This summer, the Supreme Court of Pennsylvania addressed an important question that has divided other courts: if an insurer defends a claim subject to a reservation of rights, may the insured settle the claim without the insurer’s consent?  Earlier cases considered whether or not the insurer’s reservation of rights has the effect of “narrow[ing]” the policyholder’s contractual duty to cooperate in its own defense.  E.g., United Services Auto Assoc. v. Morris, 741 P.2d 246 (Ariz. 1987).  But in The Babcock & Wilcox Company v. American Nuclear Insurers, No. 2 WAP 2014 (Pa. July 10, 2015), Pennsylvania focused on the duties of the insurer: the court held that the insured may settle only “after an insurer breaches its duty by refusing [a] fair and reasonable settlement while maintaining its reservation of rights.”  This ruling might seem straightforward, but it actually creates a deep muddle of shifting responsibilities, contradictory outcomes and unanswered questions.

Parks and Radiation

Babcock & Wilcox Company (B&W) and Atlantic Richfield Company (ARCO) owned and operated former nuclear fuel fabrication plants in two Pittsburgh suburbs, Apollo and Parks Township.  In 1994, a group of claimants filed a public liability action in federal court in Pennsylvania, alleging that emissions from the plants had caused a variety of illnesses—most commonly, various forms of cancer—among residents of the surrounding area.  Ultimately, more than 500 claimants would join the suit as named plaintiffs.

The plants were insured under four nuclear energy liability insurance policies, and the insurer retained joint counsel to defend B&W and ARCO.  The policies covered claims for damages “caused by the nuclear energy hazard,” and the insurer reserved its rights with respect to elements of the claim that might fall outside the scope of coverage:  damages caused by something other than a “nuclear energy hazard”; damages arising before the effective date of the policies; damages in excess of policy limits; injunctive relief and punitive damages.  This original reservation did not assert a basis for denying coverage for compensatory damage claims that were based on a nuclear energy hazard, and which arose during the policy period, up to the policies’ $320 million limit.

In 1998, the court conducted a trial for eight “test” claimants, which resulted in a jury award of $36.7 million.  In 1999, however, the trial court vacated the test verdicts, based on a finding that the plaintiffs’ case had been “dramatically bolstered” by expert testimony involving “unvalidated data” about the incidence of cancer in the area around the plants.  While ordering a new trial, the court denied the defendants’ concurrent motion for judgment notwithstanding the verdict.  In that motion, defendants argued that the plaintiffs had failed to make a prima facie case, because they failed to proffer admissible evidence establishing that radiation had been released at unlawful levels.

Defense counsel, supported by the defendants’ insurers, recommended that B&W and ARCO pursue an interlocutory appeal from the denial of the motion for judgment n.o.v.  B&W declined to do so, and it discouraged ARCO from pursuing the appeal alone.  No appeal was filed, and the insurer supplemented its reservation of rights, asserting that B&W had breached the policies’ cooperation clauses and violated its duty of good faith and fair dealing.  B&W and its insurer also filed separate state court coverage actions against one another.  After the cases were consolidated, the court ruled that B&W and ARCO were entitled to separate counsel, and it resolved a dispute over the policies’ limits.  The cases were then stayed with the parties’ consent.

The litigation was interrupted when B&W filed for bankruptcy protection in February 2000.  It resumed seven years later, when the court in the public liability action abandoned its “test case” approach and ordered a trial on the issue of whether the alleged emissions from the Apollo and Parks facilities were capable of causing the illnesses plaintiffs had alleged.  At that trial, the court ruled, “causation [could] only be established … from epidemiological studies of populations exposed to ionizing radiation.”  Even if the plaintiffs prevailed on this issue, each plaintiff would still have to prove at a later trial that exposure to emissions from one of the facilities had been the proximate cause of his or her illness.

