Restatement of the Law of Liability Insurance § 10 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 1. Defense

• 10 Scope of the Right to Defend

^Comment:

^{Reporters’ Note}

• When a liability insurance policy grants the insurer the right to defend a legal action, that right includes, unless otherwise stated in the policy or limited by applicable law:
• (1) The authority to direct all the activities of the defense of any legal action that the insurer has a right to defend, including the selection and oversight of defense counsel; and
• (2) The right to receive from defense counsel all information relevant to the defense or settlement of the action, subject to the exception for confidential information stated in 11(2).

Comment:

13. a. Relationship to duty to defend. Traditionally, personal liability insurance policies, such as the liability-coverage parts of homeowner’s and automobile-insurance policies, and many commercial liability insurance policies assign to the insurer the right and duty to defend any potentially covered suit brought against an insured. This Section addresses the right to direct or manage the defense of a covered suit or other legal action. The insurer’s duty to defend a covered legal action is addressed in 13.

1. b. The right to defend in the full-coverage case. The right to defend gives the insurer control over the defense of a legal action for which the insured seeks coverage, including the activities of the defense lawyer. The right to defend creates a relationship among the insurer, defense counsel, and the insured that is unproblematic and routine in the case of an ordinary liability action in which there is adequate insurance for the potential damages. In that full-coverage case, the insurer faces substantially all of the important legal risks posed by the action. As a result, the insurer has an incentive to provide a defense that is commensurate with the legal risks presented by the legal action. Indeed, precisely because the insured has shifted those legal risks to the insurer, liability insurance law and practice developed the duty to cooperate, which discourages insureds from abandoning their critical role in the defense of the action. An additional reason for assigning control over the defense to the insurer is that insurers have greater capacity to direct the defense of a legal action than all but the most sophisticated insureds. In the vast majority of cases insurance companies manage legal actions brought against their policyholders, and the insurer’s right and duty to defend do not present any problems. This Chapter addresses rules that are needed primarily in the minority of cases in which there is a potential for uninsured liability.

1. c. The right to defend when there is a substantial potential for uninsured liability. When the insurer does not bear all the risks presented by a suit or other legal action that it has the duty to defend, an unlimited right to defend can become problematic. Insureds bear the risks presented by a legal action for three possible reasons: (1) the plaintiff seeks damages in excess of the applicable limits of the insurance policy, (2) there is a possibility that some or all of the damages may be excluded from coverage, or (3) the insured faces some other kind of risk that is not covered by the liability insurance policy, such as damage to reputation or criminal liability. In such cases, the interests of the insured and insurer may diverge. In some cases, as addressed in 16, the divergence may lead to a conflict of interest that is sufficiently acute that the insurer no longer has the right to defend, but rather must provide the insured an independent defense. In most cases, however, the insurer retains the right to defend, and liability insurance law manages the divergence of interests through the rules governing the insurer’s duty to defend, the duty of good faith and fair dealing, and the rule that obligates insurers to retain counsel on terms that comply with the law governing lawyers. See generally Restatement Third, The Law Governing Lawyers.

1. d. Except as limited by law. Limits on the insurer’s right to receive information from defense counsel include the rule stated in 11, pursuant to which an insurer does not have the right to receive any information of the insured that is protected by attorney–client privilege, work-product immunity, or a defense lawyer’s duty of confidentiality under rules of professional conduct, if that information could be used to advantage the insurer at the expense of the insured.

1. e. Legal action. The term “legal action” is used in this Section and elsewhere in this Chapter as a general term that refers to a demand for redress of the kind that fits within the usual framework of insured liabilities. Which legal actions are insured under any particular liability insurance policy and when an insurer’s obligation to defend that legal action begins are defined by that policy. See 13, Comment f (regarding the “suit” requirement).

Reporters’ Note

4. Relationship to duty to defend.The majority of courts agree that the duty to defend provides the insurer with the right to direct all activities of the defense. See 1 ROBERT P. REDEMANN&MICHAEL F. SMITH, LAW AND PRACTICE OF INSURANCE COVERAGE LITIGATION § 4.9 (West 2017) (“The duty to defend gives the insurer the right to control the conduct of the litigation.”). See also Cont’l Cas. Co. v. City of Jacksonville, 550 F. Supp. 2d 1312, 1342 (M.D. Fla. 2007) (applying Florida law) (citation omitted) (“[N]ot only does an insurer have a contractual duty to defend an insured, but as a corollary, the insurer has a contractual right to defend.”); Long v. Century Indem. Co., 163 Cal. App. 4th 1460, 1468 (2008) (citations omitted) (“Generally, an insurer owing a duty to defend an insured … ‘has the right to control defense and settlement of the third party action against its insured ….’”); Safeco Ins. Co. of Am. v. Butler, 823 P.2d 499, 504 (Wash. 1992) (“The insurer’s duty to defend the insured is one of the main benefits of the insurance contract.”) (citing R. Long, 1A The Law of Liability Insurance § 5B.15 at 5B-143 (1990)). Scholarship also suggests that this is the majority rule. See Robert H. Jerry, II, Consent, Contract, and the Responsibilities of Insurance Defense Counsel, 4 CONN. INS. L.J. 153, 174–175 (1997–1998) (noting that the principle that insurance companies are entitled to control the defense of the insured “appears to have near-universal acceptance”). Insureds often purchase insurance for defense coverage as well as indemnity coverage. See 3 SETH D. LAMDEN, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 17.01[1][a] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017) (“Many insureds purchase liability insurance for the peace of mind that comes with knowing that their insurer will defend them if they are sued in an action that comes within the scope of protection provided by their policy.”). See also Montrose Chem. Corp. v. Super. Ct., 861 P.2d 1153, 1157 (Cal. 1993) (“The insured’s desire to secure the right to call on the insurer’s superior resources for the defense of third party claims is, in all likelihood, typically as significant a motive for purchase of insurance as is the wish to obtain indemnity for possible liability.”). In addition to having greater financial resources, “[i]nsurers have more expertise than most insureds in managing litigation.” William T. Barker, Insurer Control of Defense: Reservations of Rights and Right to Independent Counsel, 71 DEF. COUNS. J. 16, 16 (2004).

1. The right to defend in the full-coverage case.A “full-coverage case” is one involving an ordinary liability action in which there is adequate insurance for the potential damages. In such a full-coverage case, “[e]xercise of virtually complete control of the defense for an insured has been viewed as an appropriate approach because of the insurer’s financial interest in the resolution of the claims.” Alan I. Widiss, Abrogating the Right and Duty of Liability Insurers to Defend their Insureds: The Case for Separating the Obligation to Indemnify from the Defense of Insureds, 51 OHIO ST. L.J. 917, 918 (1990). See, e.g., Ottaviano v. Genex Coop., Inc., 15 A.D.3d 924, 924 (N.Y. App. Div. 2005) (“As a general rule, a liability insurer has a right to control the defense of underlying litigation against its insured based on the right of the insurer to protect its financial interests.”). See William T. Barker, Insurer Control of the Defense: Reservations of Rights and the Right to Independent Counsel, 71 DEF. COUNS. J. 16, 16 (“[Insurers] have stronger, more immediate incentives to manage litigation efficiently than would insureds who expect their insurers to pay defense counsel’s bills.”); James M. Fischer, Insurer or Policyholder Control of the Defense and the Duty to Fund Settlements, 2 NEV. L.J. 1, 1 (2002) (“Control by the insurer is so pervasive that for claims that are likely to be resolved within the policy limits of the insurance contract the policyholder is often treated as a mere bystander to the resolution of the underlying claim.”). For a discussion of the uncomplicated insurer–insured relationship arising from the “ordinary case,” see Charles Silver & Kent Syverud, The Professional Responsibilities of Insurance Defense Lawyers, 45 DUKE L.J. 255, 293–296 (1995). The insurer’s right to control the defense “entitles the insurer to select and direct defense counsel.” James M. Fischer, Insurer or Policyholder Control of the Defense and the Duty to Fund Settlements, 2 NEV. L.J. 1, 1 (2002). Because the “vast bulk of cases defended by insurers are fully covered,” allowing insurers plenary control of the defense “works well for insureds. Typically they have no interest in how a suit is defended, so long as the insurer pays any resulting judgment or settlement.” William T. Barker, Insurer Control of Defense: Reservations of Rights and Right to Independent Counsel, 71 DEF. COUNS. J. 16, 17 (2004).

1. The right to defend when there is a substantial potential for uninsured liability.For a discussion of the ways in which the possibility of uninsured liability affects incentives and alters the relationship between insurer and insured, see Tom Baker, Liability Insurance Conflicts and Defense Lawyers: From Triangles to Tetrahedrons, 4 CONN. INS. L.J. 101, 107–109 (1997–1998). Conflicts of interest typically complicate the insurer’s duty to defend in three circumstances. See generally Douglas R. Richmond, Lost in the Eternal Triangle of Insurance Defense Ethics, 9 GEO. J. LEGAL ETHICS 475 (1996) (discussing the common situations in which conflicts of interest may arise). First, “situations where the complaint contains certain claims that fall within the policy’s coverage and others that fall outside the scope of coverage … can lead to a conflict of interest between the insured and the insurer.” 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 200:1 (3d ed. 2017). See, e.g., Maryland Cas. Co. v. Peppers, 355 N.E.2d 24, 30 (Ill. 1976) (discussing the conflicting incentives for the insurer and the insured when the underlying complaint alleged both negligence, which would be covered, and intentional injury, which would not). See also Todd R. Smyth, Annotation, Duty of Insurer to Pay for Independent Counsel When Conflict of Interest Exists Between Insured and Insurer, 50 A.L.R.4th 932§ 2[a] (Originally published in 1986) (“Many conflict of interests cases arise in the situation where the complaint filed against the insured contains allegations which are potentially within and outside policy coverage.”). Second, “a conflict of interest between the insured and the insurer may arise … where the complaint seeks damages in excess of the policy limits.” Id. See, e.g., Golden Eagle Ins. Co. v. Foremost Ins. Co., 20 Cal. App. 4th 1372, 1394 (1993) (finding the insurer had created a conflict of interest by “pursuing a settlement … in excess of the insurers’ alleged policy limits.”). Finally, litigation may impose risks on insureds entirely unrelated to their liability policy, such as reputation damage or criminal exposure. See Douglas R. Richmond, 9 GEO. J. LEGAL ETHICS at 510 (“A professional’s reputation may be damaged by malpractice allegations. A professional’s reputation also exists wholly independent of any insurance coverage.”).

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 11 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 1. Defense

• 11 Confidentiality

^Comment:

^{Reporters’ Note}

• (1) An insurer or insured does not waive rights of confidentiality with respect to third parties by providing to the insured or the insurer, within the context of the investigation and defense of a legal action, information protected by attorney–client privilege, work-product immunity, or other confidentiality protections.
• (2) An insurer does not have the right to receive any information of the insured that is protected by attorney–client privilege, work-product immunity, or a defense lawyer’s duty of confidentiality under rules of professional conduct, if that information could be used to benefit the insurer at the expense of the insured.

Comment:

1. a. Confidentiality of information. An effective defense of an insured or potentially insured legal action requires the insurer, the insured, the defense lawyer, and their agents to share information on a confidential basis in a manner that is protected from disclosure to the claimant and other parties outside of the insurer–intermediary–insured relationship. All these parties share a common interest in protecting the insured from the action. Moreover, insurance policies should properly be regarded as appointing insurers, including non-defending insurers, as the insured’s agents for purposes of defending or considering whether to settle the legal action. With regard to parties outside of that liability insurance relationship, the confidentiality protection for information disclosed within that relationship should be as strong as if the parties to that relationship were a single entity. The scope of the information so protected is very broad. It includes information protected by attorney–client privilege, work-product immunity, and defense lawyers’ duty of confidentiality under rules of professional conduct. The non-waiver rule stated in subsection (1) applies whenever the information is provided to the insured or the insurer, including but not limited to the provision of information pursuant to the right to defend, the duty to defend, the right to associate, and the duty to cooperate. The non-waiver rule also applies when the insured or the insurer provides the information to an intermediary such as a broker or claims administrator.

• Illustrations:

1. Insured is sued in a slip-and-fall case in which the insured’s knowledge of a dangerous condition is an important fact in dispute. Insurer hires a defense lawyer to defend the insured. In a private meeting, the insured informs the defense lawyer that the insured had been aware of the dangerous condition. The defense lawyer provides that information to the insurer. The provision of that information to the insurer does not waive the confidentiality of that information with respect to the plaintiff in the underlying tort action.

2. Insured child is sued for property damage arising out of a fire allegedly started by the child at school. Insurer hires a defense lawyer to defend the insured. During a private meeting with the child and the child’s parents, the attorney obtains information indicating that the child may have intentionally set the fire for the purpose of damaging the school. The defense lawyer provides this information to the insurer without the consent of the child or the parents. That information is relevant to a potential coverage dispute between the insured and insurer and should not have been disclosed to the insurer under the circumstances. Nevertheless, the provision of that information to the insurer does not waive the confidentiality of that information with respect to the plaintiff in the underlying tort action.

1. b. Information shared with non-defending insurers. An insurer providing a defense should come within the scope of the insured’s confidentiality protections as an agent of the insured. An insurer that is not providing a defense should also be regarded as an agent of the insured for purposes of receiving confidential information related to the legal action, because the insurer may subsequently be called upon to pay a settlement or a judgment on behalf of the insured or, in some cases, even to take over the defense on behalf of the insured. A non-defending insurer should also come within the scope of the common-interest rule, pursuant to which disclosure of privileged information by parties with a common interest is protected as against third persons, with the caveat that some authorities require that both parties be represented by counsel with respect to the matter.

1. c. A note of caution. The rule stated in this Section is not universally followed. There are courts that have required the use of certain documentary formalities, such as the express appointment of the insurer as the insured’s communicating agent for purposes of managing the dispute or as the insured’s co-client under a common-interest arrangement in which the parties are represented by counsel. Such formalities may be particularly important in the case of a non-defending insurer. Even when such formalities are observed, there may be some risk that disclosure will waive a privilege or immunity, and that risk is greater when an insurer has not unequivocally accepted coverage for the claim.

1. d. No right to confidential information that could benefit the insurer at the expense of the insured. The rule stated in subsection (2) is an insurance-law rule that is complementary to the rules stated in the Restatement Third, The Law Governing Lawyers, which expressly declines to address the law governing the relationship between insurer and insured. See Restatement Third, The Law Governing Lawyers § 134, Comment a. Rules governing lawyers’ professional obligations are outside the scope of this Restatement. Under the rule stated in subsection (2), the insurer’s right to defend does not include the right to receive confidential information from the defense lawyer that could harm the insured with regard to a matter that is in dispute, or potentially in dispute, between the insurer and insured. See Restatement Third, The Law Governing Lawyers § 59 (defining confidential client information). This rule reduces the likelihood that a defense lawyer will be placed in a situation in which the lawyer has conflicting obligations to the insured and the insurer, and it reduces the concern that an insurer can use its control over the defense to further its own interests at the expense of the insured.

Section 14(1)(b) places a corresponding obligation on the insurer to require defense counsel to protect from disclosure to the insurer any information of the insured that is protected by attorney–client privilege, work-product immunity, or a defense lawyer’s duty of confidentiality under rules of professional conduct, if that information could be used to benefit the insurer at the expense of the insured. In practice, the application of this rule places a burden on defense counsel to use judgment in determining when to obtain the insured’s consent before providing information to the insurer. This burden extends only to information that counsel knows or should know may benefit the insurer at the expense of the insured. If a reservation-of-rights letter provided pursuant to § 15 is also provided to defense counsel, that letter will inform counsel of known grounds for contesting coverage, and thus identify matters in which the insurer and the insured’s interests are in conflict. It is also possible, however, that the defense lawyer may learn of facts that are relevant to different potential grounds for contesting coverage. Counsel may always provide confidential information to the insurer with the informed consent of the insured. See Restatement Third, The Law Governing Lawyers § 134, Comment e (noting that the consent must meet the requirements of § 62 of that Restatement). Thus, if there is confidential information that counsel believes, on balance, would be in the interests of the insured to provide to the insurer, even though there is some risk that it may be used to benefit the insurer at the expense of the insured, counsel may provide it to the insurer as long as the insured provides informed consent.

• Illustrations:

3. Insured child is sued for property damage arising out of a fire allegedly started by the child at school. Insurer hires a defense lawyer to defend the insured. During a private meeting with the child and the child’s parents, the attorney obtains information indicating that the child may have intentionally set the fire for the purpose of damaging the school. Because such information could lead the insurer to refuse to pay the claim based on an exclusion for intentional harm in the liability insurance policy and because the information is protected by attorney–client privilege, the insurer does not have the right to this information from the defense lawyer.

4. Insured child is sued for property damage arising out of a fire allegedly started by the child at school. Insurer hires a defense lawyer to defend the insured. During a deposition, the child provides testimony indicating that the child may have intentionally set the fire for the purpose of damaging the school. Upon request, the insurer has the right to a copy of the transcript of the deposition, even though the testimony could lead the insurer to refuse to cover the suit, because deposition testimony is not confidential.

Reporters’ Note

1. Confidentiality of information.The usual case—in which the insurer bears all the judgment risk, accepts coverage, appoints defense counsel, and directs the defense—should not present the kinds of confidentiality problems addressed in the cautionary note to this Section, because there is no basis for disputing the status of the insurer as the insured’s agent for managing the claim nor the common interest of the insurer and insured with respect to the information. See Restatement Third, The Law Governing Lawyers § 70, Comment f (AM. LAW INST. 2000):

The privilege applies to communications to and from the client disclosed to persons who hire the lawyer as an incident of the lawyer’s engagement. Thus, the privilege covers communications by a client-insured to an insurance-company investigator who is to convey the facts to the client’s lawyer designated by the insurer, as well as communications from the lawyer for the insured to the insurer in providing a progress report or discussing litigation strategy or settlement (see § 134, Comment f). Such situations must be distinguished from communications by an insured to an insurance investigator who will report to the company, to which the privilege does not apply.

The problems primarily arise, like almost all problems relating to the defense and settlement of legal actions, when the insurer does not bear all of the judgment risk. This Section states that the same non-waiver rules should apply in all such cases and, under existing law the same rules probably would apply in such cases in most jurisdictions, but, as reported in the Note to Comment c below, there is some authority to the contrary. For a recent case finding non-waiver in the context of information provided by an insurer to an insured, see State ex rel. Montpelier U.S. Ins. Co. v. Bloom, 757 S.E.2d 788, 798 (W. Va. 2014) (finding no waiver when the insurer provided a copy of a coverage opinion letter to its insured).

1. Information shared with non-defending insurers.See, e.g., Exxon Corp. v. St. Paul Fire & Marine Ins., 903 F. Supp. 1007, 1010 (E.D. La. 1995) (applying Louisiana law) (“Because of the nature of the relationship between an insured and an insurer, including excess insurers, the Court refuses to hold that [excess insurer’s] communication of a clearly privileged document to an excess insurer on behalf of the insured constitutes a waiver of the attorney–client privilege. Excess insurers are not disinterested third parties but entities who have a contractual relationship with the insured and whose interests—in most cases—are the same.”). For authority limiting the common-interest rule to information provided to attorneys, see, e.g., In re Teleglobe Commc’ns Corp., 493 F.3d 345, 363–364 (3d Cir. 2007) (applying Delaware law) (holding under Delaware law that the common-interest exception applies only to attorneys sharing privileged information, not clients); In re XL Specialty Ins. Co., 373 S.W.3d 46, 55 (Tex. 2012) (holding that the attorney–client privilege was lost when the information was provided directly to an unrepresented employer in the situation of a non-defending insurer). Because insurers commonly use non-lawyer personnel to track the developments of cases in which they have an interest but are not defending, this approach to the common-interest exception would not provide the necessary confidentiality protection in such cases. For that reason, the Comment also grounds the confidentiality protection in the (limited) agency relationship, not exclusively in the common-interest exception. As reflected in the Reporter’s Note to Restatement Third, The Law Governing Lawyers § 70, Comment f (AM. LAW INST. 2000), there is significantly greater risk when providing the information to a non-lawyer employee. Accordingly, many insurers have a practice of employing monitoring counsel for this purpose.

1. A note of caution.See, e.g., Cont’l Cas. Co. v. St. Paul Surplus Lines Ins. Co., 265 F.R.D. 510, 525 (E.D. Cal. 2010) (applying California law) (declining to protect communications between insured’s defense lawyer and a non-defending insurer that had issued a reservation of rights); In re Imperial Corp. of Am., 167 F.R.D. 447 (S.D. Cal. 1995) (applying California law) (letters sent by defense attorney to D&O insurer that had reserved rights were a waiver of the work-product immunity), aff’d on other grounds, 92 F.3d 1503 (9th Cir. 1996). See generally John P. Ludington, Annotation, Insured-Insurer Communications as Privileged, 55 A.L.R.4th 336 1[a] (Originally published in 1987) (collecting and discussing cases); John Buchanan & Wendy Feng, Protecting Privilege While Preserving Coverage, A.B.A. SEC. LITIGATION: INSURANCE COVERAGE, Mar. 8, 2012, available at http://apps.americanbar.org/litigation/committees/insurance/articles/janfeb2012-protecting-privilege.html (last visited Feb. 12, 2019) (discussing the preservation of privilege when the insured retains independent counsel).

1. No right to confidential information that could benefit the insurer at the expense of the insured. Numerous jurisdictions have held that “the cooperation clause in the insurance policies does not operate to override … the attorney client privilege,” and that insurers are therefore not entitled to protected information shared by the insured with counsel. E. Air Lines, Inc. v. U.S. Aviation Underwriters, Inc., 716 So. 2d 340, 343 (Fla. Dist. Ct. App. 1998). See, e.g., Remington Arms Co. v. Liberty Mut. Ins. Co., 142 F.R.D. 408, 419–420 (D. Del. 1992) (applying Connecticut law) (holding that the insurer could not compel discovery of certain documents because they were protected by attorney–client privilege and likewise not discoverable under work-product doctrine); Rockwell Int’l Corp. v. Super. Ct., 32 Cal. Rptr. 2d 153, 159 (Ct. App. 1994) (“[W]e refuse to read into the cooperation clause an unintended implied waiver of the attorney client privilege.”). See also John Buchanan & Wendy Feng, Protecting Privilege While Preserving Coverage, A.B.A. SEC. LITIGATION: INSURANCE COVERAGE, Mar. 8, 2012, available at http://apps.americanbar.org/litigation/committees/insurance/articles/janfeb2012-protecting-privilege.html (last visited Feb. 12, 2019) (discussing disclosure obligations of insurance defense counsel). Nevertheless, courts and commentators have reached divergent conclusions on the insurer’s right to protected information. Compare Indep. Petrochemical Corp. v. Aetna Cas. & Sur. Co., 654 F. Supp. 1334, 1365 (D.D.C. 1986) (applying Missouri law) (observing that “communications between an insured and its attorney connected with the defense of underlying litigation are normally not privileged vis-à-vis the insured’s carriers in subsequent litigation”), on reconsideration, 672 F. Supp. 1 (D.D.C. 1986), aff’d, 944 F.2d 940 (D.C. Cir. 1991); Trau-Med of Am., Inc. v. Allstate Ins. Co., 71 S.W.3d 691, 697 (Tenn. 2002) (stating that “the employment of the attorney by the insurer does not impose upon that attorney any duty or [sic] loyalty to the insurer that could impair the attorney–client relationship between the attorney and the insured”); Charles Silver & Kent Syverud, The Professional Responsibilities of Insurance Defense Lawyers, 45 DUKE L.J. 255, 343–348 (1996) (stating that the insurer has the right to information but not obligating the lawyer to provide it). Illustrations 2, 3, and 4 are modeled on Parsons v. Cont’l Nat’l Am. Grp., 550 P.2d 94 (Ariz. 1976). For further discussion of the responsibilities of insurance defense counsel when a conflict of interest exists, see KENNETH S. ABRAHAM, INSURANCE LAW AND REGULATION 587 (6th ed. 2015).

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 12 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 1. Defense

• 12 Liability of Insurer for Conduct of Defense

^Comment:

^{Reporters’ Note}

^{Case Citations - by Jurisdiction}

• (1) If an insurer undertakes to select counsel to defend a legal action against the insured and fails to take reasonable care in so doing, the insurer is subject to liability for the harm caused by any subsequent negligent act or omission of the selected counsel that is within the scope of the risk that made the selection of counsel unreasonable.
• (2) An insurer is subject to liability for the harm caused by the negligent act or omission of counsel provided by the insurer to defend a legal action when the insurer directs the conduct of the counsel with respect to the negligent act or omission in a manner that overrides the duty of the counsel to exercise independent professional judgment.

Comment:

1. a. Insurer liability for the conduct of defense. When a defense counsel selected by an insurer to represent an insured commits professional malpractice, the insured may recover from that attorney for any harm that results, subject to meeting the standard elements of a tort claim for professional malpractice. Under the rule stated in this Section, an insured may also seek recovery in tort for harms caused by that malpractice from the liability insurer in two limited sets of circumstances.

16. b. Insurer liability for negligent selection of defense counsel. Under subsection (1), a liability insurer can become subject to liability for the negligence of defense counsel if the insurer fails to exercise reasonable care in selecting defense counsel. An insurer has a duty to select defense counsel when the insurance policy obligates it to do so, provided that the insurer has not been relieved of that duty because of a conflict of interest addressed in 16. The insurer breaches that duty when it fails to take reasonable care in selecting the attorney who will provide the insured with a defense. What constitutes negligence in the selection of defense counsel is a fact-specific question that turns on the insurer’s efforts to assure that the lawyer has adequate skill and experience in relation to the claim in question. The insurer is not subject to liability for all wrongful acts of the selected counsel, but rather only for acts or omissions within the scope of the risk that made the selection of counsel unreasonable.

• Illustrations:

1. A tort action arising out of an auto accident is brought against Jane; the claims asserted in the action are covered under a duty-to-defend liability insurance policy issued by Insurer. Insurer selects defense counsel to represent Jane. Insurer’s claims personnel are aware that defense counsel has regular, substantial periods of unreliability in his trial practice. For example, defense lawyer is known for missing court appearances without excuse and for committing malpractice during trials. In the auto-accident suit brought against Jane, defense counsel commits malpractice at trial, leading to a verdict in excess of the insurance policy limit. Insurer is subject to liability for the amount by which Jane proves that the damages award was increased by defense counsel’s malpractice, to the extent that amount exceeds the policy limits.

2. A tort action arising out of an auto accident is brought against Jane; the claims asserted in the action are covered under a duty-to-defend liability insurance policy issued by Insurer. Insurer selects defense counsel to represent Jane. Insurer’s claims personnel are aware that defense counsel has regular, substantial periods of unreliability in his trial practice. For example, defense lawyer is known for missing court appearances without excuse and for committing malpractice during trials. In the auto-accident suit brought against Jane, despite defense lawyer’s reasonable efforts, which meet the standards of the legal profession, there is a plaintiff’s verdict in an amount in excess of the policy limits. Insurer is not subject to liability under the rules stated in this Section because defense counsel did not breach the standard of care. Whether the insurer may be subject to liability because of a breach of the duty to make reasonable settlement decisions is beyond the scope of this Illustration.

3. A tort action arising out of an auto accident is brought against Jane; the claims asserted in the action are covered under a duty-to-defend liability insurance policy issued by Insurer. Insurer selects defense counsel to represent Jane. Insurer’s claims personnel are aware that defense counsel has regularly missed filing deadlines in his litigation practice, causing prejudice to his clients, although counsel is otherwise a skilled practitioner. For reasons that are unrelated to the missing of any filing deadlines, defense counsel commits malpractice that leads to a verdict in excess of the policy limit. Specifically, defense counsel fails to call an expert to rebut the testimony of claimant’s expert. Insurer is not subject to liability for the amount that the damages award was increased by the malpractice, because malpractice that is unrelated to the missing of filing deadlines is not within the scope of the risks that made the insurer’s conduct unreasonable. Whether the insurer may be subject to liability because of a breach of the duty to make reasonable settlement decisions is beyond the scope of this Illustration.

1. c. Retaining defense counsel with inadequate professional liability insurance. One important way that a liability insurer protects its insureds is by requiring insurance defense counsel to demonstrate that they have purchased a reasonable amount of liability insurance. This common practice ensures that policyholders have recourse in the event that counsel commits malpractice in the course of the defense of an insured claim. See Comment e (explaining that the ability of insurers to protect policyholders by ensuring the defense counsel has adequate liability insurance is an important policy reason for rejecting the special insurance-law vicarious-liability rule recognized in some jurisdictions).

Accordingly, a court could find that an insurer’s decision to select defense counsel who does not have adequate liability insurance constitutes a form of negligent selection under subsection (1), on the grounds that it is foreseeable that the insured could be harmed by defense counsel’s lack of adequate professional-liability insurance and it is not unduly burdensome for the insurer to arrange its defense-counsel-retention procedures in a manner that ensures that defense counsel has adequate liability insurance. Nevertheless, this Restatement takes no position on this issue, because no court has yet addressed it, perhaps because liability insurers generally select defense counsel with adequate liability insurance or because insureds obtain redress through actions predicated on a breach of the duty to defend.

134. d. Insurer liability when overriding the duty of the defense counsel to exercise independent judgment. Under subsection (2), the insurer is subject to liability for harm caused by the negligence of defense counsel if the insurer has acted to override the defense counsel’s independent professional judgment and directed defense counsel to act, or fail to act, in a manner that breached the professional standard of care and caused harm to the insured. In general, a defense counsel who is retained by a liability insurer to defend a legal action brought against an insured owes a duty to that insured to take reasonable care in representing the insured’s interests as well as a duty to exercise independent professional judgment in that representation. See Restatement Third, The Law Governing Lawyers § 134. Because of this professional obligation, most courts have not applied general principles of agency and tort law—such as the doctrines of actual or apparent authority or the related doctrine of respondeat superior—to impose vicarious or direct liability on insurers for the professional malpractice of defense counsel. If an insurer takes steps to overrule the professional judgment of defense counsel, however, substituting its own judgment for that of defense counsel, then the insurer can be subject to liability if the result is a breach of defense counsel’s duty of reasonable care owed to the insured.

1. e. The vicarious-liability rule rejected. Some jurisdictions have adopted a vicarious-liability rule making an insurer liable for the actions of defense counsel. Reasons that might justify this vicarious-liability rule include the loss-prevention and loss-spreading justifications for tort liability more generally: insurers are in a better position than insureds to select and monitor the actions of defense lawyers and thereby prevent losses and to shift or spread the risk of those losses that do occur. While those reasons are valid as between insurers and insureds, defense counsel ordinarily is in a better position than an insurer to prevent losses from counsel’s own negligence. In addition, if defense counsel maintains adequate liability insurance, defense counsel is in just as good a position as the insurer to spread the risk of those losses that do occur. Thus, if liability insurers ensure that their chosen defense counsel have adequate liability insurance to cover the consequences of malpractice, there is no need for that vicarious-liability rule. This Section declines to follow the vicarious-liability rule because liability insurers’ practice of retaining counsel with adequate liability insurance, discussed in Comment c, adequately addresses the loss-spreading function of that rule.

• Illustrations:

4. A tort action arising out of an auto accident is brought against Jane; the claims asserted in the action are covered under a duty-to-defend liability insurance policy issued by Insurer. Insurer selects defense counsel to represent Jane. In preparation of the case for trial, it is counsel’s professional opinion that the defense should demand an independent medical examination and retain expert witnesses to challenge the plaintiff’s damages claim. Insurer refuses to authorize these expenses. Defense counsel informs the insurer that, in her professional judgment, both measures are standard practice in a case such as this and particularly necessary in this case. Insurer directs counsel not to incur these expenses. Fearing the loss of future business from Insurer, counsel agrees not to incur these expenses. The trial results in a verdict for the plaintiff in excess of the limits of the policy. Assuming that the failure to conduct the independent medical examination and to retain expert witnesses on damages was negligence in this case, insurer is subject to liability for the amount by which Jane proves that the damages award was increased as a result, to the extent that amount exceeds the policy limits.

5. Same facts as Illustration 4, except that the defense counsel independently chose not to conduct an independent medical examination or to retain the damages experts without consulting with the insurance company. The insurer is not subject to liability.

Reporters’ Note

1. Insurer liability for the conduct of defense.For a statement of the basic rule that lawyers are liable for the economic harms that they negligently cause their clients in the performance of their professional obligations to those clients, see generally Restatement Third, Torts: Liability for Economic Harm § 4 (AM. LAW INST., Tentative Draft No. 1, 2012; official text expected in 2019) (“A professional is subject to liability in tort for economic loss caused by the negligent performance of an undertaking to serve a client.”).

1. Insurer liability for negligent selection of defense counsel.As a general matter in the law of torts, an actor who hires an independent contractor to perform the original actor’s duty may be held liable for negligently selecting the independent contractor, when the negligent selection causes harm. See Restatement Third, Torts: Liability for Physical and Emotional Harm § 55 (AM. LAW INST. 2012). This rule, however, is limited in its application by the principle disfavoring tort-law liability for purely economic harm, particularly when such harm arises from a contractual relationship. See id. at Introduction (AM. LAW INST. 2010) (noting that Restatement does not address liability for economic loss); Restatement Third, Torts: Liability for Economic Harm § 1, Comment c(2) (AM. LAW INST., Tentative Draft No. 1, 2012; official text expected in 2019) (“[C]ourts generally do not recognize tort liability for economic losses caused by the breach of a contract between the parties ….”); id. § 3 (“Except as provided elsewhere in this Restatement, there is no liability in tort for economic loss caused by negligence in the performance … of a contract between the parties.”). As stated in § 13 of this Restatement, the duty to defend is contractual. Many courts have observed that this duty entails an obligation on the insurer to select competent and qualified counsel. See, e.g., R.C. Wegman Constr. Co. v. Admiral Ins. Co., 629 F.3d 724, 728 (7th Cir. 2011) (stating that insurer’s duty to defend includes “the hiring of competent counsel” (quoting 4 Couch on Insurance § 202:17 (3d ed. 2007))); Merritt v. Reserve Ins. Co., 34 Cal. App. 3d 858, 882 (1973) (under insurance policy, insurer assumed duty to “employ competent counsel to represent the assured”); Aetna Cas. & Sur. Co. v. Protective Nat’l Ins. Co. of Omaha, 631 So. 2d 305, 306 (Fla. Dist. Ct. App. 1994) (stating that insurer “is contractually bound to provide a qualified and competent attorney for the insured”). Thus, under the rule stated in § 48 and § 19, Comment c of this Restatement, an insured may seek damages from the insurer under a breach-of-contract theory based on the insurer’s selection of incompetent or unqualified counsel to defend its insured.

In addition to the availability of contractual remedies, this Section states that an insured may seek remedies in tort based on an insurer’s negligent selection of defense counsel. The availability of a tort-law cause of action for negligent selection is supported by several considerations. First, an insurer does not face indeterminate or disproportionate liability for harm caused to its insured by the malpractice of selected counsel; the scope of liability will be predictably limited to harms flowing from the negligent selection of counsel, through counsel’s malpractice. See Restatement Third, Torts: Liability for Economic Harm § 1, Comment c(1) (AM. LAW INST., Tentative Draft No. 1, 2012; official text expected in 2019) (observing that the risk of indeterminate or disproportionate liability is one reason why the law tends against creating tort liability for economic harms); id. § 1, Comment d(1) (stating that tort liability for professional negligence is an exception to the law’s general deference to contract, because professionals sued for malpractice are “not likely to face an unusual risk of indeterminate or disproportionate liability”). Indeed, because the insurer is liable only for harm caused by a negligent act or omission of counsel that is within the scope of the risk that made the selection of counsel unreasonable, the potential for insurer liability under the rule of this Section is significantly narrower than under a rule providing for vicarious liability for any malpractice committed by the selected counsel. See Comment e; see also Progressive N.W. Ins. Co. v. Gant, Case No. 15-9267-JAR-KGG, 2018 WL 4600716, at *6 (D. Kan. Sept. 24, 2018) (applying scope-of-the-risk principle stated in this Section to conclude that insurer could not be held liable for alleged malpractice of counsel). Second, there is little reason to expect that the allocation of risk embodied in an insurance policy’s duty-to-defend provisions would be preferable to the allocation resulting from the application of tort-law principles. See Restatement Third, Torts: Liability for Economic Harm § 1, Comment d(1) (AM. LAW INST., Tentative Draft No. 1, 2012; official text expected in 2019); id. § 4, Comment a. In many if not most cases, the scope of liability under the rule stated in this Section will mirror liability under a breach-of-contract theory. In some cases on the margins, however, the availability of a tort-law cause of action will appropriately place risk on the party best positioned to avoid it, namely the insurer, by ensuring a remedy for an insured who is harmed by defense counsel’s malpractice. The rule thus reinforces the importance of the duty-to-defend by creating an added incentive to select competent and qualified counsel. Third, insurers are highly regulated entities expected to make complex judgments in the course of discharging their contractual duty to defend, and policyholders generally cannot bargain in advance for particular results in connection with an insurer’s defense of a legal action, but instead must rely on the insurer’s judgment and expertise. Thus, many of the factors supporting the availability of a tort cause of action for professional negligence also are present in the contractual relationship between insured and insurer with respect to the duty to defend. See Restatement Third, Torts: Liability for Economic Harm § 4, Comments a and b (AM. LAW INST., Tentative Draft No. 1, 2012; official text expected in 2019). Although there are no judicial decisions that have held an insurer liable in tort for negligent selection of counsel, some courts have suggested the possibility of such a cause of action. See Brown v. Lumbermens Mut. Cas. Co., 369 S.E.2d 367, 372 (N.C. Ct. App. 1988) (rejecting vicarious insurer liability for negligence of appointed attorney but implying the possibility of negligent-selection cause of action); Evans v. Steinberg, 699 P.2d 797, 799 (Wash. Ct. App. 1985) (recognizing potential negligence action in selecting counsel). See also Hackman v. W. Agric. Ins. Co., 275 P.3d 73, at *16–17 (Kan. Ct. App. 2013) (unpublished disposition) (limiting liability under broader vicarious-liability rule adopted in Pac. Emp’rs Ins. Co. v. P.B. Hoidale Co., 789 F. Supp. 1117, 1122 (D. Kan. 1992) to circumstances that are congruent with the rule in this Section); Progressive N.W. Ins. Co. v. Gant, Case No. 15-9267-JAR-KGG, 2016 WL 4430669, at *4 (D. Kan. Aug. 22, 2016) (citing Hackman as stating Kansas law on this point). As is the case whenever courts must articulate standards of care under a negligence rule, courts applying the negligent-selection-of-counsel rule articulated in this Section will encounter some difficulties. For example, what if a particular attorney that an insurer is considering engaging to provide a defense under one of its policies settled a malpractice claim against her five years earlier? Would the insurer, under the standard set forth in this Section, be considered on notice that the attorney is likely to commit malpractice again? Is the insurer on notice that the attorney is likely to commit malpractice of any sort or only of the sort of which she was previously accused? These are the types of issues that courts will have to resolve. Again, they are not different in kind from the sorts of questions that courts frequently must resolve when applying a negligence standard.

For a general discussion of the circumstances in which liability insurers might be held directly liable for negligently selecting an attorney chosen to represent an insured, see George M. Cohen, Liability of Insurers for Defense Counsel Malpractice, 68 RUTGERS U. L. REV. 119, 129–135 (2015) (“A number of potential direct liability claims could be available to insureds seeking to hold their insurers responsible for the professional misconduct of defense counsel.”). It also should be noted that in circumstances when an insurer is not contractually obligated to provide a defense, yet does so anyway, an insured’s reliance on this defense may trigger a duty on the part of the insurer to exercise reasonable care in selecting defense counsel. See Restatement Third, Torts: Liability for Economic Harm § 6 (AM. LAW INST., Tentative Draft No. 2, 2014; official text expected in 2019) (stating standard for liability for negligent performance of services, when such performance is not pursuant to contractual duty).

Earlier drafts of this Section included Illustrations involving attorneys whose conduct was impaired by substance abuse. The subsequent revision of the Illustrations to remove the references to substance abuse does not represent a judgment by the Institute regarding the implications of retaining an impaired attorney to represent an insured.

1. Retaining defense counsel with inadequate professional liability insurance.Although there are no published cases expressly dealing with a situation in which the liability insurer hires counsel who turns out to have insufficient liability insurance coverage, and as a result is unable to pay a malpractice claim brought by insured against counsel, there is a strong argument that hiring counsel with no or inadequate liability insurance would be inconsistent with what is considered reasonable behavior by insurers within the industry and should therefore constitute a type of negligent retention. The balance of the costs and benefits supports this same conclusion: the benefits to the insured are high because of the importance of having a financially responsible defense lawyer, while the costs to the insurer are low of establishing a procedure for ensuring that defense counsel have adequate liability insurance. Under such a rule, what constitutes adequate liability insurance coverage is a question of fact that turns on factors such as the availability of liability insurance coverage, customary liability insurance purchasing patterns for defense lawyers handling matters of the sort for which the defense is provided, the potential liability of the insured in relation to that legal action, and the policy limits of the liability insurance policy pursuant to which the insurer is providing a defense. Whether the insurer has a continuing duty to monitor that adequate coverage remains in force throughout the term of the defense counsel’s representation of the insured, or whether it is sufficient to assess the adequacy of coverage only at the time that counsel is initially retained, is likewise a factual question of what constitutes reasonable behavior of a liability insurer under the circumstances.

2. Insurer liability when overriding the duty of the defense counsel to exercise independent judgment.It is a longstanding rule of both tort and agency law that an employer is vicariously liable for the torts committed by its employees while acting within the scope of their employment. Restatement Third, Agency § 2.04 (AM. LAW INST. 2006) (“An employer is subject to liability for torts committed by employees while acting within the scope of their employment”); id. § 7.07(1) (same). Likewise, it is a well-accepted proposition of tort and agency law that one who hires an agent that is not an employee can nevertheless be held vicariously liable for the torts committed by that agent if the agent is acting within his or her apparent authority. See Restatement Third, Torts: Liability for Physical and Emotional Harm § 65, Comment b (AM. LAW INST. 2012) (explaining that when an actor contracts to perform services and then hires an independent contractor to perform the services, the hirer is vicariously liable for any negligence of the independent contractor that causes physical harm to the contract promisee, where the promisee accepted the independent contractor’s services in the reasonable belief that the hirer or hirer’s employees were providing the services); Restatement Third, Agency § 7.08 (AM. LAW INST. 2006) (“A principal is subject to vicarious liability for a tort committed by an agent in dealing or communicating with a third party on or purportedly on behalf of the principal when actions taken by the agent with apparent authority constitute the tort or enable the agent to conceal its commission.”). Finally, general principles of tort and agency law provide that a principal can be held liable for the torts of its agent if the principal is negligent in the manner in which it supervises the agent. See Restatement Third, Agency § 7.05 (AM. LAW INST. 2006) (stating that a principal is liable for harm caused by his agent if the harm was caused by the principal’s negligence in supervising the agent). See also Restatement of the Law, Employment Law § 4.04 (AM. LAW INST. 2015) (stating that employer is liable for harm caused by “negligence in selecting, retaining, or supervising employees or agents whose tortious acts resulted in the harm”).

If these general rules of tort and agency law were applied straightforwardly to the liability insurance context—setting aside momentarily the general rule, explained in the Reporters’ Note to Comment b, disfavoring tort-law remedies for purely economic harms, particularly where those harms arise from contractual relationships—the negligence of an attorney hired by an insurer to represent an insured might be expected to be attributed to the insurer in many cases, either under a theory of respondeat superior or under a theory of apparent authority. Moreover, one might expect to find cases involving direct insurer liability for negligent supervision of counsel representing the insured. In fact, however, a thorough research of the case law reveals that insurers are rarely held liable in this way. In fact, with the exception of a few jurisdictions that have adopted a version of vicarious insurer liability (discussed in Comment e), very few cases can be found even hinting at insurer liability for the misconduct of counsel retained on behalf of an insured. See, e.g., Lloyd v. State Farm Mut. Auto. Ins. Co., 860 P.2d 1300, 1301 (Ariz. Ct. App. 1992) (holding “that an insurer’s voluntary assumption of the duty to defend may give rise to a cause of action for derelictions in that defense even when there is no actual coverage.”). Indeed, no cases were found holding a liability insurer liable for the torts of counsel on a theory of apparent authority or negligent supervision.

In addition to the general unavailability of tort-law remedies in economic-harm cases, a main reason for this dearth of cases likely has to do with the special professional obligations owed by attorneys to their clients. Lawyers hired by insurers to represent insureds are not understood to be agents of the insurers. Lawyers in such situations have professional and ethical obligations to represent the interests of the insured whom they are hired to defend, and not the interests of the insurer; and such lawyers are expected, indeed required, to exercise their own independent judgment, even when—perhaps especially when—it is the insurer who pays their bills. This special relationship can be seen, for example, in the Restatement rules forbidding defense counsel from sharing certain information with the insurer, if that information might be used to contest the coverage owed by the insurer to the insured. Because defense counsel are not generally agents of the insurer, vicarious, apparent-authority, and negligent-supervision liability claims would not make sense. If, however, an insurer were to take steps to override the normal professional independence of defense counsel, this prevailing presumption against vicarious and direct liability of the insurer would be overcome.

1. The vicarious-liability rule rejected.A minority of jurisdictions have held that insurers may be held vicariously liable for the wrongful acts of the defense counsel they retain. See Smoot v. State Farm Mut. Auto. Ins. Co., 299 F.2d 525, 530 (5th Cir. 1962) (applying Georgia law) (“Those whom the Insurer selects to execute its promises, whether attorneys, physicians, no less than company-employed adjusters, are its agents for whom it has the customary legal liability.”), continuing vitality called into question by Whiteside v. Infinity Cas. Ins. Co., No. 4:07-CV-87 (CDL), 2008 WL 3456508, at *13–14 (M.D. Ga. Aug. 8, 2008). See also Pac. Employers Ins. Co. v. P.B. Hoidale Co., 789 F. Supp. 1117, 1122 (D. Kan. 1992) (applying Kansas law) (holding that “[a]lthough [the counsel] may have been acting as the agent of [the insured], [he] also represented the interests of [the insurer], the principal who hired him” and thus the counsel’s negligence is attributable to the insurer), scope of holding limited by reading in Hackman v. W. Agric. Ins. Co., 275 P.3d 73, at *16–17 (Kan. Ct. App. 2013) (unpublished disposition) (limiting liability to circumstances that are congruent with the rule in this Section), and Progressive N.W. Ins. Co. v. Gant, Case No. 15-9267-JAR-KGG, 2016 WL 4430669, at *4 (D. Kan. Aug. 22, 2016) (citing Hackman as stating Kansas law on this point); Cont’l Ins. Co. v. Bayless & Roberts, Inc., 608 P.2d 281, 294 (Alaska 1980) (following vicarious-liability theory, in part, because the retained counsel’s “first loyalty was to” the insurer); Stumpf v. Cont’l Cas. Co., 794 P.2d 1228, 1232 (Or. Ct. App. 1990) (“An insurer may be vicariously liable for the actions of its agents, including counsel that it hires to defend its insured.”). Cf. Hartford Accident & Indem. Co. v. Foster, 528 So. 2d 255, 285–286 (Miss. 1988) (“We have no difficulty in holding that where an insurance carrier has employed the defense counsel, who faced with a conflict of interest between the insured and the carrier, breaches his fiduciary duty to the insured by favoring the carrier, the carrier is legally liable along with the attorney for any ensuing damage to the insured.”); Majorowicz v. Allied Mut. Ins. Co., 569 N.W.2d 472, 476–477 (Wis. Ct. App. 1997) (holding insurer vicariously liable for counsel’s failure to properly investigate and evaluate the claim on grounds that the insurer’s duty is nondelegable).

