Pennsylvania Superior Court Defines Standard for Determining Insurer’s Control of Litigation and Settlement When Seeking to Defend Insured Subject to a Reservation of Rights

The Pennsylvania Superior Court recently set forth a new standard for determining when an insured must seek the insurer’s consent to settle underlying third-party claims where the insurer had previously offered to defend the insured under a reservation of its right to decline coverage for any adverse judgment that might be entered against the insured later. In particular, the Superior Court held in Babcock & Wilcox Co. v. American Nuclear Insurers, et al., 2013 PA Super 174 (2013), that when a liability insurer tenders a defense to an insured subject to a reservation of rights, the insured has two options:

  • Accept the insurer’s defense, thereby ceding full control of the litigation to the insurer (consistent with policy terms) and being bound by the typical liability insurance policy provision requiring the insurer’s consent to settlement; or
  • Decline the insurer’s defense, furnish its own defense, and retain full control of the litigation and settlement, in which event — if coverage ultimately exists — the insured may recover both its defense costs and settlement costs, without the insurer’s consent to settlement, so long as those costs are fair, reasonable, and non-collusive.

In Babcock, the defendant insurers appealed the Trial Court’s determination that they owed the plaintiff-insureds $80 million, plus over $15 million in pre-judgment interest, as reimbursement of the plaintiffs’ settlement of the underlying claims, even though the insurers had objected to and never consented to that settlement, because the $80 million settlement was “fair and reasonable.” The Appellate Court rejected the Trial Court’s “fair and reasonable” standard, vacated the judgment against the insurers, and remanded for a new trial that must be directed at determining (1) whether the plaintiffs had actually rejected the insurers’ defense subject to a reservation of rights; and (2) whether the insurers acted in bad faith by rejecting the $80 million settlement and, as alleged, declining to participate in the underlying settlement negotiations.

Seeking to balance the insured’s incentive to develop evidence of non-coverage and to reject settlement offers at or near the policy limits against the insured’s incentive to terminate litigation by settling within its coverage limits irrespective of the merits of its defense, the Babcock Court considered three competing solutions to this balancing act adopted in other states, rejecting two and adopting the third. First, it rejected the notion of allowing the insurer to insist upon consent to any underlying settlement only as to those claims that the insurer has unconditionally assumed liability under the policy, as articulated by the Arizona Supreme Court in United Servs. Auto Ass’n v. Morris, 741 P.2d 246 (Ariz. 1987), as too tilted in favor of the insured. It also rejected the idea of relieving the insurer’s obligation to reimburse the insured for a settlement it reached without the insurer’s consent unless the insurer, in bad faith, breached the contract by arbitrarily refusing to settle, as adopted in Vincent Soybean & Grain Co., Inc. v. Lloyd’s Underwriters of London, 246 F.3d 1129 (8th Cir. 2001), as “too cavalier” regarding the risks imposed upon the insured. Instead, the Superior Court adopted the third approach set forth above, which it drew from Florida precedent, Taylor v. Safeco Ins. Co., 361 So.2d 743 (Fla. Ct. App. 1978), because it gives the insured the option of declining a defense subject to a reservation of rights — thus eliminating the prospect of a conflict-of-interest at the outset of the underlying litigation — but protects the insurer’s full control of the litigation when the insured accepts that defense, subject to its obligations of good faith.

The Babcock decision thus reassures liability insurers defending underlying litigation subject to a reservation of rights that they maintain full control of the defense and settlement of that litigation, consistent with policy terms and subject to good faith obligations, provided that the insured has accepted their tender of the defense. But the insured’s new option to reject the insurer’s conditional defense, settle on its own, and recover its defense costs and settlement “should coverage be found,” as the opinion states, raises an interesting question of whether and to what extent Pennsylvania law would allow the insurer to argue in such a later recovery proceeding that coverage does not exist, such as where the underlying settlement extinguishes both covered and non-covered claims. Assuming that the Babcock analysis withstands further appellate scrutiny, further litigation over this related question seems likely.

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