from Aspen to settle up to the policy limits. When the policyholder learned it could resolve the claims for "substantially less" than the policy limits, it informed Aspen. But the insurer refused to give policy limits settlement authority and made offers "well below" the amount requested by the married couple.

The lowball offers from Aspen prevented a settlement and drew out the negotiations, the insured said. When a settlement was ultimately reached, it completely exhausted the policy, thereby requiring Willis Allen to contribute a substantial amount of its own money.

Denying the motion to dismiss the counterclaim, U.S. District Court Judge Larry Alan Burns rejected the insurer's position that a policy limits demand was required for a claim of bad faith failure to settle.

"An insurer is obligated to act reasonably to protect their insureds from liability in excess of policy limits," the court said. "Thus 'under California law, an insurer has a duty to effectuate settlement where liability is reasonably clear, even in the absence of a settlement demand.'"

Two avenues exist for insurers to be liable for bad faith failure to pursue a settlement, the court explained: "[S]ome evidence either that the injured party has communicated to the insurer an interest in settlement, or [] some other circumstance demonstrating the insurer knew that settlement within policy limits could feasibly be negotiated," citing a Ninth Circuit Court of Appeals decision, Highlands Ins. Co. v. Continental, 64 F.3d 514 (1995).

Although Aspen contended that the injured party must express an interest in settlement to trigger an insurer's duty to pursue good faith settlement discussions, "Aspen is mistaken. All that's required is some circumstance showing that Aspen knew settlement within policy limits was feasible," Judge Burns wrote.

The counterclaim specifically alleged such a circumstance, claiming that the insurer was informed that Willis Allen likely could resolve the claim against it for substantially less than the policy limits. The counterclaim "also alleges that the [married couple] engaged in mediation in hopes of settling the case, Willis Allen's defense counsel warned Aspen of potential above policy limits damages, and defense counsel requested policy limits settlement authority, but Aspen refused."

"Accepting these factual allegations as true and construing them in the light most favorable to Willis Allen, the [counterclaim] plausibly alleges that Aspen 'refused in bad faith a reasonable opportunity to settle,' " the court said. "Thus, Willis Allen's allegations are sufficient to survive Aspen's motion to dismiss."

To read the order in Aspen Specialty Insurance Company v. Willis Allen Real Estate, click here.