The majority of jurisdictions have rejected insurer vicarious liability for the torts of defense counsel. See, e.g., Kapral v. Geico Indem. Co., 723 F. App’x 768, 770–771, 771 n.1 (11th Cir. 2018) (applying Florida law to hold that insurer is not vicariously liable for the negligence of the attorney it retains to defend the insured, even if counsel is employee of insurer); Merritt v. Reserve Ins. Co., 34 Cal. App. 3d 858, 881–882 (1973) (“Having chosen competent independent counsel to represent the insured in litigation, the carrier may rely upon the trial counsel to conduct the litigation, and the carrier does not become liable for trial counsel’s legal malpractice. If trial counsel negligently conducts the litigation, [the insured’s] remedy for this negligence is found in an action against counsel for malpractice and not in a suit against the counsel’s employer to impose vicarious liability.”); Aetna Cas. & Sur. Co. v. Protective Nat’l Ins. Co. of Omaha, 631 So. 2d 305, 306 (Fla. Dist. Ct. App. 1993) (recognizing that jurisdictions are split on vicarious liability and siding with cases holding that an insurance company is not vicariously liable for malpractice of its defense attorney); Feliberty v. Damon, 527 N.E.2d 261, 265 (N.Y. 1988) (“[G]iven the insurer’s inability to provide or control the legal services in issue, and the existence of a remedy for incompetence against counsel, we conclude that the imposition of vicarious liability in the circumstances is unwarranted”); State Farm Mut. Auto. Ins. Co. v. Traver, 980 S.W.2d 625, 627 (Tex. 1998) (“A defense attorney, as an independent contractor, has discretion regarding the day-to-day details of conducting the defense, and is not subject to the client’s control regarding those details.”). Cf. Restatement Third, Agency § 7.06 (AM. LAW INST. 2006) (stating that the independent-contractor defense does not apply if the defendant owes a direct, nondelegable duty of care to the injured person).

For a summary of the case law on this issue, see George M. Cohen, Liability of Insurers for Defense Counsel Malpractice, 68 RUTGERS U. L. REV. 119, 125–126 (2015) (stating that a majority of courts have rejected vicarious liability and the “clear trend” is in that direction, reporting the count at the time of writing as seven states in favor of vicarious liability and 12 states against). Illustrations: For examples of legal-malpractice cases involving defense counsel’s failure to undertake adequate efforts to challenge a plaintiff’s damages claim, see Transcraft, Inc. v. Galvin, Stalmack, Kirshner & Clark, 39 F.3d 812, 817–818 (7th Cir. 1994) (examining whether defense counsel’s failure to reduce the plaintiff’s claim for compensatory damages should be considered malpractice); Carbis Sales, Inc. v. Eisenberg, 935 A.2d 1236, 1250 (N.J. Super. Ct. App. Div. 2007) (discussing how defense counsel’s malpractice heightened the plaintiff’s verdict).

Case Citations - by Jurisdiction

C.A.10,

C.A.10, 2020. Cit. in sup.; subsecs. (1) and (2) and com. (d) quot. in sup. Widower of motorist killed in a crash entered into a pretrial agreement with driver, parents of driver, and employer of driver, under which driver, parents, and employer assigned widower the policy limits of their insurance policies and their right to pursue claims against their insurer arising from their assigned attorney’s failure to disclose the existence of their excess coverage insurance. Insurer brought a declaratory-judgment action against widower, alleging that widower was not entitled to damages beyond the policy limit, because the conduct of the attorney it assigned to defend the defendants in the preceding litigation did not show that it breached its duty to hire competent counsel. The district court granted insurer’s motion for summary judgment. This court affirmed, holding that insurer did not breach its duty to hire competent counsel and was not vicariously liable for any negligence by the attorney. Relying on Restatement of Liability Insurance § 12, the court reasoned that insurer was not unreasonable in selecting the attorney, liability was generally not imposed upon a defendant for the professional malpractice of its chosen counsel, and widower failed to demonstrate how insurer directed the attorney’s conduct in a manner that deprived the attorney of independent professional judgment. Progressive Northwestern Insurance Company v. Gant, 957 F.3d 1144, 1152, 1153, 1155, 1156.

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 13 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 1. Defense

• 13 Conditions Under Which the Insurer Must Defend

^Comment:

^{Reporters’ Note}

^{Case Citations - by Jurisdiction}

• (1) An insurer that has issued an insurance policy that includes a duty to defend must defend any legal action brought against an insured that is based in whole or in part on any allegations that, if proved, would be covered by the policy, without regard to the merits of those allegations.
• (2) For the purpose of determining whether an insurer must defend, the legal action is deemed to be based on:
• (a) Any allegation contained in the complaint or comparable document stating the legal action; and
• (b) Any additional allegation known to the insurer, not contained in the complaint or comparable document stating the legal action, that a reasonable insurer would regard as an actual or potential basis for all or part of the action.
• (3) An insurer that has the duty to defend under subsections (1) and (2) must defend until its duty to defend is terminated under 18 by declaratory judgment or otherwise, unless facts not at issue in the legal action for which coverage is sought and as to which there is no genuine dispute establish that:
• (a) The defendant in the action is not an insured under the insurance policy pursuant to which the duty to defend is asserted;
• (b) The vehicle or other property involved in the accident is not covered property under a liability insurance policy pursuant to which the duty to defend is asserted and the defendant is not otherwise entitled to a defense;
• (c) The claim was reported late under a claims-made-and-reported policy such that the insurer’s performance is excused under the rule stated in 35(2);
• (d) The action is subject to a prior-and-pending-litigation exclusion or a related-claim exclusion in a claims-made policy;
• (e) There is no duty to defend because the insurance policy has been properly cancelled; or
• (f) There is no duty to defend under a similar, narrowly defined exception to the complaint-allegation rule recognized by the courts in the applicable jurisdiction.

Comment:

1. a. The duty to defend and the complaint-allegation rule. When evaluating whether to defend a legal action that is brought against an insured, the insurer must take as true all the facts alleged in the complaint or comparable document that favor coverage. An allegation in a complaint that, if proven, would subject the insured to a covered liability conclusively establishes that the insurer has a duty to defend, subject only to the exceptions permitted by subsection (3), which allows an insurer to avoid the duty to defend without filing a declaratory-judgment action in narrowly defined circumstances. As stated in Comment c, it is anticipated that courts will consider additional exceptions through a common-law process of reasoning by analogy.

This widely accepted rule is variously known as the “four corners,” “eight corners,” or “complaint allegation” rule. The “four corners” label refers to the four corners of the complaint, reflecting that the insurer must defend based on the allegations in the complaint even if facts outside the complaint would demonstrate that those allegations are false. The “eight corners” label refers to the four corners of the complaint plus the four corners of the insurance policy, reflecting that, as long as the complaint contains an allegation that would be covered by the policy, parties and judges can make the duty-to-defend determination simply by reference to the complaint and the policy.

In determining whether to undertake the defense of an insured, an insurer must resolve any factual uncertainty in favor of the duty to defend. For example, any factual assertion in the complaint or comparable document favoring coverage is to be treated as if true, except to the extent that there are inconsistencies between or among assertions, in which case the assertions favoring coverage are to be treated as if true. If there is evidence outside of the complaint that favors coverage, that evidence should be treated as true for purposes of resolving factual uncertainty with respect to whether coverage exists. Similarly, subsection (3) requires that all factual uncertainty regarding matters not at issue in the underlying claim must also be resolved in favor of the duty to defend.

When an insurer has the duty to defend, it must do so until that duty terminates in one of the ways enumerated in § 18. Typically, this means the insurer must defend the legal action all the way through final adjudication of the action, unless the action is settled or the insurer prevails in a declaratory-judgment action establishing that the action is not covered by the liability insurance policy.

1. b. The potential for coverage. If the insurer knows of an allegation that, under existing pleading rules, could reasonably be expected in the circumstances to be added as an allegation in the legal action, and that, if so added, would require the insurer to defend the action, then the insurer has a duty to defend that action. The courts have not considered whether an insurer that should know of such an allegation, but because of an inadequate investigation does not in fact know of that allegation, must provide a defense. Accordingly, this Section limits the rule stated in subsection (2)(b) to facts known to the insurer. In an appropriate circumstance, an inadequate investigation could provide the basis for liability insurance bad faith, provided that the requirements of 49 are met. If the circumstances indicate that the underlying claimant (a) is aware of facts that could serve as the basis for a potentially covered allegation and (b) has made a choice not to pursue a potentially covered cause of action, then the insurer does not have a duty to defend the action because a reasonable insurer would not regard the allegation as an actual or potential basis for all or part of the action. But the duty will arise if the claimant later decides to make the allegation.

Except as provided in subsection (3) and discussed in Comment c, the consideration of facts outside the complaint works in one direction only: facts or circumstances not alleged in the complaint or comparable document generally may not be used to justify a refusal or failure to defend. Such information may be used, however, in a declaratory-judgment action brought by the insurer seeking to terminate its duty to defend an action that it is defending under a reservation of rights. See § 18, Comment j. This is the majority rule.

• Illustrations:

1. Insured is sued for assault arising out of an altercation following an auto accident. Insured’s automobile liability insurer denies coverage on the ground that the complaint alleges that the insured intentionally assaulted the plaintiff and, thus, the suit is excluded under a provision stating that the insurance policy does not apply to “bodily injury … caused intentionally by or at the direction of the insured.” Insured acknowledges striking the plaintiff, but alleges that he acted in self-defense. According to Insured, he reasonably feared for his personal safety, because the plaintiff approached the insured’s car in a menacing manner and jerked open the door. On these facts, the plaintiff has the potential to recover from Insured on a negligent self-defense theory that would be covered. Thus, the insurer has the duty to defend.

2. Insured is sued for bodily injury sustained during a fight in a bar. The complaint contains two counts. In the first count, the plaintiff alleges that Insured intentionally assaulted the plaintiff. In the second count, the plaintiff alleges that Insured negligently struck the plaintiff on the head. Insured’s homeowner’s insurer investigates the claim and determines, based on reliable witnesses, that Insured attacked the plaintiff with a wooden club. Nevertheless, the insurer has a duty to defend because count two in the complaint sets forth a covered legal theory.

3. Same facts as Illustration 2, except that Insured tenders the legal action to an automobile liability insurer for a defense. The insurer investigates. Because the facts alleged in the complaint do not contain any allegation that provides a basis for concluding that the injuries arose out of the operation of an automobile, and there is no additional information to that effect not contained in the complaint, the insurer has no duty to defend the action.

1. c. Coverage questions that turn on facts not at issue in the legal action against the insured. The general rule is that insurers may not use facts outside the complaint as the basis for refusing to defend, with the result that even an insurer with a strong factual basis for contesting coverage must defend under a reservation of rights and then file a declaratory-judgment action to terminate the duty to defend. Only in a declaratory-judgment action filed while the insurer is defending, or in a coverage action that takes place after the insurer has fulfilled the duty to defend, may the insurer use facts outside the complaint as the basis for avoiding coverage. Courts that follow this general rule have identified the five specific exceptions to this rule stated in subsection (3). In these circumstances, courts have allowed insurers to refuse to defend even when the elements of the complaint-allegation rule are otherwise met.

Courts in a few states have recognized a broader, general exception to the complaint-allegation rule that allows insurers to refuse to defend based on their unilateral assessment of any facts that are not at issue in the legal action for which coverage is sought. Although this Section does not recognize this broader exception, a court following this Section could recognize other narrow exceptions on a case-by-case basis, reasoning by analogy to the exceptions stated in subsection (3). Each such case requires striking a balance between the benefits of judicial supervision of the decision to refuse to provide a defense and the benefits of avoiding the need for declaratory-judgment actions in cases in which undisputed facts, not at issue in the liability action for which coverage is sought, establish that a legal action is not covered.

• Illustrations:

4. Homeowner is sued by Guest alleging injuries from a slip and fall. Homeowner’s liability insurer refuses to defend on the ground that it has the right to rescind the policy because the Homeowner falsely answered “no” to a question regarding prior convictions on the application for the applicable insurance policy. The insurer has breached the duty to defend because the complaint alleges a covered cause of action and a misrepresentation defense is not one of the exceptions to the complaint-allegation rule listed in subsection (3).

5. Same facts as Illustration 4, except the insurer defends under a reservation of rights and files a declaratory-judgment action seeking to terminate the duty to defend. In that declaratory-judgment action, the insurer’s duty to defend is determined based upon all the facts and circumstances including any information not included in the complaint that might show that the insurer is entitled to rescind the policy for misrepresentation.

6. Driver is sued by pedestrian alleging injuries from an automobile accident involving Sedan, which is owned by Driver’s friend. Driver requests a defense from Insurer solely on the ground that Insurer issued a policy pursuant to which Sedan is a covered vehicle. Insurer denies coverage on the ground that Sedan is not a covered vehicle. Sedan is, in fact, not a covered vehicle under the policy. Accordingly, the insurer has not breached the duty to defend.

7. Auto-Policyholder is sued by Vehicle Owner for property damage to Vehicle Owner’s car, after Vehicle Owner’s car is struck, while parked in Vehicle Owner’s driveway, by Auto-Policyholder’s car. Vehicle Owner believes that Auto-Policyholder was driving at the time of the accident, and makes this allegation in a complaint filed against Auto-Policyholder. In fact, Auto-Policyholder’s brother—an excluded driver under the policy—was driving. Auto-Policyholder informs Insurer that the brother was driving, and Insurer refuses to defend on the ground that an excluded driver caused the accident. Because the inaccurate pleading of a driver’s identity is not one of the exceptions to the complaint-allegation rule listed in subsection (3), the Insurer has breached the duty to defend, unless a court subsequently determines that this defense should be recognized as a new narrowly defined exception to the complaint-allegation rule.

8. Law firm is sued by Client for malpractice. The law firm does not provide notice of the suit to the insurer on the risk until six months after the end of the applicable claims-made-and-reported insurance policy. The policy contains a condition in the insuring agreement that requires the law firm to report the claim to the insurer no later than 120 days after the conclusion of the policy period. The insurer refuses to defend based on breach of the claim-reporting condition. The insurer did not breach the duty to defend because these are circumstances that qualify under the rule stated in § 35(2), pursuant to which the insurer need not prove prejudice in order to avoid coverage based on the insured’s failure to meet the claim-reporting condition.

1. d. The all-the-facts-and-circumstances approach distinguished. Some commentators have argued in favor of an approach that would permit a liability insurer, without resorting to a declaratory-judgment action, to decline to provide a defense based on all the facts and circumstances available to the insurer at that time. Such an all-the-facts-and-circumstances approach would go well beyond the kinds of exceptions recognized in subsection (3). Under this approach, when deciding whether to defend a legal action filed against the insured, the insurer would be able to consider any and all circumstances that bear on whether the action is covered. There would be no requirement that the insurer first defend under a reservation of rights and then seek declaratory judgment. Instead, the insurer would be able to refuse to defend based on its unilateral assessment of the coverage-relevant facts. Under this approach, the insurer could even refuse to defend based on facts that were at issue in the legal action for which the insured sought a defense. Thus, even if a complaint alleged facts that, if proven, would give rise to a covered claim, the insurer could decline to defend the case, without resort to a declaratory-judgment action, if the insurer decided that facts outside of the complaint would demonstrate that the claim was not covered. The insurer would have breached the duty to defend only if it were subsequently determined that the insurer’s assessment of all the facts and circumstances was wrong.

The problem with this approach, which has not found favor in the courts, is the uncertainty it would create for insureds, who would in a wider range of situations be put in a position of having to finance their own defense and then to bring a separate breach-of-contract action against their insurers to recoup those costs. The possibility of such an after-the-fact remedy would be of little comfort to insureds, who would find such litigation expensive and daunting. By contrast, under the rule followed in this Section, which is the clear majority rule, there is substantially less uncertainty borne by insureds regarding when they can expect to receive a defense from their insurer. As long as the complaint contains allegations that, if proven, would form the basis of a covered action, or the insurer obtains evidence outside of the complaint that supports coverage, the insured can be confident of receiving a defense, except in the limited circumstances permitted by subsection (3).

1. e. Duty to defend is independent of the merits of the legal action. The insurer’s duty to defend does not depend on the likelihood of the claimant’s success in the legal action. In almost every case in which an insured is named as a defendant in a lawsuit, the insured will need a lawyer to provide a defense—to investigate the plaintiff’s factual assertions, to determine the credibility of the evidence, and to evaluate the legal theory on which the legal claim is based. Only in a subset of cases will payment of a judgment be required. In the absence of a defense from the insurer, the insured could be forced by a nonmeritorious lawsuit either to pay an out-of-pocket settlement or to incur large legal bills to defend against the suit.

1. f. The “suit” requirement. This Section states rules regarding when an insurer must defend a legal action, using the term “legal action” in a generic sense that refers to a demand for redress of the kind that fits within the usual framework of insured liabilities but that is subject to more specific requirements or definitions in the liability insurance policy in question, such as the “suit” requirement. This Section does not address the separate question of when in the course of the procedural events attending the assertion and litigation of the legal action the insurer must begin the defense. This means, for example, that this Section does not affect the common requirement in policies that there must be a “suit” before the insurer is obligated to defend. If the liability insurance policy does contain such a suit requirement, this Section may be used to determine which suits the insurer is required to defend. In that case the insurer must defend any “suit” that is based in whole or in part on any alleged facts that, if proven, would be covered by the policy, without regard to the merits of those allegations or any associated legal theory.

Reporters’ Note

1. The duty to defend and the complaint-allegation rule.See, e.g., Stevens v. United Gen. Title Ins. Co., 801 A.2d 61, 66 n.4 (D.C. 2002) (reporting that “the majority of jurisdictions follow [the] ‘eight corners rule’ (that is, a comparison of the ‘four corners’ of the complaint with the ‘four corners’ of the policy).”). As one commentator has explained,

Courts are in accord that a determination of whether a suit against an insured is “seeking” covered damages, thereby triggering the duty to defend, is based on a review of the potentially applicable insurance policy and the allegations in the underlying complaint …. The duty to defend arises if any of the allegations in the complaint, if proven true, create the potential that the insured can be held liable for damages covered by the policy.

3 SETH D. LAMDEN, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 17.01[2][a] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017). See also Montrose Chem. Corp. of Cal. v. Super. Ct., 861 P.2d 1153, 1160 (Cal. 1993) (“Any doubt as to whether the facts establish the existence of the defense duty must be resolved in the insured’s favor.”); Frontier Ins. Co. v. State, 662 N.E.2d 251, 253 (N.Y. 1995) (citation omitted) (holding that an insurer may demonstrate no duty to defend “only if it can be concluded as a matter of law that there is no possible factual or legal basis on which the insurer will be obligated to indemnify the insured”).

The rule that “the insurer must defend any suit whose allegations would fall within coverage if the allegations were proved to be true” has become hornbook law. See KENNETH S. ABRAHAM & DANIEL SCHWARCZ, INSURANCE LAW AND REGULATION 584 (6th ed. 2015). See also Ellen S. Pryor, The Tort Liability Regime and the Duty to Defend, 58 MD. L. REV. 1, 23 (1999) (“The almost universally-used approach is the eight-corners rule: one takes the allegations in the plaintiff’s complaint, assumes the truth of those allegations without resorting to evidence extrinsic to the complaint, and then asks whether these allegations, if true, would establish a liability covered under the policy.”); C. T. Drechsler, Annotation, Allegations in third person’s action against insured as determining liability insurer’s duty to defend, 50 A.L.R.2d 458§ 4 (originally published in 1956) (“It appears to be well settled that, generally speaking, the obligation of a liability insurance company under a policy provision requiring it to defend an action brought against the insured by a third party is to be determined by the allegations of the complaint in such action.”).

1. The potential for coverage.The law is “almost equally clear that the insurer must defend even when the complaint does not allege facts within coverage, if the insurer possesses extrinsic information that the claim does fall within coverage.” KENNETH S. ABRAHAM & DANIEL SCHWARCZ, INSURANCE LAW AND REGULATION 584 (6th ed. 2015). For courts holding that facts outside of the complaint can trigger a duty to defend, see, e.g., Hyundai Motor Am. v. Nat’l Union Fire Ins. Co., 600 F.3d 1092, 1097–1098 (9th Cir. 2010) (applying California law) (“Determination of the duty to defend depends, in the first instance, on a comparison between the allegations of the complaint and the terms of the policy. But the duty also exists where extrinsic facts known to the insurer suggest that the claim may be covered.” (quoting Scottsdale Ins. Co. v. MV Transp., 115 P.3d 460, 466 (Cal. 2005))); Pennzoil Co. v. U.S. Fid. and Guar. Co., 50 F.3d 580, 583 (8th Cir. 1995) (applying North Dakota law) (“[T]he rule that has evolved in most jurisdictions is that, if the insurer acquires actual knowledge of additional facts [beyond the complaint] that establish a reasonable possibility of coverage, the duty to defend is triggered, even if the insurer made an appropriate initial decision not to defend”); Great Divide Ins. Co. v. Carpenter, 79 P.3d 599, 616 (Alaska 2003) (emphasis added) (citations omitted) (“If the complaint does not contain allegations indicating coverage, there is nonetheless a duty to defend if facts underlying the complaint are within, or potentially within, the policy coverage and are known or reasonably ascertainable by the insurer.”). See also Fitzpatrick v. Am. Honda Motor Co., 575 N.E.2d 90, 93–94 (N.Y. 1991):

The conclusion we reach here flows naturally from the fact that the duty to defend derives, in the first instance, not from the complaint drafted by a third party, but rather from the insurer’s own contract with the insured (see, e.g., 7C Appleman, op. cit., § 4682, at 27 [and authorities cited therein]). While the allegations in the complaint may provide the significant and usual touchstone for determining whether the insurer is contractually bound to provide a defense, the contract itself must always remain a primary point of reference (see also, Technicon Elecs. Corp. v. American Home Assur. Co., supra, 74 N.Y.2d at 73 [duty to defend arises from complaint and insurance contract]). Indeed, a contrary rule making the terms of the complaint controlling “would allow the insurer to construct a formal fortress of the third party’s pleadings … thereby successfully ignoring true but unpleaded facts within its knowledge that require it … to conduct the … insured’s defense” (Associated Indem. Co. v. Insurance Co., 68 Ill. App. 3d 807, 816–817, 386 N.E.2d 529, 536).

For a 50-state survey of court decisions regarding the use of extrinsic evidence in determining the insurer’s duty to defend, see 1–5 RANDY MANILOFF & JEFFREY STEMPEL, GENERAL LIABILITY INSURANCE COVERAGE: KEY ISSUES IN EVERY STATE§ 5 (3d ed. 2015). Maniloff and Stempel point out that “[w]hile many states adhere to the ‘four corners’ rule, about twice as many do not and have concluded that extrinsic evidence can be considered by a court in its duty to defend determination.” Id. (referring in that discussion to use of extrinsic evidence to expand the insurer’s duty to defend, not to narrow it). For authority that the court may consider all the facts and circumstances in a declaratory-judgment action brought while the insurer is defending under a reservation of rights, see, e.g., Estate of Sustache v. Am. Family Mut. Ins. Co., 751 N.W.2d 845, 852 (Wis. 2008) (stating that the court may use extrinsic evidence to determine the insured’s coverage in a declaratory-judgment proceeding brought while the insurer is defending under a reservation of rights). Illustration 1 is based on Gray v. Zurich Ins. Co., 419 P.2d 168 (Cal. 1966). Illustration 2 is based on Thornton v. Paul, 384 N.E.2d 335 (Ill. 1978).

1. Coverage questions that turn on facts not at issue in the legal action against the insured.For authority regarding the general rule that insurers may not consider facts outside the complaint to avoid the duty to defend, see, e.g., Woo v. Fireman’s Fund Ins. Co., 164 P.3d 454, 459 (Wash. 2007) (“The insurer may not rely on facts extrinsic to the complaint to deny the duty to defend—it may do so only to trigger the duty.”). See also Capital Envtl. Servs., Inc. v. N. River Ins. Co., 536 F. Supp. 2d 633, 642 (E.D. Va. 2008) (applying Virginia law):

[The insurer] has offered no persuasive authority in support of its proposed rule that an insurer may rely on extrinsic facts to deny its duty to defend when the Eight Corners Rule would otherwise require it to defend. Allowing an insurer to point to facts outside the pleadings to demonstrate that it would ultimately have no duty to indemnify as proof that it has no duty to defend would render the two duties indistinguishable and thus effectively depreciate the duty to defend.

York Ins. Grp. of Me. v. Lambert, 740 A.2d 984, 985–986 (Me. 1999) (holding that the court could not consider extrinsic evidence to allow the insurer to avoid its duty to defend); Fitzpatrick v. Am. Honda Motor Co., 575 N.E.2d 90, 92 (N.Y. 1991) (“[T]he courts of this State have refused to permit insurers to look beyond the complaint’s allegations to avoid their obligation to defend”). See also ROBERT H. JERRY, II & DOUGLAS R. RICHMOND, UNDERSTANDING INSURANCE LAW 801 (5th ed. 2012) (“Insurers are not allowed to refuse to defend when the complaint makes allegations within coverage simply because the insurer has knowledge of extrinsic evidence showing that the complaint’s allegations are incorrect or untrue.”); 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 200:11 (3d ed. 2017) (“When coverage under the duty to defend depends on an outstanding factual dispute, the disputes must be resolved in favor of coverage until the insurer conclusively establishes that there is no potential for coverage.”); ROBERT P. REDEMANN & MICHAEL F. SMITH, LAW AND PRAC. OF INS. COVERAGE LITIG. § 4:14 (July 2017) (emphasis added) (“For an insurer to avoid the obligation to defend, it must be concluded as a matter of law that there is no possible factual or legal basis on which the insurer might eventually be held obligated to indemnify the insured under any provision of the insurance policy…. The insurer is not obligated to defend a suit only when there is no potential for coverage.”).

For authority regarding the specific exceptions to this rule listed in subsection (3), see, e.g., HR Acquisition I Corp. v. Twin City Fire Ins. Co., 547 F.3d 1309, 1315 (11th Cir. 2008) (applying Alabama law) (permitting consideration of extrinsic evidence regarding application of the pending-litigation exclusion in a claims-made policy); Edwards v. Lexington Ins. Co., 507 F.3d 35, 40–41 (1st Cir. 2007) (applying Maine law) (permitting the insurer to refuse to defend based on incontestable extrinsic evidence regarding late reporting of a claim under a claims-made policy); Rowell v. Hodges, 434 F.2d 926, 929–930 (5th Cir. 1970) (applying Florida law) (permitting insurer to refuse to defend based on incontestable evidence that the defendant was not driving a covered automobile); Worthington Fed. Bank v. Everest Nat’l Ins. Co., 110 F. Supp. 3d 1211, 1235 (N.D. Ala. 2015) (applying Alabama law) (permitting consideration of extrinsic evidence regarding relationship between the current action and a prior action for purposes of determining coverage under a claims-made policy); Weingarten Realty Mgmt. Co. v. Liberty Mut. Fire Ins. Co., 343 S.W.3d 859, 864 (Tex. App. 2011) (permitting the insurer to refuse to defend based on incontestable extrinsic evidence to the effect that the defendant was not an insured under the policy). See also Navajo Freight Lines, Inc. v. Liberty Mut. Ins. Co., 471 P.2d 309, 315 (Ariz. Ct. App. 1970):

[C]ontractual provisions generally impose an obligation to defend against any suit alleging the occurrence of risks insured against even if the suit is groundless, false, or fraudulent …. However, these contractual provisions do not purport to obligate the insurer to defend a complete stranger to the contract. A sine qua non to the existence of any obligation to defend, or pay, whether the suit be groundless or otherwise, is the pre-existing relationship of the insurer-insured.

There is some authority in favor of a broader exception. See Pompa v. Am. Family Mut. Ins. Co., 520 F.3d 1139, 1147 (10th Cir. 2008) (applying Colorado law) (permitting insurer to refuse to defend based on “an indisputable fact that is not an element of either the cause of action or a defense in the underlying litigation”); Nationwide Mut. Fire Ins. Co. v. Keen, 658 So. 2d 1101, 1103 (Fla. Dist. Ct. App. 1995) (“[I]f uncontroverted evidence places the claim outside of coverage, and the claimant makes no attempt to plead the fact creating coverage or suggest the existence of evidence establishing coverage, we think the carrier is relieved of defending.”); Farm Family Mut. Ins. Co. v. Whelpley, 767 N.E.2d 1101, 1104 (Mass. App. Ct. 2002) (citation omitted) (“[T]his case falls within one of the rare exceptions to the rule that an insurer has a duty to defend as long as the complaint states or adumbrates a claim within the coverage, that exception being the existence of an undisputed extrinsic fact that takes the case outside of the coverage and that will not be litigated at the trial of the underlying action.”); Blake v. Nationwide Ins. Co., 904 A.2d 1071, 1076 (Vt. 2006) (permitting insurer to consider extrinsic evidence regarding undisputed “factual questions not covered in the complaint, namely, whether the accident occurred in the scope of employment,” which was not at issue in the underlying litigation). In addition, there are a small number of published opinions from courts in jurisdictions outside of Vermont and Massachusetts that permit the insurer to refuse to defend based on extrinsic evidence regarding facts not at issue in the underlying litigation in circumstances that do not fit within the exceptions noted in subsection (3), but the opinions do not express the view that there should be a broader exception to the complaint-allegation rule. Indeed, the opinions generally do not indicate an awareness that the court is acting contrary to the complaint-allegation rule. See, e.g., Acosta, Inc. v. Nat’l Union Fire Ins. Co., 39 So. 3d 565 (Fla. Dist. Ct. App. 2010) (examining complaint in prior case to evaluate whether a prior-litigation exclusion applies); Bilyeu v. Nat’l. Union Fire Ins. Co. of Pittsburgh, Pa., 184 So. 3d 69 (La. Ct. App. 2015) (permitting insurer to consider extrinsic evidence regarding the date of the wrongful act for purposes of the application of a prior-act exclusion in a claims-made policy).

1. The all-the-facts-and-circumstances approach distinguished. For an example of a commentator advocating a broader application of the all-the-facts-and-circumstances rule, see Ellen S. Pryor, The Tort Liability Regime and the Duty to Defend, 58 MD. L. REV. 1, 52 (1999), concluding that, except when the facts that matter for coverage are at issue in the underlying claim:

On balance, the actual facts approach seems preferable. It delivers the appropriate level of defense insurance in theory, and the usual breach of contract and extracontractual remedies would be available for mistakes or abuses in the application of the approach. Indeed, as just noted, it appears that many courts have been applying something akin to this approach by allowing the actual facts to govern, from the outset, with respect to questions such as the identity of the insured or the insured vehicle.

1. Duty to defend is independent of the merits of the legal action.See, e.g., Miller v. Westport Ins. Corp., 200 P.3d 419, 423 (Kan. 2009) (in contracts that provide a duty to defend, the insurer “is contractually obligated to defend even meritless suits that fall within the coverage.” (quoting JERRY & RICHMOND, UNDERSTANDING INSURANCE LAW, § 111[a] at 826–827 (4th ed. 2007))); Abouzaid v. Mansard Gardens Assocs., LLC, 23 A.3d 338, 347 (N.J. 2011) (“Notably, the potential merit of the claim is immaterial: the duty to defend ‘is not abrogated by the fact that the cause of action stated cannot be maintained against the insured either in law or in fact—in other words, because the cause is groundless, false or fraudulent’.” (quoting Danek v. Hommer, 100 A.2d 198 (N.J. Super. Ct. App. Div. 1953))); see also Scottsdale Ins. Co. v. Subscription Plus, Inc., 299 F.3d 618, 622–623 (7th Cir. 2002) (applying Wisconsin law):

Any other rule would have the paradoxical effect that the less meritorious the suit, the less protection a liability insurance policy would give the defendant…. The insured who has bought a liability policy that entitles him to defense as well as indemnification wants to be defended against claims of liability regardless of their merit. He doesn’t want to be stuck with the lawyer’s bill just because he wins and therefore doesn’t need to look to the insurer for indemnification. If he wanted that he would just buy indemnification, and not defense.

1. The “suit” requirement.See Tanya T. Austin, INSURER’S DUTY TO DEFEND: A COMPENDIUM OF STATE LAW, 2016 DRI-INSDD 96 (2016), which provides a useful explanation of the different understandings of suit. Compare, e.g., Foster-Gardner, Inc. v. Nat’l. Union Fire Ins. Co. of Pittsburgh, Pa., 959 P.2d 265, 282 (Cal. 1998) (declining to require insurer to defend based on a governmental demand letter) and Lapham-Hickey Steel Corp. v. Protection Mut. Ins. Co., 655 N.E.2d 842, 847–848 (Ill. 1995) (same) with Compass Ins. Co. v. City of Littleton, 984 P.2d 606, 622 (Colo. 1999) (holding that coercive actions begun by government demand letters are “suits”) and Hazen Paper Co. v. USF&G Co., 555 N.E.2d 576, 579–580 (Mass. 1990) (same). See also STEVEN PLITT & JORDAN ROSS PLITT, 1 PRACTICAL TOOLS FOR HANDLING INSURANCE CASES§ 2:8 (2017) (stating that the broader interpretation of suit is the significant majority view).

Case Citations - by Jurisdiction

________________________________________________________________________________________________________________________________________________________

• ^D.Cal.
•  
•  

N.D.Cal.

N.D.Cal.2019. Subsec. (1) quot. in sup. Insured landlord sued insurer, seeking a determination that insurer had a duty to defend it against an underlying action filed against it by tenant, in which tenant asserted claims for tortious interference with prospective economic relations and contract, breach of contract, negligence, and fraud. This court granted partial summary judgment for insured, holding, as a matter of law, that insurer had a duty to defend insured, because insured had established by undisputed evidence that a potential for coverage existed under the parties’ policies for claims raised in the underlying action, and that no relevant exclusions applied. The court explained that, under Restatement of Liability Insurance § 13, an insurer that issued an insurance policy that included a duty to defend had to defend any legal action brought against an insured that was based in whole or in part on any allegations that, if proved, would be covered by the policy, without regard to the merits of those allegations. Conway v. Northfield Insurance Company, 399 F.Supp.3d 950, 959.

N.D.Cal.2019. Subsec. (1) quot. in sup. Insurer that issued commercial-general liability policies to landlords sued insureds and their other insurer, seeking a declaration that it did not have a duty to defend insureds against an underlying landlord-tenant action, in which tenants alleged causes of action against insureds for, among other things, violation of state and local habitability and zoning laws, constructive eviction, and breach of the implied warranties of habitability and quiet enjoyment. This court granted summary judgment for plaintiff, holding that plaintiff did not have a duty to defend, because the undisputed material facts showed that there was no potential for coverage under the policies for claims raised in the underlying action under Restatement of Liability Insurance § 13. The court explained that the underlying action, which alleged the loss of a leasehold interest, did not raise a potentially covered claim under the policies for “loss of use of tangible property.” Scottsdale Insurance Company v. Darke, 424 F.Supp.3d 638, 642.

Nev.

Nev.2018. Com. (c) quot. in ftn. (quoting § 13, com. (c), of Prop. Final Draft No. 2, 2018, which is now § 13, com. (c) of the Official Text). Pedestrian and pedestrian’s legal guardian brought a lawsuit against truck driver, driver’s personal insurer, and driver’s commercial insurer, alleging that truck driver caused pedestrian’s injuries; commercial liability insurer refused to defend truck driver, arguing that truck driver was not acting within the scope of his commercial duties at the time of the accident. The district court entered default judgment against defendants. After defendants appeared in court, the trial court stayed proceedings to submit a certified question to this court as to whether an insurer, who had breached a contract but did not breach the duty of good faith, would be liable for damages beyond the insurance policy’s limit. This court answered in the affirmative, holding that an insurer who refused to defend an insured could be liable for all consequential damages arising from the insurer’s refusal to defend. The court cited Restatement of Liability Insurance § 13 (Prop. Final Draft No. 2, 2018) in noting that, although an insurer generally could not use facts outside the complaint as a basis for refusing to defend, it could use such facts after defending the insured. Century Surety Company v. Andrew, 432 P.3d 180, 186.

Or.

Or.2016. Com. (a) cit. in sup. (citing § 13, com. (a), of T.D. No. 1, 2016, which is now § 13, com. (a), of the Official Text). General contractor for a townhome development brought an action against insurer of subcontractor, alleging that, because contractor was named as an insured under subcontractor’s liability-insurance policy, insurer had a duty to defend contractor in a negligence action brought by development’s homeowners association. The trial court entered judgment for contractor; the court of appeals affirmed. Affirming, this court held that insurer had a duty to defend. Citing Restatement of Liability Insurance § 13, Comment a, (T.D. No. 1, 2016), the court relied on the four-corners rule and determined that the allegations against contractor in the underlying action’s complaint asserted a claim covered by subcontractor’s policy. West Hills Development Company v. Chartis Claims, Inc. Oregon Automobile Insurance Company, 385 P.3d 1053, 1055.

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 14 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 1. Defense

• 14 Duty to Defend: Basic Obligations

^Comment:

^{Reporters’ Note}

• When an insurance policy obligates an insurer to defend a legal action:
• (1) Subject to the insurer’s right to terminate the defense under 18, the insurer has a duty to provide a defense that:
• (a) Makes reasonable efforts to defend the insured from all of the causes of action and remedies sought in the action, including those not even potentially covered by the liability insurance policy; and
• (b) Requires defense counsel to protect from disclosure to the insurer any information of the insured that is protected by attorney–client privilege, work-product immunity, or a defense lawyer’s duty of confidentiality under rules of professional conduct, if that information could be used to benefit the insurer at the expense of the insured;
• (2) The insurer may fulfill the duty to defend using its own employees, except when an independent defense is required; and
• (3) Unless otherwise stated in the policy, the costs of the defense of the action are borne by the insurer in addition to the policy limits.

Comment:

1. a. Importance of the duty to defend. Liability insurance not only provides financial protection against judgments; it also protects insureds against the liability action itself. Some liability insurance policies highlight this protection by stating that the insurer will defend a suit even if it is “groundless, false or fraudulent.” The insurer’s promise to defend a legal action provides litigation insurance that is at least as important as the insurer’s promise to pay a judgment or settlement.

13. b. The duty to defend the whole action. It is often said that the insurer has a duty to defend the “whole claim.” This Section states that rule more precisely: the insurer’s duty is to defend the insured from all of the causes of action and remedies sought in a suit or other proceeding that the insurer has the duty to defend. This way of stating the duty distinguishes between judgment risks and nonjudgment risks. Judgment risks are the potential direct legal consequences of the legal action to the insured: the entry of judgment and the associated obligation to pay damages or provide other remedies. Those risks are sometimes not fully insured because the damages may exceed the policy limits, some of the remedies sought may be of a type that is not insured by the policy, or the insurer may have grounds for contesting indemnity coverage of one or more causes of action. The insurer’s duty to defend includes the obligation to provide a defense of the legal action that makes reasonable efforts to defend the insured from all of the judgment risks, whether they are insured or not, as long as there is one actual or potential cause of action that obligates the insurer to provide a defense under the rules stated in 13. Nonjudgment risks are the other possible consequences of the legal action, such as loss of reputation or goodwill. Such risks typically are not insured. In defending the insured against judgment risks, insurers as a practical matter do protect insureds against nonjudgment risks, but courts have not identified specific obligations regarding nonjudgment risks. Thus, the insurer’s duties with regard to nonjudgment risks are subject only to the obligations it agrees to assume as well as the general duty of good faith and fair dealing.

• Illustrations:

1. An individual insured with a $100,000 limit liability insurance policy, with the duty to defend, cuts off a stranger’s foot with a lawn mower. The stranger files suit for negligence seeking $1 million in damages. The insurer must defend the suit as if it faced liability for the full extent of the claimed damages.

2. Insured Company supplies a piping system to a manufacturer for use in a manufacturing plant. Due to defects in the pipe, the piping system leaks, causing some damage to a part of the plant other than the piping system and requiring the plant to be shut down while the piping system is replaced. Manufacturer sues Company for the damage to the plant, the costs of replacing the piping system, and lost profits and consequential damages from the shutdown. Company is insured under a general-liability insurance policy with the duty to defend. Notwithstanding the fact that the policy excludes coverage for property damage to Company’s product arising out of that product, and, thus, a significant portion of the potential damages is unlikely to be insured, the insurer must defend the suit as if it faced liability for the full extent of the claimed damages.

3. Insured Company is sued by a former business partner for breach of contract, intentional interference with contractual relations, and defamation. Under Company’s general-liability policy, which includes the duty to defend a covered suit, a suit seeking damages solely because of breach of contract or intentional interference with contractual relations would not be covered. The policy provides coverage, however, for suits seeking damages because of “personal injury,” which is defined in a manner that includes the allegations of defamation in the suit, and there are no exclusions in the policy that would apply to the defamation allegations in this suit. Because the suit includes allegations of defamation that, if proven, would be covered by the policy, the insurer must defend the suit as if it faced liability for the full extent of the claimed damages.

1. c. Benefits to insurers and insureds. The rule that the duty to defend a legal action requires the insurer to make a reasonable effort to protect the insured against all causes of action and remedies sought in that legal action addresses a potential conflict of interest between insurers and their insureds that could otherwise arise when only a portion of an action being defended by the insurer is covered. The rule provides a benefit to both parties. The reasonable-effort requirement benefits insurers by allowing them to scale the defense effort to the judgment risk at stake in a legal action: what is reasonable will generally depend on the expected value of the potential damages or other remedies, taking into account the probability of the plaintiff’s success. The requirement that the defense protect the insured against all of the causes of action and remedies sought in the legal action benefits insureds by reducing the insurer’s incentive to underinvest in the defense of a legal action that poses a mix of insured and uninsured causes of action or remedies.

1. d. Relationship to the law of lawyering. The rules stated in this Section are insurance-law rules. When the law of lawyering provides additional protection for the insured, that protection is incorporated in the insurer’s duty to defend through the general obligation to appoint a defense lawyer under conditions that comply with the law governing lawyers. See, e.g., Restatement Third, The Law Governing Lawyers § 134 (regarding compensation or direction of a lawyer by a third person).

1. e. Protecting the insured’s confidential information. Because of the potential for uninsured risks, there are circumstances in which confidential information of the insured could be used to benefit the insurer at the expense of the insured—for example, confidential information that would assist the insurer to avoid coverage for a legal action. In such circumstances, as stated in 11, the insurer does not have the right to receive that confidential information from defense counsel, notwithstanding that such information may be relevant to the defense or settlement of the claim. This Section states the corollary rule that the insurer’s duty to defend includes the obligation to arrange the defense so that the lawyer retained by the insurer does not have an obligation to the insurer to reveal such confidential information, directly or indirectly, including through withdrawal from the representation of the insured.

This rule is consistent with the Restatement Third, The Law Governing Lawyers, which expressly declined to address the relationship between insurer and insured. See Restatement Third, The Law Governing Lawyers § 134, Comment a. Indeed, Comment f to § 134 of the Restatement Third, The Law Governing Lawyers, which states that a lawyer may be obligated to withdraw from the representation in certain circumstances, illustrates the need for an insurance-law rule requiring the insurer to arrange the representation to avoid those circumstances, so that the lawyer does not have an obligation to the insurer that would obligate the lawyer to withdraw in a manner that may alert the insurer to the potential availability of a ground for contesting coverage. The rule in subsection (1)(b) does not restrict the lawyer’s ability to withdraw from the representation for other reasons that are required or permitted under the law governing lawyers, such as when a client persists in a course of action involving the lawyer’s services that the lawyer reasonably believes is criminal or fraudulent. See § 11, Comment d (regarding management of the burden placed on defense counsel).

• Illustration:

4. Insured child is sued for property damage arising out of a fire allegedly started by the child at school. Insurer hires a defense lawyer to defend the insured. During a private meeting with the child and the child’s parents, the attorney obtains information indicating that the child may have intentionally set the fire for the purpose of damaging the school. Because this information could be used by the insurer to avoid coverage for the suit, the defense lawyer may not provide this information to the insurer without the consent of the parents. The parents instruct the lawyer not to provide the information to the insurer. The insurer has retained the defense lawyer on terms that obligate the lawyer to withdraw from the representation in the event that such a conflict of interest materializes. The terms imposing this obligation on the lawyer constitute a breach of the insurer’s duty to defend because such a withdrawal would signal to the insurer that the defense lawyer has come into possession of confidential information that may be useful to the insurer in avoiding coverage for the claim.

1. f. The insurer’s own employees as defense counsel. Liability insurance law permits insurers to fulfill the duty to defend using lawyers who are employees of the insurer, as well as lawyers employed by law firms. These are the kinds of decisions that, subject to adherence to professional and contractual obligations, are appropriately committed to the insurance market and, if necessary, regulatory authorities.

1. g. The costs of defense. The stated default rule regarding the costs of defense under a duty-to-defend policy is the longstanding approach in the personal liability insurance market. The rule also reflects what was and to some extent remains the prevailing approach in the commercial liability insurance market. (Commercial liability insurance policies became more varied in this regard beginning in the 1970s.) Most purchasers of liability insurance are unlikely to have a sound basis for predicting the costs of defense when deciding how much insurance to purchase. The default rule provides coverage that more closely comports with the expectations of most insureds than the alternative approach in which the costs of defense erode the limits of coverage. See 22 (on defense-cost-indemnification policies).

Reporters’ Note

1. Importance of the duty to defend.In insurance policies containing a duty to defend, the duty “is a valuable service paid for by the insured and one of the principal benefits of the liability insurance policy.” Woo v. Fireman’s Fund Ins. Co., 164 P.3d 454, 459–460 (Wash. 2007). Because the duty to defend is a distinct benefit of the policy that protects the insured against the threat of liability:

[I]t is well-recognized that the duty to defend is broader than the duty to indemnity [sic] inasmuch as the duty to defend turns on a complaint’s allegations whereas the duty to indemnify requires established or litigated facts. A duty to defend limited to and coextensive with the duty to indemnify would be essentially meaningless; insureds pay a premium for what is partly “litigation insurance” designed to “protect[ ] the insured from the expense of defending suits brought against him.”

Capital Envtl. Servs., Inc. v. N. River Ins. Co., 536 F. Supp. 2d 633, 640 (E.D. Va. 2008) (applying Virginia law) (quoting Perdue Farms, Inc. v. Travelers Cas. & Sur. Co. of Am., 448 F.3d 252, 258 (4th Cir. 2006)). See also Beckwith Mach. Co. v. Travelers Indem. Co., 638 F. Supp. 1179, 1186 (W.D. Pa. 1986) (applying Pennsylvania law) (“[The insurer’s duty to defend] is separate and distinct from its duty to indemnify; the insurer’s duty to defend is broader than its obligation to indemnify the insured.”). In order to effectively protect the insured from the burden of litigation, the obligation to defend “arises whenever allegations against the insured state a claim which is potentially within the scope of the policy’s coverage, even if such allegations are ‘groundless, false or fraudulent.’” Id., quoting Gedeon v. State Farm Mut. Auto. Ins. Co., 188 A.2d 320, 321 (Pa. 1963); KENNETH S. ABRAHAM & DANIEL SCHWARCZ, INSURANCE LAW AND REGULATION 577 (6th ed. 2015) (noting that older policies specified that the duty to defend extended even to suits that are “groundless, false, or fraudulent,” and although this language has since dropped out “[i]n the drive for plain language,” courts will likely “continue to interpret policies as though they contained this clarification”).

17. The duty to defend the whole action.“In the majority of jurisdictions, an insurer’s duty to defend extends to the entire action, which includes covered, potentially covered, and uncovered allegations within the claim.” 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 200:25 (3d ed. 2017). See also 3 SETH D. LAMDEN, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 17.01[3][a] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017) (“Virtually all courts agree that if an action contains both potentially covered and noncovered claims—a so-called ‘mixed’ action—the insurer must defend the entire action.”). As explained by one court,

To defend meaningfully, the insurer must defend immediately. To defend immediately, it must defend entirely. It cannot parse the claims, dividing those that are at least potentially covered from those that are not. To do so would be time consuming. It might also be futile: The plasticity of modern pleading allows the transformation of claims that are at least potentially covered into claims that are not, and vice versa.

Buss v. Super. Ct., 939 P.2d 766, 775 (Cal. 1997) (citations and quotation marks omitted). See also Travelers Cas. & Sur. Co. v. Am. Int’l Surplus Lines Ins. Co., 465 F. Supp. 2d 1005, 1013 (S.D. Cal. 2006) (applying California law) (“Even if only a single claim in a multi-count complaint is potentially covered, the insurer normally must defend the entire action.”); Reinsurance Ass’n of Minn. v. Timmer, 641 N.W.2d 302, 307 (Minn. Ct. App. 2002) (“If a complaint alleges several claims, and any one of them would require the insurer to indemnify, the insurer must provide a defense against all claims.”). Note that courts differ regarding the insurer’s ability to obtain recoupment of defense costs in “mixed actions” that contain both covered and noncovered claims. See § 21, Reporters’ Note to Comment a. For example, California permits recoupment, while Wyoming does not. See Buss, 939 P.2d at 775 (permitting recoupment); Shoshone First Bank v. Pac. Emp’rs Ins. Co., 2 P.3d 510, 515 (Wyo. 2000) (observing “we think the court in Buss very eloquently articulated the pragmatic difficulty of mounting only a partial defense of the insured,” but rejecting the recoupment rule adopted in Buss on the grounds that the insurer has an obligation under the insurance policy to defend the whole action and, thus, there is no basis for recoupment).

1. Benefits to insurers and insureds.Many courts and commentators have recognized that a cause of action exists for a negligently or inadequately handled defense proffered by an insurer pursuant to the duty to defend. See Lloyd v. State Farm Mut. Auto. Ins. Co., 860 P.2d 1300, 1301 (Ariz. Ct. App. 1992) (holding “that an insurer’s voluntary assumption of the duty to defend may give rise to a cause of action for derelictions in that defense even when there is no actual coverage”); BellSouth Telecomms., Inc. v. Church & Tower of Florida, Inc., 930 So. 2d 668, 673 (Fla. Dist. Ct. App. 2006) (labeling “meritless” an insurer’s attempted distinction that a case relied on by the insured “involved a failure to provide an adequate defense, rather than a refusal to provide a defense at all”); Aaron v. Allstate Ins. Co., 559 So. 2d 275, 277 (Fla. Dist. Ct. App. 1990) (holding not only that an insured has “a cause of action for inadequate defense” stemming from the insurer’s “duty to adequately defend,” but also that the insured can assign its rights under a suit for breach of that duty to the plaintiff); Carrousel Concessions, Inc. v. Florida Ins. Guar. Ass’n, 483 So. 2d 513, 518 (Fla. Dist. Ct. App. 1986) (holding that the “principles” surrounding a breach of the duty to defend “are equally applicable here where it is alleged that the insurer breached its duty to defend because it provided an inadequate defense”); O’Keefe v. Safeco Ins. Co. of Am., 639 P.2d 1312 (Or. Ct. App. 1982) (finding a jury question as to whether the insurer breached the duty to defend by defending a $2,000,000 action as if it were a $20,000 action).

19. Protecting the insured’s confidential information.The principle stated in this Section addresses the issue underlying the debate between differing approaches to the tripartite relationship between the defense lawyer, the insured, and the insurer, such as the “primary client” and “equal weighting” approaches. Compare Tom Baker, Liability Insurance Conflicts and Defense Lawyers: From Triangles to Tetrahedrons, 4 CONN. INS. L.J. 101, 146–147 (1998) (explaining why the equal-weighting rule is impracticable) with Charles Silver & Kent Syverud, The Professional Responsibilities of Insurance Defense Lawyers, 45 DUKE L.J. 255, 343–348 (1996) (urging an equal co-client approach that would require the defense lawyer to disclose the existence of a conflict of interest and withdraw). See generally ROBERT H. JERRY, II & DOUGLAS R. RICHMOND, UNDERSTANDING INSURANCE LAW 860 (5th ed. 2012) (discussing what happens when dual representation is not possible). This Section does not take any position on the question of whether the insurer is a client of the defense lawyer, as such matters are properly addressed by the law governing lawyers. Although the law governing lawyers is beyond the scope of this project, it is worth noting that ABA Formal Opinion 08-450 concludes that, even when the insurer is a co-client, the defense lawyer is not obligated to withdraw “if the substantive law precludes the lawyer from acting contrary to the interests of the insured.” As ABA Formal Opinion 08-450 notes, the majority of states require the defense lawyer to treat the insured as either the sole or primary client in the event of a conflict. Id. at note 19. Illustration 4 is loosely based on the facts in Parsons v. Continental Nat’l Am. Group, 550 P.2d 94, 96 (Ariz. 1976).

7. The insurer’s own employees as defense counsel.A majority of jurisdictions adhere to the principle set forth in subsection (2). See WILLIAM T. BARKER & CHARLES SILVER, PROFESSIONAL RESPONSIBILITIES OF INSURANCE DEFENSE COUNSEL§ 7.02 (2017); ROBERT H. JERRY, II & DOUGLAS R. RICHMOND, UNDERSTANDING INSURANCE LAW 868 (5th ed. 2012) (“The vast majority of courts and state ethics authorities that have considered the validity of the arrangements [permitting insurer’s use of its own employees to defend] have approved them ….”); Denise Purpura, Should Insurers in Texas Be Prohibited From Using Staff Attorneys to Defend Third Party Claims Brought Against Insureds?: A Closer Look at American Home Assurance, 13 CONN. INS. L.J. 177, 179 (2006–2007) (“[T]he majority of states have held that the use of staff attorneys by insurance companies neither constitutes the unauthorized practice of law nor violates the professional rules of responsibility.”). Nonetheless, at least three jurisdictions have held that there is a per se prohibition on an insurer’s use of staff attorneys to defend third-party actions brought against insureds. See Brown v. Kelton, 380 S.W.3d 361, 365 (Ark. 2011); Am. Ins. Ass’n v. Ky. Bar Ass’n, 917 S.W.2d 568, 570 (Ky. 1996); Gardner v. N.C. State Bar, 341 S.E.2d 517, 520 (N.C. 1986).

1. The costs of defense.In most insurance policies, “the sums paid by the insurer pursuant to its duty to defend are owed in addition to the full policy limit.” 1 ALLAN D. WINDT, INSURANCE CLAIMS AND DISPUTES, 6TH§ 4:12 (2017). See, e.g., DPC Indus., Inc. v. Am. Specialty Lines Ins., 615 F.3d 609, 615 n.3 (5th Cir. 2010) (applying Texas law) (noting that most commercial general-liability policies exclude defense costs from the policy limits); O’Keefe v. Safeco Ins. Co. of Am., 639 P.2d 1312, 1315 (Or. Ct. App. 1982) (“[The insurer’s] duty to defendant includes the duty to investigate properly and to prepare the case for trial or settlement. This duty is owed to the insured over and beyond the policy limits of coverage and is without limitation.”). “It is well established that the insurer may be obligated to pay the cost of defending a suit against the insured, although these expenses may bring the total amount paid beyond the coverage limits set out in the policy.” 1 ROBERT P. REDEMANN & MICHAEL F. SMITH, LAW AND PRAC. OF INS. COVERAGE LITIG.§ 4:19 (Database Updated July 2017). Nevertheless, policies may provide that defense costs will be capped by policy limits.

[A] policy that provides for a duty to defend subject to an overall limit of liability is “cost inclusive.” Under a cost-inclusive policy, the maximum liability of the insurer is capped by the limit of liability expressed in the policy, and both indemnity payments for claimants and the costs of defending against such claims will be charged against the limit of liability. After the cap is reached, the insurer bears no further obligation under the policy.

Aetna Cas. & Sur. Co. v. Home Ins. Co., 882 F. Supp. 1328, 1335 (S.D.N.Y. 1995) (applying New York law). See also DPC Industries, Inc., 615 F.3d at 615 n.3 (contrasting “the typical comprehensive general liability policy where defense costs are excluded from the calculation of the policy limits” with “an eroding policy under which defense costs ‘count’ against and ‘erode’ the policy limits.”); 1 STEVEN PLITT & JORDAN R. PLITT, PRACTICAL TOOLS FOR HANDLING INSURANCE CASES§ 2:19 (July 2017) (“Where the policy is an eroding policy, the duty to defend terminates once the expenditure of defense costs exceeds the policy limits.”).

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 15 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 1. Defense

• 15 Reserving the Right to Contest Coverage

^Comment:

^{Reporters’ Note}

• (1) An insurer may reserve the right to contest coverage for an action before undertaking the defense of the action if it gives timely notice to the insured of any ground for contesting coverage of which it knows or should know.
• (2) If an insurer already defending a legal action learns of information, which it did not have constructive notice of under subsection (1), that provides a ground for contesting coverage for that action, the insurer must give notice of that ground to the insured within a reasonable time to reserve the right to contest coverage for the action on that ground.
• (3) Notice to the insured of a ground for contesting coverage must include a written explanation of the ground, including the specific insurance policy terms and facts upon which the potential ground for contesting coverage is based, in language that is understandable by a reasonable person in the position of the insured.
• (4) When an insurer reasonably cannot complete its investigation before undertaking the defense of a legal action, the insurer may temporarily reserve its right to contest coverage for the action by providing to the insured an initial, general notice of reservation of rights, in language that is understandable by a reasonable person in the position of the insured, but to preserve that reservation of rights the insurer must pursue that investigation with reasonable diligence and must provide the detailed notice stated in subsection (3) within a reasonable time.

Comment:

1. a. The basis for the reservation-of-rights requirement. The rule requiring insurers to provide timely notice in order to preserve the right to contest coverage was originally grounded in estoppel. The underlying idea is that insureds’ expectations about their liability insurance protection are formed in relation to a full-coverage case. In a full-coverage case, the insurer faces substantially all the risk, and a rational insured not only can safely concede full control over the defense to the insurer, but also can choose to engage with the defense at the minimal level required to satisfy the duty to cooperate. Once there is the possibility that the insurer may refuse to pay a judgment, however, the insured faces a very different calculus. Now the insurer asserts that it does not face substantially all the risk. That leads to potential conflicts of interest regarding the scope and direction of the defense and settlement strategy. If insureds do not receive notice of the possibility that the insurer may later deny coverage, they are deprived of the opportunity to engage with the defense at a level appropriate to the risk, and they may not realize, for example, that they have the right to independent counsel.

This situation may meet the requirements of estoppel in many cases. For example, the insurer’s provision of a defense of an action without providing notice of the potential ground for contesting coverage can be understood as a promise to pay the settlement or judgment that may result. The insured’s passive acceptance of, rather than active engagement in, the defense can be treated as reasonable and detrimental reliance on the insurer’s promise. There are two problems with grounding this rule entirely in estoppel, however. First, the rule is now so well established that an insurer that does not raise a ground for contesting coverage should be understood to have waived its right to contest coverage in nearly all cases. Second, there are situations in which it would be very difficult for the insured to demonstrate detrimental reliance, particularly in the consumer context. For these reasons, among others, courts in practice have dispensed with the need to explicitly satisfy the requirements of estoppel in the reservation-of-rights context. This Section recognizes that practical reality by stating a simple-to-apply, straightforward rule that requires an insurer to inform the insured about the insurer’s possible defenses to coverage at the outset of the defense of a claim, or, pursuant to subsection (4), within a reasonable time thereafter. Insurers that do not timely reserve their rights to contest coverage lose those rights.

1. b. A ground for contesting coverage. The rules stated in this Section apply to any ground for contesting coverage, without regard to such distinctions as those between conditions and coverage provisions or between policy and coverage defenses. (For purposes other than the reservation-of-rights requirement, some courts distinguish between “coverage defenses,” which are based on the insurance policy terms setting forth the scope of coverage, and “policy defenses,” which are based on other rules or requirements such as misrepresentation, non-cooperation, or breach of a condition in the policy. Other courts use these terms interchangeably.) An insurer that undertakes to provide a defense without providing timely notice to the insured of any ground of any kind for contesting coverage of which it knows or should know loses the opportunity to contest coverage on that basis.

1. c. Which the insurer knows or should know. What an insurer knows or reasonably should know is a question of fact. In many cases, the relevant facts are amenable to summary resolution by the court. The insurer knows of any information contained in its own records. The insurer also knows of any information obtained by its agents. (Importantly, the defense lawyer is not an agent of the insurer in relation to information germane to any grounds for contesting coverage.) An insurer should know within a reasonable time any allegation contained in any pleading and in any other filing or transcript that a reasonable insurer managing the defense of a case would have reviewed. In addition, the insurer should know of any information that would be obtained through a reasonable investigation. Whether the new information identified in any specific case is something that the insurer should already have known may be readily ascertainable in many cases, particularly by a judge with civil-litigation experience. To the extent that it is difficult to determine whether the insurer should have known this information earlier, however, the insured bears the burden of proof, as is appropriate given the harsh consequences for an insurer that has not adequately reserved its rights.

1. d. Insurers are entitled to a reasonable time to investigate in order to identify potential grounds for contesting coverage. If circumstances require an insurer to begin defending a legal action before it has a reasonable time to conclude its investigation, the insurer may preserve the right to contest coverage by providing the insured with a general notice that the insurer is not yet able to make a determination about whether the action is covered. Thereafter, the insurer must timely provide the specific notice required by this Section in order to avoid losing a potential ground for contesting coverage. In some cases, an insurer may be required to provide multiple notices. For example, depending on the circumstances, an insurer may be obligated to provide a general notice at the outset of undertaking a defense, a specific notice once it has completed its initial investigation, and yet another notice when it later learns of additional facts that provide a basis for another ground for contesting coverage.

1. e. No right to reject the defense. This Section does not follow a minority rule that gives an insured the option to “reject the defense” under a reservation of rights issued pursuant to a liability insurance policy that does not explicitly grant the insured this option. Under this “reject the defense” rule, an insurer, in effect, gives up the right to defend whenever it provides notice to the insured of a potential ground for contesting coverage: the insured may choose to allow the insurer to continue defending under a reservation of rights, but it has the option of hiring and paying the lawyer directly and later seeking reimbursement from the insurer. This rule has been justified on the ground of protecting insureds from conflicts of interest. Yet, managing conflicts of interest does not require the insurer to relinquish the right to defend in every case in which the insurer reserves the right to contest coverage. A reservation of rights undeniably reduces the alignment of interest between insurer and insured from that of a full-coverage case, but other rules governing the duty to defend and the duty to make reasonable settlement decisions better protect the insured than a rule that gives the insured the option of self-funding its own defense and then seeking reimbursement.

In some cases, the independent-defense requirement of § 16 provides better protection to insureds than the “reject-the-defense” rule, because the insurer is required to pay for an independent defense on an ongoing basis. In other cases, insureds are protected by the rule stated in § 14 requiring the insurer to provide a defense that makes reasonable efforts to protect them from all the judgment risks posed by the legal action and the rule stated in § 25(3) authorizing them to settle without the insurer’s consent unless the insurer waives any grounds for coverage. Moreover, a reject-the-defense approach would be meaningless in many, if not most, cases involving consumer insureds, as such insureds are unlikely to have the resources to self-fund the defense of a legal action.

Nevertheless, the rules stated in this Section do not prohibit parties from entering into insurance contracts that provide the insured the right to reject the defense. In addition, insureds that wish to have the option to reject the defense may also contract for that right through a claims-handling agreement, which is a common form of contract entered into as part of a liability insurance program assembled by commercial policyholders.

Reporters’ Note

16. The basis for the reservation-of-rights requirement.In most jurisdictions, “if an insurer conducts an insured’s defense without timely reserving its right to deny coverage, it cannot later disclaim based on any policy defense as to which it was on notice at the time it assumed the insured’s defense.” 1 ALLAN D. WINDT, INSURANCE CLAIMS & DISPUTES § 2:7 (6th ed. 2017). See also Gibson v. Preferred Risk Mut. Ins. Co., 456 S.E.2d 248, 250 (Ga. Ct. App. 1995) (“‘[I]f a liability insurer, with knowledge of a ground of forfeiture or noncoverage under the policy, assumes and conducts the defense of an action brought against the insured, without disclaiming liability and giving notice of its reservation of rights, it is thereafter precluded in an action upon the policy from setting up such ground of forfeiture or noncoverage.’” (quoting Jones v. Ga. Cas., etc., Co., 78 S.E.2d 861, 864 (Ga. Ct. App. 1953)); 3 PAUL E.B. GLAD, WILLIAM T. BARKER & MICHAEL BARNES, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 16.03[3][a] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017) (stating the general rule that “[i]f the insurer provides a defense without indicating that it reserves the right to deny coverage, it will typically be deemed to have acknowledged coverage and may be estopped to later deny coverage”); 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 202:64 (3d ed. 2017) (“Where an insurer defends its insured in an underlying action but neither defends under a reservation of rights nor files a declaratory judgment proceeding, an insurer may be estopped from denying its own liability under the policy ….”).

Although the requirement that the insurer must reserve its rights was originally grounded in estoppel, “a review of the case law reveals it has since developed into a distinct doctrine that stands on its own.” Emp’rs Ins. of Wausau v. Ehlco Liquidating Tr., 708 N.E.2d 1122, 1135 (Ill. 1999). See also Pendleton v. Pan Am. Fire & Cas. Co., 317 F.2d 96, 99 (10th Cir. 1963) (applying New Mexico law) (citation omitted) (“[T]his case is controlled by the long established rule that a liability insurance carrier, which assumes and conducts the defense of an action brought against its insured with knowledge of a ground of forfeiture or noncoverage under the policy, and without disclaiming liability or giving notice of a reservation of its right to deny coverage, is thereafter precluded in an action upon the policy from setting up the ground of forfeiture or noncoverage as a defense. In other words, the insurer’s unconditional defense of an action brought against its insured constitutes a waiver of the terms of the policy and an estoppel of the insurer to assert the defense of noncoverage.”); Collins v. Orange Mut. Cas. Co., 706 N.E.2d 856, 859 (Ohio Ct. App. 1997) (citation omitted) (“Generally, ‘the doctrine of waiver cannot be employed to expand the coverage of a policy.’ An exception to that general rule may occur, however, when the insurer provides a defense to the insured without reserving its rights under the policy.”). Treating the doctrine as distinct from estoppel relieves the insured of the “impossible burden of proving that he or she is demonstrably worse off because of having been denied the opportunity to assert his or her rights.” 1 WINDT § 2:10. Many courts have therefore either adopted a non-rebuttable presumption of prejudice or else determined that prejudice occurs as a matter of law when the insurer defends without reserving its rights. See Knox-Tenn Rental Co. v. Home Ins. Co., 2 F.3d 678, 684 (6th Cir. 1993) (applying Tennessee law) (“The rule [regarding an insurer’s failure to inform an insured that it was defending pursuant to a reservation of rights] by its very language establishes the presumption of prejudice. Otherwise, there would be no necessity for its promulgation.” (quoting Am. Home Assur. Co. v. Ozburn-Hessey Storage Co., 817 S.W.2d 672, 675 (Tenn. 1991))); Transcon. Ins. Co. v. J.L. Manta, Inc., 714 N.E.2d 1277, 1282 (Ind. Ct. App. 1999) (“[A]n insured suffers prejudice as a matter of law where an insurer, without reserving its rights and giving the insured an opportunity to determine whether to accept the tender of defense, assumes a complete defense of the underlying suit against the insured and controls the litigation for an extended period of time after becoming aware of a coverage defense.”).

1. A ground for contesting coverage.See Cozzens v. Bazzani Bldg. Co., 456 F. Supp. 192, 200 (E.D. Mich. 1978) (applying Michigan law) (holding the sufficiency of a reservation “doubtful,” even though it set out the language of the pertinent exclusions verbatim, on grounds that the notice was directed at a layman and yet was “silent as to the meaning of the specific exclusions and as to how and why [the exclusions] would apply”); World Harvest Church, Inc. v. GuideOne Mut. Ins. Co., 695 S.E.2d 6, 10 (Ga. 2010) (oral reservation of rights is insufficient); Mobil Oil Corp. v. Md. Cas. Co., 681 N.E.2d 552, 560 (Ill. App. Ct. 1997) (“A notice of a reservation of rights must make specific reference to the policy defense to be asserted by the insurer and to the potential conflict of interest.”); Bogle v. Conway, 433 P.2d 407, 412 (Kan. 1967) (finding inadequate a reservation notice that made “no mention of any exclusionary clause in the policy or of any purported factual basis upon which a denial of coverage might be predicated”); Harleysville Grp. Ins. v. Heritage Comtys., Inc., 803 S.E.2d 288, 297–299 (S.C. 2017) (holding that a general reservation-of-rights letter that contained a cut and paste of the insurance policy was insufficient to reserve the insurer’s right to contest coverage based on an exclusion in the liability insurance policy); Richards Mfg. Co. v. Great Am. Ins. Co., 773 S.W.2d 916, 919 (Tenn. Ct. App. 1988) (“notice will be held sufficient only if it fairly informs the insured of the insurer’s position”); Weber v. Biddle, 483 P.2d 155, 159 (Wash. Ct. App. 1971), quoting Meirthew v. Last, 135 N.W.2d 353, 355 (Mich. 1965) (suggesting that a reservation-of-rights letter “smacks of bad faith for want of specific reference to that clause of the policy the garnishee has pleaded”). See generally 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 202:64 (3d ed. 2017) (discussing the sufficiency of a reservation of rights).

16. Which the insurer knows or should know.An insurer’s undertaking of a defense will preclude it from disputing coverage only if it failed to reserve its rights “after having received information sufficient to put it upon inquiry as to the ground of nonliability which it later seeks to assert against the insured.” 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 202:59 (3d ed. 2017). See also First United Bank of Bellevue v. First Am. Title Ins. Co., 496 N.W.2d 474, 480 (Neb. 1993) (identifying a “widely recognized” exception to the typical estoppel rule that holds “when an insurance company assumes the defense of an action against its insured, without reservation of rights, and with knowledge, actual or presumed, of facts which would have permitted it to deny coverage, it may be estopped from subsequently raising the defense of non-coverage.”); 3 PAUL E.B. GLAD, WILLIAM T. BARKER & MICHAEL BARNES, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 16.03[3][d][i] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017) (“If an insurer, having notice of possible grounds to deny indemnification, assumes control of an insured’s defense without reserving its right to deny coverage on such grounds, it may later be estopped to deny.”). Any possible basis for contesting coverage arising from information in the complaint or within the insurer’s actual possession must, therefore, be specified in a reservation of rights. See, e.g., Founders Ins. Co. v. Olivares, 894 N.E.2d 586, 593 (Ind. Ct. App. 2008) (finding the insurer was estopped to deny coverage when the allegations clearly named a driver explicitly excluded under the policy, and the insurer failed to prove that it notified the insureds of its “excluded driver” defense before assuming their defense).

An insurer will also be deemed to know or be on notice of any information that would have been uncovered in a reasonable investigation of the action. See, e.g., City of Carter Lake v. Aetna Cas. and Sur. Co., 604 F.2d 1052, 1062 (8th Cir. 1979) (applying Nebraska law) (finding that the insurer could not dispute coverage when it failed to conduct “an early initial investigation and [consider] all possible lines of defense.”); Beckwith Mach. Co. v. Travelers Indem. Co., 638 F. Supp. 1179, 1187 (W.D. Pa. 1986) (applying Pennsylvania law) (holding that the insurer, which had defended the insured for 13 months unconditionally and had failed to conduct a proper investigation, was estopped to deny coverage). See generally 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 202:59 (3d ed. 2017) (“[I]t is the insurer’s duty to investigate all the facts in connection with the supposed loss, as well as any possible defense upon the policy, before undertaking the defense of the case against the insured.”).

16. Timing.See generally 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 202:3 (3d ed. 2017) (discussing procedural rules surrounding the declaratory-judgment action, including timing, issues of joinder and stay, and justiciability). Although insurers are on notice of facts that would have been uncovered in a reasonable investigation, courts have generally allowed them a “reasonable time to investigate the facts to determine [their] acceptance of liability.” Diamond Serv. Co. v. Utica Mut. Ins. Co., 476 A.2d 648, 656 (D.C. 1984). See, e.g., Capoferri v. Allstate Ins. Co., 322 So. 2d 625, 627 (Fla. Dist. Ct. App. 1975) (holding that initial appearance by insurer’s attorneys did not preclude the insurer from later disputing coverage because the insurer “is entitled to a reasonable time in which to investigate and determine whether it desires to avail itself of any defense that may be found to exist”). See also 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 202:50 (3d ed. 2017) (“Courts generally allow an insurer the right to reasonably investigate the facts and circumstances underlying the action against the insured, and will not find such actions to be a subsequent waiver” and “[t]he bulk of authority is to the effect that, assuming that the reservation of rights is sufficiently specific, the insurer will not be estopped or otherwise prevented from asserting, or found to have waived, the defense that the insured’s loss was not covered by the insurance policy”). Therefore, “[a]s long as the insurer conducts any such investigation and analysis with reasonable diligence and promptly notifies the insured of its position once the process is complete, that is generally sufficient.” 3 PAUL E.B. GLAD, WILLIAM T. BARKER & MICHAEL BARNES, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 16.03[3][d][i] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017).

While the investigation is underway, however, an insurer must provide a general reservation of rights to put the insured on notice “that the insurer reserves the right to disclaim coverage based on further factual development.” BARRY R. OSTRAGER & THOMAS R. NEWMAN, HANDBOOK ON INSURANCE COVERAGE DISPUTES§ 2.02(b) (18th ed. 2016). See, e.g., Standard Fire Ins. Co. v. Donnelly, 689 F. Supp. 2d 696, 704 (D. Vt. 2010) (“If further investigation is required to ascertain whether coverage is available, the reservation of rights letter (or non-waiver agreement) should state that the insurer reserves the right to disclaim coverage based on further factual development.” (quoting In re Lynch, 226 B.R. 813, 816 n.7 (Bankr. D. Vt. 1998))). See also 1 ALLAN D. WINDT, INSURANCE CLAIMS AND DISPUTES, 6TH§ 2:14 (2017) (“The only circumstance, therefore, in which an insurer can properly send a reservation of rights letter in which it merely reserves all of its rights is when it assumes the insured’s defense without having had a reasonable opportunity to analyze the existence of coverage.”).

But once the insurer’s investigation directs it to “information concerning the possible absence of coverage, the insurer must promptly serve upon the insured a reservation of rights.” AIG Haw. Ins. Co. Inc. v. Smith, 891 P.2d 261, 264 (Haw. 1995). See also 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 202:46 (3d ed. 2017) (“When an insurer obtains knowledge … which may raise the possibility of conflict between the insurer’s duty to represent and defend the insured and its duty to assume liabilities under the policy, the insurer must promptly provide notice of its reservation of rights on peril of estoppel to assert such policy defenses.”).

1. No right to reject the defense.“[A] reservation of rights does not alter the insurer’s duty to defend; the insurer remains obligated to defend the insured reasonably, responsibly, and in good faith.” Douglas R. Richmond, Reconsidering the Rejection of Reservation of Rights, 34 No. 1 Ins. Litig. Rep. 5 § II.C (2012). Numerous courts have therefore held that insurers may defend under a reservation of rights without the insured’s consent. See, e.g., Draft Sys., Inc. v. Alspach, 756 F.2d 293, 296 & n.2 (3d Cir. 1985) (applying Pennsylvania law) (“‘[R]eservations of rights’ letters do not require assent of the insured” to be “valid and effective in Pennsylvania.”); Walbrook Ins. Co. v. Goshgarian & Goshgarian, 726 F. Supp. 777, 783 (C.D. Cal. 1989) (applying California law) (“[A] survey of the limited number of cases on refusals to consent to reservations of rights from other jurisdictions shows that the modern trend is to find a unilateral reservation to be effective without the insured’s consent.”); McGouch v. Ins. Co. of N. Am., 691 P.2d 738, 745 (Ariz. Ct. App. 1984) (holding that an insurer may defend under a reservation of rights, and “an insured may not condition the insurer’s right to defend upon an agreement by the insurer to waive its right to later litigate the question of coverage.”).

Only a minority of jurisdictions allow insureds to reject a defense under a reservation of rights. See Douglas R. Richmond, Reconsidering the Rejection of Reservation of Rights, 34 No. 1 Ins. Litig. Rep. 5 § I (2012) (“A defense under reservation of rights is enormously beneficial to the insured…. In a few jurisdictions, however, insureds may reject a defense under a reservation.”). See also William T. Barker, Insurer Control of Defense: Reservations of Rights and Right to Independent Counsel, 71 DEF. COUNS. J. 16, 17–18 (2004) (“A few states authorize the insured to reject the insurer’s defense whenever there is a reservation of the right to deny indemnification…. [This doctrine] is not generally accepted.”). For cases adopting the minority rule, see, e.g., Mid-Continent Cas. Co. v. Am. Pride Bldg. Co. LLC., 601 F.3d 1143, 1149 (11th Cir. 2010) (applying Florida law) (“While an insurer must defend its insured, and may tender its defense subject to a reservation of rights, Florida law does not require an insured to accept such a defense.”); Rhodes v. Chi. Ins. Co., 719 F.2d 116, 120 (5th Cir. 1983) (applying Texas law) (“When a reservation of rights is made, however, the insured may properly refuse the tender of defense and pursue his own defense.”).The minority rule is sometimes justified as protecting the insureds from a conflict of interest. See, e.g., Rhodes v. Chi. Ins. Co., 719 F.2d at 120 & n.6 (noting that the “reservation of rights serves as notice to the insured of the potential conflict of interest” and enables the insured to “properly refuse the tender of defense and pursue his own defense”). But “[t]he fact that a case is defended under a reservation of rights … does not necessarily mean that there is a conflict of interest ….” Douglas R. Richmond, Reconsidering the Rejection of Reservation of Rights, 34 No. 1 Ins. Litig. Rep. 5 § II.C (2012). See, e.g., Twin City Fire Ins. Co. v. Ben Arnold-Sunbelt Beverage Co., 433 F.3d 365, 372 (4th Cir. 2005) (applying South Carolina law) (“[W]e … reject the notion that the reservation of rights letter issued in this case creates a per se conflict [of interest] … ”); Rx.com Inc. v. Hartford Fire Ins. Co., 426 F. Supp. 2d 546, 559 (S.D. Tex. 2006) (applying Texas law) (“Not every reservation of rights creates a conflict of interest …. Rather, the existence of a conflict depends on the nature of the coverage issue as it relates to the underlying case.”). See also William T. Barker, Insurer Control of Defense: Reservations of Rights and Right to Independent Counsel, 71 DEF. COUNS. J. 16, 18 (2004) (“[M]ost jurisdictions that have addressed the issue consider questions of the right to control the defense in terms of whether there is a conflict of interest, implying that a reservation of rights alone is not enough to deprive the insurer of this right.”). Finally, “if a reservation of rights presents a conflict of interest between the insurer and the insured, a preferable solution would be to require the insurer to provide the insured with independent counsel at the insurer’s expense. This approach assures the insured of an adequate defense without forcing unreasonable choices on the insurer.” Douglas R. Richmond, Reconsidering the Rejection of Reservation of Rights, 34 No. 1 Ins. Litig. Rep. 5 § II.C (2012).

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 24 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 2. Settlement

• 24 The Insurer’s Duty to Make Reasonable Settlement Decisions

^Comment:

^{Reporters’ Note}

• (1) When an insurer has the authority to settle a legal action brought against the insured, or the insurer’s prior consent is required for any settlement by the insured to be payable by the insurer, and there is a potential for a judgment in excess of the applicable policy limit, the insurer has a duty to the insured to make reasonable settlement decisions.
• (2) A reasonable settlement decision is one that would be made by a reasonable insurer that bears the sole financial responsibility for the full amount of the potential judgment.
• (3) An insurer’s duty to make reasonable settlement decisions includes the duty to make its policy limits available to the insured for the settlement of a covered legal action that exceeds those policy limits if a reasonable insurer would do so in the circumstances.

Comment:

1. a. Relationship to the duty of good faith and fair dealing. Because of its origins in the duty of good faith and fair dealing, courts in many jurisdictions refer to the standard for breach of the duty to make reasonable settlement decisions as one of “bad faith.” That formulation suggests the need to prove bad intent on the part of the insurer that goes beyond the reasonableness standard stated in this Section, and some courts do require such a showing. In most breach-of-settlement-duty cases, however, even those that invoke the language of bad faith, the ultimate test of liability is whether the insurer’s conduct was reasonable under the circumstances.

This Restatement clarifies the law by making a clear distinction among several categories of insurance-law cases that many courts classify together as insurance bad-faith cases but in practice treat as distinct from each other. Two of these categories of cases deal with the settlement context; the third deals with contexts not involving settlement.

The first category is that of an insurer that allegedly made an unreasonable settlement decision that resulted in, or could result in, an excess verdict against the insured. This is the category of cases addressed in this Section. For this category of cases, courts generally apply an objective, commercial-reasonableness standard, as distinct from a standard that relies primarily on proof of bad intent. To make clear that an insurer’s settlement duty is grounded in commercial reasonableness, this Section does not use the term “bad faith” to describe the insurer’s breach of the duty to make reasonable settlement decisions. Rather, this Section states expressly the commercial-reasonableness standard that most courts actually apply.

The second category of cases that many courts classify as involving insurance bad faith is that of an insurer that allegedly engaged in improper conduct outside of the settlement context. For those cases, which are much less frequently the subject of published liability insurance opinions than breach-of-settlement-duty cases, this Restatement uses the term “bad faith” and, like most courts, applies a more demanding two-prong test, as stated in § 49. Separating these first two categories of cases clarifies and improves the law by reducing the likelihood that an inexperienced judge or lawyer will mistakenly conclude that the same legal standard applies in both categories.

The third category of cases that many courts classify as involving insurance bad faith is that of an insurer whose improper conduct in the settlement context goes beyond unreasonableness and satisfies the more demanding two-prong test stated in § 49. Under the rules as clarified in this Restatement, such an insurer would be subject to additional liability for bad faith under § 49. That additional liability can include attorneys’ fees and, if the relevant state-law standard is met, punitive damages. See § 50. To be clear: a liability insurer that breaches the duty to make reasonable settlement decisions stated in this Section is subject to liability for damages under § 27, but it is not thereby subject to liability for insurance bad faith unless the insured proves that the insurer’s conduct also meets the more demanding requirements of § 49. See Comment c to § 49.

1. b. A duty to make reasonable settlement decisions rather than the “duty to settle.” The duty set forth in this Section is a longstanding rule of insurance law that is frequently referred to in shorthand by commentators and some courts as the “duty to settle.” This Section uses a more accurate term, the “duty to make reasonable settlement decisions,” to emphasize that the insurer’s duty is not to settle every legal action, but rather to protect the insured from unreasonable exposure to a judgment in excess of the limits of the liability insurance policy. Although a strict-liability standard of the sort that might be suggested by the label “duty to settle” would eliminate the need for the reasonableness evaluation, a strict-liability standard has not found favor in the courts. Moreover, the reasonableness standard followed in this Section is more closely tailored to the conflict of interest that underlies the legal duty.

The insurer’s duty to make reasonable settlement decisions arose as a special application of the general contract-law duty of good faith and fair dealing in the context of insurance policies that granted the insurer discretion over the settlement of an insured liability action. As courts early recognized, when the insured faces a potential judgment in excess of the policy limit (an “excess judgment”), the insurer may have an incentive to undervalue the possibility of a loss at trial, because a portion of that loss will be borne by the insured rather than by the insurer, absent a legal rule assigning the risk of excess judgment to the insurer. For example, if an insurer receives a settlement offer that is equal to or just under the policy limits, the insurer has little financial incentive, other than a reduction in defense costs, to accept that offer as long as there is some chance of a judgment at trial in favor of the defense. By going to trial in such cases, the insurer maintains the possibility of eliminating its own liability by winning the case against the claimant. Moreover, as long as the insurer’s liability is bounded by the policy limit, taking the case to trial imposes no added risk on the insurer, beyond the additional defense costs required to try the case. As courts have described this conflict-of-interest problem, an insurer that rejects a reasonable settlement offer in favor of going to trial is effectively “gambling with the insured’s money,” or gambling with the excess insurer’s money, because the insured or the insured’s excess insurer will have to pay any verdict in excess of the policy limit.

The duty to make reasonable settlement decisions creates an incentive for insurers to take into account this risk to insureds and excess insurers. Because the purpose of the duty to make reasonable settlement decisions is to align the interests of insurer and insured in cases that expose the insured to damages in excess of the policy limits, the duty is owed only with respect to the exposure to such excess damages. With respect to liability for damages within the policy limits, the insurer’s contractual liability for those damages already provides an incentive for the insurer to make reasonable settlement decisions. Because the duty to make reasonable settlement decisions is owed only to protect the insured from damages in excess of the policy limits, an insurer can eliminate the risk that gives rise to that duty by waiving the policy limit.

1. c. Equal consideration and the “disregard the limits” rule. In the insurance context, the general duty of good faith and fair dealing is often described as requiring the insurer to give equal consideration to the interests of its insured. The duty to make reasonable settlement decisions can be similarly described as requiring the insurer to give equal consideration to the insured’s exposure in excess of the policy limits. Where there is the potential for a judgment in excess of the policy limit, equal consideration requires managing the litigation and settlement process in a manner that neutralizes, to the extent possible, the conflict of interest described in Comment b. Courts and commentators use a variety of verbal formulas to articulate that requirement more precisely. The standard stated in subsection (2) implements the equal-consideration requirement in actionable terms. A reasonable settlement offer is one that would be accepted or made by a reasonable insurer that bears the sole financial responsibility for the full amount of the potential judgment. Courts and commentators sometimes refer to this formulation of the standard as the “disregard the limits” rule, because it requires the insurer to evaluate the reasonableness of a settlement offer without regard to the policy limits, or, to put it another way, in a manner that “disregards the limits” of the policy.

3. d. Applying the reasonableness standard. The “reasonable insurer” referred to here is a legal construct, like that of the “reasonable person” in tort law. As such, it can be understood to incorporate both the concept of an average or ordinary insurer that sells liability insurance of the kind and in the amounts of the liability insurance policy at issue as well as a more aspirational concept that protects against circumstances in which average conduct is objectively unreasonable. See Restatement Third, Torts: Liability for Physical and Emotional Harm § 3. The duty to make reasonable settlement decisions includes the duty to accept a settlement offer that a reasonable insurer would accept and to make an offer to settle when a reasonable insurer would do so, if that reasonable insurer had sold an insurance policy with limits that were sufficient to cover any likely outcome of the legal action. See also Comment f (on the insurer’s failure to make settlement offers).

In determining whether a settlement decision was reasonable, the factfinder should view the settlement decision from the perspective of the parties at the time the settlement decision was made. A reasonable insurer is expected, at the time of the settlement negotiations, to consider the realistically possible outcomes of a trial and, to the extent possible, to weigh those outcomes according to their likelihood. In a complex case, these evaluations are difficult, both for the insurer making the settlement decision and for the trier of fact in a subsequent suit challenging the reasonableness of the insurer’s settlement decision. This difficulty, however, cannot be avoided. If a reasonableness standard is to be applied, such qualitative evaluations are inevitable. The insurer will be liable for any excess judgment against the insured in the underlying litigation if the trier of fact finds that the insurer rejected a settlement offer that a reasonable insurer would have accepted (or failed to consent to a settlement to which a reasonable insurer would have consented).

In evaluating the reasonableness of an insurer’s settlement decisions, the trier of fact may consider, among other evidence, expert testimony as well as testimony from the lawyers and others involved in the underlying insured liability claim. Courts assessing the reasonableness of settlement offers may also consider other facts, such as the amount of time that is given to evaluate an offer and the jurisdiction in which the case would be tried. It is also appropriate for the trier of fact to consider the procedural factors addressed in Comment e. It is important to note that this standard considers the interests of the insurer and the insured only in relation to the legal action at issue, not the insurer’s interest in minimizing the overall size of the losses in its portfolio of claims. Otherwise, the insurer would not be giving equal consideration to the interests of the insured.

The effect of this rule is that, once a claimant has made a settlement offer in the underlying litigation that a reasonable insurer would have accepted, an insurer that rejects that offer thereafter bears the risk of an excess judgment against the insured at trial. One practical effect of this rule is to give claimants an incentive during the pretrial phase to make reasonable settlement offers within the policy limits, because the insurer’s rejection of such an offer sets the stage for a subsequent breach-of-settlement-duty lawsuit in the event of a verdict that produces an excess judgment that is covered by the policy. In that subsequent lawsuit, it will not be sufficient for the policyholder to simply demonstrate that the amount of the offer was reasonable; the policyholder must also demonstrate that a reasonable insurer would have accepted the offer. Nevertheless, evidence that the amount of the offer was reasonable would ordinarily be enough to make the reasonableness of the insurer’s decision to reject the offer a question of fact.

• Illustrations:

1. A claimant files a personal-injury lawsuit against the insured seeking damages. The insured has a duty-to-defend liability insurance policy that assigns settlement discretion to the insurer. The policy contains a policy limit of $75,000 and no deductible. The claimant offers to settle for $45,000. The insurer rejects the offer. The case proceeds to trial and a judgment of $175,000 is entered against the insured. In a subsequent action for breach of the duty to make reasonable settlement decisions, the insured introduces evidence supporting the conclusion that, at the time of the settlement negotiations, $45,000 was a reasonable settlement value of the case, based on the judgment that it was reasonable to conclude that the plaintiff had a 30 percent chance of success and likely damages of $150,000. Based on this evidence, a trier of fact could conclude that a reasonable insurer would have accepted the offer and, thus, the insurer breached its duty.

2. Same facts as Illustration 1, except that the insurer makes a counteroffer of $35,000 and, in the subsequent breach-of-settlement-duty case, the adjuster managing the claim for the insurer testifies that, based on her extensive experience managing similar claims, she believed that the claimant would eventually accept the counteroffer. The parties offer conflicting expert testimony regarding the reasonableness of the adjuster’s decision to reject an offer that represented a reasonable settlement value of the suit in these circumstances. Even if the trier of fact concludes that the adjuster had made every reasonable effort to become informed about the suit and honestly held the opinion to which she testified and, accordingly, that the rejection of the settlement offer was in good faith, the trier of fact could nevertheless conclude that a reasonable insurer would have accepted the initial offer, and, thus, the insurer breached its duty. Based on this evidence, the trier of fact could also conclude, however, that the insurer did not breach its duty.

1. e. Procedural factors may be considered. The reasonableness standard requires the trier of fact in the breach-of-settlement-duty suit to evaluate the expected value of the underlying legal action at the time of the failed settlement negotiations. That inquiry may be complex and difficult in some cases. Because of the difficulty of determining, in hindsight, whether a settlement offer was reasonable, it may be appropriate in some cases for the trier of fact also to consider procedural factors that affected the quality of the insurer’s decisionmaking or that deprived the insured of evidence that would have been available if the insurer had behaved reasonably. Factors that may affect the quality of the insurer’s decisionmaking include: a failure to conduct a reasonable investigation, a failure to conduct negotiations in a reasonable manner, a failure to follow the recommendation of its adjuster or chosen defense lawyer, and a failure to seek the defense lawyer’s assessment of the settlement value of the case. Factors that may deprive the insured of evidence include: a failure to conduct a reasonable investigation, a failure to follow the insurer’s claims-handling procedures, a failure to keep the insured informed of within-limits offers or the risk of excess judgment, and the provision of misleading information to the insured.

Such factors are not enough to transform a plainly unreasonable settlement offer into a reasonable offer, but they can make the difference in a close case by allowing the jury to draw a negative inference from the lack of information that reasonably should have been available or from the low quality of the insurer’s decisionmaking and fact-gathering processes. Just as reasonable investigation and settlement procedures cannot guarantee that an insurer will make a decision that is substantively reasonable, however, the failure to employ reasonable procedures does not necessarily mean that the insurer’s decision was substantively unreasonable. In breach-of-settlement-duty cases in which the facts do not make clear that the insurer’s settlement decision was substantively reasonable, however, the factfinder may decide based on these other procedural factors that the settlement decision was unreasonable. In an extreme case of the breach of the duty to make reasonable settlement decisions, the insurer may be subject to liability for bad-faith breach, when all of the elements of a bad-faith breach are present. See § 49 (stating the elements of a bad-faith claim).

By the same token, it may also be appropriate in some cases for the trier of fact to consider procedural factors that affect whether the claimant in fact would have accepted a reasonable offer to settle within the policy limits. One example is refusing to give the insurer a reasonable amount of time to investigate a claim or consider an offer. If the trier of fact concludes that the claimant would not have accepted a reasonable settlement offer within the policy limits, then the causation element required to recover for a breach of the duty to make reasonable settlement decisions will not be satisfied and, thus, the insurer’s liability will be limited to the policy limits. See Comment g.

• Illustration:

3. A claimant files a tort suit against the insured seeking compensatory damages of $500,000. The insured has a duty-to-defend liability insurance policy that assigns settlement discretion to the insurer, with a policy limit of $100,000. Early in the litigation the claimant makes a time-limited settlement offer for the policy limits directly to the insurance-claims manager, giving the insurer 60 days to investigate and either accept or reject the offer. The insurer immediately rejects the offer without conducting a reasonable investigation. The claim goes to trial and results in a jury verdict against the insured of $500,000. In the subsequent breach-of-settlement-duty lawsuit brought by the insured against the insurer, the trier of fact may, but need not, properly conclude from the insurer’s failure to investigate that the insurer’s settlement decisions were unreasonable. If the trier of fact concludes that the $100,000 offer was unreasonably high at the time it was made and that the claimant was unwilling to accept any reasonable settlement offer, the insurer will not be held liable for the excess judgment. One relevant consideration would be a showing of what the investigation would have revealed had it been conducted.

1. f. The insurer’s failure to make settlement offers and counteroffers. This Section adopts a reasonableness standard, not a hard-and-fast rule regarding the insurer’s obligation to make settlement offers or counteroffers. As with an insurer’s settlement decisions generally, the question is what a reasonable insurer would do under the circumstances. In the absence of a reasonable offer by the plaintiff, there can be circumstances in which it would be unreasonable for an insurer not to make a settlement offer before trial, such as, for example, when the facts known to the insurer make clear that the policy limits are significantly less than the reasonable settlement value of the underlying case (perhaps because the claimant’s damages are indisputable and very large and the likelihood of the insured’s being found liable is high). In such circumstances, the insurer’s obligation to attempt to protect its insured from an excess judgment may include making a reasonable settlement offer to the claimant. By making such an offer, and by otherwise behaving reasonably in the settlement negotiations, the insurer can eliminate its potential liability for an excess judgment, even if that offer is rejected. It is important to emphasize, however, that there may be good reasons for an insurer not to make an offer. For example, it may be strategically useful, from the perspective of a reasonable insurer that bears the full risk of judgment, to refrain from making a settlement offer in order to gather more information, to encourage the claimant to reveal more about its case, or to place pressure on the claimant to initiate settlement discussions. Of course, the insurer’s strategic reasons for not making a settlement offer must relate solely to the legal action at issue, not to the insurer’s interest in managing its portfolio of legal actions. It should also be noted that an insurer has no obligation to make a settlement offer that exceeds the policy limits. However, in situations in which a reasonable insurer bearing sole responsibility for the entire judgment would make an above-limits offer, the insurer may have an obligation to invite the insured to contribute to an above-limits settlement offer.

1. g. The causation difference between rejecting a settlement offer and choosing not to make an offer. An insurer’s decision to reject a reasonable settlement offer made by a claimant potentially has different consequences than an insurer’s decision not to make its own reasonable settlement offer, even in those situations in which a reasonable insurer would have made such an offer. The difference comes from the causation requirement in an action for breach of the duty. When an insurer breaches the duty by failing to accept a settlement offer (in situations in which failing to accept such an offer constitutes a breach of the duty), and the case goes to trial resulting in an excess judgment against the insured, the causation requirement is satisfied: had the insurer accepted the settlement offer, there would have been no trial and no possibility of an excess judgment. By contrast, when the insurer breaches the duty by failing to make its own settlement offer (in situations in which failing to make its own settlement offer constitutes a breach of the duty), and the case goes to trial and an excess judgment ensues, causation remains in question. The insurer’s failure to make an offer caused the excess judgment only if the claimant would have accepted a reasonable offer from the insurer. Proving causation is difficult. Before the trial, the claimant would have been in the best position to answer the question whether he or she would have accepted the settlement offer, but after the excess judgment the claimant’s interests will often be too closely aligned with those of the insured defendant to be objective. Other good sources of objective evidence on the matter will be scarce. Nevertheless, a trier of fact may conclude that an insurer’s decision not to make a settlement offer or counteroffer constituted an unreasonable settlement decision, that the claimant would have accepted a reasonable offer had it been made, and that the unreasonable settlement decision therefore was the cause of the excess judgment against the insured.

• Illustrations:

4. A claimant files a personal-injury lawsuit against the insured seeking damages. The insured has a duty-to-defend liability insurance policy that assigns settlement discretion to the insurer. The policy contains a policy limit of $100,000 and no deductible. As found by the trier of fact in a subsequent action for breach of the duty to make reasonable settlement decisions, reasonable estimates of the value of the underlying claim range between $30,000 and $45,000. The claimant makes no settlement offers during the period leading up to the trial. The insurer, however, makes a settlement offer of $35,000, which is rejected by the claimant. The jury in the personal-injury lawsuit finds for the claimant and awards damages of $150,000. The insurer is not subject to liability for the amount of the judgment in excess of the policy limits. By making a reasonable settlement offer in a circumstance in which the claimant did not make a reasonable settlement offer, the insurer satisfied its duty to make reasonable settlement decisions.

5. Same facts as Illustration 4, except that the insurer, rather than making a $35,000 settlement offer, makes a $5000 settlement offer, well below the minimum reasonable offer. The claimant rejects the offer. The insurer makes no other settlement offers. The case then goes to trial, resulting in a jury verdict of $150,000 for the claimant, which includes an excess judgment of $50,000. The trier of fact in a subsequent action alleging breach of the duty to make reasonable settlement decisions may take into account that the insurer, having received no reasonable settlement offer from the claimant, failed to make a reasonable settlement offer of its own. Indeed, the trier of fact may conclude from this fact, in the absence of compelling reasons to the contrary, that the insurer acted unreasonably and thus breached its settlement duty. Whether the insurer is subject to liability for the amount in excess of the policy limits for any breach, however, will depend on whether the trier of fact determines that the claimant would have accepted a reasonable offer.

6. Same facts as Illustration 4, except that the claimant makes a settlement offer of $45,000. The insurer rejects that offer and makes a counteroffer of $35,000 in circumstances in which a reasonable insurer would have accepted the $45,000 offer. The claimant rejects the insurer’s offer, and the settlement negotiations break down. The case goes to trial, resulting in a $150,000 judgment against the insured, which is $50,000 more than the policy limits. In the subsequent breach-of-settlement-duty case against the insurer, the insurer is subject to liability for the full amount of the judgment, because the insurer rejected a settlement offer in the underlying litigation that a reasonable insurer would have accepted.

1. h. Settlement offers in excess of policy limits. In some cases, the expected value of the underlying legal action is greater than the limits on coverage contained in the policy. In such cases a reasonable insurer that bore the risk of the entire liability would settle the case for an amount in excess of the policy limits. The duty to make reasonable settlement decisions, however, does not obligate the insurer to accept or make such settlement offers in excess of its policy limits. In such cases the insurer may satisfy the duty by informing the insured that the insurer is prepared to offer the policy limits toward a reasonable settlement. The insurer may also make the insured aware of the option to pay the amount of the settlement in excess of the policy limits and explain why the insurer has concluded that settlement would be reasonable (for example, by pointing out the high likelihood of an excess judgment in the event of a trial). If the insured opts not to pay to settle in excess of the policy limits, the insurer is not thereby excused from its obligation to defend the claim. See 18 (terminating the duty to defend). This duty to make the policy limits available to the insured in response to reasonable settlement offers in excess of the policy limits is sometimes referred to as the “duty to contribute.” The duty to contribute does not apply to settlement offers that are unreasonable.

• Illustration:

7. A claimant files a tort suit against the insured seeking compensatory damages of $500,000 and punitive damages of $700,000. The insured has a duty-to-defend liability insurance policy that gives settlement discretion to the insurer and provides coverage for punitive damages, which are insurable in the jurisdiction. The policy also contains a policy limit of $500,000 and no deductible. At the time of settlement negotiations in the underlying tort action, the reasonable settlement value of the case ranges between $525,000 and $600,000. The claimant makes a settlement offer of $545,000. A reasonable insurer—a rational insurer that is the sole holder of the full $1.2 million potential liability—would accept the offer. The insurer satisfies its obligations under the duty to make reasonable settlement decisions by notifying the insured of the offer and by offering to contribute the policy limits in support of the settlement. The insurer has no obligation to pay more than the policy limits to settle the claim.

1. i. When there are covered and noncovered components of a legal action. As explained in 25, an insurer’s reservation of rights to deny coverage for all or part of a legal action does not relieve the insurer of the obligation to make reasonable settlement decisions under this Section. The application of this rule is straightforward in a circumstance in which there is a single coverage defense that either will or will not apply to the entire judgment in the legal action at issue. If the insurer decides not to accept a settlement offer that a reasonable insurer that bore the sole financial responsibility for the full amount of the potential judgment would have accepted, then the insurer’s obligation to pay any excess verdict will depend on the outcome of the coverage dispute. If the insurer prevails in that coverage dispute, it will have no obligation to pay the judgment. If the insured prevails, the insurer will be obligated to pay the judgment.

The rule in this Section is similarly straightforward to apply in circumstances in which the insurer and the insured agree that there are covered and uncovered components of the damages sought in the underlying legal action. In that circumstance, the reasonableness of the insurer’s settlement decisions is assessed only in relation to the covered components of the damages, because the insurer does not have an obligation to pay for the components of the damages that are not covered. Thus, the reasonableness of the insurer’s decision will depend on the relationship between the amount of the settlement that the insurer is asked to pay and the potential exposure to the insured that is posed by the covered portion of the claim. Note that this Comment does not express this relationship in terms of the percentage of the settlement that the insurer is asked to pay, because an underlying claimant may be prepared to accept a lesser recovery for an uncovered component of its damages than for a covered component, and there may even be some circumstances in which the reverse is true.

The rule is more complicated to apply when the insurer and the insured do not agree that there are uncovered portions of the damages sought in the legal action. In such circumstances, the question whether the insurer breached the duty to make reasonable settlement decisions cannot be answered with confidence until the coverage dispute is resolved. As provided in § 25, the presence of the potential coverage dispute does not relieve the insurer of the duty to make reasonable settlement decisions. Therefore, an insurer that chooses not to settle, in a circumstance in which an insurer that bore the full responsibility for the potential judgment would settle, bears some risk.

• Illustrations:

8. A claimant files a personal-injury lawsuit against the insured seeking damages. The insured has a duty-to-defend general-liability insurance policy that assigns settlement discretion to the insurer. The policy contains a policy limit of $75,000 and no deductible. The insurer agrees to defend subject to a reservation of rights based on the insured’s noncompliance with a notice condition in the policy. The claimant offers to settle for $45,000, which is an amount that a reasonable insurer that bore the full responsibility for the judgment would accept. The insurer rejects the offer. The case proceeds to trial and a judgment of $175,000 is entered against the insured. The insurer refuses to pay the judgment based on the reserved late-notice defense. The insured brings a breach-of-contract action against the insurer. In that action, the insurer fails to satisfy the requirements stated in § 35(1) for a late-notice defense. Thus, the insurer is obligated to pay the judgment without regard to the policy limit.

9. A claimant files a tort action against the insured seeking damages for property damage caused to the claimant’s factory allegedly as the result of defective pipe that the insured sold to the claimant. The insured has a duty-to-defend liability insurance policy that assigns settlement discretion to the insurer. The policy contains a policy limit of $500,000 and no deductible. The complaint alleges damages for the repair and replacement of the pipe and for damages to other parts of the factory. The insurer agrees to defend subject to a reservation of the right not to pay for the cost of repair and replacement of the pipe, based on the “impaired property” exclusion in the policy. The insured agrees that there is no coverage for that component of the alleged damages. The claimant offers to settle for $500,000. The insured offers to pay $100,000 of the settlement and demands that the insurer pay the remaining $400,000, which is an amount that a reasonable insurer that bore the full responsibility solely for the covered portion of the damages would have accepted. The insurer rejects the offer. If the tort action proceeds to trial, the insurer will be obligated to pay the full amount of the portion of any judgment that is assessed against the insured for damages other than the cost of repairing and replacing the pipe.

10. Same facts as Illustration 9, except that the insured does not agree that the impaired-property exclusion excludes coverage for the repair and replacement of the pipe and, therefore, demands that the insurer pay the full $500,000 of the settlement. $500,000 is an amount that a reasonable insurer that bore the responsibility for the full amount of a judgment would pay, but it is more than a reasonable insurer would pay if that insurer did not bear the responsibility for the costs of the repair and replacement of the pipe. Thus, the question whether the insurer breached the duty to make reasonable settlement decisions depends on whether the impaired-property exclusion excludes coverage for the repair and replacement of the pipe. If so, the insurer did not breach that duty and, thus, its obligation to pay for any judgment is capped at the policy limit.

28. j. No direct duty owed to excess insurers. The duty stated in this Section is owed to insureds, not to excess insurers. Excess insurers nevertheless may recover through equitable subrogation for damages incurred as a result of a breach of the duty to make reasonable settlement decisions. Excess insurers’ subrogation rights are addressed in 28.

36. k. No duty owed to third parties. The duty to make reasonable settlement decisions is owed to insureds, not to the third-party claimants that bring tort suits against insured defendants. A claimant has no independent common-law right to recover against the insurer for breach of the duty to make reasonable settlement decisions. The courts in a few states have interpreted state insurance consumer-protection statutes to grant tort claimants an implied statutory private right of action against insurers for unfair settlement practices in individual cases, but courts have not done so as a matter of common law. An insured may assign its rights under a liability insurance policy, including for breach of the duty to make reasonable settlement decisions, to a third-party claimant. See 36.

1. l. Settlement by insured after insurer’s breach of duty. Section 27 addresses the damages payable for breach of the duty to make reasonable settlement decisions. Those damages include the amount of a judgment that is in excess of the applicable policy limit and the amount of a reasonable and noncollusive settlement entered into by the insured, or another insurer acting on the insured’s behalf, following a breach of the duty to make reasonable settlement decisions. See 27, Comment b.

Reporters’ Note

23. Relationship to the duty of good faith and fair dealing.For an explanation of how the duty to settle evolved from the duty of good faith and fair dealing, see generally 3 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 23.01[d] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017). As a result of this historical development of the doctrine, some courts have expressed a breach of the duty to settle as a bad-faith failure to settle and have hinged their rulings on whether subjective bad faith could be ascribed to the insurer. See, e.g., Nat’l Farmers Union Prop. & Cas. Co. v. O’Daniel, 329 F.2d 60, 65 (9th Cir. 1964) (applying Montana law) (“We think it clear that, if Lucas’s knowledge and conduct are imputed to [the insurer] under recognized agency principles, there is ample evidence to sustain the finding of bad faith on the part of [the insurer] in failing to consider the interests of its insured[.]”); David Novak, Comment, Insurance Carrier’s Duty to Settle: Strict Liability in Excess Liability Cases?, 6 SETON HALL L. REV. 662, 671 n.58 (1972) (“Under the bad faith standard, the plaintiff in an excess case has the burden of producing evidence which demonstrates either an intent on the part of the insurance company to commit fraud or that the insurer is guilty of willful misconduct.”). However, most courts employ an objective-reasonableness standard, as this Section does. See, e.g., LensCrafters, Inc. v. Liberty Mut. Fire Ins. Co., No. C 07-2853 SBA, 2008 WL 410243, at *3 (N.D. Cal. Feb. 12, 2008) (applying California law) (“The duty to settle arises from the implied covenant of good faith and fair dealing, which is inherent in every contract of insurance…. Both primary and excess insurers have an obligation to accept a reasonable settlement.”); Hartford Accident & Indem. Co. v. Foster, 528 So. 2d 255, 282 (Miss. 1988) (“The insurer has a duty to accept an objectively reasonable settlement demand … The proper execution of this implied duty is one example of good faith.”). See 1 William T. Barker & Ronald D. Kent, New Appleman Insurance Bad Faith Litigation § 2.03[2][a][iii] (2d ed. 2017) (“States requiring subjective culpability are now a small and dwindling minority.”). See also Novak, supra at 671–672 (observing that as early as 1938, “Professor Appleman observed that the negligence test was apparently becoming the majority rule, supplanting the bad faith test.”). For an example of a court adopting the terminology used in this Section, see Maine Bonding & Cas. Co. v. Centennial Ins. Co., 693 P.2d 1296, 1299 (Or. 1985):

Although our previous decisions have referred to concepts of “good faith,” “bad faith” and “due care” in stating the duty, the insurer’s duty to the insured comes down to this: In conducting the defense of a claim against an insured, including the investigation, negotiation, and litigation of the claim, the insurer must use such care as would have been used by an ordinarily prudent insurer with no policy limit applicable to the claim. The insurer is negligent in failing to settle, where an opportunity to settle exists, if in choosing not to settle it would be taking an unreasonable risk—that is, a risk that would involve chances of unfavorable results out of reasonable proportion to the chances of favorable results. Stating the rule in terms of “good faith” or “bad faith” tends to inject an inappropriate subjective element—the insurer’s state of mind—into the formula. The insurer’s duty is best expressed by an objective test: Did the insurer exercise due care under the circumstances.

A number of sources have noted that “[w]hether the respective court examining the matter applies a bad faith or negligence standard … a test often applied … is whether a prudent insurer without policy limits would have accepted the settlement offer.” 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 203:25 (3d ed. 2017). See also Bollinger v. Nuss, 449 P.2d 502, 509 (Kan. 1969) (“[T]he divergency between the good faith test and negligence test may be more a difference in verbiage than results. While the terms … are not synonymous or interchangeable in a strict legal sense, they share common hues in the insurer’s spectrum of duty[.]”); Robert E. Keeton, Liability Insurance and Responsibility for Settlement, 67 HARV. L. REV. 1136, 1140 (1954) (noting that “[t]he distinction between the ‘bad faith rule’ and the ‘negligence rule’ is less marked than these terms would suggest.”); Kent D. Syverud, The Duty to Settle, 76 VA. L. REV. 1113, 1123 (1990) (“The practical distinction between a negligent failure to settle and a bad faith failure to settle remains elusive”); James Martin Truss, Case Note, Insurance – Stowers Doctrine – A Settlement Offer Above Policy Limits Does Not Trigger an Insurer’s Stowers Duty to Act Reasonably, 26 ST. MARY’S L.J. 673, 691 (1995) (“Although bad faith entails a nominally greater burden than negligence, many courts coalesce the bad faith and negligence standards in practice and focus upon the amount of consideration given to the insured’s interests.”).

16. A duty to make reasonable settlement decisions rather than the “duty to settle.”For support that the standard stated in this Section is the most common, see 3 PAUL E.B. GLAD, WILLIAM T. BARKER & MICHAEL BARNES, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 16.06[4][a] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017) (“The most widely used test is typically formulated as ‘whether a prudent insurer without policy limits would have accepted the settlement offer’.”). See also 16 WILLISTON ON CONTRACTS § 49:107 (4th ed. 2017) (“Most courts require that an insurer act reasonably when deciding whether to settle a claim ….”); Ellen S. Pryor & Charles Silver, Defense Lawyers’ Professional Responsibilities: Part I—Excess Exposure Cases, 78 TEX. L. REV. 599, 656–657 (2000) (concluding that “all jurisdictions require carriers to make reasonable settlement decisions”); Cindie Keegan McMahon, Annotation, Duty of liability insurer to initiate settlement negotiations, 51 A.L.R.5th 701 (originally published in 1997) (“When the claimant makes an offer to settle within the policy limits, courts generally agree that the insurer’s good-faith duty requires the insurer to accept the offer if it would be reasonably prudent to do so.”). For a discussion of the origin of the phrase “duty to settle,” see Kent D. Syverud, The Duty to Settle, 76 VA. L. REV. 1113, 1116 (1990) (“For [a century], courts have invoked a doctrine known as ‘the duty to settle’ to impose liability on insurance companies who fail to settle lawsuits against the people they insure.”). For an explanation of the advantages of insurer control over settlement decisions, see id. at 1138–1139. The duty to make reasonable settlement decisions not only benefits individual insureds, but also encourages efficient settlement decisionmaking by insurance companies by requiring insurers to internalize “all of the costs of going to trial before rejecting a settlement.” Id. at 1164. For an early discussion of the circumstances in which the settlement duty is implicated, see Robert Keeton, Liability Insurance and Responsibility for Settlement, 67 HARV. L. REV. 1136, 1160–1161 (1954).

The reasonableness standard stated in this Section is analogous to the negligence standard in tort law. Some commentators have suggested a strict-liability standard pursuant to which any insurer that rejects a settlement offer within the policy limits would be subject to liability for a judgment against the insured in excess of the policy limits, without regard to whether the offer was reasonable. See, e.g., Bruce L. Hay, A No-Fault Approach to the Duty to Settle, 68 RUTGERS U. L. REV. 321 (2015) (arguing that making insurers liable for excess judgment following any rejected within-limits settlement offer would actually work to the benefit of insurers and policyholders); Phillip L. Deaver, Note, Insurer’s Liability for Refusal to Settle: Beyond Strict Liability, 50 S. CAL. L. REV. 751, 752 n.11 (1977) (listing numerous articles from the 1970s urging strict liability for the insurer when a within-limits settlement offer is rejected). By eliminating the need to undertake a reasonableness analysis, a strict-liability standard would eliminate some of the complexity and costs of breach-of-settlement-duty suits. Thus, there would be no need for the trier of fact in the settlement-duty case to gather evidence on the range of reasonable settlement values. In addition, an argument can be made that, when policyholders purchase liability insurance coverage, they are in a sense paying insurers to make lawsuits “go away,” which usually means by settlement. Thus, despite the language in liability insurance policies giving settlement discretion to the insurer, insureds are often surprised to learn, after the fact, that their insurers can refuse to accept settlement offers that are within the policy limits and can thereby expose the insureds to the risk of an excess judgment. A strict-liability rule, therefore, might be more consistent with the reasonable expectations of policyholders.

The primary criticism of the strict-liability approach, however, is that under such a rule any tort claimant could eliminate the binding effect of the policy limit simply by making a settlement offer within the limit through a “set up” letter. This effect would in turn lead to an increase in premiums. An argument can be made that both of these effects of the strict-liability rule are desirable, insofar as they encourage insurers to provide coverage that includes adequate policy limits. Moreover, given the hindsight bias that might be present in settlement-duty cases that apply a reasonableness standard (that is, the tendency of triers of fact, faced with an excess judgment against the insured, to overestimate the ex ante likelihood of that judgment occurring and thus to overestimate the reasonableness of some settlement offers), the effects of a strict-liability duty-to-settle rule might not be substantially different from the effects of the reasonableness/disregard-the-limits rule followed in this Section and that is already applied in many jurisdictions. Some appellate courts have gone so far as to encourage such hindsight bias by requiring that juries in settlement-duty cases be specifically instructed to consider the actual excess tort judgment in the underlying case as evidence of the expected value of the tort suit at the time the settlement offer was made and rejected. Despite the good arguments in favor of a strict-liability rule for the duty to settle, this Section does not endorse such a rule, because such a rule has not been adopted in the courts. Instead the Section follows and clarifies the prevailing reasonableness rule. The majority of jurisdictions impose on the insurer a general duty to make reasonable settlement decisions.

1. Equal consideration and the “disregard the limits” rule.For the proposition that most courts in “duty to settle” cases apply some version of an equal-consideration test, see, e.g., Syverud, supra at 1122 (“The majority of states today require the insurance company to give ‘equal consideration’ to the interests of the insured and the company in evaluating settlements.”). See also Cowden v. Aetna Cas. & Sur. Co., 134 A.2d 223, 228 (Pa. 1957) (“The requirement is that the insurer consider in good faith the interest of the insured as a factor in coming to a decision as to whether to settle or litigate a claim against the insured…. the predominant majority rule is that the insurer must accord the interest of its insured the same faithful consideration it gives its own interest.”).

The most straightforward and frequently used formulation of the “equal consideration” standard is the disregard-the-limits test. The disregard-the-limits standard was first articulated by Professor Keeton in 1954: “With respect to the decision whether to settle or try the case, the insurer, acting through its representatives, must use such care as would have been used by an ordinarily prudent insurer with no policy limit applicable to the claim.” Robert E. Keeton, Liability Insurance and Responsibility for Settlement, 67 HARV. L. REV. 1136, 1147 (1954). The Supreme Court of California adopted Keeton’s articulation in Crisci v. Security Ins. Co. of New Haven, Connecticut, 426 P.2d 173 (Cal. 1967), and the disregard-the-limits rule has since become the most common test for determining whether an insurer gave “equal consideration” to its insured’s interests in duty-to-settle cases. Id. at 176 (“In determining whether an insurer has given consideration to the interests of the insured, the test is whether a prudent insurer without policy limits would have accepted the settlement offer.”); Bollinger v. Nuss, 449 P.2d 502, 511 (Kan. 1969) (“As Professor Keeton suggests, equal consideration of the conflicting interests of the company and the insured means consideration of each portion of the total risk without regard to who is bearing that portion of the risk … [t]his undoubtedly is the meaning intended by courts which have said the insurer must accord the interests of its insured the same faithful consideration it gives its own interests[.]”); Cowden v. Aetna Cas. & Sur. Co., 134 A.2d 223, 228 (Pa. 1957) (“[T]he fairest method of balancing the interests is for the insurer to treat the claim as if it were alone liable for the entire amount.”). See also KENNETH S. ABRAHAM & DANIEL SCHWARCZ, INSURANCE LAW AND REGULATION 614–617 (6th ed. 2015) (“The Crisci rule is standard law in most jurisdictions ….”); 3 PAUL E.B. GLAD, WILLIAM T. BARKER & MICHAEL BARNES, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 16.06[4][a] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017) (“The most widely used test is typically formulated as ‘whether a prudent insurer without policy limits would have accepted the settlement offer.’” (quoting Crisci, 426 P.2d at 176)).

For courts applying the disregard-the-limits approach to discern whether “equal consideration” was given to the insured’s interests by the insurer, see, e.g., Herges v. Western Cas. & Sur. Co., 408 F.2d 1157, 1163–1164 (8th Cir. 1969) (applying Minnesota law) (using Keeton’s “no policy limits approach” to determine if the insurer had given equal consideration to the insured’s interests); Koppie v. Allied Mut. Ins. Co., 210 N.W.2d 844, 848 (Iowa 1973) (“Modern decisions require the insurer … to view the settlement situation as if there were no policy limit applicable to the claim. When it does so, it views the claim objectively and renders equal consideration to the interests of itself and of the insured.”); Bowers v. Camden Fire Ins. Ass’n, 237 A.2d 857, 862 (N.J. 1968) (holding that the insurer acts in good faith “only if the insurer treats any settlement offer as if it had full coverage for whatever verdict might be recovered, regardless of policy limits[.]”).

Some courts have held that the “equal consideration” standard imposes a stricter obligation on insurers to defer to the individual insured’s greater pecuniary interests in the outcome of a single case, even when it would be reasonable for an insurer properly disregarding the limit to reject the settlement offer, see, e.g., Clearwater v. State Farm Mut. Auto. Ins. Co., 792 P.2d 719, 723 (Ariz. 1990) (“[T]he debatability of the claim is not determinative; the insurer must also weigh other considerations, such as the financial risk to the insured in the event of a judgment in excess of the policy limits[.]”); Loudon v. State Farm Mut. Auto. Ins. Co., 360 N.W.2d 575, 581–582 (Iowa Ct. App. 1984) (reasoning that even when an insurer fairly evaluates a settlement offer and claim without regard to policy limits, equal consideration mandates giving greater weight to the catastrophic effect of a judgment over the policy limits on a single insured’s financial status in comparison to the nominal effect that settling a single claim has on the insurer); Dumas v. State Farm Mut. Auto. Ins. Co., 274 A.2d 781, 784 (N.H. 1971) (“The unlimited coverage approach has a superficial appearance of fairness to the insured but in fact does not give proper consideration to the insured’s interest. An unlimited risk to an insurance company with thousands of claims may in fact be minimal on the average but catastrophic to an underinsured individual with a single claim.”).

1. Applying the reasonableness standard.For examples and explanations regarding what constitutes a reasonable settlement offer, see, e.g., Transp. Ins. Co. v. Post Express Co., 138 F.3d 1189, 1192 (7th Cir. 1998) (applying Illinois law) (citations omitted):

Most states, of which Illinois is one, require insurers to devise a litigation strategy (and make settlement offers within the policy limits) as if the insurer bore the full exposure. That is to say, an insurer must give “its insured’s interests at least equal consideration with its own when the insured is a defendant in a suit in which the recovery may exceed [the] policy limits.” Intentional or negligent failure to avert a preventable excess judgment requires the insurer to bear the full loss—avoiding the injury to the client that is attributable to unsound litigation decisions.

Buntin v. Cont’l Ins. Co., 525 F. Supp. 1077, 1083 (D.V.I. 1981) (applying Virgin Islands law) (“We hold that an insurer’s honest but erroneous belief that there is no coverage under its policy of insurance in no way lessens the insurer’s obligation to view a settlement offer as if it alone were liable for any eventual judgment, nor does it diminish the insurer’s liability in the event it breaches its settlement obligations.”); Parsons v. Cont’l Nat’l Am. Grp., 550 P.2d 94, 100 (Ariz. 1976) (“[T]hat the carrier believed there was no coverage under the policy and so refused to give any consideration to the proposed settlements did not absolve them from liability for the entire judgment entered against the insured.”); Johansen v. Cal. State Auto. Ass’n Inter-Ins. Bureau, 538 P.2d 744, 746 (Cal. 1975) (“[A]n insurer who fails to accept a reasonable settlement offer within policy limits because it believes the policy does not provide coverage assumes the risk that it will be held liable for all damages resulting from such refusal, including damages in excess of applicable policy limits.”); Eskridge v. Educator & Executive Insurers, Inc., 677 S.W.2d 887, 889–890 (Ky. 1984):

Bad faith is determined upon the basis of whether the refusal to settle subjected the insured to an unreasonable risk of having a judgment entered against him in excess of the policy limits. The factors to be considered are the probability of recovery, the likelihood that judgment will exceed the policy limits, negotiations for settlement, offers to settle within or for less than the policy limits, and whether the insured made a demand for settlement.

Hartford Cas. Ins. Co. v. N.H. Ins. Co., 628 N.E.2d 14 (Mass. 1994).

For cases holding that the failure to accept a reasonable settlement offer leads to liability for the excess verdict, see, e.g., McNally v. Nationwide Ins. Co., 815 F.2d 254, 259 (3d Cir. 1987) (applying Delaware law) (affirming judgment for insured in case in which insurer had failed to accept a reasonable settlement); Rupp v. Transcon. Ins. Co., 627 F. Supp. 2d 1304, 1320 (D. Utah 2008) (deciding that, although “the Utah Supreme Court has not addressed whether breach of the duty to accept reasonable settlement offers releases the insured from complying with a legal action limitation provision,” that the court likely would find the insured released); Escambia Treating Co. v. Aetna Cas. & Sur. Co., 421 F. Supp. 1367, 1370 (N.D. Fla. 1976) (“Florida courts have clearly recognized the insurer’s duty to act in good faith and accept reasonable settlements.”); Whitney v. State Farm Mut. Auto. Ins. Co., 258 P.3d 113 (Alaska 2011) (the implied covenant of good faith and fair dealing obligates insurers to “accept reasonable offers of settlement in a prompt fashion”) (quoting Guin v. Ha, 591 P.2d 1281, 1291 (Alaska 1979) (allowing insured to recoup prejudgment interest attributable to the bad faith of the insurer, regardless of policy limits); Hamilton v. Maryland Cas. Co., 41 P.3d 128, 132 (Cal. 2002) (citing Kransco v. Am. Empire Surplus Lines Ins. Co., 2 P.3d 1, 9 (Cal. 2000), as modified (July 26, 2000)) (“the covenant of good faith and fair dealing implied by law in all contracts” combines with the “duty to defend and indemnify covered claims” to imply a “duty on the part of the insurer to accept reasonable settlement demands on [ ] claims within the policy limits”); Am. Physicians Ins. Exch. v. Garcia, 876 S.W.2d 842, 846–847 (Tex. 1994) (Texas courts require insurers “to accept reasonable settlement demands within policy limits.”). But see Pavia v. State Farm Mut. Auto. Ins. Co., 626 N.E.2d 24, 28 (N.Y. 1993) (citations omitted) (New York law requires that a plaintiff in a bad-faith action show that “the insured lost an actual opportunity to settle the … claim … at a time when all serious doubts about the insured’s liability were removed.”).

Some have suggested that the duty to make reasonable settlement decisions is breached—or the insurer is negligent—when declining to accept a reasonable within-limits settlement offer only if no reasonable insurer would have declined the offer. See Hartford Cas. Ins. Co., 628 N.E.2d at 18 (“The test is not whether a reasonable insurer might have settled the case within the policy limits, but rather whether no reasonable insurer would have failed to settle the case within the policy limits.”) Subsection (2) of this Section, however, does not adopt that version of the negligence standard in the settlement context. Rather, Subsection (2) follows the majority of courts that have spoken to the issue in stating that the duty to make reasonable settlement decisions is breached when the insurer fails to make a settlement decision that a reasonable insurer (that bears the full financial responsibility for the liability) would make under the circumstances. See, e.g., Buntin v. Cont’l Ins. Co., 525 F. Supp. 1077, 1082 (D.V.I. 1981) (applying Virgin Islands law) (“The judicial measure of an insurer’s compliance with his settlement obligations is whether a reasonably prudent insurer, without policy limits, would have accepted the settlement.”); Baxter v. Royal Indem. Co., 285 So. 2d 652, 655–656 (Fla. Dist. Ct. App. 1973), superseded by statute on other grounds, Fla Stat. Ann. § 624.155, as recognized in McLeod v. Cont’l Ins. Co., 591 So. 2d 621, 623 (Fla. 1992):

If the circumstances are such that a reasonable and prudent man with the obligation to pay all the recoverable damages would settle for an amount within the policy limits, it is the legal duty of the insurer to do so. Failure to effect such a settlement would unreasonably risk the danger of a judgment in excess of the policy limits for which the insured would be liable but for which the insurer would not. By taking such an unreasonable risk, the insurer would be gambling with the insured’s money to the latter’s prejudice.

Farmers Grp., Inc. v. Trimble, 691 P.2d 1138, 1142 (Colo. 1984) (citations omitted):

Given the quasi-fiduciary nature of the insurance relationship, we are persuaded that the standard of conduct of an insurer in relation to its insured in a third party context must be characterized by general principles of negligence. The question of whether an insurer has breached its duties of good faith and fair dealing with its insured is one of reasonableness under the circumstances. The relevant inquiry is whether the facts pleaded show the absence of any reasonable basis for denying the claim, “i.e., would a reasonable insurer under the circumstances have denied or delayed payment of the claim under the facts and circumstances.”

Likewise, the articulation of the duty to make reasonable settlement decisions in subsection (2) is consistent with the canonical formulation of the negligence standard in tort law generally, which states that a person’s negligence consists in the failure to do what a reasonable person would do under the circumstances. See, e.g., Stephen G. Gilles, On Determining Negligence: Hand Formula Balancing, the Reasonable Person Standard, and the Jury, 54 VAND. L. REV. 813, 822 (2001) (“For as long [as] there has been a tort of negligence, American courts have defined negligence as conduct in which a reasonable man (nowadays, a reasonable person) would not have engaged.”).

An insurer has not breached its duty to settle by rejecting a settlement offer well above the range of reasonable settlement amounts. See, e.g., Christian Builders, Inc. v. Cincinnati Ins. Co., 501 F. Supp. 2d 1224, 1237 (D. Minn. 2007) (applying Minnesota law) (holding that the insurer had not unreasonably refused to settle when the plaintiff refused to lower its $2 million offer and the insurer had accurately assessed the reasonable settlement value between $400,000 and $600,000). As with any liability standard, the reasonableness standard stated in this Section does not require the insurer to do anything. Rather, the standard simply assigns to the insurer the legal responsibility for excess judgments that result from a breach of the standard. Moreover, the standard imposes no consequences on the insurer for rejecting a settlement offer that is unreasonable.

1. Procedural factors may be considered.For a general discussion of the multiple factors that courts take into account in the duty-to-settle analysis, see Kenneth S. Abraham, The Natural History of the Insurer’s Liability for Bad Faith, 72 TEX. L. REV. 1295, 1302–1306 (1994) (describing factors that courts take into account in duty-to-settle analysis); Douglas R. Richmond, Bad Insurance Bad Faith Law, 39 TORT TRIAL & INS. PRAC. L.J. 1, 5 (2003) (listing factors). For instances of these factors being relied upon in case law, see generally Truck Ins. Exch. v. Bishara, 916 P.2d 1275, 1279–1280 (Idaho 1996); O’Neill v. Gallant Ins. Co., 769 N.E.2d 100, 106–109 (Ill. App. Ct. 2002); Smith v. Gen. Accident Ins. Co., 697 N.E.2d 168, 170–171 (N.Y. 1998).

For authority regarding consideration of procedural factors relating to the claimant’s conduct, see, e.g., Wade v. EMASCO Ins. Co., 483 F.3d 657, 672 (10th Cir. 2007) (applying Kansas law) (arguing that courts should exercise caution to “‘avoid creating the incentive to manufacture bad faith claims’”); Peckham v. Cont’l Casualty Insurance Co., 895 F.2d 830, 835 (1st Cir. 1990) (applying Massachusetts law):

[T]he justification for bad faith jurisprudence is as a shield for insureds—not as a sword for claimants. Courts should not permit bad faith in the insurance milieu to become a game of cat-and-mouse between claimants and insurer, letting claimants induce damages that they then seek to recover, whilst relegating the insured to the sidelines as if only a mildly curious spectator.

Grumbling v. Medallion Ins. Co., 392 F. Supp. 717, 721 (D. Or. 1975) (applying Oregon law):

Nothing in this decision is intended to lay down a rule of law that would mean that a plaintiff’s attorney under similar circumstances could “set up” an insurer for an excess judgment merely by offering to settle within the policy limits and by imposing an unreasonably short time within which the offer … would remain open.

Pavia v. State Farm Mut. Auto. Ins. Co., 626 N.E.2d 24, 28–29 (N.Y. 1993) (“Permitting an injured plaintiff’s chosen timetable for settlement to govern the bad-faith inquiry would promote the customary manufacturing of bad-faith claims ….”). Cf. Clegg v. Butler, 676 N.E.2d 1134, 1140 (Mass. 1997) (“Insurers must be given the time to investigate claims thoroughly to determine their liability. Our decisions interpreting the obligations contained within G.L. c. 176D, § 3(9), in no way penalize insurers who delay in good faith when liability is not clear and requires further investigation.”).

2. The insurer’s failure to make settlement offers and counteroffers.There is a split of authority on the question whether the duty to make reasonable settlement decisions can obligate the insurer to explore settlement negotiations should the claimant or claimants not come forward with a settlement offer. See 1 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN INSURANCE BAD FAITH LITIGATION§ 2.03[6][d][iii] (discussing the split of authority) (2d ed. 2017). At least one leading treatise has suggested that the view stated in this Section is a minority rule. See ROBERT H. JERRY, II & DOUGLAS R. RICHMOND, UNDERSTANDING INSURANCE LAW 840 (5th ed. 2012) (“In most jurisdictions, the insurer cannot be liable for breaching the duty to settle unless the plaintiff makes a settlement offer within policy limits. Without a settlement offer, it is not possible for the insurer to have breached its duty.”). But a more recent review of the authority concludes that many of the courts cited as requiring an offer by the plaintiff hold simply that the insurer did not breach the duty in the particular case, not that there must always be an offer by the plaintiff. See Dennis J. Wall, The American Law Institute and Good Faith Settlement Duties of Liability Carriers: The Scope of a Duty to Initiate Settlement Negotiations, What the ALI Restatement of the Law of Liability Insurance Has to Say About it, and the ALI Reporters’ Notes, 37 Ins. Litig. Rep. 597, 601 (Dec. 23, 2015). For courts holding that a settlement offer from the claimant is a prerequisite to a claim against the insurer of breach of the settlement duty, see, e.g., Jackson v. Am. Equity Ins. Co., 90 P.3d 136, 142 (Alaska 2004); Graciano v. Mercury Gen. Corp., 179 Cal. Rptr. 3d 717, 726 (Ct. App. 2014) (“An insured’s claim for bad faith based on an alleged wrongful refusal to settle first requires proof the third party made a reasonable offer to settle the claims against the insured for an amount within the policy limits.”); First Acceptance Ins. Co. of Ga., Inc. v. Hughes, S18G0517, 2019 WL 1103831, at *3 (Ga. Mar. 11, 2019) (adopting a bright-line rule requiring the presentation of a valid offer by the plaintiff in the underlying legal action as a prerequisite to a “duty to settle”); Rocor Int’l, Inc. v. Nat’l Union Fire Ins. Co. of Pittsburgh, Pa., 77 S.W.3d 253, 261–262 (Tex. 2002).

Other courts, however, have held that a settlement offer from the claimant is not a prerequisite to a finding of breach of the insurer’s settlement duties. For cases holding that the insurer has a duty to make an offer in certain circumstances, see, e.g., Fulton v. Woodford, 545 P.2d 979, 984 (Ariz. Ct. App. Div. 1, Dep’t B, 1976) (holding that the “legal duty” is not absolute but is instead one factor among many to be considered on the question of whether the carrier conducted settlement negotiations in bad faith; held that under the evidence in this case, the carrier at bar did not breach its duties); Gutierrez v. Yochim, 23 So. 3d 1221, 1226 (Fla. Dist. Ct. App. 2009); Powell v. Prudential Prop. & Cas. Ins. Co., 584 So. 2d 12, 14 (Fla. Dist. Ct. App. 1991) (“insurer has an affirmative duty to initiate settlement negotiations,” citing cases from Kansas, New Jersey, Wisconsin, and Oregon); Commercial Union Ins. Co. v. Liberty Mut. Ins. Co., 393 N.W.2d 161, 165 (Mich. 1986) (recognizing an obligation to make an offer but “when warranted under the circumstances” and only one factor among many to consider in deciding question of carrier’s liability for bad-faith breach of settlement duties); Rova Farms Resort, Inc. v. Inv’rs Ins. Co. of Am., 323 A.2d 495, 505 (N.J. 1974) (“Despite the fact that the holdings in [earlier New Jersey cases] involved firm claimant offers, it would be unrealistic to believe that such an offer is a prerequisite for finding the insurer to have acted other than in good faith…. The better view is that the insurer has an affirmative duty to explore settlement possibilities.” (citing Self v. Allstate Ins. Co., 345 F. Supp. 191 (M.D. Fla. 1972))); Goddard v. Farmers Ins. Co. of Or., 22 P.3d 1224, 1227 (Or. Ct. App. 2001), review denied, 34 P.3d 1178 (2001) (“Thus, an insurer has an affirmative duty of care to its insured, which in an appropriate case requires the insurer to initiate settlement efforts”); Alt v. Am. Family Mut. Ins. Co., 237 N.W.2d 706, 713 (Wis. 1976) (holding that settlement offer from claimant is not a prerequisite to insurer liability for breach of settlement duties and noting that “[a]ll prior Wisconsin cases indicate that an insurance company has more than a passive role—that, in some circumstances at least it has an affirmative duty to seize whatever reasonable opportunity may present itself to protect its insured from excess liability.”). In addition, a number of scholars have argued that such an affirmative obligation should be imposed. See, e.g., ROBERT KEETON, ALAN I. WIDISS & JAMES M. FISCHER, INSURANCE LAW: A GUIDE TO FUNDAMENTAL PRINCIPLES, LEGAL DOCTRINES, AND COMMERCIAL PRACTICES§ 7.8(c), 744–745 (2d ed. 1988) (“Courts have divided whether the insurer must initiate settlement discussions with the claimant. It might be argued that the dominant ‘disregard the limits’ standard would only require the insurer to initiate settlement discussions when an insurer with only its interests at stake would do so … The better rule is that a duty to initiate settlement discussion exists.”).

1. The causation difference between rejecting a settlement offer and choosing not to make an offer.See, e.g., Gibbs v. State Farm Mut. Ins. Co., 544 F.2d 423, 427 (9th Cir. 1976) (applying California law) (“On numerous occasions, [claimant] told [State Farm’s investigator and the insured] that he wanted coverage only to the limits of the insurance policy. [The investigator and the insured both] wrote letters to State Farm apprising it of [claimant’s] desire. Though no formal, written offer existed, the jury could find that [claimant’s] statements gave State Farm a reasonable opportunity to settle the claim within the policy limits. Instead, State Farm failed to conduct any negotiations with [claimant], neglecting its good faith duty to take affirmative action in settling the claim.”); Mirville v. Allstate Indem. Co., 87 F. Supp. 2d 1184, 1190 (D. Kan. 2000) (applying New York law) (“Clearly, a plaintiff who brings a bad faith failure to settle claim against an insurance company must show that but for the insurance company’s actions, the case could have settled within the policy limits or for an amount in excess of the policy limits wherein the insured agreed to contribute any excess amount.”), aff’d sub nom. Mirville v. Mirville, 10 F. App’x 640 (10th Cir. 2001); Boicourt v. Amex Assurance Co., 93 Cal. Rptr. 2d 763, 768, 770 (Ct. App. 2000) (“[A] formal settlement offer is not an absolute prerequisite to a bad faith action…. All we know on this record is that the claimant would have accepted a policy limits offer prior to filing a complaint and that no negotiations were even started which might have elicited such an offer because the insurer had a company rule against disclosure of policy limits irrespective of whether the insured might, if given the opportunity, have authorized their disclosure.”); Me. Bonding & Cas. Co. v. Centennial Ins. Co., 693 P.2d 1296, 1303 (Or. 1985) (“There is evidence from which the trier of fact could have found that had Centennial instituted settlement discussions, it would have learned that the case could have been settled for $227,000. The trier of fact could have found that the failure to do so was negligence. The evidence suggests that, with the passage of time, [claimant] became antagonistic by reason of the delay and lack of attention to the claim, suffered greater difficulty in running his business and came to insist upon a higher settlement figure than he would have if the claim had been handled more expeditiously.”).

1. Settlement offers in excess of policy limits.The term “duty to contribute” comes from Richard Squire. In the context in which courts and commentators refer to the “duty to settle,” the duty to contribute nicely distinguishes cases that the insurer can settle unilaterally from those in which the insurer cannot do so because the limits of the insurance policy are insufficient. See Richard Squire, How Collective Settlements Camouflage the Costs of Shareholder Lawsuits, 62 DUKE L.J. 1 (2012) (arguing that the duty to contribute leads to a collective-action problem among insurers in the securities-class-action settlement context). Some jurisdictions have held that an insurer’s failure to offer its policy limits in response to a reasonable above-limits settlement offer can constitute a breach of the duty to settle. See, e.g., Fireman’s Fund Ins. Co. v. Sec. Ins. Co. of Hartford, 367 A.2d 864, 869 (N.J. 1976) (explaining that an insurer’s failure “to exercise good faith in considering an offer to settle for an amount in excess of its policy limits” can be considered a breach of an implied covenant). Some commentators have even characterized this as the majority position. According to some commentators, however, a majority of jurisdictions hold that an insurer does not breach any settlement obligation if it rejects an offer that exceeds the limits in the policy. See, e.g., ROBERT H. JERRY, II & DOUGLAS R. RICHMOND, UNDERSTANDING INSURANCE LAW 840 (5th ed. 2012) (footnote omitted) (“In most jurisdictions, the insurer cannot be liable for breaching the duty to settle unless the plaintiff makes a settlement offer within policy limits.”). Other commentators stop short of characterizing this as the majority position. See, e.g., 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 203:20 (3d ed. 2017) (“Some authority states that an insurer’s duty to make reasonable settlements is only triggered when a claimant makes an offer to settle within policy limits. Under this view, an offer in excess of policy limits does not give rise to the duty, even where the offer is reasonable.”). For cases holding that an insurer has no duty to accept a settlement offer in excess of policy limits, see, e.g., Haddick ex rel. Griffth v. Valor Ins., 763 N.E.2d 299, 305 (Ill. 2001) (noting that the duty to settle “does not arise until a third party demands settlement within policy limits.”); Rocor Int’l, Inc. v. Nat’l Union Fire Ins. Co. of Pittsburgh, Pa., 77 S.W.3d 253, 262 (Tex. 2002) (“[A]n insurer’s settlement duty is not activated until a settlement demand within policy limits is made, and the terms of the demand are such that an ordinarily prudent insurer would accept it.”).

2. When there are covered and noncovered components of a legal action.See generally Kenneth S. Abraham, The Liability Insurer’s Duty to Settle Uncertain and Mixed Claims, 68 RUTGERS U. L. REV. 337 (2015). See also WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN INSURANCE BAD FAITH LITIGATION§ 2.03[6][c][i] (2d ed. 2017) (“[F]or purposes of determining what settlement contribution it will offer, the insurer may treat the case as if only the covered claims were asserted”). For case support, see, e.g., Magnum Foods, Inc. v. Cont’l Cas. Co., 36 F.3d 1491, 1506 (10th Cir. 1994) (applying Oklahoma law) (duty of good faith does not require insurer to contribute to settlement of uncovered punitive-damages portion of the legal action); Camelot by the Bay Condo. Owners’ Ass’n v. Scottsdale Ins. Co., 32 Cal. Rptr. 2d 354 (Ct. App. 1994) (insurer need not contribute to settlement of uncovered aspects of damages).

28. No direct duty owed to excess insurers.See § 28.

2. No duty owed to third parties.Because insurers lack a preexisting relationship with third-party tort plaintiffs, the majority of courts and commentators agree that insurers have no common-law tort or contractual duty to tort plaintiffs to settle. See, e.g., WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN INSURANCE BAD FAITH LITIGATION§ 2.07[1] (2d ed. 2017) (“An insurer has no ‘special relationship’ with a third party claiming against its insured and owes such a third party no unusual duties…. absent a contrary statute, neither [the insurer nor the defendant] owes the third party any duty to settle.”). For cases rejecting a common-law duty because of the lack of a preexisting relationship, see, e.g., Bean v. Allstate Ins. Co., 403 A.2d 793, 795 (Md. 1979) (citations omitted) (“[T]he insurer owes no duty to a claimant to settle a claim, and …. any obligation to deal with settlement offers in good faith runs only to the insured…. [T]he claimant is a stranger to the relationship between the insurer and the insured and is not in privity of contract with them.”); Kranzush v. Badger State Mut. Cas. Co., 307 N.W.2d 256, 265 (Wis. 1981) (“The insurer’s duty of good faith and fair dealing arises from the insurance contract and runs to the insured. No such duty can be implied in favor of the claimant from the contract since the claimant is a stranger to the contract and to the fiduciary relationship it signifies.”). Courts have similarly rejected the argument that accident victims are third-party beneficiaries to the tortfeasor’s insurance policy. See, e.g., Leal v. Allstate Ins. Co., 17 P.3d 95, 100 (Ariz. Ct. App. 2000) (“Although accident victims may be intended beneficiaries of state-mandated insurance, this does not mean that they are intended beneficiaries of every insurance policy provision.”); Long v. McAllister, 319 N.W.2d 256, 262 (Iowa 1982) (citation omitted) (“Because plaintiff relies only on the fact that he will benefit if the contract is carried out in accordance with its terms, he has alleged only a basis for finding he is an incidental beneficiary…. We refuse to extend the third party beneficiary concept to the limits advocated by the plaintiff.”).

Although most states have enacted some version of an Unfair Settlement Practices Act, the vast majority of courts have declined to read the provision to give third-party plaintiffs a private right of action against the insurer for failing to settle. See, e.g., Leal, 17 P.3d at 100 (finding that the statute explicitly denies any private remedy); Moradi-Shalal v. Fireman’s Fund Ins. Cos., 758 P.2d 58 (Cal. 1988) (overturning a prior ruling granting a statutory cause of action).

Only a handful of states have interpreted their Unfair Settlement Practices statute to provide a private right of action to third-party claimants. Montana’s statute specifies that third-party claimants have an independent cause of action, and courts have therefore allowed claimants to proceed directly against insurers for a bad-faith failure to settle. See Holmgren v. State Farm Mut. Auto. Ins. Co., 976 F.2d 573 (9th Cir. 1992) (applying Montana law). A few other states have enacted statutes granting a private right of action to “anyone” injured by a fair-practice violation, and some courts have interpreted this language to include third-party claimants. See, e.g., Auto-Owners Ins. Co. v. Conquest, 658 So. 2d 928 (Fla. 1995); Van Dyke v. St. Paul Fire & Marine Ins. Co., 448 N.E.2d 357 (Mass. 1983); Hovet v. Allstate Ins. Co., 89 P.3d 69 (N.M. 2004).

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 25 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 2. Settlement

• 25 The Effect of a Reservation of Rights on Settlement Rights and Duties

^Comment:

^{Reporters’ Note}

• (1) A reservation of the right to contest coverage does not relieve an insurer of the duty to make reasonable settlement decisions stated in 24, but the insurer is not required to cover a judgment on a noncovered claim.
• (2) Unless otherwise stated in an insurance policy or agreed to by the insured, an insurer may not settle a legal action and thereafter demand recoupment of the settlement amount from the insured on the ground that the action was not covered.
• (3) When an insurer has reserved the right to contest coverage for a legal action, the insured may settle the action without the insurer’s consent and without violating the duty to cooperate or other restrictions on the insured’s settlement rights contained in the policy if:
• (a) The insurer receives all information reasonably necessary to evaluate the legal action and has a reasonable amount of time to do so;
• (b) The insurer is given a reasonable opportunity to participate, and is kept reasonably informed of developments, in the settlement process;
• (c) The insured makes a reasonable effort to obtain the insurer’s consent or approval of the settlement, including by providing the insurer with a reasonable amount of time to evaluate all the terms of the settlement agreement;
• (d) The insurer declines to withdraw its reservation of rights after receiving prior notice of the proposed settlement; and
• (e) The settlement agreed to by the insured is one that a reasonable person who bears the sole financial responsibility for the full amount of the potential covered judgment would make.

Comment:

1. a. Reservation of rights does not eliminate the duty to make reasonable settlement decisions, but there is no such duty for noncovered actions. Under the rule set forth in this subsection (1), an insurer is subject to the duty to make reasonable settlement decisions even if that insurer reasonably believes that the policy at issue does not cover the legal action. What this means in practice is that, if an insurer that is defending a legal action against an insured under a reservation of rights makes an unreasonable settlement decision as defined in 24, the insurer will be responsible for any excess judgment that results at the trial of the legal action along with other appropriate damages, provided that the action is determined to be covered. If the action is determined not to be covered, the insurer will of course not be liable for any of the judgment. An insurer has no duty to settle noncovered legal actions. Thus, an insurer that reserves the right to contest coverage and then receives a settlement offer within the policy limits must choose whether to accept the settlement (and bear the cost of the settlement above the deductible) or to reject the settlement and risk the possibility of facing liability for an excess judgment against the insured if the action turns out to be covered.

This widely adopted rule allocates to the insurer a portion of the risk associated with reasonable but mistaken beliefs on the part of the insurer regarding coverage and discourages insurers from delaying settlement negotiations in the underlying lawsuit while potential coverage disputes with the insured are being resolved. A few jurisdictions, however, follow an alternative rule, which permits the insurer to take into account its doubts about coverage when deciding whether to accept a settlement demand. In other words, under this minority rule, the insurer may, when calculating the maximum reasonable settlement that it will accept, discount the expected value of the case further by the probability that there will be no coverage and thus no requirement that the insurer contribute to the settlement. This alternative approach places the risk of the insurer’s mistaken coverage decisions upon the insured, increasing the likelihood of substantial uninsured excess judgments. This is because there will be a broader range of litigated cases that potentially will produce trials and fewer settlements, because insurers, in reservation-of-rights cases, will be willing to contribute less to a settlement than is the case under the majority rule. The majority rule is superior because it places the risk of mistaken coverage decisions upon the party best able to reduce and spread that risk.

• Illustration:

1. A claimant files a tort suit against the insured seeking damages of $500,000. The insured has a duty-to-defend liability insurance policy that has policy limits of $100,000 and that assigns settlement discretion to the insurer. The insured tenders the defense of the suit to the insurer, which agrees to defend under a reservation of rights. The insurer reasonably believes that it has a ground for contesting coverage that relieves it from any duty to indemnify the insured for the suit. As the case approaches trial, the claimant makes a reasonable settlement demand of $80,000. The insurer rejects the settlement demand. The suit then goes to trial, resulting in a $500,000 verdict against the insured. If the coverage dispute is resolved in the insured’s favor, the insurer is liable for its coverage limit plus the excess judgment of $400,000, along with other reasonably foreseeable consequential damages. If the coverage dispute is resolved in the insurer’s favor, the insurer is not liable to the insured for any damages.

24. b. When a legal action has both covered and noncovered components. Some legal actions brought against an insured will have both covered and noncovered components. In such a situation, the reasonableness of the insurer’s settlement decisions is to be evaluated based on the valuation of the covered component(s) of the action. That is, if the settlement demand is reasonable, taking into account the covered components alone (that is, as a settlement of only the covered cause(s) of action), then rejection of the settlement demand will constitute a breach of the duty to make reasonable settlement decisions. If, however, the settlement demand is unreasonable, taking into account the covered components alone, then the insurer’s rejection of the settlement will not by itself be considered a breach of the duty to make reasonable settlement decisions. In such a case, whether the insurer has breached its settlement duty will depend on other factors that bear on the question of insurer reasonableness, such as the procedural factors addressed in Comment e of 24. For example, when a legal action involves both a covered component and a noncovered component (such as punitive damages when such damages are expressly excluded from coverage under the policy or the law in the jurisdiction treats such coverage as a violation of public policy), the duty to make reasonable settlement decisions would include a duty on the part of the insurer to investigate the facts relevant to both the covered and noncovered components and to convey that information to the insured. The insurer would also have an obligation to inform the insured of the amount it (the insurer) would be willing to contribute to an overall settlement. However, the control of the settlement of the noncovered components of the legal action would rest with the insured, or, if appropriate, with the excess insurer or insurers.

1. c. The default rule is no right to recoupment. Subsection (2) sets forth the default rule, analogous to the default rule followed in 21 for defense costs, that an insurer that settles a legal action brought against an insured may not later recoup the settlement amount from the insured on the ground that the action was determined not to be covered. Because this rule is merely a default rule, it may be altered by agreement of the parties. For example, if an insurer agrees to pay for a settlement of a potentially insured legal action only on the condition that it be permitted to subsequently litigate coverage and seek recoupment if it prevails in the coverage litigation, and if the insured agrees to this condition, then the insurer would be able to seek recoupment. While most states have not addressed this issue, the majority of state courts that have addressed the issue have not permitted recoupment in the absence of a provision in the insurance policy granting the insurer this right or an express agreement by the insured. Other courts, primarily federal courts making an Erie prediction, have gone the other way, applying theories of unjust enrichment and implied-in-fact contract that allow insurers defending under a reservation of rights the option of settling the case and seeking recoupment of the cost of the settlement from the insured if the claim turns out not to be covered. Every court that has addressed the issue, however, has held that a term inserted in the policy that clearly provides the insurer with a right of recoupment would be enforced, as would a term that denies the insurer such a right.

Because insurance policies often do not include a term expressly addressing the recoupment question, however, insurance law must determine whether to require that recoupment have an explicit contractual basis or to permit recovery based on unjust enrichment in the absence of a contractual provision. This Section follows the exclusively contractual approach—in effect, a no-recoupment default rule—for several reasons based in fairness and efficiency.

The strongest argument in favor of a no-recoupment default rule is more practical than theoretical. The current practice in most liability insurance markets is for insurers not to seek recoupment of the noncovered portion of settlements paid by insurers. Rather, in the overwhelming majority of cases in which the insurer agrees to settle a claim, insurers do not pursue recoupment. Moreover, insurers have not developed a regular practice of inserting settlement-recoupment provisions in their policies. Given that such provisions would be enforceable, the absence of such provisions in policies can be taken as evidence that the fairest and most efficient default rule, and the one that is most consistent with the parties’ reasonable expectations, is one of no recoupment. As mentioned, insurers and insureds are of course free to alter this rule by clear contractual language. The fact that insurers, which are in the best position to revise the policy language, have so rarely attempted to include such a term in their policies suggests that there is relatively little demand for policies with such terms.

It is sometimes argued that the no-recoupment rule provides insureds with a type of coverage that the policy language itself does not. The problem with this argument is that, in cases in which the courts have adopted a no-recoupment rule (and in cases in which this Section would apply such a rule), the liability insurance policies do not expressly provide one way or the other whether there should be recoupment of noncovered settlements. It is the omission of any policy term addressing the issue that gives rise to the need for a default rule, which is what subsection (2) provides. Indeed, it is this absence of any clear language on point that has persuaded many of the courts that have adopted the no-recoupment rule. If there were a term expressly included in the policies that provided for reimbursement, courts would enforce it, which is consistent with the rule followed in this Section.

Although this Section follows the majority default rule of no recoupment, it must be acknowledged that the rule comes with some costs. For one thing, it may mean that insurance premiums are somewhat higher than they would be under an alternative, pro-recoupment default rule. In addition, this no-recoupment rule may give insurers, in a legal action in which they believe they have a strong ground for contesting coverage, an incentive to resist settlement and litigate the action, thereby delaying any payment to the claimant and preserving the possibility of shifting any resulting judgment to the insured. Of course, to follow this strategy the insurer would have to incur defense costs, and those costs may or may not be recoverable from the insured. (See § 21 dealing with recoupment of defense costs.) Nevertheless, even taking the defense costs into account, there will be some cases in which the no-recoupment rule would increase the risk to the insured of suffering a judgment that is wholly uninsured.

The insured can avoid this risk by entering into a settlement authorized by subsection (3), but that requires that the insured pay the settlement itself, or that the claimant be willing to accept an assignment of the insured’s rights against the insurer, neither of which may be possible or desirable in many cases. Alternatively, an insured could agree at the time of settlement to allow the insurer to obtain recoupment of the settlement if it is later determined that the legal action is not covered under the policy. If the insured were to agree to allow the potential for recoupment, the insurer’s incentive to continue to litigate potentially noncovered actions would be reduced, and perhaps even eliminated. For this approach to fully protect insureds from the increased risk of noncovered judgments created by the no-recoupment default rule, however, insurers and insureds would need to have a degree of foresight and judgment that is unrealistic to expect in every case. For example, the insured would need to assess not only the likelihood of a loss in the underlying legal action against the insured but also the likely size of the judgment if a loss were to occur, as well as the strength of the insurer’s grounds for contesting coverage. Thus, the fact that the no-recoupment rule may be altered in the settlement process does not eliminate the additional litigation risk to insureds that such a rule poses.

By contrast, the alternative default rule, which permits insurers to seek recoupment of a settlement that is subsequently determined not to be covered, creates the opposite incentive for insurers. Under a pro-recoupment rule, insurers with grounds for contesting coverage would tend to settle more actions than otherwise and to work less hard to keep the amount of the settlements low. Thus, a pro-recoupment rule would create a moral hazard on the part of insurers. From the insured’s perspective, a relevant question would be which prospect is more worrisome: the increased risk of noncovered trial judgments (resulting from a no-recoupment rule) or the increased risk of noncovered settlements (resulting from a pro-recoupment rule). This is an empirical question that has no easy answer.

12. d. Relationship to the Restatement Third, Restitution and Unjust Enrichment. As is the case for the no-recoupment default rule followed in § 21, the Restatement Third, Restitution and Unjust Enrichment (R3RUE), takes the contrary position as an application of general principles of unjust enrichment. See R3RUE § 35, Comment c, Illustrations 9–12. The special insurance-law reasons for following the no-recoupment default rule in this Section, as stated in Comment c above, are similar to those for following the no-recoupment default rule in 21. As with the rule in § 21, the insurance-law rule followed by this Section can be reconciled with the general rule in R3RUE § 35 by recognizing that the premise underlying the general rule (that the party is rendering an extra-contractual performance) and the conclusion (that the other party is unjustly enriched) do not apply in the context addressed in this Section once insurance law is understood to include a no-recoupment default rule. In that case, an insurer that pays a settlement without an explicit agreement regarding the right to recoupment is not performing beyond its contractual obligation, because that obligation incorporates the default no-recoupment rule implied by insurance law. Compare § 21, Comment b. Most restitution claims between insurers and policyholders arise in contexts unrelated to coverage disputes; they more typically involve problems of mistake or subrogation. See R3RUE §§ 6, 24. The rule of this Section has no bearing on the insurer’s entitlement to restitution in these fundamentally different settings.

1. e. Settlements by the insured prior to coverage determination. In circumstances in which an insurer that has not accepted coverage refuses to withdraw either its coverage contest or its control over settlement, courts have reached different conclusions about whether an insured may protect its interests by accepting a settlement within the limits of the policy. While perhaps not yet the majority rule, an increasingly large number of states permit the insured to settle without the consent of the insurer even if the policy contains a provision requiring consent. Subsection (3) follows this emerging rule while adding some procedural requirements designed to protect against collusive or improvident settlements. This rule allows the insured to protect itself against the risk of a large, uncovered verdict while preserving the insurer’s right to contest both coverage and the reasonableness of the settlement. The insurer’s liability for such settlements is subject to the policy limits, as well as any potential grounds for contesting coverage. The rule in subsection (3) does not authorize the insured to enter into a settlement or consent judgment in excess of the policy limits that obligates the insurer to pay for the amount by which that settlement or consent judgment exceeds the policy limits.

The effect of the rule is to give an insurer that is disputing coverage for a legal action the choice between (a) accepting the coverage obligation and retaining control of the defense and the settlement of the legal action or (b) preserving the right to contest coverage and permitting the insured to make a reasonable settlement of the legal action. The rule encourages insurers to drop a weak ground for contesting coverage in order to maintain control over settlement of the legal action because it is primarily the insurer’s money at stake in that action when its grounds for contesting coverage are weak. The rule encourages insurers with strong grounds for contesting coverage to grant control over settlement to the insured. Granting the insured control over settlement in such cases is appropriate: because of the strong grounds for contesting coverage, it is primarily the insured’s money at stake.

Because of the potential for collusion, all such settlements should be scrutinized to ensure that they are reasonable both in substance and procedure. In addition to interrogating the reasonableness of the terms of the settlement, courts should ask questions such as the following: (1) Did the insurer receive all information reasonably necessary to evaluate the legal action? (2) Did the insurer have a reasonable opportunity to participate in the settlement process? (3) Did the insurer have a reasonable amount of time to evaluate the legal action and all the terms of any proposed settlement agreement? (4) Were any reservations regarding the terms of the settlement expressed by the insurer fully and fairly communicated to the insured? (5) Was the insurer informed of material developments in the settlement process? (6) Are there any indicia of collusion between the insured and the underlying claimant in the settlement process?

• Illustration:

2. A claimant files a tort suit against the insured seeking damages of $500,000. The insured has a duty-to-defend liability insurance policy with policy limits of $100,000 and that assigns settlement discretion to the insurer. The insured tenders the defense of the suit to the insurer, which agrees to defend under a reservation of rights. As the case approaches trial, the claimant makes a settlement demand of $100,000. The insurer rejects the settlement demand, preferring to negotiate for a lower settlement or to take the case to trial. The insured, however, believes that the settlement demand should be accepted. The insured notifies the insurer that she is in settlement negotiations with the claimant. The insurer declines to participate or to withdraw its coverage contest. The insured enters into a settlement with the claimant for $100,000. The insured may bring a breach-of-contract action against the insurer to recover the amount of the settlement or, if the claimant is willing to wait, to require the insurer to pay the settlement. In the breach-of-contract action, the insurer’s coverage contest will be resolved on the basis of all of the facts and circumstances, because the insurer did not breach the duty to defend.

Reporters’ Note

9. Reservation of rights does not eliminate the duty to make reasonable settlement decisions, but there is no such duty for noncovered actions.Consistent with the principle stated in subsection (1), the majority of jurisdictions have held that an insurer defending an action under a reservation of rights still has a duty to accept reasonable settlement offers. See, e.g., 1 JEFFREY W. STEMPEL & ERIK S. KNUTSEN, STEMPEL AND KNUTSEN ON INSURANCE COVERAGE§ 9.05[C] (4th ed. 2016) (“It appears that the majority view holds that an insurer defending a claim must reasonably facilitate settlement on favorable terms for the policyholder even when it believes that the policy provides no indemnity coverage on the claim.”). Cf. Luke v. Am. Family Mut. Ins. Co., 476 F.2d 1015, 1021 (8th Cir. 1972) (applying South Dakota law) (citations omitted) (“[T]he vast number of jurisdictions which have considered the question hold that when an offer of settlement within policy limits has been made and ignored, a good faith refusal to defend is not a valid defense to a claim in excess of the policy limits.”). For courts adopting this stance, see, e.g., Parsons v. Cont’l Nat’l Am. Group, 550 P.2d 94, 100 (Ariz. 1976) (“In the instant case the further fact that the carrier believed there was no coverage under the policy and so refused to give any consideration to the proposed settlement did not absolve them from liability for the entire judgment entered against the insured.”); Johansen v. Cal. State Auto. Ass’n Inter-Ins. Bureau, 538 P.2d 744 (Cal. 1975) (“[A]n insurer’s ‘good faith,’ though erroneous, belief in noncoverage affords no defense to liability flowing from the insurer’s refusal to accept a reasonable settlement offer” and a reservation of rights did not relieve the insurer of its duty to settle); Eskridge v. Educator and Exec. Insurers, Inc., 677 S.W.2d 887, 890 (Ky. 1984) (“[The insurer’s] erroneous belief that the policy had lapsed is not relevant to the determination” of whether the insurer had breached its duty to settle). These courts further maintain that doubts about whether the policy provides coverage “should not affect a decision as to whether the settlement offer in question is a reasonable one.” Johansen, 538 P.2d at 749. See also Eskridge, 677 S.W.2d at 890 (“The factors to be considered are probability of recovery, the likelihood that judgment will exceed policy limits, negotiations for settlement, offers to settle within or for less than the policy limits, and whether the insured made a demand for settlement.”). See generally STEPHEN S. ASHLEY, BAD FAITH ACTIONS LIABILITY & DAMAGES § 4:13 (2d ed. 2017) (“In recent times the majority of jurisdictions have held that the insurer allows coverage doubts to affect its settlement decisions at its peril.”).

By contrast, some courts allow insurers to take coverage doubts into account and to reject otherwise reasonable settlement offers. See KENNETH S. ABRAHAM & DANIEL SCHWARCZ, INSURANCE LAW AND REGULATION 616 (6th ed. 2015). See also 1 STEMPEL & KNUTSEN, § 9.05[C] (“However, a substantial number of cases have found that an insurer who fails to settle a case because of a colorable or good faith belief that no coverage exists can avoid the duty to settle liability.”). See, e.g., Mowry v. Badger State Mut. Cas. Ins. Co., 385 N.W.2d 171, 180 (Wis. 1986) (rejecting the Johansen rule and holding that “[w]hether an insurer who rejects an offer to settle within policy limits because of a coverage question shall be liable … upon a determination of coverage depends upon whether the insurer acted in bad faith in determining that a coverage question existed.”).

Courts and commentators advance three reasons for precluding insurers from factoring coverage doubts into their settlement decisions. First, allowing insurers to reject reasonable settlement offers while resolving coverage disputes would result in more actions reaching trial. See ABRAHAM & SCHWARCZ at 616 (The result of the Johansen approach “is to avoid unnecessary litigation, at least in cases where the insured simply cannot produce the funds necessary to accept the claimant’s offer of settlement.”); 1 STEMPEL & KNUTSEN§ 9.05[C] (“[V]aluable social interests in compensation and risk spreading are served when insurers are encouraged to facilitate settlement even where coverage is in doubt.”). Second, the rule ensures that the duty to settle functions properly by allocating to the insurer the risk as well as the benefits of settlement decisions. See Johansen, 538 P.2d at 748–749 (explaining that the duty-to-settle doctrine forces insurers to absorb the risks of excess judgments by requiring that they act as if they were responsible for the entire potential judgment, which necessarily precludes them from considering coverage doubts). Third, the rule places the risk of loss on the party best situated to avoid or bear the costs:

In determining who bears the loss we must remember we are dealing with an insurance contract. The policyholder buys insurance to avoid the risk of loss. The insurance company is in the business of evaluating risks, assuming risks, and spreading the costs of the risks…. In refusing to pay policy limits [in settlement] in this case, the insurance company decided to impose a risk on the policyholder. As it turned out, the insurance company was wrong about the coverage.

Mowry v. Badger State Cas. Co., 385 N.W.2d 171, 190 (Wis. 1986) (Abrahamson, J., dissenting). See also 1 STEMPEL & KNUTSEN§ 9.05[C] (“Mowry is thus a most problematic holding in that it exposes the policyholder to substantial risk that could have been avoided at relatively low cost in order to vindicate the insurer’s interest … in refusing to pay claims it believes fall outside of coverage.”).

Although a reservation of rights does not eliminate the duty to make reasonable settlement decisions, there is no duty to settle claims that turn out not to be covered. See, e.g., Rocor Int’l, Inc. v. Nat’l Union Fire Ins. Co. of Pittsburgh, Pa., 77 S.W.3d 253, 261 (Tex. 2002) (explaining that insurers “generally [have] no obligation to settle a third-party claim … unless the claim is covered by the policy.”). Accordingly, determination that a claim is not covered precludes the insured from holding the insurer liable for failure to settle that claim, even though the issue of coverage was unresolved when the insurer rejected the settlement demand. See 3 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 23.02[6][c][ii][A] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017) (“An insurer may be presented with a settlement demand at a time when a coverage question is unresolved. If it refuses the demand and it turns out that there is no coverage, it will have no liability.”); Michael Aylward, Other People’s Money: Insurer Liability for Failing to Settle Within Policy Limits, 54 FDCC QUART. 267, 278 (2004) (“In short, the insurer’s obligation is only to effect a settlement of covered claims.”).

For other cases holding that insurers cannot be held liable for failure to settle a noncovered action, see, e.g., Twin City Fire Ins. Co. v. Colonial Life & Accident Ins. Co., 375 F.3d 1097, 1103 (11th Cir. 2004) (applying South Dakota law) (declining to hold an “insurer liable in tort for declining to contribute money toward a settlement of a third-party claim when there is no coverage of the claim under the insured’s policy at all.”); Bell v. Tilton, 674 P.2d 468, 473 (Kan. 1983) (holding that the insurer could not be liable for failure to settle when the trial court had correctly determined that the policy provided no coverage); Rocor, 77 S.W.3d at 261 (“Accordingly, we hold that to trigger an insurer’s statutory duty to reasonably attempt settlement of a third-party claim against its insured, the policy must cover the claim ….”).

2. When a legal action has both covered and noncovered components.1 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN INSURANCE BAD FAITH LITIGATION§ 2.03[6][c][i] (2d ed. 2017) (citations omitted).

If an insurer correctly determines that there is no coverage for any of the liabilities that the insured might incur, it is not liable for failure to settle those liabilities. If the suit includes both covered and noncovered claims, the insurer need contribute no more than the fair settlement value of the covered claims.

See, e.g., Capstone Bldg. Corp. v. Am. Motorists Ins. Co., 67 A.3d 961, 969 (Conn. 2013) (holding that, in cases in which only some of the claims asserted against the insured are potentially covered and there is a global settlement, the insurer is required to pay only so much of the settlement as can fairly be allocated to potentially covered claims).

1. The default rule is no right to recoupment.The vast majority of states have not addressed this issue, perhaps “because until recently few observers would have thought that there could be any right to recoup indemnity payments.” KENNETH S. ABRAHAM & DANIEL SCHWARCZ, INSURANCE LAW AND REGULATION 616 (6th ed. 2015). The courts of only two states have permitted an insurer to obtain recoupment of a settlement payment without prior agreement of the insured. See Blue Ridge Ins. Co. v. Jacobsen, 22 P.3d 313, 320–321 (Cal. 2001) (permitting insurers to “seek reimbursement for the settlement paid on the [insureds’] behalf even in the absence of [their] express agreement,” so long as the insurer satisfies three prerequisites: “(1) a timely and express reservation of rights; (2) an express notification to the insureds of the insurer’s intent to accept a proposed settlement offer; and (3) an express offer to the insureds that they may assume their own defense when the insurer and insureds disagree whether to accept the proposed settlement.”); Horace Mann Ins. Co. v. Hanke, 312 P.3d 429, 434–435 (Mont. 2013) (permitting insurer to obtain reimbursement of settlement amount when insurer reserved right to do so, in circumstance when insured previously had committed to paying the amount but was unable to come up with funds, and insurer then paid the amount subject to reservation of right to recoup). For further discussion of the Blue Ridge rule, see Michael Aylward, Other People’s Money: Insurer Liability for Failing to Settle Within Policy Limits, 54 FDCC QUART. 267, 277–278 (2004). By contrast the courts in five states permit insurers to obtain recoupment of a settlement payment only when the insured has consented to a settlement subject to recoupment if the insurer’s coverage defenses are upheld, or when such a recoupment right is stated in the insurance policy. See Mount Airy Ins. Co. v. Doe Law Firm, 668 So. 2d 534, 537–538 (Ala. 1995) (citations omitted) (“It has been the law in Alabama for over 150 years that where one party, with full knowledge of all the facts, voluntarily pays money to satisfy the colorable legal demand of another, no action will lie to recover such a voluntary payment, in the absence of fraud, duress, or extortion” and “the mere threat of legal proceedings is insufficient to constitute the duress needed to make the payment of money involuntary”); Lexington Ins. Co. v. Ill. Union Ins. Co., No. 12A668035, 2016 WL 4772711, at *8 (Nev. Dist. Ct. July 13, 2016) (“Lexington cannot assert a reservation of a right it did not have under its own insurance policy at issue in that it would be tantamount to allowing an insurer the right to a unilateral amendment to the contract of insurance.”); Excess Underwriters at Lloyd’s, London v. Frank’s Casing Crew & Rental Tools, Inc., 246 S.W.3d 42, 43 (Tex. 2008) (quotations omitted) (“In Texas, an insurer that settles a claim against its insured when coverage is disputed may seek reimbursement from the insured should coverage later be determined not to exist if the insurer obtains the insured’s clear and unequivocal consent to the settlement and the insurer’s right to seek reimbursement.”); U.S. Fid. & Guar. Co. v. U.S. Sports Specialty Ass’n, 270 P.3d 464, 468 (Utah 2012):

Because an insurer’s right to reimbursement from an insured substantially affects the relative levels of risk assumed by each, Utah law does not allow an insurer to seek reimbursement or restitution through an extracontractual claim of unjust enrichment. Instead, we hold that an insurer’s right to reimbursement from an insured must be expressly provided in an insurance policy before it can be enforced.

See also Med. Malpractice Joint Underwriting Ass’n of Mass. v. Goldberg, 680 N.E.2d 1121, 1129 & n.31 (Mass. 1997) (refusing to permit reimbursement because the policy did not so provide and the insured had not agreed, with dicta suggesting that recoupment might be appropriate in other limited circumstances). The Texas Supreme Court provided one rationale for imposing a strict consent requirement: “[o]therwise, the insured is forced to choose between rejecting a settlement within policy limits or accepting a possible financial obligation to pay an amount that may be beyond its means, at a time when the insured is most vulnerable.” Texas Ass’n of Counties County Gov’t Risk Mgmt. Pool v. Matagorda County, 52 S.W.3d 128, 135 (Tex. 2000).

Notwithstanding the dearth of state-court authority, several federal courts have made Erie predictions that state courts would permit recoupment in the absence of the insured’s agreement. See Cont’l Cas. Co. v. Indian Head Indus. Inc., 666 F. App’x 456, 468 (6th Cir. 2016) (applying Michigan law) (relying exclusively on other Sixth Circuit Erie predictions); Travelers Prop. Cas. Co. of Am. v. Hillerich & Bradsby Co., 598 F.3d 257, 267 (6th Cir. 2010) (applying Kentucky law) (asserting that this is the majority rule and relying on an implied-in-fact contract theory based on the insured accepting the payment of defense costs under a reservation of rights that waived any right of reimbursement of defense costs but asserted the right to seek recoupment of any settlement payments); Interstate Fire & Cas. Co. v. Underwriters at Lloyd’s, London, 139 F.3d 1234, 1238 (9th Cir. 1998) (applying Oregon law) (permitting insurer to litigate the number of occurrences and obtain reimbursement from the insured of an amount equal to a second SIR despite lack of insured’s consent); Philips & Assocs., P.C. v. Navigators Ins. Co., 764 F. Supp. 2d 1174, 1175–1176 (D. Ariz. 2011) (in a case in which there was a dispute about whether California or Arizona law applied, court declined to make choice-of-law decision because, making an Erie prediction about Arizona law, both states would permit an insurer to recoup a settlement payment); Cincinnati Ins. Co. v. Grand Pointe, LLC, 501 F. Supp. 2d 1145, 1151–1153 (E.D. Tenn. 2007) (applying Tennessee law) (permitting recoupment of defense costs and settlement payment); Melton Truck Lines, Inc. v. Indem. Ins. Co. of N. Am., No. 04-CV-263-JHP-SAJ, 2006 WL 1876528, at *2 (N.D. Okla. June 26, 2006) (applying Oklahoma law) (relying on lower-Texas-court opinion in Frank’s Casing, which was subsequently overruled in the opinion cited earlier in this Note). Other federal courts have made the opposite Erie prediction. See Am. Modern Home Ins. Co. v. Reeds at Bayview Mobile Home Park, LLC, 176 F. App’x 363, 367 (4th Cir. 2006) (applying Maryland law) (“Because neither the policy nor any subsequent agreement between American Modern and its insureds grants American Modern a right to reimbursement, we cannot conclude that American Modern has such a right.”); Am. Motorist Ins. Co. v. Custom Rubber Extrusions, Inc., No. 1:05cv2331, 2006 WL 2460861, at *7 (N.D. Ohio Aug. 23, 2006) (discussing the Sixth Circuit’s Erie prediction that Ohio law would permit recoupment of defense costs and refusing to permit an insurer to recoup amounts paid to satisfy a judgment); Steadfast Ins. Co. v. Sheridan Children’s Healthcare Servs, Inc., 34 F. Supp. 2d 1364, 1367 (S.D. Fla. 1998) (relying on Goldberg opinion from Massachusetts and Mount Airy opinion from Alabama, both cited above, to support its Erie prediction that the Florida courts would not permit an insurer to recoup a settlement absent an agreement by the insured to this procedure).

Note that the Third Circuit has made an Erie prediction that the Pennsylvania courts would permit recoupment of an amount paid to satisfy a judgment after a contested trial. See Essex Ins. Co. v. RMJC, Inc., 306 F. App’x 749, 755 (3d Cir. 2009). Because this opinion predates the Pennsylvania Supreme Court’s decision in Am. & Foreign Ins. Co. v. Jerry’s Sport Ctr., Inc., 2 A.3d 526 (Pa. 2010) (rejecting insurer’s right to recoup defense costs), there is considerable doubt about the Erie prediction. In any event, permitting an insurer to recoup an amount paid to satisfy a judgment after a contested trial is distinguishable from permitting an insurer to recoup an amount paid to settle a claim, because it does not expose the insured to the same pressure described by the Texas Supreme Court in Matagorda County, as quoted above. For a general discussion of the case law on recoupment, in both the defense costs and settlement contexts, see 1 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN INSURANCE BAD FAITH LITIGATION, § 2.11 (2d ed. 2017). For a persuasive argument that the choice of default recoupment rule would be unlikely to result in different outcomes in practice, as long as the parties behave rationally and are aware whether the insured has sufficient assets to pay an uncovered claim, see Kenneth S. Abraham, The Liability Insurer’s Duty to Settle Uncertain and Mixed Claims, 68 RUTGERS U. L. REV. 337, 353–357 (2015) (explaining the conclusion that “in many cases, and perhaps even most cases, it does not matter which approach is adopted”).

1. Relationship to the Restatement Third, Restitution and Unjust Enrichment.See generally Restatement Third, Restitution and Unjust Enrichment § 35, Comment c (AM. LAW INST. 2011).

1. Settlements by the insured prior to coverage determination.See 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 199:48 (3d ed. 2017):

A cooperation clause prohibiting an insured’s settlement without the insurer’s consent forbids an insured from settling only claims for which the insurer unconditionally assumes liability under the policy. Since an insurer, by reserving its right to deny coverage, loses its right to control the litigation, an insured does not breach a policy’s “duty to cooperate with insurer” provision by entering into an unauthorized settlement or stipulated liability, so long as such agreements are made fairly, with notice to the insurer, and without fraud or collusion on the insurer, and the settlement is reasonable and prudent.

See also 16 RICHARD A. LORD, WILLISTON ON CONTRACTS § 49:108 (4th ed. 2017) (“Once the insurer … defends under a reservation of rights, the duty to cooperate does not preclude the insured from entering into a reasonable settlement with a claimant that is in the insured’s best interests.”); Benjamin A. Kahn & Ronald H. Nemirow, Unauthorized Settlement Agreements in a Reservation of Rights Context, 34 TORT & INS. L.J. 799, 818 (1999) (noting increasing adoption of the rule that “an insured can enter into an unauthorized settlement agreement despite the insured’s duty to cooperate ….”).

A number of courts have held that “when the insurer defends under a reservation of rights the cooperation clause may not be invoked to prevent the insured from entering into a settlement without the insurer’s consent.” Parking Concepts, Inc. v. Tenney, 83 P.3d 19, 24 (Ariz. 2004). See also Kelly v. Iowa Mut. Ins. Co., 620 N.W.2d 637, 644–645 & n.5 (Iowa 2000):

At the point in time that the insurer is faced with a fair and reasonable settlement demand that a reasonable and prudent insurer would pay, the insurer must either abandon its coverage defense and pay the demand or lose its right to control the conditions of settlement. If the insurer prefers to debate coverage and, accordingly, refuses to pay the settlement demand, the insured is free to either pay the settlement demand or stipulate to the entry of judgment in the amount of the demand. The insurer, if found to have coverage, will be liable for the insured’s settlement if the settlement is found to be fair and reasonable.

Patrons Oxford Ins. Co. v. Harris, 905 A.2d 819, 828 (Me. 2006) (“[A]n insured being defended under a reservation of rights is entitled to enter into a reasonable, noncollusive, nonfraudulent settlement with a claimant, after notice to, but without the consent of, the insurer.”); Miller v. Shugart, 316 N.W.2d 729, 731, 734 (Minn. 1982) (“[T]he insureds did not breach their duty to cooperate with the insurer, which was then contesting coverage, by settling directly with the plaintiff.”); Chausee v. Maryland Cas. Co., 803 P.2d 1339, 1342 (Wash. Ct. App. 1991) (citing United Servs. Auto. Ass’n v. Morris, 154 Ariz. 113, 741 P.2d 246 (1987)) (applying rule that an insured can settle a claim when the insurer that is defending under a reservation of rights has refused to do so but holding that the insureds failed to demonstrate that the settlement was reasonable); Gainsco Ins. Co. v. Amoco Prod. Co., 53 P.3d 1051, 1079 (Wyo. 2002) (holding stipulated judgment enforceable when insurer defends under reservation of rights and declines an offer to settle within policy limits). Most recently, the Pennsylvania Supreme Court held:

[W]e adopt a variation on the Morris fair and reasonable standard limited to those cases where an insured accepts a settlement offer after an insurer breaches its duty by refusing the fair and reasonable settlement while maintaining its reservation of rights and, thus, subjects an insured to potential responsibility for the judgment in a case where the policy is ultimately deemed to cover the relevant claims.

Babcock & Wilcox Co. v. Am. Nuclear Insurers, 131 A.3d 445, 462 (Pa. 2015) (citing United Servs. Auto. Ass’n v. Morris, 154 Ariz. 113, 741 P.2d 246 (1987) and the Kelly case from Iowa, supra).

Other courts, however, “expressly hold that where an insurer provides a defense to its insured, even under a reservation of rights, the insured may not settle the matter without its insurer’s consent” without breaching his or her duty to cooperate. 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 203:37 (3d ed. 2017) (noting the division of authority without providing guidance as to the majority rule). See, e.g., Motiva Enters., LLC v. St. Paul Fire and Marine Ins. Co., 445 F.3d 381, 385 (5th Cir. 2006) (applying Texas law) (predicting that, under Texas law, “an insurer which tenders a defense with a reservation of rights is entitled to enforce a consent-to-settle clause ….”); Klepper v. ACE Am. Ins. Co., 999 N.E.2d 86, 96–97 (Ind. Ct. App. 2013) (“To hold otherwise, would, effectively require us to write the ‘voluntary payment’ and ‘legally obligated to pay’ provisions out of the Policy, which we cannot do.”).

This Section follows a middle-ground approach by requiring insureds to notify insurers and give them a reasonable opportunity to participate, but ultimately allowing insureds to settle without insurer consent as long as the amount of the settlement that the insurer is asked to pay is reasonable and the insurer’s contribution is consistent with its policy obligations. This rule relieves insurers of the choice between “defend[ing] unconditionally or … refus[ing] to defend at its peril” while allowing “the insured to take reasonable measures to protect himself against the danger of personal liability.” United Servs. Auto. Ass’n v. Morris, 741 P.2d 246, 251–252 (Ariz. 1987). As the Supreme Court of Maine explained, the Morris rule

strikes a fair balance between the insurer and the insured …. By allowing the insured to control his own case when the insurer issues a reservation of rights, the insured can protect himself from the sharp thrust of personal liability, and the insurer still has a meaningful opportunity to protect its own interests in a declaratory judgment action where it may assert, among other things, a coverage defense.

Patrons Oxford Ins. Co., 905 A.2d at 826 (quotations omitted). For further discussion, see Steven Plitt, The Evolving Boundaries of Damron/Morris Agreements: A Search for the Missing Link, A Judicial Determination of the Length of a Reasonable Person’s Arm, and Other Progressive Issues, 35 ARIZ. ST. L.J. 1331, 1333–1335, 1351–1353 (2003) (discussing the rationales behind Arizona’s adoption of the reservation-of-rights approach and its corresponding abridgment of insureds’ duty to cooperate).

Although subsection (3) states that the insurer must be given notice and a reasonable opportunity to participate in the proposed settlement in order for the settlement to be acceptable, some jurisdictions permit this type of settlement without imposing these requirements. See generally Kahn and Nemirow, 34 TORT & INS. L.J. at 822–824 (noting that only some courts require notice to the insurer of the settlement). Among jurisdictions that allow insureds to settle without insurer consent, most seem to follow Arizona’s requirement that the insured provide the insurer with notice of the settlement. See, e.g., Morris, 741 P.2d at 252 (“Thus, an insured being defended under a reservation of rights may” settle “fairly, with notice to the insurer, and without fraud or collusion.”); Patrons Oxford Ins. Co., 905 A.2d at 828 (requiring notice but not consent); Gainsco Ins. Co., 53 P.3d at 1067 (“[A]n insured does not violate the cooperation clause of an insurance policy by settling a claim being defended under a reservation of rights, so long as such settlement is preceded by adequate notice to the insurer.”). See generally Kahn & Nemirow, 34 TORT & INS. L.J. at 822–823 (discussing how different courts have interpreted Morris). The U.S. District Court for the District of Maine determined further that the cooperation clause requires not only “notice of settlement opportunities,” but also “the option to participate therein, even where the insurer has reserved the right to contest coverage.” Gates Formed Fibre Prods., Inc. v. Imperial Cas. & Indem. Co., 702 F. Supp. 343, 347 (D. Me. 1988) (applying Maine law). At the other end of the notice spectrum, at least one court has held that “notice is not a separate procedural requirement …. Instead notice is a component of the factual question of whether the insured’s settlement of the claims defended under a reservation of rights was reasonable, in good faith and without fraud or collusion.” Ins. Co. of N. Am. v. Spangler, 881 F. Supp. 539, 545 (D. Wyo. 1995) (applying Wyoming law). The procedural requirements listed in subsection (3) protect the insurer’s legitimate interest in having the opportunity to determine whether to waive its coverage defenses and thereby retain authority over settlement, and they help to ensure that settlements entered into without an insurer’s consent are reasonable. Nevertheless, it may be appropriate that they be applied for the first time in a jurisdiction only on a prospective basis.

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 26 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 2. Settlement

• 26 The Effect of Multiple Claimants on the Duty to Make Reasonable Settlement Decisions

^Comment:

^{Reporters’ Note}

• (1) If multiple legal actions that would count toward a single policy limit are brought against an insured, the insurer has a duty to the insured to make a good-faith effort to settle the actions in a manner that minimizes the insured’s overall exposure.
• (2) The insurer may, but need not, satisfy this duty by interpleading the policy limits to the court, naming all known claimants, and, if the insurer has a duty to defend or a duty to pay defense costs on an ongoing basis, continuing to defend or pay the defense costs of its insured until:
• (a) Settlement of the legal actions;
• (b) Final adjudication of the actions; or
• (c) Adjudication that the insurer does not have a duty to defend or to pay the defense costs of the actions.

Comment:

1. a. Minimizing the insured’s exposure. When an insured faces multiple legal actions that would count against the policy limit of a liability insurance policy (or would count against the limit of a set of insurance policies in the event there are additional insurance policies that provide coverage), the question arises how the insurer should manage the settlement of those actions when the policy limit is not sufficient to cover the full settlement value of all of them. If some claimants make early settlement offers while others delay, the insurer must decide whether to accept the early offers. Accepting the early offers may exhaust the policy limits and expose the insured to greater liability in excess of the policy limits than if the insurer had managed the legal actions as a unit. If the insurer rejects the early settlement offers, however, the insurer may later face a breach-of-settlement-duty suit if those claimants obtain excess judgments against the insured. Some jurisdictions have adopted a first-come, first-served approach to multiple claimants, allowing the insurer to accept the first reasonable, within-limits settlement offers that are made. This eliminates the insurer’s risk of a breach-of-settlement-duty suit, but it can result in increased exposure for insureds, if the non-settling parties decide to litigate their actions.

The better settlement strategy is to seek to minimize the overall liability exposure of the insured. In addition to providing greater protection to insureds, this strategy will also generally lead to more equitable results for claimants than does the rule that rewards the claimant that is fastest to the settlement table. Subsection (1) provides the basic rule that insurers are obligated to seek such a settlement with all potential claimants in a manner that minimizes the insured’s overall exposure. Often the exposure-minimizing settlement agreement will be one that allocates the policy limits among the various claimants on the basis of the relative expected value of their claims. Of course, the obligation to seek such a settlement does not mean that it will be possible to obtain such a settlement, especially if the insured has substantial assets in addition to the available insurance limits.

1. b. The safe harbor. The rule stated in subsection (1) leaves the insurer subject to a considerable degree of uncertainty. For this reason, subsection (2) creates a safe harbor for insurers. Under this rule, the insurer can interplead the policy limits to the court, naming all known potential claimants, and continuing to defend the insured. When the insured has few or no assets that can be used to satisfy a judgment, this procedure will likely lead the claimants to resolve their actions within the context of the interpleader action. When the insured has substantial assets, however, one or more of the claimants may well pursue the case to trial. This result is consistent with the fact that, as a practical matter, insurers bear a greater defense burden when they sell low-limit policies to policyholders with substantial assets, because claimants will be less willing to settle for the policy limits against such defendants.

1. c. Complex liability insurance arrangements. The safe harbor stated in this Section is principally directed at simple liability-insurance-coverage situations involving a single policy period and a single, well-integrated liability insurance program consisting of a primary insurance policy and, possibly, one or more excess insurance policies. The more complex a liability insurance arrangement is, the more likely the insured will have the resources needed to actively work with its insurer(s) to manage the risk of excess liability. In complex situations, the duty stated in this Section simply obligates the insurer to act reasonably in its dealings with the insured in order to assist the insured in minimizing the overall exposure. In such situations, the safe harbor provided in subsection (2) may not be practicable.

Reporters’ Note

2. Minimizing the insured’s exposure.For a discussion of the problem of applying the duty to settle when there are multiple claimants and insufficient policy limits and a review of the various approaches that courts have taken to address the problem, see generally 1 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN INSURANCE BAD FAITH LITIGATION§ 2.03[9][A] (2d ed. 2017); KEETON, WIDISS & FISCHER, INSURANCE LAW§ 7.4 (2d ed. 2017). Keeton appears to have been the first to suggest the idea of prorating settlement offers based on the relative expected values of the various actions. See Robert E. Keeton, Preferential Settlement of Liability Insurance Claims, 70 HARV. L. REV. 27, 40–46 (1956). See also KEETON, WIDISS & FISCHER 669–671 (2d ed. 2017). The two leading alternatives are the “first-come, first-served” approach and a rule that grants the insurer wide discretion. The first-come, first-served rule is preferred by some courts because it does not require delaying settlement with some claimants based upon speculation about future settlement offers, and it allows insurers to accept reasonable settlement offers. See 3 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 23.02[9] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017). For cases approving of the first-come, first-served approach, see, e.g., Voccio v. Reliance Ins. Cos., 703 F.2d 1, 3 (1st Cir. 1983) (applying Rhode Island law); Standard Accident Ins. Co. of Detroit, Mich. v. Winget, 197 F.2d 97, 104 (9th Cir. 1952) (applying California law); Bartlett v. Travelers’ Ins. Co., 167 A. 180, 183 (Conn. 1933); Pekin Ins. Co. v. Home Ins. Co., 479 N.E.2d 1078 (Ill. App. Ct. 1985); Bennett v. Conrady, 305 P.2d 823, 828 (Kan. 1957); Liguori v. Allstate Ins. Co., 184 A.2d 12, 17 (N.J. Ch. 1962); Alford v. Textile Ins. Co., 103 S.E.2d 8, 13 (N.C. 1958); Tex. Farmers Ins. Co. v. Soriano, 881 S.W.2d 312, 315 (Tex. 1994). See also Thomas R. Newman, Ending Duty to Defend: Exhausting Policy Limits When Settling Less than All Lawsuits, FOR THE DEFENSE 38, 41 (March 2013) (collecting cases).

The “wide-discretion” approach differs from the first-come, first-served in requiring the insurer to consider the possibility of other actions. See, e.g., Schwartz v. State Farm Fire & Cas. Co., 88 Cal. App. 4th 1329, 1337 (2001) (insurer has a “duty not to favor the interest of one of its insureds over the interests of the other.”); Shell Oil Co. v. Nat’l Union Fire Ins. Co. of Pittsburgh, Pa., 44 Cal. App. 4th 1633, 1647 (1996) (an insurer’s disbursement of its entire policy limits to indemnify a co-insured “did not discharge [the insurer’s] policy obligations … but rather constituted an actionable breach of those duties” to its other insured); Smoral v. Hanover Ins. Co., 37 A.D.2d 23, 25 (N.Y. App. Div. 1971) (“It is absolutely no answer for the company to say that it paid the full amount of its policy if in doing so it fully protected one of its insureds and left the other completely exposed.”). See also 3 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 23.02[9][a][i] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017) (“Of course, an insurer cannot hastily make excessive settlements that deplete its limits in order to relieve itself of the responsibility of further protecting its insured.”). The First Circuit described the obligation of the insurer as follows:

The insurer has both the right and the duty to exercise its professional judgment in settling, or refusing to settle, such claims—but it must do so mindful of the insured’s best interests and in good faith. The insurer’s goal should be to try to effect settlement of all or some of the multiple claims so as to relieve its insured of so much of his potential liability as is reasonably possible, considering the paucity of the policy limits. So long as it acts in good faith, the insurer is not held to standards of omniscience or perfection; it has leeway to use, and should consistently employ, its honest business judgment. The carrier … “will not be held to prophesy.”

Peckham v. Cont’l Cas. Ins. Co., 895 F.2d 830, 835 (1st Cir. 1990) (applying Massachusetts law) (citations omitted). In general, these courts have encouraged insurers to make a good-faith effort to resolve all of the claims against their insureds. If that proves impossible, some courts permit insurers to expend their limits to resolve as many of the claims that can be settled, even if that leaves some insureds without coverage. See, e.g., Underwriters Guar. Ins. Co. v. Nationwide Mut. Fire Ins. Co., 578 So. 2d 34 (Fla. Dist. Ct. App. 1991); Millers Mut. Ins. Ass’n of Illinois v. Shell Oil Co., 959 S.W.2d 864 (Mo. Ct. App. 1997). In many if not most cases, the result under the rule stated in this Section will be the same as the result under the wide-discretion approach.

7. The safe harbor.See KEETON, WIDISS & FISCHER§ 7.4(d), n.194 (“In most jurisdictions, an insurer may institute a proceeding, usually in the nature of interpleader, to obtain a court order allocating among various claims the limited fund within the per-accident limit of policy coverage.” (citing, among other sources, Zechariah Chafee, The Federal Interpleader Act of 1936: II, 45 YALE L.J. 1161 (1936))). For a recent example of a court creating a “safe harbor” for the insurer similar to that created by subsection (2), see McReynolds v. Am. Commerce Ins. Co., 235 P.3d 278, 284 (Ariz. Ct. App. 2010) (holding that an insurer, faced with multiple claims in excess of its policy limits, satisfied its duty to settle when it promptly and in good faith interpleaded its policy limits into court, naming all known claimants, and continued to provide a defense to its insured).

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 27 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 2. Settlement

• 27 Remedies for Breach of the Duty to Make Reasonable Settlement Decisions

^Comment:

^{Reporters’ Note}

• (1) An insurer that breaches the duty to make reasonable settlement decisions is subject to liability for any foreseeable harm caused by the breach, including the full amount of damages assessed against the insured in the underlying legal action, without regard to the policy limits.
• (2) When an insurer has breached the duty to make reasonable settlement decisions, the insured may settle the action without the insurer’s consent and without violating the duty to cooperate or other restrictions on the insured’s settlement rights contained in the policy if:
• (a) The insurer receives all information reasonably necessary to evaluate the legal action and has a reasonable amount of time to do so;
• (b) The insurer is given a reasonable opportunity to participate, and is kept reasonably informed of developments, in the settlement process;
• (c) The insured makes a reasonable effort to obtain the insurer’s consent or approval of the settlement, including by providing the insurer with a reasonable amount of time to evaluate all the terms of the settlement agreement; and
• (d) The settlement agreed to by the insured is one that a reasonable person who bears the sole financial responsibility for the full amount of the potential covered judgment would make.

Comment:

1. a. Liability for excess judgment. If the insurer’s breach of the duty to make a reasonable settlement decision causes an excess judgment against the insured, the insured is entitled to recover from the insurer, in addition to the policy limit, the difference between the policy limit and the underlying judgment. This is the paradigmatic measure of damages in a breach-of-settlement-duty lawsuit against an insurer.

28. b. Liability for settlement. If an insurer breaches the duty to make a reasonable settlement decision under 24 by unreasonably refusing to contribute its limit to an above-limits settlement of a covered legal action, the insured (or another insurer acting on the insured’s behalf) may make a reasonable, noncollusive settlement with the claimant, notwithstanding any term in the insurance policy requiring the insurer’s consent to, or approval of, the settlement of a covered claim and without regard to whether the insurer is defending under a reservation of rights. According to the reasoning of the courts that have adopted this rule, the insurer’s breach of the contractual duty to make reasonable settlement decisions relieves the insured of the obligation to comply with terms in the insurance policy that ordinarily prevent the insured from settling without the insurer’s consent. When an excess insurer acts for the insured to settle a covered legal action in such a situation, the excess insurer may recover from the underlying insurer under the doctrine of equitable subrogation. See § 28.

Similarly, if an insurer breaches the duty to make a reasonable settlement decision under § 24 by unreasonably failing to settle a covered legal action within the policy limits when there is a potential for a judgment in excess of those limits, the insured (or another insurer acting on the insured’s behalf, such as an excess insurer) may make a reasonable, noncollusive settlement with the claimant, notwithstanding any term in the insurance policy requiring the insurer’s consent to, or approval of, the settlement of a covered claim. As with the cases involving above-limits settlement offers, the courts adopting this rule reason that the insurer’s breach of its duty to the insured relieves the insured of the obligation to comply with terms in the insurance policy that ordinarily prevent the insured from settling without the insurer’s consent.

The duty to cooperate requires the insured to exercise reasonable diligence in providing information to the insurer and seeking the insurer’s consent to such settlements. See § 29. Because of the potential for collusion between the insured and the claimant, such settlements should be scrutinized by the court to ensure that they are reasonable in both substance and procedure. In addition to interrogating the reasonableness of the terms of such settlements, courts should ask questions such as the following: (1) Did the insurer receive all information reasonably necessary to evaluate the legal action? (2) Did the insurer have a reasonable opportunity to participate in the settlement process? (3) Was the insurer informed of material developments in the settlement process? (4) Did the insurer have a reasonable amount of time to evaluate the legal action and all the terms of any proposed settlement agreement? (5) Were any reservations regarding the terms of the settlement expressed by the insurer fully and fairly communicated to the insured? (6) Are there any indicia of collusion between the insured and the underlying claimant in the settlement process?

Although most of the procedural requirements in subsection (2) of this Section are identical to those in subsection (3) of § 25, the two circumstances are not identical. The justification for the rule in subsection (2) of this Section is that the insurer has breached the duty to make reasonable settlement decisions when there is a potential for a judgment in excess of the policy limits. This Section applies only after there has been a breach of that duty. Section 25(3), by contrast, applies when the insurer has reserved its rights but there has been no breach of the duty to make reasonable settlement decisions. When the insurer has breached the duty to make reasonable settlement decisions under § 24, the insured may, depending on the nature and circumstances of the breach, have some basis for asserting that it should be relieved of any conditions or requirements restricting its ability to enter into a reasonable settlement. For this reason, there may be a narrow set of circumstances after an insurer’s breach of the duty to make reasonable settlement decisions in which it would be appropriate for a court to excuse the insured’s failure to follow the procedural requirements of subsection (2) of this Section, for example if the insured can demonstrate that no prejudice to the insurer resulted from the insured’s failure to do so. Permitting the insured to settle without the insurer’s consent in such circumstances is consistent with the general rule regarding the duty to cooperate, the breach of which relieves the insurer of its obligations under the policy only if the insurer is prejudiced as a result. See § 30.

In the event of a dispute over the reasonableness of a settlement offer, an insurer can conclusively foreclose an argument that the insured is permitted to settle the case without the insurer’s consent by waiving the policy limit and any coverage defenses. As explained in Comment b to § 24, the duty to make reasonable settlement decisions is owed only to protect the insured from damages in excess of the policy limits. The elimination of that risk eliminates that duty and, hence, any corresponding basis for excusing the insured’s obligation to comply with any consent-to-settlement conditions in the policy.

1. c. Other foreseeable loss. At least a plurality of jurisdictions permit an insured to recover damages for all foreseeable loss arising out of a breach of the duty to make reasonable settlement decisions, not only the amount by which the judgment awarded in the underlying legal action exceeds the policy limit. Jurisdictions differ with regard to whether the duty to make reasonable settlement decisions is a contract duty, a tort duty, or both. Under the rules of contract law, a promisee is entitled to recover for loss that was foreseeable at the time of contracting as a probable result of a breach. By contrast, under the rules of tort law, foreseeability generally is assessed as of the time of the breach. Because of the expertise of insurers in assessing risks at the time of underwriting and in handling legal actions, they are likely in many, if not most, cases to be aware at the time of contracting of the kinds of consequences that follow from a lost opportunity to settle a legal action. Thus, it is hardly surprising that most courts have not explicitly considered the question of the timing of foreseeability, as the result would be the same either way in many cases, provided that the meaning of “foreseeable” is the same for both tort and contract law. Although the insurance-law cases generally do not highlight this distinction, some courts employ a concept of foreseeability in contract cases that is much narrower than the same concept in tort law, not because of differences in the timing of when a loss must be “foreseeable” for contract- and tort-damages purposes, but rather because of a policy preference in favor of more restricted damages in contract law than in tort law. Although this Section is agnostic as to the doctrinal label, the broader approach to whether a loss is foreseeable, which is most commonly associated with the tort-law label, is the proper approach. Taking the broader approach to foreseeability promotes more efficient and fair settlement decisions by placing the insurer in the position of the insured, responsible for the full potential loss facing the insured, consistent with the core objective of the duty: mitigating the conflict between insurer and insured that would otherwise be present whenever there is a significant risk of a judgment that is in excess of the policy limits.

No damages are available under this Section if the underlying legal action goes to trial and there is no excess judgment. Put differently, the insurer’s duty to make reasonable settlement decisions does not provide protection against even foreseeable harms to the insured resulting from a judgment or settlement that is within the policy limits. The rationale for this limitation of the duty is one of practicality. It is often the case that an insurer’s decision not to settle a suit against the insured will cause the insured aggravation and inconvenience, and perhaps even uninsured out-of-pocket expenditures, even when the judgment is within the limits of the policy. Such costs are typically relatively minor. To include them in the measure of damages in a settlement-duty case would encourage litigation, by creating the potential for a lawsuit alleging a breach of the duty to make reasonable settlement decisions in every case with a plaintiff’s verdict. This rule does not preclude insureds from being able to recover for such costs should the insurer’s actions rise to the level of bad faith, nor does it preclude statutory or administrative remedies. However, when the allegation is merely that the insurer’s decision was unreasonable in an individual case, no such common-law damages will be available when a judgment or settlement is within the limits of the insurance policy. This is the prevailing rule.

• Illustrations:

1. Insured is an individual consumer who has a homeowner’s policy with the duty to defend and policy limits of $100,000. A claim is brought against the insured for a bodily injury, seeking $1 million in compensatory damages. As the case nears trial, the claimant makes a settlement demand of $100,000, which is reasonable, since there is a high likelihood that the insured will be found liable for the harm. Because of the obviously fragile emotional state of the insured, it is foreseeable that the insured will suffer significant emotional distress from an excess verdict that exposes the insured to significant financial distress. The insurer nevertheless rejects the settlement demand and takes the case to trial. The trial results in a $1 million verdict against the insured. As a result of the verdict, the insured is forced into severe financial difficulties and is hospitalized with severe depression and anxiety, incurring substantial medical expenses. Because of its rejection of a reasonable settlement demand, the insurer is liable to the insured, or to the insured’s assignees, for the excess judgment of $900,000 as well as the medical expenses and the emotional distress.

2. Same facts as Illustration 1, except that the insured prevails in the underlying litigation, and the jury returns a verdict of no liability. As a result of the stress of the trial, the insured is hospitalized with severe depression and anxiety, incurring substantial medical expenses and severe emotional distress. The insurer is not liable to the insured for breach of the duty to make reasonable settlement decisions, as the underlying litigation did not result in an excess verdict against the insured.

3. Same facts as Illustration 1, except that the verdict for the claimant produces only a $100,000 verdict against the insured. Thus, there is no excess verdict. However, the insured is humiliated at having been found responsible for the underlying civil claim and suffers emotional distress. The insurer is not liable to the insured for any damages, despite having made an unreasonable settlement decision.

4. Commercial policyholder has a duty-to-defend liability insurance policy with policy limits of $500,000. A claim is brought against the policyholder seeking $1,400,000 in compensatory damages. As the date of trial approaches, the claimant makes a settlement demand of $500,000, which is reasonable under the circumstances. It is reasonably foreseeable that the insured will suffer substantial, quantifiable damage to its business reputation as a result of an adverse judgment. The insurer, however, rejects this settlement demand and opts instead to try the case. The suit results in a verdict of $1,400,000 against the insured. The insurer’s liability for breach of its settlement duties includes the $900,000 excess judgment as well as damages for any foreseeable loss to the insured’s business reputation.

5. Same facts as Illustration 4, except that the underlying suit results in a verdict of $500,000. Thus, there is no excess verdict; however, the insured’s commercial reputation is severely damaged, causing the insured to lose substantial amounts of business. The insurer is not liable to the insured for any damages under this Section, despite having made an unreasonable settlement decision.

6. SecureCo is sued for securities violations. Primary Insurer agrees to pay for the costs of defense pursuant to a D&O policy with an applicable policy limit of $15 million and a provision requiring the insurer’s consent to any settlement. There are several settlement meetings with underlying Plaintiffs, SecureCo, Primary Insurer, and Excess Insurer. In the last such meeting, Plaintiffs offer to settle the action for $30 million, which SecureCo and Excess Insurer conclude is a reasonable settlement. Primary Insurer refuses to consent to the settlement. The other parties nevertheless settle. SecureCo and Excess Insurer subsequently bring an action against Primary Insurer seeking payment of the policy limit of the primary D&O policy. If SecureCo and Excess Insurer prove that Primary Insurer breached the duty to make reasonable settlement decisions, Primary Insurer may not avoid payment because of noncompliance with the consent-to-settlement provision in the primary D&O policy.

1. d. Judgment-proof insureds. A minority of jurisdictions limit the damages imposed in duty-to-settle cases when the insured has insufficient assets to cover the excess judgment. Specifically, these jurisdictions require that breach-of-settlement-duty damages may be assessed against the insurer only to the extent there has been a showing that the insured has made a payment on the judgment or that the insured has assets that are available for satisfaction of a tort judgment. The argument given for this limitation is that, as a financial matter, the insured is harmed by an excess judgment only to the extent that the insured has assets that can be used to satisfy a judgment. Thus, if the insured has no such assets (for example, the only asset is a personal residence that happens to be protected by a state homestead exemption), it is argued that the insured has not been financially harmed by a tort judgment in excess of the policy limits; the excess judgment will simply go unpaid. Under the majority rule, however, the insured’s damages are measured by the difference between the policy limit and the judgment against the insured.

This Section follows the majority rule for several reasons. First, the majority rule in many cases provides a better measure of the financial harm to the insured, because the excess trial judgment remains a debt owed by the insured unless and until the insured files for bankruptcy or the tort plaintiff voluntarily waives that debt. Any assets that can be used to satisfy a judgment acquired by the insured after the verdict would have to be made available to satisfy the excess judgment. Thus, the full amount of the excess judgment does cause financial harm to the insured. Second, the minority rule is more difficult to administer, as the court is required to make an assessment of the value of the insured’s assets that can be used to satisfy a judgment and, in some jurisdictions, to make predictions about the likely acquisition of additional assets. Third, the minority rule discourages settlement compared with the majority rule. Finally, by using the amount of the excess judgment as the basic measure of damages, the majority rule encourages insurers to sell liability insurance coverage in amounts that fully cover the risks of the insured activity. That is, if the potential damages for an insurer’s breach of settlement duties include the full excess judgment, and are not limited to the insured’s assets that can be used to satisfy a judgment, the insurer will have an incentive to negotiate for higher policy limits and higher rates adequate to cover the full risk of the activity being insured.

1. e. When the underlying suit results in punitive damages. If a liability insurer’s unreasonable failure to settle a legal action against the policyholder results in a compensatory-damages award in excess of the policy limits and a punitive-damages award against the policyholder in that action, the amount of that punitive-damages award is included in the consequential damages owed for breach of the insurer’s duty. This rule is unproblematic in most jurisdictions, because a punitive-damages award is a foreseeable consequence of the insurer’s breach and the majority rule permits insurance for punitive damages.

In jurisdictions in which insurance for punitive damages is contrary to public policy, however, there is tension between a rule forbidding the sale of liability insurance against punitive damages and a rule that requires an insurer to indemnify the insured for such damages when the insurer has breached the duty to make reasonable settlement decisions. Although most courts have not addressed this issue, the very few state courts that have addressed it have resolved the tension in favor of the public policy against insurance for punitive damages, typically in divided judgments with strong dissents indicating that there is considerable uncertainty regarding the direction insurance law should take. This Section follows the approach of the dissenting judges in those cases for several reasons. First, this approach furthers the public policy in favor of encouraging reasonable settlement decisions by insurers. Second, the incentive argument in favor of the contrary approach—i.e., that the deterrent power of punitive damages would be extinguished by having the insurer pay the punitive-damages amount—is implausible, because insureds will not base their conduct on a speculative possibility their insurer might later breach the duty to make reasonable settlement decisions. Thus, this approach does not in fact undercut the public-policy interest against insuring punitive damages. Finally, the contrary approach could create a conflict of interest in the defense of the claim that might increase the frequency of cases in which independent counsel would be required under § 16, reducing liability insurers’ ability to manage defense costs. See § 16, Comment d.

• Illustration:

7. Insured has a duty-to-defend liability insurance policy with policy limits of $1 million. A claim is brought against the insured seeking $5 million in compensatory damages and $3 million in punitive damages. The liability insurance policy excludes punitive damages from coverage. Moreover, the relevant state law provides that insurance coverage for punitive damages is a violation of public policy. However, it was reasonably foreseeable at the time of contracting that, if the insured loses this kind of suit, she will be liable for both compensatory and punitive damages. As the trial approaches, the claimant makes a settlement demand equal to the value of the policy limits. According to the evidence available to the insurer at the time of the settlement negotiations, this demand was reasonable in light of the expected compensatory damages, alone, because there was a high likelihood of liability at trial. The insurer nevertheless rejects the demand and takes the case to trial, which results in a verdict against the insured for $5 million of compensatory damages and $3 million of punitive damages. The insurer is liable for the full amount of the excess judgment ($7 million).

36. f. Assignment of the breach-of-settlement-duty claim to the plaintiff in the underlying suit. Once there has been an excess judgment in the trial of the underlying claim, the claimant may proceed against the insured for the amount of the difference between the policy limit and the judgment. In many cases, however, the insured has insufficient assets to cover the full amount of the excess judgment and will not have an excess policy that covers the excess judgment. See Comment d for a discussion of the problem of judgment-proof insureds. In many cases involving insured defendants that are consumers or very small businesses, the only significant asset of the insured that can be reached by the claimant in the event of an excess judgment is the claim against the insurer. In such cases, the insured commonly assigns its breach-of-settlement-duty claim to the claimant, who in return agrees not to pursue satisfaction of the judgment against the insured. The plaintiff may then bring the claim against the insurer, standing in the shoes of the insured. Such assignments are permissible under the general rule regarding assignment of liability insurance claims stated in 36. The primary justifications for allowing the assignment of these claims are the same as the rationale for allowing causes of action to be assigned generally: Permitting assignment maximizes the value to the insured of its claim against the insurer and enhances the deterrence provided by the duty to make reasonable settlement decisions.

Reporters’ Note

9. Liability for excess judgment.The majority of jurisdictions have adopted the principle followed in this Section. See Med. Mut. Liab. Ins. Soc. of Md. v. Evans, 622 A.2d 103, 114 (Md. 1993) (“[T]he majority rule, is that the measure of damages in a bad faith failure to settle case is the amount by which the judgment rendered in the underlying action exceeds the amount of insurance coverage.”). See also 1 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN INSURANCE BAD FAITH LITIGATION§ 9.03[2] (2d ed. 2017) (footnote omitted) (“At the very least, in an action for breach of the insurer’s duty to settle, an insured can recover the difference between the total amount of the judgment in the third party suit and the amount of the policy limits, plus interest and costs.”); Eric M. Larsson, Insurer’s Liability to Its Insured for Wrongful Refusal to Settle with Third Party Within Policy Limits, 146 AM. JUR. PROOF OF FACTS, 3D 421§ 29 (Database updated 2017) (“[T]he usual recovery when an insurer is found liable for breaching its duty to settle is the amount of the policy limits, if it has not been paid, plus the amount of a judgment or settlement beyond the policy limits.”) See also 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 206:5 (3d ed. 2017) (“[S]ome courts have held that a liability insurer, having assumed control of the right to settle claims against the insured, may become liable in excess of its undertaking under the policy provisions if it fails to exercise ‘good faith’ in considering offers to compromise the claim for an amount within the policy limits.”). For a general discussion of the rationale for allowing the insured to recover damages in excess of the policy limits when the insurer breaches the duty to settle, see ROBERT H. JERRY, II & DOUGLAS R. RICHMOND, UNDERSTANDING INSURANCE LAW 844 (5th ed. 2012) (“Whether the duty to settle sounds in tort or contract it is clear that the insured can recover damages in excess of the policy limits if the insurer breaches this duty.”).

For cases allowing the insured to recover the difference between the policy limits and the total judgment, see Comunale v. Traders & Gen. Ins. Co., 328 P.2d 198, 201 (Cal. 1958) (“It is generally held that since the insurer has reserved control over the litigation and settlement it is liable for the entire amount of a judgment against the insured, including any portion in excess of the policy limits, if in the exercise of such control it is guilty of bad faith in refusing a settlement.”); Cotton States Mut. Ins. Co. v. Brightman, 568 S.E.2d 498, 502 (Ga. Ct. App. 2002) (“After an insurer’s liability for wrongful refusal to settle a claim against its insured is established, the insured or its assignee is entitled as a matter of law to recover damages equal to the amount by which the judgment exceeds policy coverage.”). Note that in some cases portions of the excess judgment might not be caused by the breach, as in cases involving missed settlement opportunities that would have been partially funded by the insured. In such cases, the insurer’s liability actually would equal the amount of the excess judgment minus the amount the insured would have paid toward the settlement. See, e.g., Cont’l Cas. Co. v. U.S. Fid. & Guar. Co., 516 F. Supp. 384, 391 (N.D. Cal. 1981) (“Where the evidence indicates that a settlement would have required a contribution by the insured or excess carrier, any recovery must be limited to the difference between the amount that would have been contributed to the settlement and the amount ultimately paid by the insured or excess carrier in satisfaction of judgment.”).

1. Liability for settlement.When an insured contends that it has the right to settle without the insurer’s consent because the insurer has breached the duty to make reasonable settlement decisions, the insurer has a legitimate interest in considering whether to waive the policy limits and thereby retain unquestioned authority over the settlement of the claim. The procedures stated in subsection (2) protect that legitimate interest and they help to ensure that settlements entered into without an insurer’s consent are reasonable. With that said, these specific procedural requirements are an innovation that may be appropriate for courts to apply only on a prospective basis following notice by the courts within a jurisdiction.

For authority supporting the settling insured’s or excess insurer’s ability to recover the amount of the policy limits based on breach of the insurer’s duty to contribute the policy limits toward a reasonable excess settlement, see, e.g., SwedishAm. Hosp. Ass’n of Rockford v. Ill. State Med. Inter-Ins. Exch., 916 N.E.2d 80, 96–97 (Ill. App. Ct. 2009) (citing Fireman’s Fund, 367 A.2d at 870):

If the circumstances at the time of settlement establish that the potential loss and the proposed settlement by far exceed … the limits of the policy, the insured need not await the outcome of the trial and may proceed to make a prudent settlement. Then, upon proof of the insurer’s breach of its good-faith duty to settle, it may recover the amount of the policy limits from the insurer.

Cont’l Cas. Co. v. Reserve Ins. Co., 238 N.W.2d 862, 864–865, 867 (Minn. 1976):

[W]hen a primary insurer breaches its good-faith duty to settle within policy limits, it imperils the public and judicial interests in fair and reasonable settlement of lawsuits. If the excess insurer elects to settle in spite of the primary insurer’s bad-faith objections, as is alleged in this case, the excess insurer risks losing the policy-limit contributions of the primary insurer and being forced to pay the entire settlement itself, even though the settlement may have been in the overall best interest of the insured…. In such a case the insured should certainly be able to protect itself by settling a claim against it within primary policy limits, and then recovering from its primary insurer who refused to settle in bad faith.

Fireman’s Fund Ins. Co. v. Sec. Ins. Co. of Hartford, 367 A.2d 864, 868–869 (N.J. 1976) (citations omitted) (permitting the insured to recover the policy limits from the primary insurer to defray the costs of an above-limits settlement, based on a breach of the insurer’s settlement duties, stating: “while the right to control settlements reserved to insurers is an important and significant provision of the policy contract, it is a right which an insurer forfeits when it violates its own contractual obligation to the insured” and “[t]he breach of an insurer’s covenant, whether it be express or implied, leaves the insured free, despite the limiting policy provisions, to protect his own interest in minimizing a potential liability in excess of the policy limits by agreeing to a reasonable good faith settlement of the negligence actions and then, on proof of the insurer’s default, to recover from it the amount of its policy limits.”).

There is substantial authority that an above-limits verdict is not required before an action can be brought against an insurer that breached the duty to make reasonable settlement decisions. For authority supporting the insured’s or excess insurer’s ability to recover for an above-limits settlement entered into following breach of the insurer’s settlement duties, see, e.g., Twin City Fire Ins. Co. v. Country Mut. Ins. Co., 23 F.3d 1175 (7th Cir. 1994) (applying Illinois law) (permitting an excess insurer to recover under equitable subrogation from the primary insurer settlement amounts in excess of the limits of the primary insurance policy based on the primary insurer’s breach of settlement duties); Certain Underwriters of Lloyd’s v. Gen. Accident Ins. Co., 909 F.2d 228 (7th Cir. 1990) (applying Indiana law) (same); Ace Am. Ins. Co. v. Fireman’s Fund Ins. Co., 206 Cal. Rptr. 3d 176 (Ct. App. 2016) (same); RLI Ins. Co. v. Scottsdale Ins. Co., 691 So. 2d 1095 (Fla. Dist. Ct. App. 1997) (same, though no finding of breach of duty in this case); St. Paul Fire & Marine Ins. Co. v. Liberty Mut. Ins. Co., 353 P.3d 991, 992 (Haw. 2015) (same); Commercial Union Ins. Co. v. Med. Protective Co., 393 N.W.2d 479, 483 (Mich. 1986) (same); Scottsdale Ins. Co. v. Addison Ins. Co., 448 S.W.3d 818 (Mo. 2014) (same); Centennial Ins. Co. v. Liberty Mut. Ins. Co., 404 N.E.2d 759, 762 (Ohio 1980) (same); Maine Bonding & Cas. Co. v. Centennial Ins. Co., 693 P.2d 1296 (Or. 1985) (same); Am. Centennial Ins. Co. v. Canal Ins. Co., 843 S.W.2d 480, 483 (Tex. 1992) (same); Besel v. Viking Ins. Co. of Wis., 49 P.3d 887, 890 (Wash. 2002) (permitting claimant-assignee to recover for excess-of-limits settlement based on insurer’s breach of settlement duties). But see Romstadt v. Allstate Ins. Co., 59 F.3d 608, 615 (6th Cir. 1995) (Ohio law) (holding that “where the insurer has not refused to defend the insured, but has only refused to settle the case, an injured third party cannot sue the insurer directly, or via assignment, for bad faith refusal to settle in the absence of an adjudicated excess judgment against the insured”); RLI Ins. Co. v. CNA Cas. of California, 45 Cal. Rptr. 3d 667, 673 (Ct. App. 2006) (contrary to Ace American, declining to follow Fortman v. Safeco Ins. Co., 271 Cal. Rptr. 117 (Ct. App. 1990) on the ground that an excess verdict is a necessary component of a breach-of-settlement-duty case); Safeco Ins. Co. v. Super. Ct., 84 Cal. Rptr. 2d 43, 46–47 (Ct. App. 1999) (holding that insured cannot sue for breach of the duty to make reasonable settlement decisions unless and until an adjudicated excess judgment is rendered against the insured).

For authority supporting the insured’s ability to recover for a within-limits settlement entered into to avoid an excess verdict, see, e.g., Traders & Gen. Ins. Co. v. Rudco Oil & Gas Co., 129 F.2d 621, 627–628 (10th Cir. 1942) (applying Oklahoma law) (finding that an insurer lacked standing to “interpose the voluntary settlement made by [the insured] as a bar to recovery upon the policy” because the insurer failed to show that, when it previously rejected the settlement offer, “it acted in good faith and dealt fairly with the assured”); Rupp v. Transcon. Ins. Co., 627 F. Supp. 2d 1304, 1324 (D. Utah 2008) (predicting that the Utah Supreme Court would join “most of the courts that have faced th[e] issue” in “reject[ing] the proposition that a ‘no action’ provision and voluntary payment provision may be used by an insurance company accused of bad faith to avoid liability for gambling with the insured’s (and excess insurer’s) money”); Crawford v. Infinity Ins. Co., 139 F. Supp. 2d 1226, 1230 (D. Wyo. 2003) (applying Wyoming law) (“[A]n insured may enter into a reasonable settlement agreement where the insurer acts with bad faith in failing to settle a claim within policy limits.”); Nat’l Union Fire Ins. Co. of Pittsburgh, Pa. v. Cont’l Ill. Corp., 673 F. Supp. 267, 274 (N.D. Ill. 1987) (claiming “all the courts that have considered the question have allowed insureds (1) to effect reasonable settlements on their own after their insurers have breached their duty to settle and (2) to enforce those settlements against the insurers if reasonable and made in good faith”); Cent. Armature Works, Inc. v. Am. Motorists Ins. Co., 520 F. Supp. 283, 289 (D.D.C. 1980) (holding that “contract provisions prohibiting settlement [by the insured] without the consent of the insurer will not be enforced” after the insurer “fail[s] to exercise diligence, good faith, and conscientious fidelity in safeguarding the interests of the insured” by rejecting an attractive settlement offer); N. Am. Van Lines, Inc. v. Lexington Ins. Co., 678 So. 2d 1325, 1334 (Fla. Dist. Ct. App. 1996) (permitting insured to bring an action to recover a within-limits settlement amount from insurer based on the allegation that the insurer had breached its settlement duties and the settlement was reasonable in light of the significant potential for an excess verdict); Swedish Am. Hosp. Ass’n of Rockford v. Ill. State Med. Inter-Ins. Exch., 916 N.E.2d 80, 98 (Ill. App. Ct. 2009) (“[I]t would be unfair to enforce the no-action provision against [the insured] for securing a reasonable settlement if [the insurer] breached its good-faith duty to settle and exposed [the insured] to liability exceeding the policy limits…. [T]he no-action provision may be rendered unenforceable if plaintiffs establish that [the insurer] breached its good-faith duty to settle.”); Cont’l Cas. Co. v. Res. Ins. Co., 238 N.W.2d 862, 867 (Minn. 1976) (“[T]he insured should certainly be able to protect itself by settling a claim against it within primary policy limits, and then recovering from its primary insurer who refused to settle in bad faith” and “[s]ince bad faith failure to settle occurs prior to trial, and the relevant standard involves evaluation of the insurer’s decision at the time it is made and not from hindsight, we see no reason to allow the primary insurer to force a trial of the principal action.”); Hyatt Corp. v. Occidental Fire & Cas. Co. of N.C., 801 S.W.2d 382, 389 (Mo. Ct. App. 1990) (“Where an insurer breaches its good faith duty to consider offers of settlement, the insured may effect reasonable good faith settlements on its own and enforce such settlements against the insurer.”); Fireman’s Fund Ins. Co. v. Sec. Ins. Co. of Hartford, 367 A.2d 864, 870 (N.J. 1976) (“A different situation is presented when, viewed as of the time the settlement offer is received, the potential loss and the proposed settlement exceed … the limits of the policy. In such a situation, the insured … should be and is permitted … to proceed to make a prudent good faith settlement for an amount in excess of the policy limits and then, upon proof of the breach of the insurer’s obligation and the reasonableness and good faith of the settlement made, to recover the amount of the policy limits from the insurer.”). See also 1 ALLAN D. WINDT, INSURANCE CLAIMS & DISPUTES § 5:16 (3d ed. 1995) (“If … the carrier wrongfully rejects a settlement offer, the insured should be free to accept it.”). But see Piedmont Office Realty Trust, Inc. v. XL Specialty Ins. Co., 771 S.E.2d 864, 866–867 (Ga. 2015) (holding that insured may not settle without consent or challenge insurer’s failure to consent as unreasonable unless and until an adverse judgment has been entered).

Courts differ on whether an insured may recover for breach of settlement duties when the insured enters into a settlement or stipulated judgment, before a contested trial on the merits, that includes a covenant not to execute against the insured’s assets, and this Section does not take a position on that issue. Compare Hamilton v. Maryland Cas. Co., 41 P.3d 128 (Cal. 2002) (refusing to allow insured to recover for breach of settlement duties when the alleged breach was followed by a stipulated verdict and covenant not to execute, on the ground that the insured suffered no harm) with Nunn v. Mid-Century Ins. Co., 244 P.3d 116, 122 (Colo. 2010) (holding that insured suffered actual damages when it entered into a stipulated judgment in an amount in excess of the policy limit subject to a covenant not to execute and asserting that this approach is followed by “an increasing majority of jurisdictions”) and Bird v. Best Plumbing Group, LLC, 260 P.3d 209, 215–217 (Wash. Ct. App. 2011) (reasonableness of settlement with covenant not to execute is a question of fact, disagreeing with Hamilton).

Finally, for the avoidance of doubt, subsection (2) authorizes an insured to settle without the consent of the insurer only if the insurer has breached the duty to make reasonable settlement decisions under § 24. If the insured mistakenly concludes that the insurer has breached the duty, and the insured thereafter settles the case, subsection (2) will not excuse the insured from compliance with applicable conditions in the policy.

7. Other foreseeable loss.For the general proposition that an insurer that breaches the duty to make reasonable settlement decisions is liable for all losses foreseeably caused thereby, see KEETON, WIDISS & FISCHER, INSURANCE LAW§ 7.8(h) at 753 (2d ed. 2017) (footnote omitted) (“[S]ome courts hold the insurer’s liability extends to all detriments that are the proximate result of an entry of a judgment in excess of the insured’s policy limits, including consequential economic loss and even emotional distress.”). See also 1 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN INSURANCE BAD FAITH LITIGATION§ 9.03[4] (2d ed. 2017); ROBERT H. JERRY, II & DOUGLAS R. RICHMOND, UNDERSTANDING INSURANCE LAW 846 (5th ed. 2012). For cases awarding foreseeable damages beyond the judgment against the insured, see Truestone, Inc. v. Travelers Ins. Co., 55 Cal. App. 3d 165, 170 (1976) (holding that given the function of insurance is to provide the insured with peace of mind, damages for mental suffering are recoverable for the insurer’s breach of the duty to settle in good faith); Birth Ctr. v. St. Paul Cos. Inc., 787 A.2d 376, 379 (Pa. 2001) (awarding damages for harm to the insured’s business reputation that were a foreseeable result of the insurer’s failure to settle); Meccia v. Pioneer Life Ins. Co., 13 Va. Cir. 17 (Va. Cir. Ct. 1987) (“The basic principle is reimbursement for foreseeable loss resulting from the insurer’s breach of duty to settle within policy limits on a claim against the insured.”); 1 STEVEN PLITT & JORDAN R. PLITT, PRACTICAL TOOLS FOR HANDLING INSURANCE CASES§ 7:33 (Database updated 2017) (“A plurality of jurisdictions that have specifically considered the question have permitted the award of consequential damages in bad-faith litigation. Several jurisdictions limit the extent of the consequential damages to those that were reasonably foreseeable to have occurred from the breach of the duty.”). This source goes on to state that “consequential damages can include the full-value of an excess judgment … and also a wide variety of economic loss including lost profits, loss of income, [etc.].” Id. See Restatement Second, Contracts § 351 (AM. LAW INST. 1981).

There is support in the case law in various jurisdictions for treating duty-to-settle claims as sounding in contract or tort or both. As a result, insureds sometimes rely on the contract theory to avoid the shorter statute of limitations that applies to pure tort actions. See KEETON, WIDISS & FISCHER, INSURANCE LAW§ 7.8(j) (2d ed. 2017). See also Comunale v. Traders & Gen. Ins. Co., 328 P.2d 198, 203 (Cal. 1958) (holding that a cause of action for breach of the duty to settle sounds in tort and contract, and the plaintiff may therefore take advantage of the longer statute of limitations under the contract theory). Characterizing the cause of action as a tort duty, however, may broaden the measure of damages. See KEETON, BASIC TEXT ON INSURANCE LAW 509 (1971). See Crisci v. Sec. Ins. Co. of New Haven, Conn., 426 P.2d 173, 179 (Cal. 1967) (explaining that the plaintiff could recover damages for mental distress under the tort theory of breach of duty to settle but not under the contract theory). The majority of courts and commentators find that the duty to settle sounds in tort rather than in contract. See KEETON, BASIC TEXT ON INSURANCE LAW 509 (1971). See Swedish Am. Hosp. Ass’n of Rockford v. Ill. State Med. Inter-Ins. Exch., 916 N.E.2d 80, 96 (Ill. App. Ct. 2009); Zumwalt v. Utilities Ins. Co., 228 S.W.2d 750, 755 (Mo. 1950). The cleaner conceptual understanding is that the duty to settle sounds in contract. See TOM BAKER & KYLE D. LOGUE, INSURANCE LAW AND POLICY 539 (4th ed. 2017). In most cases, however, the doctrinal label is unlikely to make a practical difference. See Restatement Third, Torts: Liability for Economic Harm § 4, Reporters’ Note to Comment a (AM. LAW INST., Tentative Draft No. 1, 2012; official text expected in 2019) (observing that it usually does not matter whether a professional is sued in tort or in contract and, therefore, the doctrinal label ultimately should not be of great importance).

Jurisdictions that treat the bad-faith action as entirely involving a breach of contract tend to permit fewer consequential damages. See 1 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN INSURANCE BAD FAITH LITIGATION§ 9.03 (2d ed. 2017). Some courts have interpreted the strict foreseeability requirement from the time of contracting as precluding any consequential damages. See, e.g., DiBlasi v. Aetna Life & Cas. Ins. Co., 147 A.D.2d 93, 100–101 (N.Y. App. Div. 1989) (basing a decision to reject all compensatory damages from a bad-faith claim on the contract nature of the claim). Other courts that continue to hold that a bad-faith action sounds in contract have allowed consequential damages that meet the foreseeability requirements of contract law. See, e.g., Birth Ctr., 787 A.2d at 380, 385. The same rule applies in the first-party context. See, e.g., 3 RONALD J. CLARK, DIANNE K. DAILEY & LINDA M. BOLDUAN, LAW AND PRAC. OF INS. COVERAGE LITIG.§ 28:42 (Database updated July 2017). “[C]onsequential damages resulting from a breach of the covenant of good faith and fair dealing may be asserted in an insurance contract context, so long as the damages were within the contemplation of the parties as the probable result of a breach at the time of or prior to contracting.” Stein, LLC v. Lawyers Title Ins. Corp., 100 A.D.3d 622, 622 (N.Y. App. Div. 2012) (quotations omitted). “Consequently, although breach of an insurance contract may result in consequential damages, such as economic loss, emotional distress, inconvenience, and legal expenses, insureds generally cannot recover such damages” as they are not found to be within the contemplation of the parties prior to contracting. 3 LAW AND PRAC. OF INS. COVERAGE LITIG. § 28:42.

Jurisdictions that hold that a bad-faith breach of the duty to settle is a tort action allow recovery for “damages in addition to the excess [which] have been caused proximately by the failure to effect settlement in a reasonable manner.” Larraburu Bros., Inc. v. Royal Indem. Co., 604 F.2d 1208, 1215 (9th Cir. 1979) (applying California law). Thus, “there is little question that economic damages resulting from entry of an excess judgment are recoverable.” 1–9 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN INSURANCE BAD FAITH LITIGATION§ 9.03 (2d ed. 2017). The breach of the duty to settle is a tort action, and “[t]he statutory rule for measure of damages in tort cases is the amount which will compensate the injured party for all the detriment proximately caused thereby, whether it could have been anticipated or not.” Gibson v. W. Fire Ins. Co., 682 P.2d 725, 738 (Mont. 1984). See also Atlas Constr. Co. v. Slater, 746 P.2d 352, 359 (Wyo. 1987). This can include emotional damages as well. Id.

23. Judgment-proof insureds.For a general discussion of the majority and minority rules regarding how damages should be determined in duty-to-settle cases involving judgment-proof or insolvent insureds, see 3 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 23.02[6][f] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017); KEETON, WIDISS & FISCHER, INSURANCE LAW§ 7.8(i) (2d ed. 2017). Although some older cases adopted the view that no duty-to-settle damages were owing except to the extent the insured actually made payments on the excess judgment, the vast majority of recent cases that have addressed the issue have held that no such showing is required—and that a showing of an excess judgment is sufficient to prove damages. See generally 3 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 23.02[6][f][i] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017) (surveying case law).

For cases holding an insurer liable for breach of the duty to settle without regard to whether the insured paid the excess judgment, see Torrez v. State Farm Mut. Auto. Ins. Co., 705 F.2d 1192, 1201 (10th Cir. 1982) (applying New Mexico law) (“The fullness or the emptiness of an insured’s purse should be irrelevant. It is a poor measure of liability by the insurer under its contract.”); Purdy v. Pac. Auto. Ins. Co., 203 Cal. Rptr. 524, 532 (Ct. App. 1984) (rejecting the insurer’s argument that the bankrupt insured suffered no economic harm from an excess judgment); Nunn v. Mid-Century Ins. Co., 244 P.3d 116, 122 (Colo. 2010) (“[I]n our view, regardless of whether the insured can or will pay the judgment, entry of a judgment in excess of policy limits harms the insured because it may result in damage to an insured’s credit, its ability to successfully apply for loans, or its reputation.”); Carter v. Pioneer Mut. Casualty Co., 423 N.E.2d 188, 190 (Ohio 1981) (holding that an excess judgment may be recovered from an insurer by an insured’s estate or its assignee despite the insolvency of the estate).

1225. When the underlying suit results in punitive damages.Whether a liability insurer that breaches the duty to settle may be held liable for the punitive damages sustained by the insured at the trial of the underlying action—when the insured would not have been allowed to purchase punitive-damage coverage because of public-policy restrictions—has been addressed by the courts in only three states. See PPG Indus., Inc. v. Transamerica Ins. Co., 975 P.2d 652, 654 (Cal. 1999); Lira v. Shelter Ins. Co., 913 P.2d 514, 516–517 (Colo. 1996); Soto v. State Farm Ins. Co., 635 N.E.2d 1222, 1223–1224 (N.Y. 1994). In addition, two Federal Circuits have made an Erie prediction in accord with the holdings in PPG, Lira, and Soto. See Wolfe v. Allstate Prop. & Cas. Ins. Co., 790 F.3d 487, 494–495 (3d Cir. 2015) (applying Pennsylvania law); Magnum Foods, Inc. v. Cont’l Cas. Co., 36 F.3d 1491, 1506–1507 (10th Cir. 1994) (applying Oklahoma law). Cf. Carpenter v. Auto. Club Interinsurance Exch., 58 F.3d 1296, 1302 (8th Cir. 1995) (applying Arkansas law) (allowing recovery when the insurance contract excluded punitive damages, in a jurisdiction that permits insurance for punitive damages). Those five courts concluded that the insurer may not be held responsible for such punitive damages, and they have offered three related rationales. The first rationale is that recovery is inappropriate because public policy and many insurance contracts prohibit indemnification for punitive damages. See Soto, 635 N.E.2d at 1225. Plaintiffs are not allowed to recharacterize punitive damages from an underlying lawsuit as compensatory damages in a bad-faith action and thereby circumvent both public policy and contract law. See PPG, 975 P.2d at 657. Second, public policy also militates against allowing the intentional wrongdoing of one to be offset by the negligence of another. Id. at 656. Finally, punitive damages are awarded as punishment and deterrence and must rest with the responsible party. The wrongdoer should not be allowed to shift responsibility for his or her morally culpable behavior onto an insurer and avoid punishment, while at the same time causing the insurer to pass these costs onto the public. Id. at 657.

The dissenting opinions in PPG and Lira, each decided by a 4-3 court, contend that the majority misinterprets the law and offer four rationales for allowing recovery. First, an insurer’s duty to defend and indemnify its insured is maintained even when an insured may suffer an adverse judgment that includes punitive damages. Even if an insurer is not liable for the punitive-damages portion of an award, it still maintains a duty to make reasonable efforts to settle all claims against its insured within the insured’s policy limits. Justice and fairness require holding insurers liable in these cases because no damages would have resulted but for the insurer’s tortious breach of duty. See PPG, 975 P.2d at 658–660. Second, public policy, which disallows comparative negligence to offset punitive damages, is not implicated in these matters because “[t]he identified public policy operates by comparing the relative culpability of the plaintiff and the defendant within a single action … not … by comparing the relative culpability of the defendants in two separate actions—for example, the culpability of the insured in an action brought against it by its victim for bodily injury and property damage vis-à-vis the culpability of the insurer in an action brought against it by its insured for tortious breach of its duty to settle.” Id. at 661. Third, allowing for recovery would not defeat the purpose of punitive damages as punishment and deterrence because “it is inconceivable that the insured would be enticed to engage in oppressive, fraudulent, or malicious conduct on the speculation that its insurer might perhaps tortiously breach its duty to settle, and then might perhaps be held liable to it for damages therefor.” Id. at 662. Accord Lira, 913 P.2d at 521–522. Fourth, allowing for recovery would not implicate the public-policy or contractual prohibition of indemnifying against punitive damages because the insurer’s payment to its insured is not indemnification, but rather, consequential damages in tort. The insurer should be liable for all damages proximately caused by its breach of duty. See PPG, 975 P.2d at 662; Lira, 913 P.2d at 521–522. See generally Jennifer A. Emmaneel, Note, Hiding Behind Policy: Confusing Compensation with Indemnification, 30 GOLDEN GATE U. L. REV. 637 (2000) (analyzing the arguments of the majority and dissent in PPG, summarized above, and arguing that the dissent’s position presents a better interpretation of both California law and public policy).

23. Assignment of the breach-of-settlement-duty claim to the plaintiff in the underlying suit.See V. Woerner, Annotation, Assignability of Insured’s Right to Recover Over Against Liability Insurer for Rejection of Settlement Offer, 12 A.L.R.3d 1158 (Originally published in 1967). See also 2 ALLAN D. WINDT, INSURANCE CLAIMS & DISPUTES § 9:12, n.3 (6th ed. 2017) (“If an insured assigns to the injured party the insured’s cause of action for breach of the duty to settle, virtually all courts will allow the injured party to sue the insurer for excess liability.”). The exception appears to be Tennessee, which appears to be the only state that does not allow the assignment of duty-to-settle claims. See Dillingham v. Tri-State Ins. Co. Inc., 381 S.W.2d 914, 919 (Tenn. 1964), cited in 3 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 23.05[3] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017). For discussion of authority regarding settlements or stipulated judgments entered into after the insurer has allegedly breached the duty to make reasonable settlement decisions but before there is a contested trial on the merits in the underlying action, see Reporters’ Note to Comment b.

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 28 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 2. Settlement

• 28 Excess Insurer’s Right of Subrogation

^Comment:

^{Reporters’ Note}

• An excess insurer has an equitable right of subrogation for loss incurred as a result of an underlying insurer’s breach of the duty to make reasonable settlement decisions.

Comment:

24. a. The function of breach-of-settlement-duty cases brought by excess insurers. Most jurisdictions permit an excess insurer to recover, via subrogation, from a primary insurer that has breached the duty to make reasonable settlement decisions. This Section follows that rule. Such a rule provides appropriate incentives to make reasonable settlement decisions and preserves the intended allocation of risk between primary and excess insurers, consistent with the law of restitution and unjust enrichment. See Restatement Third, Restitution and Unjust Enrichment § 24.

1. b. Equitable subrogation. The excess insurer’s ability to recover for a primary insurer’s breach of the duty to make reasonable settlement decisions is derivative of the rights of the insured through the doctrine of equitable subrogation. When the excess insurer pays a judgment or settlement on behalf of the insured, it steps into the shoes of the insured and is subrogated to any breach-of-settlement-duty claim that the insured has against the primary insurer. This rule is consistent with the law in the majority of states. In some states, courts have held that excess insurers lose their subrogation claims against primary insurers if the excess insurer settles the claim before the insured is required to make a payment, but such a result is a misapplication of equitable subrogation. Failure to allow the excess insurer to bring a subrogation claim against the primary insurer in such cases would result in unjust enrichment.

• Illustrations:

1. A claimant files a tort suit against the insured seeking compensatory damages of $500,000. The insured has an underlying duty-to-defend liability insurance policy that assigns settlement discretion to the insurer and that has a policy limit of $100,000. The insured also has an excess liability insurance policy that covers claims in excess of $100,000 with a policy limit of $1 million. At the time of the settlement negotiations between the primary insurer and the claimant, the claimant makes a settlement demand of $100,000, which a reasonable insurer would have accepted. The underlying insurer rejects this reasonable settlement demand, and the case goes to trial, resulting in a verdict against the insured of $500,000. The excess insurer is liable to the insured for the $400,000 excess verdict and subrogated to the insured’s breach-of-settlement-duty claim against the underlying insurer for the $400,000 excess judgment.

2. The estates of four boys killed in a bus accident file suit against Bus Company. Bus has a primary insurance policy with a $1 million per accident limit and an excess policy with a $5 million limit. Primary Insurer defends Bus. Primary Insurer has an early opportunity to settle within the limits for all four of the boys’ estates for a total of $1 million. Primary Insurer settles with three of the boys’ estates for $700,000. On the eve of trial, the estate of the fourth boy increases its demand from $300,000 to $600,000 based on new developments in the case. Primary Insurer agrees that the amount is reasonable and offers the remaining $300,000 of its limit. Bus Company demands that Excess Insurer pay the rest. Excess Insurer agrees to pay the $300,000 and the case settles. If Excess Insurer can demonstrate that Primary Insurer breached the duty to make reasonable settlement decisions by failing to settle all four of the claims within the limit of the primary insurance policy, Excess insurer may recover the $300,000 from Primary Insurer under equitable subrogation.

Reporters’ Note

1. The function of breach-of-settlement-duty cases brought by excess insurers.Allowing excess insurers to proceed against primary insurers for unreasonable refusal to settle provides important incentives for the primary insurer to settle when appropriate:

This right to the excess insurer encourages appropriate settlements by maintaining the primary insurer’s incentive to settle within limits and to refrain from gambling with the excess insurer’s money when it would not gamble with its own. It also prevents an unfair distribution of losses between primary and excess insurers and undue inflation of excess insurance premiums.

1–2 WILLIAM T. BARKER & RONALD D. KENT, NEW APPLEMAN INSURANCE BAD FAITH LITIGATION§ 2.09[1] (2d ed. 2017). Equitable subrogation adjusts the incidence of liability between two obligors that are independently liable to a third party—here the insured—seeking to fix liability on the obligor that is primarily rather than secondarily liable for the loss in question. The distinction between primary and secondary obligors is nowhere clearer than between primary and excess insurers of the same risk. See Restatement Third, Restitution and Unjust Enrichment § 24 (AM. LAW INST. 2011). See also Valentine v. Aetna Ins. Co., 564 F.2d 292, 298 (9th Cir. 1977) (applying California law) (“[I]f during settlement negotiations the primary insurer is allowed to force the excess insurer to cover part of the primary’s insurance exposure, the coverages and rate structures of the two different types of insurance primary and excess would be distorted …. On the other hand, allowing an excess insurer to enforce a primary carrier’s duty to negotiate and settle in good faith to the full limits of the primary carrier’s policy does not add to or change that carrier’s duties.”); Truck Ins. Exch. of Farmers Ins. Grp. v. Century Indem. Co., 887 P.2d 455, 458 (Wash. Ct. App. 1995) (“Other jurisdictions have noted the application of equitable subrogation to the excess carrier’s claims against primary insurers furthers policies of encouraging reasonable settlements of lawsuits, preventing unfair distribution of losses among primary and excess insurers, preventing primary insurers from obstructing settlements in bad faith, and reducing premiums paid for excess coverage.”).

1. Equitable subrogation.Most courts allow the excess insurer to step into the shoes of the insured through equitable subrogation and bring an action for the primary insurer’s failure to settle. See Twin City Fire Ins. Co. v. Country Mut. Ins. Co., 23 F.3d 1175, 1178 (7th Cir. 1994) (applying Illinois law) (“[T]he overwhelming majority of American cases describe the duty that a primary insurer owes an excess insurer as one derivative from the primary insurer’s duty to the insured.”); Douglas R. Richmond, Rights and Responsibilities of Excess Insurers, 78 DENV. U. L. REV. 29, 72 (2000) (“Under the majority rule, the duty to settle that a primary insurer owes an excess insurer derives from the primary insurer’s duty to the insured, such that an aggrieved excess insurer may sue on an equitable subrogation theory.”). See, e.g., Westchester Fire Ins. Co. v. Gen. Star Indem. Co., 183 F.3d 578, 583 (7th Cir. 1999) (applying Illinois law) (“The duty that a primary insurer owes to an excess insurer is derivative of the duty to the insured; an excess insurer can use the doctrine of equitable subrogation to assert the insured’s right to insist that the primary insurer use due care to avoid an excess judgment against the insured.”); Am. Centennial Ins. Co. v. Canal Ins. Co., 843 S.W.2d 480, 483 (Tex. 1992) (“[W]e hold that an excess carrier may bring an equitable subrogation action against the primary carrier.”). This means that the excess insurer’s rights depend on the rights of the insured. See Am. Guar. and Liab. Ins. Co. v. U.S. Fid. & Guar. Co., 668 F.3d 991, 994–995 (8th Cir. 2012) (applying Missouri law) (holding that the excess insurer could not recover against the primary insurer for bad-faith refusal to settle because, although the excess insurer had urged the primary insurer to settle, the insured’s bankruptcy trustee had made no settlement demand); Puritan Ins. Co. v. Canadian Universal Ins. Co., 775 F.2d 76, 80–81 (3d Cir. 1985) (applying Pennsylvania law) (holding that the excess insurer could not proceed against the primary insurer because the insured had advocated going to trial and could not itself succeed on a bad-faith failure-to-settle action, and “[u]nder equitable subrogation the rights of the excess carrier may not rise above those of the insured,” so the excess insurer had no avenue to recovery).

For a discussion of cases holding that, if an excess insurer pays for a settlement because the primary has earlier refused to settle for a sum within its limits, the excess has no cause of action against the primary for failure to settle, because the insured was never subject to personal loss from a final judgment, see ABRAHAM & SCHWARCZ, INSURANCE LAW 630 (6th ed. 2015) (discussing Fed. Ins. Co. v. Travelers Cas. & Sur. Co., 843 So. 2d 140 (Ala. 2002)). See also RLI Ins. Co. v. CNA Cas. of Cal., 45 Cal. Rptr. 3d 667, 672 (Ct. App. 2006) (citation omitted) (refusing to allow the excess insurer to proceed against the primary insurer for wrongful refusal to settle because the excess insurer had entered a pretrial settlement, and, under the doctrine of equitable subrogation, there was “no assurance that the insured will suffer any damage from the insurer’s breach of its implied obligation to accept a reasonable settlement offer until judgment is entered against the insured after trial.”). But see Nat’l Sur. Co. v. Hartford Cas. Ins. Co., 493 F.3d 752, 757 (6th Cir. 2007) (applying Kentucky law) (describing the Fed. Ins. case as contrary to the majority rule and contrary to the public policy of encouraging settlement); Ace Am. Ins. Co. v. Fireman’s Fund Ins. Co., 206 Cal. Rptr. 3d 176 (Ct. App. 2016), review granted, 382 P.3d 1135 and dismissed, 390 P.3d 373 (declining to follow RLI Ins., supra).

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 29 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 3. Cooperation

• 29 The Insured’s Duty to Cooperate

^Comment:

^{Reporters’ Note}

• When an insured seeks liability insurance coverage from an insurer, the insured has a duty to cooperate with the insurer. The duty to cooperate includes the obligation to provide reasonable assistance to the insurer:
• (1) In the investigation and settlement of the legal action for which the insured seeks coverage;
• (2) If the insurer is providing a defense, in the insurer’s defense of the action; and
• (3) If the insurer has the right to associate in the defense of the action, in the insurer’s exercise of the right to associate.

Comment:

1. a. Purpose of the duty to cooperate. Like much of the law governing the management of potentially insured legal actions, the duty to cooperate serves to align the incentives of insurer and insured. The duty to cooperate primarily addresses the incentives of the insured. In a full-coverage liability action, in which a liability insurance policy shifts all or most of the important legal risks of a legal action to the insurer, the insured may lack adequate incentives to assist the insurer in managing the defense. In some cases, the insured may even have an incentive to collude with the claimant—for example, because of a prior relationship with the claimant or simply to avoid the aggravation and inconvenience of a fully adversarial suit. The duty to cooperate addresses this problem by encouraging insured defendants to give an insured legal action the same attention that they would give to an uninsured legal action that puts their own assets at risk. In addition, the duty to cooperate obligates the insured to provide information that the insurer needs to investigate whether the legal action is covered, subject to the rule protecting confidential information stated in 11(2).

1. b. Reasonable assistance. The duty to cooperate should take into account the position of the particular insured whose conduct is at issue, as well as the needs of the insurer. What is reasonable depends on, among other things, the knowledge and experience of the insured, the extent of the risks presented by the legal action, the complexity of the action, the ability of the insurer to obtain the information or other object of cooperation from sources other than the insured, the good-faith effort of the insured, and the extent to which cooperation is needed to reduce the insurer’s exposure.

• Illustration:

1. A claim is filed against an insured arising out of an altercation that was the subject of an incident report filed with the local police department. The insurer asks the insured to obtain a copy of the report for the insurer. The insured provides the insurer with the incident report number given to her by the police officer but does not go through the steps necessary to obtain the report. Because the incident report is a public document that the insurer can obtain directly from the police department using the incident report number provided by the insured, the insured’s failure to provide the report to the insurer is not a breach of the duty to cooperate. It is unreasonable for the insurer to demand that the insured get the report when the insurer can easily do so itself.

11. c. Not a trap for the insured. It is important that the duty to cooperate not become a trap for the insured. For example, the insured’s duty to cooperate does not include the obligation to provide information to the insurer relating to an actual or potential conflict of interest between the insurer and the insured that is protected from disclosure by a privilege or immunity. See 11. In addition, the insurer may not unilaterally withdraw from the defense of an action based on noncooperation. An insurer that wishes to withdraw from the defense on the basis of noncooperation must follow the usual procedures for contesting coverage enumerated in §§ 15 and 18, such as reserving rights and instituting a declaratory-judgment action.

1. d. Reasonable conduct and diligence on the part of the insurer. The duty to cooperate assumes reasonable conduct and diligence on the part of the insurer. The duty to cooperate does not obligate the insured to comply with unreasonable requests. For example, in scheduling and other matters that may intrude upon the time or privacy or peace of mind of the insured, the insured is entitled to the deference that would ordinarily be accorded to a client or customer who is paying for the services on an after-the-fact basis and has the ability to hire alternative service providers if dissatisfied. In addition, the insurer must be diligent in seeking cooperation.

• Illustration:

2. Insured is a defendant in a tort action. The insured’s deposition is scheduled at a time that is convenient for the insured. Despite receiving many notices and despite the diligent efforts of the defense lawyer, the insured does not show up at the deposition. The deposition is rescheduled two more times. Each time the insured fails to appear, without a good excuse, despite the diligent efforts of the defense lawyer (e.g., calling the insured at home the morning of each of the rescheduled depositions). The insured has breached the duty to cooperate. The consequences of the insured’s breach of the duty to cooperate will depend on the harm to the insurer arising from the breach. See § 30.

1. e. The duty to cooperate with an insurer defending under a reservation of rights. Although an insurer’s reservation of rights can affect the rights and obligations of the parties in some respects, it does not abrogate the insured’s duty to cooperate with the insurer. For example, an insured that settles a legal action under the process stated in 25 has not breached the duty to cooperate, but the insured does have an obligation to cooperate with the insurer as long as the defense continues.

1. f. The duty to cooperate with an insurer exercising the right to associate. When an insurer has the right to associate in the defense of an action, as enumerated in 23, the insured’s duty to cooperate is dependent on the insurer’s exercise of that right. Like the right to associate itself, the insured’s duty to cooperate depends on the insurer’s level of engagement with the legal action, the likelihood that the insurer will be subject to liability for the action, and other circumstances. When an insured faces a substantial risk of an excess or uninsured judgment, the incentive problem that underlies the duty to cooperate is less likely to be present. In that context, an insurer’s requests for information and involvement should be evaluated in relation to the insurer’s potential exposure, the likelihood that the insured will mismanage the defense or settlement of the legal action in a manner that is prejudicial to the insurer, and the potential for the requested cooperation to disadvantage the insured in the defense of the action (for example, through the loss of confidentiality protections for defense-related information).

1. g. The duty to cooperate with an insurer that has breached the duty to make reasonable settlement decisions. When an insurer has breached the duty to make reasonable settlement decisions, the insured (or another insurer acting on the insured’s behalf) may protect itself from a potential excess verdict by entering into a reasonable and noncollusive settlement. See 27(2). Such a settlement does not constitute a breach of the duty to cooperate per se. As recognized in Comment b to § 27, however, the duty to cooperate does require the insured to exercise reasonable diligence in providing information to the insurer and seeking the insurer’s consent to such settlements.

Reporters’ Note

1. Purpose of the duty to cooperate.Virtually all standard-form liability policies include a cooperation clause and “[i]n instances where a policy does not include such a clause, one has been implied in law.” 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 199:3 (3d ed. 2017); Nicholas J. Giles, Rethinking the Cooperation Clause in Standard Liability Insurance Contracts, 161 U. PA. L. REV. 585, 590 (2013) (“The policyholder’s duty to cooperate is reflected in the virtual omnipresence of a cooperation clause in consumer liability insurance policies”). The duty to cooperate “protect[s] the insurer’s interests” by providing a financial incentive to assist the insurer in a fully covered case. Waste Mgmt., Inc. v. Int’l Surplus Lines Ins. Co., 579 N.E.2d 322, 327 (Ill. 1991). See also Am. Sur. Co. of N.Y. v. Diamond, 136 N.E.2d 876, 879 (N.Y. 1956) (“The purpose of the co-operation clause is to constrain the assured to co-operate in good faith with the insurance company in the defense of claims”). Commonly mentioned benefits of the duty to cooperate include providing the insurer with the true and complete account of the events that generated the action it needs adequately to defend the action and discouraging fraudulent or collusive actions. See Westbrook Ins. Co. v. Jeter, 117 F. Supp. 2d 139, 141 (D. Conn. 2000) (applying Connecticut law) (alteration in original) (quotation omitted) (“The purpose of the cooperation clause is to enable the insurer to obtain all knowledge and facts concerning the [claim] and the loss involved while the information is fresh ….”); State Farm Mut. Auto. Ins. Co. v. Secrist, 33 P.3d 1272, 1275 (Colo. App. 2001) (“The purpose of a cooperation clause is to protect the insurer in its defense of claims by obligating the insured not to take any action intentionally and deliberately that would have a substantial, adverse effect on the insurer’s defense, settlement, or other handling of the claim.”); M.F.A. Mut. Ins. Co. v. Cheek, 363 N.E.2d 809, 811 (Ill. 1977) (noting the “objective” of the duty to cooperate “to prevent collusion between the insured and the injured”); Iowa Mut. Ins. Co. of De Witt, Iowa v. Meckna, 144 N.W.2d 73, 81 (Neb. 1966); 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 199:4 (3d ed. 2017) (noting that “the main purpose of a cooperation clause is to prevent collusion while making it possible for the insurer to make a proper investigation ….[,] to enable the insurer to obtain relevant information concerning the loss while the information is fresh, [and] to enable it to decide upon its obligations”). For examples of policyholders breaching the duty by not providing any information to their insurers, see Revolution Rent A Car v. Premier Ins. Co. of Mass., 2005 Mass. App. Div. 155, No. 04-WAD-018, 2005 WL 3623520, at *2 (Dist. Ct. 2005) (finding the duty breached by a policyholder who failed to attend three scheduled interviews); Eldin v. Farmers Alliance Mut. Ins. Co., 890 P.2d 823, 834 (N.M. Ct. App. 1994) (finding the duty breached by a policyholder who caused an “eighteen-month delay” by refusing to answer questions under oath); Progressive Cty. Mut. Ins. Co. v. Trevino, 202 S.W.3d 811, 816–818 (Tex. App. 2006) (finding the duty breached by a policyholder who refused to respond to repeated letters and phone calls from his insurer seeking information about an accident for which he was potentially covered). See also 1 ALLAN D. WINDT, INSURANCE CLAIMS AND DISPUTES § 3:2 (6th ed. 2017) (“A common sense interpretation of language requiring (an insured) to ‘fully cooperate’ and ‘assist in the preparation and trial of any claims’ include(s) the duty to assist (the insurer) in its defense strategy, provide relevant documents, answer interrogatories, submit depositions, and testify at trial if necessary.” (quoting Med. Protective Co. v. Bubenik, 594 F.3d 1047, 1052 (8th Cir. 2010))). For a note on the duty to cooperate, see generally Nicholas J. Giles, Note, Rethinking the Cooperation Clause in Standard Liability Insurance Contracts, 161 U. PA. L. REV. 585 (2013).

1. Reasonable assistance.Courts have consistently subjected the duty to cooperate to a reasonableness test. See Lodgenet Entm’t Corp. v. Am. Int’l Specialty Lines Ins. Co., 299 F. Supp. 2d 987, 995 (D.S.D. 2003) (applying South Dakota law) (emphasis added) (“Insureds have a duty to cooperate with an insurer’s requests allowing a reasonable investigation of a claim.”); Forest City Grant Liberty Assocs. v. Genro II, Inc., 652 A.2d 948, 951–952 (Pa. Super. Ct. 1995) (citation omitted) (“An insured’s duty to cooperate is breached where the insured … ‘fails to render all reasonable assistance necessary to the defense of the suit.’”). “It has been stated that the scope of examination under a cooperation clause of an insurance policy is broader than the statutory right of discovery,” but courts also require that the information sought be material and significant to the claim at hand. 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 199:15 (3d ed. 2017). See also State Farm Mut. Auto. Ins. Co. v. Palmer, 237 F.2d 887, 893 (9th Cir. 1956) (applying Arizona law) (finding no breach of the duty to cooperate because the ill effects of the policyholder’s failure to appear at trial could have been easily mitigated and rendered inconsequential by the insurer’s counsel); Waste Mgmt., Inc. v. Int’l Surplus Lines Ins. Co., 579 N.E.2d 322, 333 (Ill. 1991) (“While the insured has no obligation to assist the insurer in any effort to defeat recovery of a proper claim, the cooperation clause does obligate the insured to disclose all of the facts within his knowledge and otherwise to aid the insurer in its determination of coverage under the policy.”).

1. Not a trap for the insured.The rule that the insurer may not request cooperation in the form of information implicating a conflict of interest or violating a privilege is well-established. See O’Morrow v. Borad, 167 P.2d 483, 485 (Cal. 1946) (finding that insurance “companies are estopped from taking advantage of the cooperation … provisions of [their] policies” when a conflict of interest exists between themselves and the policyholder); 14 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 199:9 (3d ed. 2017) (finding the duty to cooperate inapposite both when a conflict exists and when cooperation would potentially override the attorney–client privilege). See also id. (“The duty applies only when the insurer and insured are in a relationship of some trust to each other.”).

138. Reasonable conduct and diligence on the part of the insurer.The rule that the insurer must act reasonably and in good faith is well-established. See Priority Finishing Corp. v. Hartford Steam Boiler Inspection & Ins. Co., No. CV 940544055S, 1998 WL 731081, at *17 (Conn. Super. Ct. Oct. 6, 1998) (“The obligations under a cooperation clause are reciprocal. The insured must cooperate; but the insurer is under a duty to exercise diligence and good faith in bringing that about.” (quoting Imperiali v. Pica, 156 N.E.2d 44, 47 (Mass. 1959))). Equally well-established is the rule that policyholders have no duty to cooperate with unreasonable or overly burdensome requests for cooperation. See id. (“The demand for cooperation by the insurer must not be unreasonable.” (quoting Imperiali, 156 N.E.2d at 47)); 22 ERIC MILLS HOLMES, HOLMES’ APPLEMAN ON INSURANCE 2D§ 138.6 (2003) (“The duty of the insured to cooperate is triggered only if the insurer’s request for cooperation is reasonable”). See also State Farm Fire & Cas. Co. v. King Sports, Inc., 827 F. Supp. 2d 1364, 1373 (N.D. Ga. 2011) (applying Georgia law) (“The failure to cooperate must be material as opposed to technical or inconsequential.”).

1. The duty to cooperate with an insurer defending under a reservation of rights.See, e.g., James M. Fischer, The Professional Obligations of Cumis Counsel Retained for the Policyholder But Not Subject to Insurer Control, 43 TORT TRIAL & INS. PRAC. L.J. 173, 185–186 (2008) (explaining that a reservation of rights does not excuse the insured’s duty to cooperate and that principle remains true even when a conflict of interest necessitates the appointment of independent counsel); Douglas R. Richmond, Independent Counsel in Insurance, 48 SAN DIEGO L. REV. 857, 890 n.205 (2011) (“An insurer’s reservation of rights does not eliminate the insured’s duty to cooperate because a defense under reservation is not a breach of contract that would excuse the insured’s performance.”). For cases stating that a reservation of rights is not a breach of the duty to defend, see, e.g., Travelers Indem. Co. of Ill. v. Royal Oak Enters., Inc., 344 F. Supp. 2d 1358, 1371 (M.D. Fla. 2004) (applying Florida law); Pink v. Knoche, 103 S.W.3d 221, 228 (Mo. Ct. App. 2003). Note that this rule is consistent with the holding of the court in Ariz. Prop. & Cas. Ins. Guar. Fund v. Helme, 735 P.2d 451, 459 (Ariz. 1987), which permitted the insured to make a § 25 settlement on the ground that the insurer had anticipatorily breached the duty to indemnify. The court stated “once an insurer breaches any duty to its insured, the insured is no longer fully bound by the cooperation clause.” Id. (Emphasis added).

1. The duty to cooperate with an insurer exercising the right to associate.There are major differences between the duty to cooperate owed to an insurer with the right to direct the defense of the claim and the duty to cooperate owed to an insurer with the right merely to associate in that defense. Because an insurer with the right to associate is not controlling the defense of the claim, the role of the duty to cooperate is slightly altered, centering more on policyholder accountability and deterring collusion and fraud. See LAW OF CORPORATE OFFICERS & DIRECTORS: INDEMNITY & INSURANCE§ 4:40 (2017 Update) (observing that the “purpose of … [the cooperation] clauses is to prevent collusion between the insured and [the] allegedly injured party during a settlement”). As in the standard context, an insurer with the right to associate must diligently request cooperation before claiming that the policyholder breached the corresponding duty. See Nat’l Union Fire Ins. Co. of Pittsburgh, Pa. v. Cagle, 68 F.3d 905, 912 (5th Cir. 1995) (applying Louisiana law) (“[B]efore proving a breach by the insured of the cooperation clause, the [D&O] insurer must show a diligent effort to obtain the information.”). Similarly, the duty in this context is subject to a rule of tailored reasonableness and should not be used in a manner that causes the insured to lose immunity or privilege. See Great Am. Ins. Co. v. Christopher, No. 3:02–CV–2112–P, 2003 WL 21414676, at *1 (N.D. Tex. June 13, 2003) (applying Texas law) (emphasis added) (“The D & O policy includes a so-called ‘cooperation clause,’ which requires the insured persons to ‘provide the Insurer with all information and particulars it may reasonably request in order to reach a decision as to [its consent to incur costs of defense].’”); First Fid. Bancorporation v. Nat’l Union Fire Ins. Co. of Pittsburgh, Pa., No. CIV.A. 90–1866, 1994 WL 111363, at *5 (E.D. Pa. Mar. 29, 1994) (applying New Jersey law) (refusing to overturn a jury verdict that the insured did not violate the cooperation clause when there was evidence suggesting that the insurer had requested access to certain privileged documents and had been denied that access). Although § 23 states that insureds should be able to provide confidential information to an insurer exercising the right to associate, without the loss of any confidentiality protections in relation to third parties, not all jurisdictions have adopted this rule.

What an insurer may reasonably request access to, pursuant to the right to associate, is highly fact-dependent. At a minimum, the insurer does “not need to know everything about the suit,” Caterpillar, Inc. v. Great Am. Ins. Co., 62 F.3d 955, 966 (7th Cir. 1995) (applying Illinois law). For examples of cases adjudicating a cooperation dispute against the backdrop of an insurer’s right to associate, see Utah Power & Light Co. v. Fed. Ins. Co., 983 F.2d 1549, 1558 (10th Cir. 1993) (applying Utah law) (rejecting the insurer’s argument that the insured’s limited involvement in settlement negotiations amounted to a breach of the duty to cooperate); Nat’l Union Fire Ins. Co. of Pittsburgh, Pa. v. Cont’l Ill. Corp., 658 F. Supp. 781, 792–793 (N.D. Ill. 1987) (applying Illinois law) (involving a dispute over coverage in underlying securities litigation); Fuller-Austin Insulation Co. v. Highlands Ins. Co., 38 Cal. Rptr. 3d 716, 740 (Ct. App. 2006) (holding that a policyholder’s letter sent to the insurer, declining the insurer the opportunity to assume the defense but offering the right to participate in settlement negotiations in exchange for a guarantee of confidentiality, was insufficient to demonstrate a breach of the duty to cooperate).

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 30 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 2. Management of Potentially Insured

Liability Claims

Topic 3. Cooperation

• 30 Consequences of the Breach of the Duty to Cooperate

^Comment:

^{Reporters’ Note}

• (1) An insured’s breach of the duty to cooperate relieves an insurer of its obligations under an insurance policy only if the insurer demonstrates that the failure caused or will cause prejudice to the insurer.
• (2) If an insured’s collusion with a claimant is discovered before prejudice has occurred, the prejudice requirement is satisfied if the insurer demonstrates that the collusion would have caused prejudice to the insurer had it not been discovered.

Comment:

1. a. Relationship to existing law. Existing duty-to-cooperate law follows two main approaches. A minority of jurisdictions follow a strict-condition rule, in which any material breach of the duty to cooperate relieves the insurer of its obligations, whether or not that breach causes prejudice to the insurer in regard to the legal action, as long as the duty to cooperate is stated in the insurance policy as a condition. Consistent with the approach taken in this Section, the majority of jurisdictions impose a prejudice requirement, regardless of the language of the insurance policy, such that a breach of the duty to cooperate relieves the insurer of its obligations only if that breach prejudices the insurer in regard to the legal action. Commentators agree that the prejudice standard in the duty-to-cooperate context is difficult for insurers to satisfy. One reason is the traditional concern of liability insurance law not to interfere with the objectives of the underlying liability regime, which may depend on the presence of liability insurance. In that regard, many courts do not enforce the duty to cooperate in automobile liability insurance cases, because of the state’s public policy in favor of compensation embodied in the state’s automobile financial-responsibility statute.

1. b. The standard for prejudice. Courts differ in how they apply the prejudice requirement. The approach that is most protective of insureds uses the “substantial likelihood” test, which requires the insurer to demonstrate a substantial likelihood that the insured’s cooperation would have allowed the insurer to defeat the legal action brought against the insured. The approach that is least protective of insureds employs a presumption that a breach of the duty to cooperate causes prejudice to the insurer, with the insured bearing the burden of rebutting the presumption, and an undemanding standard for prejudice to the insurer (for example, increased costs or difficulty in investigating or defending the legal action, even if the failure to cooperate did not affect the outcome of the action). In practice, this least protective approach can become the functional equivalent to the strict-condition rule and, accordingly, is inappropriate for the reasons stated in Comment Most courts articulate an intermediate position that requires the insurer to prove that it has or will suffer significant harm from the breach of the duty to cooperate, but does not require that the insurer demonstrate that the cooperation would have allowed it to defeat the legal action.

Courts rarely specify whether an increase in the cost of defending the legal action, alone, would be sufficient prejudice. Close examination of the facts in the case law reveals that, in practice, there must be some harm to the insurer that goes beyond increased defense costs before an insurer is able to avoid coverage on the basis of a breach of the duty to cooperate. Accordingly, it is appropriate to conclude that the prejudice determination focuses primarily on the impact of the failure to cooperate on the outcome of the action. It is not ordinarily enough that the insured’s failure to cooperate increased the cost or difficulty of the defense. Rather, that failure must be one that has affected or will affect the outcome of the action for the insurer—for example, by depriving the insurer of a full or partial defense to liability, substantially increasing the amount of the judgment, or depriving the insurer of an opportunity to settle the action for a substantially lower amount than the insured damages ultimately awarded.

• Illustrations:

1. Insured is involved in an altercation outside a sporting event and wakes up in the emergency room with no memory of the incident or any of the events leading up to it. The other person (Plaintiff) involved in the altercation brings a suit against Insured seeking damages. Insurer investigates and develops a theory with supporting eyewitness evidence that Plaintiff was drunk and attacked the insured, who simply attempted to defend himself. Insurer assumes the defense and files a cross-claim against Plaintiff. Insured leaves the jurisdiction and fails to attend his deposition or the trial. Insurer appropriately reserved its rights to deny coverage based on Insured’s breach of the duty to cooperate. At trial, Insurer puts on its evidence regarding the alleged fault of Plaintiff and the actions taken in self-defense by Insured. There is a verdict in favor of Plaintiff and against Insured in the amount of $50,000. Because the absence of Insured did not affect the Insurer’s defense of the case, the breach of the duty to cooperate does not relieve Insurer of its obligation to pay the judgment.

2. Insured is involved in an altercation outside a sporting event that is identical to that in Illustration 1, except that there are no witnesses aside from Insured and Plaintiff. Plaintiff brings a suit against Insured seeking damages. When Insured fails to appear for a deposition, Insurer reserves its rights to deny coverage based on a breach of the duty to cooperate. Insured also fails to appear at trial, with the result that Insurer is unable to prove any fault on the part of Plaintiff. There is a verdict for Plaintiff in the amount of $100,000. Insured’s failure to appear at a deposition or trial substantially prejudiced Insurer by depriving Insurer of the benefits of a comparative-fault defense and increasing the amount of the insured damages. The breach of the duty to cooperate relieves Insurer of the obligation to pay the judgment.

1. c. Promise versus condition. Courts that adopt the prejudice requirement sometimes state that they are treating the duty to cooperate as a promise, rather than a condition. That is not completely correct. If the insured’s duty to cooperate were treated entirely as a promise, the breach of this duty would subject the insured to liability for damages, not to the forfeiture of coverage. A few courts have applied the prejudice rule in a manner that approximates a true-promise approach, by reducing the insurer’s obligation to pay for the legal action to the degree that it suffered any prejudice from a breach of the duty to cooperate. Similar results can also be reached by allowing the insured to cure a breach of the duty to cooperate by compensating the insurer for the harm caused by the breach. Most courts have not taken either of these true-promise approaches to the prejudice requirement. As a result, even when a high degree of prejudice is required, the prejudice requirement functions as an all-or-nothing rule, like the strict-condition approach. Thus the difference between the strict-condition and prejudice approaches is as much a matter of degree as kind. When courts set an undemanding standard for prejudice, the prejudice rule functions much like the strict-condition rule, because it provides the insurer with a complete defense to coverage even though the prejudice to the insurer is small in comparison to the resulting loss of coverage. This Section does not follow the true-promise approach because that approach could lead to excessive disputing—for example, whenever there is less than optimally cooperative behavior by insureds that could be said to have increased the costs of defense.

1. d. Objections to a strong-condition approach. There are a number of problems with a strong-condition approach, regardless of whether it employs the strict-condition rule or an undemanding-prejudice standard. First, these rules expose insureds to a substantial risk of disproportionate forfeiture of insurance coverage, because the value of the coverage to the insured very often substantially exceeds the harm to the insurer from the breach of the duty to cooperate. Second, these rules interfere more than is necessary with the objectives of the underlying liability regime, which depend in many instances on the presence of liability insurance. Third, by holding out the possibility that the insurer can avoid coverage altogether in more cases, these rules may discourage insurers from moving quickly to resolve claims. Finally, the strict-condition approach may create an incentive for insurers to increase the demands on insureds to cooperate, beyond what is truly necessary, in order to increase the possibility that the insured will fail to cooperate. The purpose of the duty to cooperate is to align the incentives of insurer and insured defendants, so that defendants give insured legal actions the kind of attention that they would give to an uninsured legal action that risked their own assets. The rule stated in this Section achieves that purpose without creating the risk of disproportionate forfeiture, interfering as fully with the underlying liability regime, slowing down the resolution of insured liability actions, or creating perverse incentives.

It is worth noting that the objections to the strong-condition approach do not apply with as much force when the insured breaches the duty to cooperate by colluding with the plaintiff. Collusion with a plaintiff significantly interferes with the underlying liability regime, which presumes an adversarial relationship between plaintiff and defendant. Moreover, allowing plaintiffs to attempt to collude with the defendant in order to recover significantly larger amounts from the insurance company would create perverse incentives for both plaintiffs and defendants. Because the object of such collusion is to collect additional money from the insurer, an insurer that proves collusion will almost certainly satisfy the prejudice requirement. If the collusion is discovered before substantial harm has already occurred, the prejudice requirement is satisfied as long as the collusion would have prejudiced the insurer if the collusion had not been discovered.

• Illustrations:

3. Insured is throwing a large party on the back patio of his townhouse and cooking hamburgers for the crowd on an old, built-in grill on his gas cooktop. His Friend tells him that cooking hamburgers for so many people on this kind of cooktop is dangerous, because the grease from the hamburgers can build up, spill off, and catch fire. Friend offers to help. After every batch of hamburgers, Friend removes the grease from the grill and collects it in a coffee can on the counter next to the cooktop. As the afternoon wears on, Friend gets distracted and stops taking this precaution. As predicted, the grease catches fire, which quickly spreads to flammable towels and mitts by the cooktop and, from there, to the can of grease on the counter. Friend picks up the burning can of grease to bring it outside and gets very badly burned (incurring medical expenses and lost wages that will eventually amount to $500,000). Insured feels terrible about the situation and tells Friend to bring a lawsuit to collect money from Insured’s insurance policy, saying that it was all the Insured’s fault, and Friend simply came into the kitchen after the fire started and tried to help put it out. They agree to say nothing about Friend’s involvement in the cooking and starting of the fire. Friend brings a claim against Insured, who has a homeowner’s policy and an umbrella policy with total limits of more than $2 million. Insured notifies his insurer. The adjuster from the insurer interviews both Friend and Insured, who each give the identical, false account of the events. Adjuster also interviews other people at the party, who convincingly report the true facts as described above. Insurer reserves its right to deny coverage based on a breach of the duty to cooperate and files a declaratory-judgment action seeking to terminate the duty to defend based on the collusion between Insured and Friend. This collusion is a breach of the duty to cooperate that, if it had been successful, would have substantially prejudiced Insurer by depriving Insurer of the benefits of a comparative-fault defense. Insurer is relieved from the duty to defend or settle this claim.

4. Same facts as Illustration 3, except that Insured’s policy limits are $100,000. Under the comparative-fault rules of the jurisdiction, the damages payable to a plaintiff are reduced according to the percentage of fault of the victim, so that even a plaintiff who was equally or more at fault may recover from an at-fault defendant. Insured proves that Friend would have offered to settle for the policy limits with or without the collusion, a reasonable insurance company would have accepted the offer, and, thus, the collusion would not have substantially prejudiced Insurer even if it had not been detected. Insurer is not relieved from the duty to defend or to offer its limits in settlement of the suit.

5. Insured negligently runs over the foot of his neighbor and friend with a lawn mower. Insured tells the neighbor, “I’m very sorry. I have lots of liability insurance. You should go ahead and sue me so that you receive the compensation that you deserve.” This is not collusion. Insured has not breached the duty to cooperate.

1. e. The disproportionate-forfeiture principle. The rule stated in this Section is an application of the disproportionate-forfeiture principle in liability insurance law. Under this principle, a small and minimally blameworthy breach of a condition by an insured does not excuse the insurer from performance, because the harm to the insurer from the breach is so much less than the value of the coverage to the insured. There are both efficiency and fairness rationales for the disproportionate-forfeiture principle. The principle is efficient in the sense that it applies contract terms in a manner that most insureds would bargain for, if they had the information and bargaining power, because the principle protects insureds from the precise kinds of risks for which they purchase liability insurance: their own negligence. The principle is fair because it is consistent with widely accepted proportionality norms, as well as the public policy in favor of compensation of the underlying claimants. See also 34 for a general discussion of the application of the disproportionate-forfeiture principle to conditions in liability insurance policies.

18. f. Ordinary procedure for contesting coverage. When a breach of the duty to cooperate provides a defense to coverage, the ordinary procedural rules for contesting coverage apply. The insurer must reserve its rights under 15 and, if it wishes to withdraw from the defense of the action, it must seek adjudication that it does not have a duty to defend. See § 18.

• Illustration:

6. Same facts as Illustration 3, except that, instead of reserving the right to deny coverage on the ground of breach of the duty to cooperate, Insurer withdraws from the defense. Insurer has breached the duty to defend by withdrawing from the defense when the duty to defend has not terminated under § 18.

Reporters’ Note

20. Relationship to existing law.The majority of jurisdictions impose a demanding prejudice requirement similar to that followed in this Section. See 3 FRANKLIN D. CORDELL, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 20.02[6][a] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017) (“Most jurisdictions require the insurer to show that it was actually and substantially prejudiced by a violation of the duty to cooperate.”); 3 PAUL E.B. GLAD, WILLIAM T. BARKER & MICHAEL BARNES, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 16.03[4] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017) (“[I]f a breach of the duty of cooperation can be shown, most jurisdictions will permit avoidance of coverage only on a showing of material prejudice to the insurer from the breach.); 1 ALLAN D. WINDT, INSURANCE CLAIMS AND DISPUTES § 3:2 (6th ed. 2017) (“[T]he majority of jurisdictions … insist that the [insurer] demonstrate that it was prejudiced as a result of the lack of cooperation [in order for the insurer’s coverage obligation to be affected].”). See, e.g., Alcazar v. Hayes, 982 S.W.2d 845, 852 (Tenn. 1998); Or. Auto. Ins. Co. v. Salzberg, 535 P.2d 816, 819 (Wash. 1975) (“The requirement of a showing of prejudice would pertain irrespective of whether the cooperation clause could be said to be a covenant or an express condition precedent….”). At least one state has statutorily defined the duty to cooperate as a covenant rather than a condition even when the policy lists the duty to cooperate as a condition precedent. See St. Paul Fire & Marine Ins. Co. v. House, 554 A.2d 404, 406 (Md. 1989) (characterizing MD. CODE § 482 of Article 48A (later recodified as Md. Code Ann., Ins. § 19-110) as making “policy provisions requiring notice to, and cooperation with, the insurer covenants and not conditions”).

In contrast, a few courts follow a strict condition-precedent rule. See 6 CHRISTOPHER J. ROBINETTE, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 61.08[3][a] (Jeffrey E. Thomas & Christopher J. Robinette eds., Lexis 2017) (concluding a minority of courts “only require a material breach” to avoid coverage.). For cases reflecting the strict condition-precedent approach, see H.Y. Akers & Sons, Inc. v. St. Louis Fire & Marine Ins. Co., 172 S.E.2d 355, 358 (Ga. Ct. App. 1969) (“The co-operation clause is a material condition of a liability policy and a breach of it in any material respect relieves the insurer of liability.”); N.J. Eye Ctr., P.A. v. Princeton Ins. Co., 928 A.2d 25, 33 (N.J. Super. Ct. App. Div. 2007) (stating that compliance with provisions of a cooperation clause is a condition precedent to recovery under the policy and that breach of the provisions can cause a forfeiture of coverage); N.Y. Cent. Mut. Fire Ins. Co. v. Rafailov, 41 A.D.3d 603, 604 (N.Y. App. Div. 2007) (“Compliance with such a clause is a condition precedent to coverage”).

Many courts and commentators agree that satisfying the prejudice requirement can be extremely difficult. See Campbell v. Allstate Ins. Co., 384 P.2d 155, 157 (Cal. 1963) (acknowledging that “it may be difficult for an insurer to prove prejudice in some situations”); Goodner v. Occidental Fire & Cas. Co., 440 S.W.2d 614, 617 (Tenn. Ct. App. 1968) (“[W]ho can assess the effect upon the jury of a defendant so indifferent to the outcome of the suits and to the amounts to be adjudged against him that he doesn’t deign to appear?”); 8f-198 JEFFREY E. THOMAS, APPLEMAN ON INSURANCE LAW & PRACTICE ARCHIVE§ 4732 (2d ed. 2011) (noting that prejudice is a difficult matter to affirmatively prove).

Some courts have eliminated any penalty for a breach of the duty to cooperate in compulsory-insurance schemes. See, e.g., Royal Indem. Co. v. Olmstead, 193 F.2d 451, 453 (9th Cir. 1951) (applying California law):

An exception to the general rule has been made in situations where the insurance policy was issued to satisfy the requirements of a statute having as its purpose the protection of the public. Under such circumstances the beneficial purpose of compulsory insurance would be thwarted in the event the insurer be permitted technical defenses under the policy relating to conditions wholly outside the ability of the injured person to secure performance of. Hence, it has been held that in cases involving compulsory insurance the insurer cannot urge lack of cooperation by the insured as a defense in a suit brought by an injured member of the public within the class sought to be protected by statute.

Coburn v. Fox, 389 N.W.2d 424, 428 (Mich. 1986) (holding that a breach of the duty to cooperate cannot relieve an automobile liability insurer of its duty to indemnify up to the statutorily mandated minimum coverage); Rodgers-Ward v. Am. Standard Ins. Co. of Wis., 182 S.W.3d 589, 593 (Mo. Ct. App. 2005); Tibbs v. Johnson, 632 P.2d 904, 906 (Wash. Ct. App. 1981). Motivating these courts is the notion that mandatory-insurance statutes are intended to ensure compensation for innocent accident victims and that unilateral post-loss policyholder action like noncooperation should not defeat that goal. See also Kambeitz v. Acuity Ins. Co., 772 N.W.2d 632, 638 (N.D. 2009) (citations omitted) (citing many cases from other jurisdictions) (“[A]n insurance company cannot avoid coverage under any compulsory automobile liability insurance policy provisions after an accident when a claim against the policy is made by an injured innocent third party,” explaining that this position “is consistent with the view of courts in other jurisdictions which prevent, based either on specific statutory provisions or the overriding purpose of statutory schemes governing compulsory automobile liability insurance, post-loss avoidance of an insurance policy to defeat the insurer’s liability to an innocent third party.”); Ryan v. Knoller, 695 A.2d 990, 992 (R.I. 1997):

In circumstances in which the purpose of statutorily required insurance coverage is intended for the protection of the public, that purpose may not be thwarted by permitting an insurer to avail itself of technical defenses included in its policy relating to conditions whose performance is wholly beyond the ability of the injured person to control.

Similar goals motivate broader systems of both liability insurance and tort law. See Kyle D. Logue, Solving the Judgment-Proof Problem, 72 TEX. L. REV. 1375, 1375–1376 (1994) (“Liability insurance can ameliorate [the] judgment-proof problem [by] … increas[ing] the amount of assets available to compensate plaintiffs.”). See also Gary T. Schwartz, The Ethics and the Economics of Tort Liability Insurance, 75 CORNELL L. REV. 313, 363 (1990) (“Liability insurance, regardless of its form, is highly desirable if compensatory justice is tort law’s objective.”).

1. The standard for prejudice.For cases applying the “substantial likelihood” test, see Billington v. Interinsurance Exch. of S. Cal., 456 P.2d 982, 987 (Cal. 1969) (“[A]n insurer, in order to establish it was prejudiced by the failure of the insured to cooperate in his defense, must establish at the very least that if the cooperation clause had not been breached there was a substantial likelihood the trier of fact would have found in the insured’s favor.”); Brooks v. Haggard, 481 P.2d 131, 134 (Colo. App. 1970) (“[I[f, after consideration of all factors involved, it appears that the presence of the insured or his testimony was so potentially valuable as to have materially affected the outcome of the trial, then his nonappearance is regarded as a material or prejudicial breach of the policy.”); Boone v. Lowry, 657 P.2d 64, 72 (Kan. Ct. App. 1983) (“The insurer must establish at the very least that if the cooperation clause had not been breached there was a substantial likelihood that the trier of fact, in an action against the insured, would have found in the insured’s favor.”); Allstate Ins. Co. v. State Farm Mut. Auto. Ins. Co., 767 A.2d 831, 843 (Md. 2001) (“[W]e believe that the proper focus should be on whether the insured’s wilful conduct has, or may reasonably have, precluded the insurer from establishing a legitimate jury issue of the insured’s liability, either liability vel non or for the damages awarded.”); Smith v. Nationwide Mut. Ins. Co., 830 A.2d 108, 114 (Vt. 2003) (“An insured’s failure to cooperate with its insurer will not relieve the insurer of its coverage obligations unless that noncooperation has, in a significant way, hindered or precluded the insurer from presenting a credible defense to the underlying claim.”). Some courts have even dismissed an insured’s claim to enforce a policy without prejudice to allow the insured the opportunity to cure the failure to cooperate and reassert the claim against the insurer. See Yeo v. State Farm Ins. Co., 555 N.W.2d 893, 894 (Mich. Ct. App. 1996) (upholding the trial court’s decision to dismiss the case without prejudice and with the “hope that the parties can proceed with the examination under oath and refile [sic] this case”); Marmorato v. Allstate Ins. Co., 226 A.D.2d 156, 156 (N.Y. App. Div. 1996) (holding that the insured’s noncompliance did not “warrant dismissal of the action without giving plaintiff one last chance to answer the questions”). Cf. United Servs. Auto. Ass’n v. Martin, 174 Cal. Rptr. 835, 837 (Ct. App. 1981) (holding that it is impossible for an insurer to show prejudice until after the underlying tort action has been resolved). For an example of a court reciting a less precise standard while finding prejudice based on facts that would satisfy the standard in this Section, see, e.g., Medical Assurance Co. v. Miller, 779 F. Supp. 2d 902, 909 (N.D. Ind. 2011) (applying Indiana law). Illustration 2 is loosely based on the facts in Wildrick v. N. River Ins. Co., 75 F.3d 432 (8th Cir. 1996).

1. Promise versus condition.For a case requiring the insurer to pay only the amount it would have paid had the insured cooperated with the insurer, see Fid. & Cas. Co. of N.Y. v. McConnaughy, 179 A.2d 117, 124 (Md. 1962) (allowing the insurer to avoid only the portion of liability in excess of “the amount it would have paid if [the insured] had been frank and fair”). For cases allowing the insured to cure prejudice, see Romano v. Arbella Mut. Ins. Co., 429 F. Supp. 2d 202, 208 (D. Mass. 2006) (applying Massachusetts law) (holding that the insurer could not disclaim coverage when the insured eventually produced requested documents and the delay did not prejudice the insurer’s ability to make an assessment of the insured’s coverage claim); Crook v. State Farm Mut. Auto. Ins. Co., 112 S.E.2d 241, 246 (S.C. 1960) (allowing the insured to withdraw and correct misstatements made without forfeiting coverage when the insurance company’s ability to defend was not prejudiced).

1. Objections to a strong-condition approach.For cases that discuss how the duty to cooperate interferes with the objectives of the underlying liability regime, see Carpenter v. Super. Ct. in & for Maricopa Cty., 422 P.2d 129, 134 (Ariz. 1966) (“Liability insurance is intended not only to indemnify the assured, but also to protect members of the public who may be injured through negligence.”); Billington v. Interinsurance Exch. of S. Cal., 456 P.2d 982, 988–989 (Cal. 1969) (insurance policies “are for the protection of the public, not merely for the benefit of the contracting parties”); Or. Auto. Ins. Co. v. Salzberg, 535 P.2d 816, 819 (Wash. 1975) (“[T]he risk-spreading theory of [liability insurance] policies should operate to afford to affected members of the public—frequently innocent third persons—the maximum protection possible”).

1. The disproportionate-forfeiture principle.Courts acknowledge that disproportionate-forfeiture considerations are appropriate in the duty-to-cooperate context. See, e.g., Mistler v. Horace Mann Ins. Co., No. 933430, 1994 WL 879038, at *6 (Mass. App. Ct. 1994) (“[T]he requirement that the insured’s failure to perform must amount to a material breach and not result in a disproportionate loss, or forfeiture, to the breachor is tantamount to a requirement that the insurer must be ‘prejudiced’ in order to be excused from covering the loss.”). For a general statement of the disproportionate-forfeiture principle, see Restatement Second, Contracts § 229 (AM. LAW INST. 1981) (“To the extent that the non-occurrence of a condition would cause disproportionate forfeiture, a court may excuse the non-occurrence of that condition unless its occurrence was a material part of the agreed exchange.”); id., Comment b (“‘[F]orfeiture’ is used to refer to the denial of compensation that results when the obligee loses his right to the agreed exchange after he has relied substantially, as by preparation or performance on the expectation of that exchange.”). A forfeiture is disproportionate when the importance of the rights lost by the obligee outweigh “the importance to the obligor of the risk from which he sought to be protected and the degree to which that protection will be lost if the non-occurrence of the condition is excused.” Id.

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 31 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 3. General Principles Regarding the Risks Insured

Topic 1. Coverage

• 31 Insuring Clauses

^Comment:

^{Reporters’ Note}

• (1) An “insuring clause” is a term in a liability insurance policy that grants insurance coverage.
• (2) Whether a term in a liability insurance policy is an insuring clause does not depend on where the term is in the policy or the label associated with the term in the policy.
• (3) Insuring clauses are interpreted broadly.

Comment:

1. a. Classification of a term as an insuring clause is to be made on a functional rather than a formal basis. In contemporary liability insurance policies, insuring clauses most commonly appear in sections of the policy with the label “insuring agreement” or similar labels, but they also appear in other parts of a liability insurance policy.

34. b. Insuring agreements. Contemporary insurance policies commonly contain a section labeled “insuring agreement” that specifies what will be covered under the policy provided that all of the conditions in the policy are met and no exclusions apply. Insuring agreements always contain insuring clauses, but they may also contain exclusions and conditions. An exclusion or condition that appears in an insuring agreement is subject to the ordinary rules governing exclusions and conditions. See §§ 32 and 34.

1. c. Insuring clauses in endorsements. Contemporary insurance policies commonly consist of one or more standard-form parts that could function as complete insurance policies, along with additional parts, known as “endorsements,” that modify the coverage. Typically, the endorsements are also standard forms. Whether a term in an endorsement is an insuring clause, an exclusion, a condition, or none of these is to be determined on the same basis as if it were in the main body of the policy.

32. d. Exception clauses in exclusions. Contemporary insurance policies commonly contain a section labeled “exclusions” that includes a set of terms that restrict the coverage that otherwise would be provided by the policy. See 32. Exclusions may contain exceptions that narrow the application of the exclusion. Such exceptions operate only to narrow the exclusions in which they appear, not to expand coverage beyond that stated by other insuring clauses in the policy. See § 32(5).

4. e. Relation between broad interpretation of insuring clauses and contra proferentem. Judicial opinions issued in insurance-coverage cases commonly state that grants of coverage are to be interpreted broadly. This statement does not represent an independent, analytically distinct canon of construction but rather an application of the ordinary insurance policy interpretation rules stated in §§ 3 and 4.

1. f. Burden of proof. The insured bears the burden of proving that a claim falls within the scope of an insuring clause in the policy. This is the prevailing legal rule.

Reporters’ Note

16. Purpose.Appleman notes that an “insuring clause … sets forth the basic scope of the insured risk and represents the requirements that must be satisfied for a covered loss to be present.” 3 PAUL E.B. GLAD, WILLIAM T. BARKER & MICHAEL BARNES, NEW APPLEMAN ON INSURANCE LIBRARY EDITION§ 16.09[1][c] (Jeffrey E. Thomas & Francis J. Mootz, III eds., Lexis 2017). See, e.g., Liberty Nat’l Enters., L.P. v. Chi. Title Ins. Co., 217 Cal. App. 4th 62, 77 (2013) (“Before considering whether any exclusions apply, we examine the insuring clause to determine whether coverage exists at all.”).

1. Insuring agreements.See, e.g., Clemco Indus. v. Commercial Union Ins. Co., 665 F. Supp. 816, 820 (N.D. Cal. 1987) (applying California law) (“The placement of the phrase, however, in no way changed the effect or character of the phrase; ‘expected or intended’ remained an exclusion of the coverage grant by the very operation of its terms.”).

1. Insuring clauses in endorsements.See, e.g., 2 STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 21:21 (3d ed. 2017) (“Endorsements, riders, marginal references, and other similar writings are a part of the contract of insurance and are to be read and construed with the policy proper.”). See also Haynes v. Farmers Ins. Exch., 89 P.3d 381, 385 (Cal. 2004) (citation omitted) (“Coverage may be limited by a valid endorsement and, if a conflict exists between the main body of the policy and an endorsement, the endorsement prevails.”); Adams v. Explorer Ins. Co., 107 Cal. App. 4th 438, 451 (2003) (“[A]n endorsement is an amendment to or modification of an existing policy of insurance. It is not a separate contract of insurance. Standing alone, an endorsement means nothing.”); Hart Constr. Co. v. Am. Family Mut. Ins. Co., 514 N.W.2d 384, 391 (N.D. 1994) (“When there is a conflict between the provisions of an insurance policy and an attached endorsement, the provisions of the endorsement prevail.”).

1. Exception clauses in exclusions.See § 32, Reporters’ Note to Comment f.

1. Relation between broad interpretation of insuring clauses and contra proferentem.See La. Civ. Code Ann. art. 2056 (2018) (“In case of doubt that cannot be otherwise resolved, a provision in a contract must be interpreted against the party who furnished its text. A contract executed in a standard form of one party must be interpreted, in case of doubt, in favor of the other party.”); Miller v. Cont’l Ins. Co., 358 N.E.2d 258, 260 (N.Y. 1976) (“The hornbook rule [states] that policies of insurance, drawn as they ordinarily are by the insurer, are to be liberally construed in favor of the insured”); Richards v. Standard Accident Ins. Co., 200 P. 1017, 1020 (Utah 1921) (“[I]nsurance policies should be construed liberally in favor of the insured and their beneficiaries so as to promote and not defeat the purpose of insurance.”). See also Uniroyal, Inc. v. Home Ins. Co., 707 F. Supp. 1368, 1376 (E.D.N.Y. 1988) (applying New York law) (citations omitted) (“At this stage, ‘after it has exhausted every effort to derive the meaning of the terms that accurately reflects the intent of the parties,’ the court must follow the rule of contra proferentem to construe any ambiguity against the insurer as drafter.”). For a discussion of how the maxim of construing an insuring clause broadly represents an application of the ambiguity principle, see Woodson v. Manhattan Life Ins. Co. of New York, N.Y., 743 S.W.2d 835 (Ky. 1987).

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.

Restatement of the Law of Liability Insurance § 32 (2019)

Restatement of the Law - Liability Insurance | June 2021 Update

Restatement of the Law of Liability Insurance

Chapter 3. General Principles Regarding the Risks Insured

Topic 1. Coverage

• 32 Exclusions

^Comment:

^{Reporters’ Note}

^{Case Citations - by Jurisdiction}

• (1) An “exclusion” is a term in an insurance policy that identifies a category of claims that are not covered by the policy.
• (2) Whether a term in an insurance policy is an exclusion does not depend on where the term is in the policy or the label associated with the term in the policy.
• (3) Exclusions are interpreted narrowly.
• (4) Unless otherwise stated in the insurance policy, words in an exclusion regarding the expectation or intent of the insured refer to the subjective state of mind of the insured.
• (5) An exception to an exclusion narrows the application of the exclusion; the exception does not grant coverage beyond that provided in the insuring clauses.

Comment:

1. a. Exclusions can appear anywhere in an insurance policy. Insurance law takes a functional approach to determine whether an insurance policy term is an exclusion. Under the prevailing conventions of insurance policy drafting, exclusions typically appear in a part of the insurance policy with the specific heading “Exclusions.” But exclusions can appear in almost any part of an insurance policy: the insuring agreement, the definitions section, endorsements, and even in the conditions section.

• Illustration:

1. The 1966 edition of the Commercial General Liability Insurance policy defines “occurrence” as follows:

• “occurrence” means an accident, including injurious exposure to conditions, which results, during the policy period, in bodily injury or property damage neither expected nor intended from the standpoint of the insured.
•  
• The clause “neither expected nor intended from the standpoint of the insured” is an exclusion despite the fact that it is included in a term that is contained in a section of the policy labeled “Definitions” and not in the section of the policy labeled “Exclusions.”
•  

4. b. Courts regularly state that exclusions in insurance policies are to be interpreted narrowly. This statement does not represent an independent, analytically distinct canon of construction but rather an application of the ordinary insurance policy interpretation rules stated in §§ 3 and 4.

1. c. Severability of exclusions. Liability insurance policies often contain exclusions whose application depends upon specified conduct of the insured that serves as the basis for the alleged liability. Examples include exclusions for liability arising out of expected-or-intended injury, criminal or malicious acts, the use of intoxicating substances, sexual molestation, corporal punishment, physical or mental abuse, fraud, wrongful profit or advantage, and knowing violation of rights. The default rule is that such exclusions are severable, meaning that they apply only to insureds whose conduct meets the requirements of the exclusion. This rule is an application of the general rule regarding the narrow interpretation of exclusions. In addition, this rule reflects the underlying purposes of such exclusions: limiting the impact of liability insurance on incentives to engage in highly wrongful conduct, and preventing those who in fact engage in such conduct from drawing on the resources of those in the insurance pool. Applying these exclusions to insureds who did not engage in the wrongful conduct does not promote these purposes of the exclusions. Because these insureds did not engage in the wrongful conduct, there is less concern that the presence of insurance changed their incentives to engage in that conduct, nor is there the same concern about using the resources of the insurance pool on their behalf.

1. d. The default rule in favor of a subjective standard for expectation and intent. Many liability insurance policies contain an exclusion for legal actions arising out of injuries that are “expected or intended from the standpoint of the insured.” Courts have articulated different standards governing the application of this expected-or-intended exclusion. This Section follows the subjective standard that is the majority rule, while making clear that this standard is a default rule. Under the subjective standard, an insured intends harm when such harm is the object of the insured’s action, and an insured expects harm when the insured foresees that harm is practically certain to occur as the result of the insured’s intentional act, even if that harm was not the object of the action. This default rule is an application of the general rule in favor of the narrow interpretation of exclusions. Because the traditional expected-or-intended exclusion is silent regarding the subjective or objective nature of the standard, it is ambiguous in that regard. As demonstrated by the many judicial opinions adopting the subjective standard as the proper interpretation of the expected-or-intended exclusion, the subjective standard is a reasonable interpretation of the exclusion. Of course, subjective intent can be determined only on the basis of objective evidence, as even an insured’s admission of intent to harm is subject to cross-examination and the jury’s assessment of credibility. Moreover, courts at times have determined that subjective intent to harm can be inferred as a matter of law, for example in cases involving sexual abuse. Subject to any restrictions that may be imposed on public-policy or other grounds through the procedures governing the approval of liability-insurance-policy forms, insurers may draft around the subjective standard (as has occurred through the criminal-acts exclusion now included in many homeowner’s insurance policies).

• Illustrations:

2. Insured fires a .22 caliber rifle high and away from A, B, and C, who are 200 yards away, intending to scare them away from stealing his watermelons. One of the shots hits C. C files a tort action against Insured alleging that Insured negligently injured C. Insured has a standard homeowner’s insurance policy that excludes coverage for suits arising out of bodily injury that is expected or intended from the standpoint of the insured. Insurer defends the action, properly reserving the right to deny coverage on the basis of the exclusion. The judgment entered in the action against Insured is not excluded by the expected-or-intended exclusion because the Insured did not expect or intend the injury.

3. Insured kicks A from behind, believing that person to be his wife. A is not in fact his wife. A brings a tort action against Insured alleging that Insured negligently injured A. Insured has a standard homeowner’s insurance policy that excludes coverage for suits arising out of bodily injury that is expected or intended from the standpoint of the insured. Insurer defends the action, properly reserving the right to deny coverage on the basis of the exclusion. The judgment entered in the action against Insured is excluded by the expected-or-intended exclusion because Insured intended to injure A even though he was mistaken about the identity of A.

4. Manager deliberately fires a worker and intentionally discriminated on the basis of age, causing emotional distress that is sufficiently severe that it leads to bodily injury. The fired worker files suit against Manager’s Company, which has a standard commercial general-liability insurance policy that excludes coverage for suits arising out of bodily injury that is expected or intended from the standpoint of the insured. The suit is not excluded by the expected-or-intended exclusion because Manager did not expect or intend to cause bodily injury.

1. e. Burden of proof. The insurer bears the burden of proving that a claim falls within the scope of an exclusion in the policy. This is the prevailing legal rule. This burden of proof reflects the basic structure of liability insurance policies, which generally contain a relatively broad grant of coverage and a set of narrower exclusions from coverage. Each exclusion represents an insurer’s efforts to identify a class of claims that differs in some material way from the broad class of claims that are covered by the policy. It is the insurer that has identified the excluded classes of claims and will benefit from being able to place a specific claim into an excluded class. Thus, assigning the insurer the burden of proving that the claim fits into the exclusion is appropriate.

1. f. An exception to an exclusion. The rule in subsection (5) regarding exceptions to exclusions is a straightforward application of logic to the interpretation of a liability insurance policy. An exception to an exclusion narrows the application of the exclusion; it does not extend the coverage provided by the insuring clauses in the policy. See also 31, Comment d.

Reporters’ Note

1. Exclusions can appear anywhere in an insurance policy.See, e.g., Borough of Moosic v. Darwin Nat’l Assurance Co., 556 F. App’x 92, 97 (3d Cir. 2014) (applying Pennsylvania law) (“While the Related Claims provision appears in the section titled ‘Conditions,’ rather than the section titled ‘Exclusions,’ the location of the provision in the policy is not determinative.”); Stonewall Ins. Co. v. Asbestos Claims Mgmt. Corp., 73 F.3d 1178, 1205 (2d Cir. 1995) (applying New York law) (“[U]nder New York law, the exclusionary effect of policy language, not its placement, controls allocation of the burden of proof.”), op. modified on other grounds, 85 F.3d 49 (2d Cir. 1996); United Pac. Ins. Co. v. McGuire Co., 281 Cal. Rptr. 375, 378 (Ct. App. 1991) (“It does not matter that the [provision limiting coverage] appears in the ‘definitions’ section of the policy rather than the ‘exclusions’ section; in either case it performs the function of an exclusion.”); Jones v. Philip Atkins Constr. Co., 371 N.W.2d 508, 512 (Mich. Ct. App. 1985) (holding that an exclusion that appeared on a separate endorsement to the policy barred coverage for plaintiff’s injuries).

1. Interpretation.Courts regularly state that exclusions should be narrowly construed. See, e.g., Gore Design Completions, Ltd. v. Hartford Fire Ins. Co., 538 F.3d 365, 370 (5th Cir. 2008) (applying Texas law) (“Exclusions are narrowly construed.”); An-son Corp. v. Holland-Am. Ins. Co., 767 F.2d 700, 703 (10th Cir. 1985) (applying Oklahoma law) (“An insurance policy’s words of exclusion are to be narrowly viewed.” (citing Conner v. Transamerica Ins. Co., 496 P.2d 770, 774 (Okla. 1972))); First Ins. Co. of Haw., Ltd. v. Contl. Cas. Co., 466 F.2d 807, 809 (9th Cir. 1972) (applying Hawai’i law) (“Insurance exclusions are narrowly construed against the insurer.”); Reserve Ins. Co. v. Pisciotta, 640 P.2d 764, 770 (Cal. 1982) (holding that the policy’s family exclusion did not apply by reasoning that “[b]ecause the word ‘family’ is susceptible of several reasonable definitions, the most appropriate resolution is to construe the term narrowly, i.e., in favor of the insured.”); Eyler v. Nationwide Mut. Fire Ins. Co., 824 S.W.2d 855, 859 (Ky. 1992) (“Kentucky law is crystal clear that exclusions are to be narrowly interpreted”); Snell v. Stein, 259 So. 2d 876, 879 (La. 1972) (citation omitted) (“Construing the exclusionary clause strictly, as we must, … we cannot conclude it applies here.”); Seaboard Sur. Co. v. Gillette Co., 476 N.E.2d 272, 275 (N.Y. 1984) (“[Exclusions] are to be accorded a strict and narrow construction.”); 7A STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 108:6 (3d ed. 2017) (“[E]xclusions from coverage in insurance policies are to be strictly construed.”).

1. Severability of exclusions.See generally 7A STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 103:37 (3d ed. 2017) (“Liability insurance policies employ any number of exclusions that attempt to describe certain types of behavior, liability for the consequences of which the insurer intends to exclude from coverage.”). For cases determining the applicability of exclusions by examining whether the insured engaged in the excluded conduct, see, e.g., Aetna Cas. and Sur. Co. v. Dow Chem. Co., 28 F. Supp. 2d 421, 431 (E.D. Mich. 1998) (applying Michigan law) (“It should also be noted that it is important to focus on whether the insured engaged in culpable conduct in order to enforce the important public policies at issue.”); Arenson v. Nat’l Auto. & Cas. Ins. Co., 286 P.2d 816, 818 (Cal. 1955) (concluding that an intentional-act exclusion did not exclude coverage for parents for intentional act of vandalism committed by son, who also was an insured under policy); Catholic Diocese of Dodge City v. Raymer, 840 P.2d 456, 462 (Kan. 1992) (holding that the intentional-act exclusion did not apply to parents who had been found to have been negligent in supervising their minor child); Worcester Mut. Ins. Co. v. Marnell, 496 N.E.2d 158, 160–161 (Mass. 1986) (finding that severability clause in policy created separate insurable interests and did not exclude parents from coverage for damage caused by son, who was also an insured under the policy). For cases holding that a policy’s exclusion applies only if it applies with respect to the specific insured seeking coverage, see, e.g., Float–Away Door Co. v. Cont’l Cas. Co., 372 F.2d 701 (5th Cir. 1966) (applying Georgia law); Phoenix Assurance Co. v. Hartford Ins. Co., 488 P.2d 206 (Colo. App. 1971); Shelby Mut. Ins. Co. v. Schuitema, 183 So. 2d 571 (Fla. Dist. Ct. App. 1966), aff’d per curiam, 193 So. 2d 435 (Fla. 1967); Pa. Nat’l Mut. Cas. Ins. Co. v. Bierman, 292 A.2d 674 (Md. 1972); Am. Nat’l Fire Ins. Co. v. Estate of Fournelle, 472 N.W.2d 292 (Minn. 1991); Travelers Ins. Co. v. Auto–Owners Ins. Co., 203 N.E.2d 846 (Ohio Ct. App. 1964); Commercial Standard Ins. Co. v. Am. Gen. Ins. Co., 455 S.W.2d 714 (Tex. 1970); Bankers & Shippers Ins. Co. v. U.S. Fire Ins. Co., 224 S.E.2d 312 (Va. 1976).

In general, the reasoning in the severability cases employs an ambiguity-centric analysis that is consistent with a default-rule approach. The following statement from the Kansas Supreme Court in Catholic Diocese of Dodge City v. Raymer is representative:

In Kansas, the general rule is that exceptions, limitations, and exclusions to insuring agreements require a narrow construction on the theory that the insurer, having affirmatively expressed coverage through broad promises, assumes a duty to define any limitations on that coverage in clear and explicit terms.

840 P.2d 456, 462 (Kan. 1992). Dicta from the Massachusetts Supreme Judicial Court in Worcester Mut. Ins. Co. v. Marnell suggests that, at least in the homeowner’s-insurance context, severability may be a mandatory rule, not just a default rule:

Finally, our decision is in keeping with the long-standing rule of construction that the favored interpretation of an insurance policy is one which “best effectuates the main manifested design of the parties.” [citation omitted] Clearly, the manifest design of homeowners’ insurance is to protect homeowners from risks associated with the home and activities related to the home. Contrary to the position taken by Worcester Mutual, negligent supervision, unlike negligent entrustment, is a theory of recovery that is separate and distinct from the use or operation of an automobile. Thus, the negligent supervision theory advanced by Alioto and the cause of action pertaining to the negligent failure of the Marnells to prevent their son from drinking relate only to activities that are alleged to have taken place within the Marnells’ home. Therefore, the Marnells could reasonably expect to be protected by their homeowners’ policy in an action based on those activities.

496 N.E.2d 158, 161 (Mass. 1986).

1. The default rule in favor of a subjective standard for expectation and intent.The expected-or-intended exclusion originally appeared as part of the definition of occurrence, as part of the shift from accident- to occurrence-based coverage, see Donald F. Farbstein & Francis J. Stillman, Insurance for the Commission of Intentional Torts, 20 HASTINGS L.J. 1219, 1220–1221 & 1236–1237 (1969) (describing the two ambiguities of the term “accident” in relation to gradual events and the perspective from which to consider whether an event is accidental and explaining that “[b]y replacing the term ‘accident’ with that of ‘occurrence,’ and by supplying the definition [of occurrence] quoted above, the new policy seeks to eliminate the major ambiguities noted earlier”). The formulation for what it means to subjectively expect harms is taken from Shell Oil Co. v. Winterthur Swiss Ins. Co., 15 Cal. Rptr. 2d 815, 835–836 (Ct. App. 1993) (adopting subjective standard for expected):

Our conclusion on the meaning of “expected or intended” is not unique. Patrons–Oxford Mut. Ins. Co. v. Dodge, 426 A.2d [888] 892, [(Me. 1981)] adopted essentially the same interpretation, albeit without examining the words’ ordinary and popular meanings. The court decided that damage “‘… which is either expected or intended from the standpoint of the Insured’” refers only to damage “that the insured in fact subjectively wanted (‘intended’) to be a result of his conduct or in fact subjectively foresaw as practically certain (‘expected’) to be a result of his conduct.” (Ibid., original emphasis.) Similarly, Quincy Mut. Fire Ins. Co. v. Abernathy (1984) 393 Mass. 81, 469 N.E.2d 797, 800, held that “expected” requires a showing that the insured “knew to a substantial certainty” that damage would ensue. “Had the insurer intended a different result, it could have used more appropriate language in the exclusion clause.” (Ibid.)

Most courts have held that liability insurance uses the subjective expected-or-intended standard to determine if an accident took place. See, e.g., City of Johnstown, N.Y. v. Bankers Standard Ins. Co., 877 F.2d 1146, 1150-1151 (2d Cir. 1989) (applying New York law) (citations omitted) (“It is not enough that an insured was warned that damages might ensue from its actions, or that, once warned, an insured decided to take a calculated risk and proceed as before. Recovery will be barred only if the insured intended the damages, or if it can be said that the damages were, in a broader sense, ‘intended’ by the insured because the insured knew that the damages would flow directly and immediately from its intentional act. In those instances, coverage is precluded because the damages are not ‘accidental.’”); Brooklyn Law School v. Aetna Cas. & Sur. Co., 849 F.2d 788, 789 (2d Cir. 1988) (applying New York law) (citations omitted) (“Ordinary negligence does not constitute an intention to cause damage; neither does a calculated risk amount to an expectation of damage. To deny coverage, then, the fact finder must find that the insured intended to cause damage.”); Hecla Mining Co. v. N.H. Ins. Co., 811 P.2d 1083, 1088 (Colo. 1991) (citations omitted):

[W]hat make injuries or damages expected or intended rather than accidental are the knowledge and intent of the insured. It is not enough that an insured was warned that damages might ensue from its actions, or that, once warned, an insured decided to take a calculated risk and proceed as before. Recovery will be barred only if the insured intended the damages, or if it can be said that the damages were, in a broader sense, “intended” by the insured because the insured knew that the damages would flow directly and immediately from its intentional act.

SL Indus. Inc. v. Am. Motorists Ins. Co., 607 A.2d 1266, 1278 (N.J. 1992):

[If the insured] subjectively intends or expects to cause some sort of injury, that intent will generally preclude coverage. If there is evidence that the extent of the injuries was improbable, however, then the court must inquire as to whether the insured subjectively intended or expected to cause that injury. Lacking that intent, the injury was “accidental” and coverage will be provided.

Cf. Shell Oil Co. v. Winterthur Swiss Ins. Co., 15 Cal. Rptr. 2d 815 (Ct. App. 1993) (adopting subjective standard for expected); State Farm Fire & Cas. Co. v. CTC Dev. Corp., 720 So. 2d 1072, 1076 (Fla. 1998) (“Uzdevenes did not expect or intend for damages to result from his act of constructing the home. He did not openly defy the setback requirements; he mistakenly believed that he had received a variance for the construction. Therefore, the fact that he intentionally constructed the house knowing that it was outside of the setback line does not preclude a finding of coverage under his liability policy for this ‘occurrence.’”); S. Macomb Disposal Auth. v. Am. Ins. Co., 572 N.W.2d 686, 696 (Mich. Ct. App. 1997) (citation omitted) (“[T]he subjective test applies where an insurance policy uses the term ‘accident’ but is otherwise silent with respect to from whose perspective the event is to be deemed an accident.”); Am. Family Ins. Co. v. Walser, 628 N.W.2d 605, 612 (Minn. 2001) (citation omitted) (“[W]here there is specific intent to cause injury, conduct is intentional for purposes of an intentional act exclusion, and not accidental for purposes of a coverage provision…. [W]here there is no intent to injure, the incident is an accident, even if the conduct itself was intentional.”); Physicians Ins. Co. of Ohio v. Swanson, 569 N.E.2d 906 (Ohio 1991) (adopting subjective standard); Tennessee Farmers Mut. Ins. Co. v. Evans, 814 S.W.2d 49, 54-55 (Tenn. 1991) (detailing seven approaches taken by courts in construing “expected or intended” provisions). But see City of Carter Lake v. Aetna Cas. & Sur. Co., 604 F.2d 1052, 1058–1059 (8th Cir. 1979) (applying Nebraska law) (“For the purposes of an exclusionary clause in an insurance policy, the word ‘expected’ denotes that the actor knew or should have known that there was a substantial probability that certain consequences will result from his actions.”); Employers Mut. Cas. Co. v. Fisher Builders, Inc., 371 P.3d 375, 379 (Mont. 2016) (finding a purely subjective intent analysis of an “expected or intended” policy exclusion “incomplete” and incorporating an objective “second prong of the analysis”). For an example of a case from a jurisdiction with an objective standard adopting an exception, see Amco Ins. Co. v. Haht, 490 N.W.2d 843, 848 (Iowa 1992) (finding an exception to an intentional tort-like standard in a case in which a young boy killed a friend by throwing a baseball at him).

For authority on the relationship between mental illness and the expected-or-intended exclusion, see, e.g., Globe Am. Cas. Co. v. Lyons, 641 P.2d 251, 254 (Ariz. Ct. App. 1981) (“if [insured] was suffering from mental derangement which deprived her of her capacity to act in accordance with reason and while in that condition acted on an irrational compulsion to drive her vehicle into oncoming traffic, her act was not ‘intentional’”); Prasad v. Allstate Ins. Co., 644 So. 2d 992, 995 (Fla. 1994) (stabbing injury by psychotic brother on his sister was not an “accident”); Rajspic v. Nationwide Mut. Ins. Co., 662 P.2d 534, 536 (Idaho 1983) (comparing the standards for intentional conduct that apply in tort and insurance law, respectively, with respect to insanity); Shelter Mut. Ins. Co. v. Williams, 804 P.2d 1374, 1382 (Kan. 1991) (“We hold that an injury inflicted by an insured who is mentally ill is ‘intentional’ within the meaning of the policy provision excluding coverage for intentional acts of the insured if the insured understands the nature and quality of his acts and intends to cause the injury, even though he is unable to recognize his conduct as wrongful.”); State Farm Fire & Cas. Co. v. Wicka, 474 N.W.2d 324, 331 (Minn. 1991) (“an intent to cause bodily injury requires that the insured possess both cognitive and volitional capacities, either of which may be affected by the insured’s mental illness”); Municipal Mut. Ins. Co. of West Virginia v. Mangus, 443 S.E.2d 455, 458 (W. Va. 1994) (“coverage under an intentional injury exclusion clause in a homeowners insurance policy may be denied when one who commits a criminal act has a minimal awareness of the nature of his act”). See also Catherine A. Salton, Mental Incapacity and Liability Insurance Exclusionary Clauses: The Effect of Insanity Upon Intent, 78 Cal. L. Rev. 1027 (1990) (discussing two lines of authority). On inferred intent, see, e.g., Fire Ins. Exch. v. Abbott, 251 Cal. Rptr. 620, 629 (Ct. App. 1988) (“Most courts … have inferred a specific intent to injure as a matter of law from the fact of sexual misconduct with a minor.”). See also Kenneth S. Abraham, Insurance Law and Regulation: Cases and Materials 538 (5th ed. 2010) (“Sometimes … subjective intent or expectation can be inferred from the circumstances, perhaps even as a matter of law.”); 3-18 Appleman on Insurance § 18.03 (“Many jurisdictions have recognized that the intent to injure, especially when guns or sexual abuse are involved, can be inferred as a matter of law based on the egregious nature of the act involved and the accompanying foreseeability of harm.”). On limiting imputation of intent to a corporation see, e.g., Travelers Indem. Co. v. Bloomington Steel & Supply Co., 718 N.W.2d 888, 895 (Minn. 2006) (holding that under the terms of the insurance policy, intent or knowledge of an agent of the insured corporation would not automatically be imputed to the corporation for the purposes of determining whether bodily injury inflicted by the agent upon a third party was “expected or intended”); RJC Realty Holding Corp. v. Republic Franklin Ins. Co., 808 N.E.2d 1263, 1265-1266 (N.Y. 2004) (knowledge of masseur who had sexually assaulted customer could not be attributed to employer for purposes of “expect or intend” analysis of coverage for liability of employer). For authority enforcing expected or intended exclusions that explicitly adopt an objective standard, see, e.g., Allstate Ins. Co. v. Barnett, 816 F. Supp. 492, 496 (S.D. Ind. 1993) (holding that a provision excluding losses “which may reasonably be expected to result from the intentional or criminal acts of an insured person or which are in fact intended by an insured person” was “clear and unambiguous and provides an objective standard”); Allstate Ins. v. Cruse, 734 F. Supp. 1574, 1581 (M.D. Fla. 1989) (“This Court … finds that the intentional acts exclusion at issue in this case requires the Court to apply an objective standard to [insured’s] intentional acts.”); Allstate Ins. Co. v. Peasley, 932 P.2d 1244, 1247 (Wash. 1997) (excluding losses from “any bodily injury which may reasonably be expected to result from the intentional or criminal acts of an insured person or which are in fact intended by an insured person.”). Cf. Eric S. Knutsen, Fortuity Victims and the Compensation Gap: Re-envisioning Liability Insurance Coverage for Intentional and Criminal Conduct, 21 CONN. INS. L.J. 209, 243 (2014) (proposing that the subjective standard should also be applied to the criminal-acts exclusion). Note that there is a minority rule that holds that an intentional injury committed by a third party is not an “accident” with respect to an insured who is sued for failure to supervise that third party. See, e.g., Farm Bur. Mut. Ins. Co. of Idaho v. Cook, 414 P.3d 1194, 1198 (Idaho 2018).

Illustration 2 is based on the facts in State Farm Mut. Auto. Ins. Co. v. Worthington, 405 F.2d 683 (8th Cir. 1968). Illustration 3 is based on Am. Family Mut. Ins. Co. v. Johnson, 816 P.2d 952 (Colo. 1991).

1. Burden of proof.Courts generally require the insurer to bear the burden of proving that a claim falls within the scope of an exclusion in the policy. See, e.g., Ment Bros. Iron Works Co. v. Interstate Fire & Cas. Co., 702 F.3d 118, 121 (2d Cir. 2012) (applying New York law) (“Under New York law … an insurer bears the burden of proving that an exclusion applies.”); N.H. Ins. Co. v. Martech USA, Inc., 993 F.2d 1195, 1199 (5th Cir. 1993) (applying Texas law) (“[U]nder … Texas law, the burden is on the insurer to prove the applicability of policy exclusions.”); Capital Envtl. Servs., Inc. v. N. River Ins. Co., 536 F. Supp. 2d 633, 640 (E.D. Va. 2008) (applying Virginia law) (citations omitted) (“[T]he insurer bears the burden of proving that any coverage exclusion applies.”); HLTH Corp. v. Clarendon Nat’l Ins. Co., No. 07C-09-102 RRC, 2009 WL 2849779, at *22 (Del. Super. Ct. Aug. 31, 2009), aff’d sub nom. Axis Reinsurance Co. v. HLTH Corp., 993 A.2d 1057 (Del. 2010), as corrected (May 10, 2010) (“Under Delaware law, because the Plaintiffs have established, and the parties do not dispute, that their loss is within the terms of the policies, Defendants, as insurers, bear the burden of establishing that the Prior Notice Exclusion bars coverage.”); Great Am. Ins. Co. v. Gaspard, 608 So. 2d 981, 984 (La. 1992) (“As with any exclusion in an insurance policy, the insurer bears the burden of proving that the intentional injury provision is applicable.”); Int’l Paper Co. v. Cont’l Cas. Co., 320 N.E.2d 619, 622 (N.Y. 1974) (citation omitted) (“The insurer is cloaked with the burden of proving that the incident and claim thereunder came within the exclusions of the policy”); Madison Constr. Co. v. Harleysville Mut. Ins. Co., 735 A.2d 100, 106 (Pa. 1999) (“Where an insurer relies on a policy exclusion as the basis for its denial of coverage and refusal to defend, the insurer has asserted an affirmative defense and, accordingly, bears the burden of proving such defense.”); 17A STEVEN PLITT, DANIEL MALDONADO, JOSHUA D. ROGERS & JORDAN R. PLITT, COUCH ON INSURANCE § 254:12 (3d ed. 2017) (“The insurer bears the burden of proving the applicability of policy exclusions and limitations or other types of affirmative defenses, in order to avoid an adverse judgment after the insured has sustained its burden and made its prima facie case.”).

1. An exception to an exclusion.See, e.g., Sikirica v. Nationwide Ins. Co., 416 F.3d 214, 228 (3d Cir. 2005) (applying Pennsylvania law) (“The Contractual Liability provision broadens the definition of ‘incidental contract’ as used in the exception to the exclusion provision, but it does not extend coverage of the Policy to injury or damages that are not the result of an ‘occurrence’ or ‘accident.’”); Sheehan Constr. Co. v. Cont’l Cas. Co., 935 N.E.2d 160, 162 (Ind. 2010) (citations omitted) (“Exceptions to exclusions narrow the scope of the exclusion and, as a consequence, add back coverage. However, it is the initial broad grant of coverage, not the exception to the exclusion, that ultimately creates (or does not create) the coverage sought.”); Nav-Its, Inc. v. Selective Ins. Co. of Am., 869 A.2d 929, 939 (N.J. 2005) (“We interpret that exception to limit the reach of the pollution clause, i.e. if the environmental pollution occurs within a building within a single forty-eight hour period, and the other conditions are met, then the insured may receive coverage for that environmental pollution claim. Simply put, if the pollution exclusion is not applicable, neither is the exception to the pollution exclusion.”); K & L Homes, Inc. v. Am. Family Mut. Ins. Co., 829 N.W.2d 724, 728 (N.D. 2013) (citation omitted) (“Likewise, although an exception to an exclusion from coverage results in coverage, an exception to an exclusion is incapable of initially providing coverage; rather, an exception may become applicable if, and only if, there is an initial grant of coverage under the policy and the relevant exclusion containing the exception operates to preclude coverage.”). For an example of a court using an exception to an exclusion as a guide to interpretation of coverage, see Panfil v. Nautilus Ins. Co., No. 12 C 6481, 2014 WL 52774, at *2 (N.D. Ill. Jan. 7, 2014), aff’d, 799 F.3d 716 (7th Cir. 2015) (applying Illinois law):

Defendant correctly notes that, under Illinois law, “an exception to an exclusion does not create coverage or provide an additional basis for coverage, but, rather, merely preserves coverage already granted in the insuring provision.” [citation omitted] I do not suggest that this exception to an exclusion has “created” coverage. But by “preserving coverage already granted in the insuring provision,” an exception to an exclusion does offer some indication as to what the policy itself is meant to cover.

See also Architex Ass’n, Inc. v. Scottsdale Ins. Co., 27 So. 3d 1148, 1160 (Miss. 2010) (“The policy exclusions and exceptions thereto can be (and often are) valuable in determining the parameters of coverage, generally, and the meaning of ‘accident’ within the definition of ‘occurrence,’ specifically.”).

Case Citations - by Jurisdiction

________________________________________________________________________________________________________________________________________________________

• ^Me.
• ^N.M.

D.Me.

D.Me.2019. Com. (e) cit. in sup. Insured lawyer and law firm sued insurer, seeking a defense against a class action filed against them by investors who alleged, among other things, that insureds drafted faulty and misleading legal documents and were involved in the improper sale of securities in violation of federal securities laws. This court denied in part insurer’s motion for summary judgment, holding that it had a duty to defend insureds against the class action, notwithstanding the policy’s investment-advice exclusion. The court reasoned, in part, that insurer failed to meet its burden under Restatement of Liability Insurance § 32 of establishing that the investment-advice exclusion applied, because investors did not allege that insureds rendered investment advice to them, or advised them to make an investment or refrain from doing so. Marcus v. Allied World Insurance Company, 384 F.Supp.3d 115, 123.

D.N.M.

D.N.M.2020. Subsecs. (1) and (5) quot. in sup. Insurer that had issued a professional-liability-insurance policy to nonprofit provider of trustee services for disabled individuals sued insured after its CEO pleaded guilty to embezzlement, seeking rescission of the policy, as well as a declaration that it had no duty to defend or indemnify insured against claims arising from CEO’s actions, on the ground that CEO made material misrepresentations in insured’s policy application. This court denied insurer’s motion for summary judgment, but rejected insured’s argument that insurer had the burden to prove that insured knew of CEO’s embezzlement in order to establish a lack of coverage. The court held that the prior-knowledge provision contained in the policy created a condition precedent to coverage under Restatement of Liability Insurance § 34, rather than an exclusion under § 32, such that insured had the burden to show that it had no knowledge of circumstances that were likely to lead to a claim in order to be entitled to coverage. Evanston Insurance Company v. Desert State Life Management, 434 F.Supp.3d 1051, 1098, 1103.

Restatement of the Law - Liability Insurance © 2012-2021 American Law Institute. Reproduced with permission. Other editorial enhancements © Thomson Reuters.