According to the insurers, B&W’s defense attorneys were optimistic about the initial trial, advising their client that the reports of plaintiffs’ experts were “just trash.”  Further, the defense expert advised B&W and ARCO that there were no published epidemiological studies connecting any of the types of cancers alleged by the plaintiffs with exposure to uranium or low doses of plutonium.  The insurers had already expended about $40 million on the defense of the claims, but the defendants still had about $280 million in remaining coverage.  Nevertheless, ARCO tendered a proposed settlement for $27.5 million in January 2008, and B&W negotiated a $52.5 million settlement the following September.

The facilities’ insurance policies expressly required the insureds to “cooperate with [the insurer] … and assist in making settlements,” and, further, that the insureds

shall not, except at [their] own cost, make any payment, assume any obligation or incur any expense.

Consequently, the policies provided coverage only for settlements concluded “by written agreement of the insured, the claimant and [the insurer].”

The insurers refused to agree to the settlements negotiated by B&W and ARCO, based on what they considered to be the insureds’ “high likelihood of success” at trial.  The insureds executed the settlements over the insurers’ objections and sought coverage for it in the state court coverage lawsuit that had previously been stayed.

Going Off the Reservation

An insurer’s reservation of rights can alter the risks associated with the underlying litigation.  For the policyholder, a reservation can make trying the case to a conclusion more dangerous than it otherwise would be, because it adds a second risk to the risk of an adverse judgment—i.e., the possibility that the judgment will not be covered by the insurer.  For the same reason, the reservation can make settlement less attractive to the insurer—because the non-settling insurer will have two chances to avoid liability entirely.  In short, a reservation of rights potentially adds an element of tension to the relationship between insurer and insured.

But a reservation of rights can also work to the policyholder’s benefit, making it possible for the insurer to provide a defense in cases where coverage is in doubt.  And, as amici curiae asserted in Babcock & Wilcox, not every reservation creates a conflict of interest, because only “a relatively small percentage of reservation[s] of rights actually … expose an insured to uninsured losses.”  In many (if not most) cases, the insurer issues reservations that

resolve during the course of the litigation and are merely a ‘reminder of the terms of the contract as applied to the facts in the lawsuit …’

Babcock & Wilcox arguably provided examples of such “soft” reservations”:  it was unlikely, for example, that claims based on emissions of radiation from a nuclear fuel fabrication plant would turn out to involve any cause other than a “nuclear energy hazard.”

Furthermore, the potential for a conflict of interest between insured and insurer is not unique to cases involving reservations of rights: a similar tension arises whenever it is clear that any judgment against the insured will far exceed policy limits—a situation that is often encountered in cases based on bodily injury claims.

The case law available to the Pennsylvania court did not offer a clear mechanism for balancing these competing considerations.  Nearly sixty years ago, in Cowden v. Aetna Cas. & Surety Co., 134 A.2d 223 (Pa. 1957), Pennsylvania’s high court articulated the duties of a liability insurer when confronted with an offer of settlement.  The insurer in that case had declined to approve a settlement within policy limits, the case had not settled, and the insured had been hit with an excess judgment.  The court held that the insurer could be liable for the entire judgment, if its refusal to settle failed the following test of good faith:

[W]hen there is little possibility of a verdict or settlement within the limits of the policy, the decision to expose the insured to personal pecuniary loss [by rejecting a settlement within policy limits] must be based on a bona fide belief by the insurer … that it has a good possibility of winning the suit.  … Good faith requires that the chance of a finding of nonliability be real and substantial and that the decision to litigate be made honestly.

Cowden did not involve a reservation of rights, and the insured in Cowden did not settle without consent.  But cases from other jurisdictions have applied a similar analysis to those facts.  For example, in Vincent Soybean & Grain Co. v. Lloyd’s Underwriters of London, 246 F.3d 1129 (8th Cir. 2001), the court (applying Arkansas law) found that the insured could not receive coverage for an unauthorized settlement, notwithstanding the insurer’s reservation of rights, “unless [the insurer], in bad faith, breach[ed] the contract by arbitrarily refusing to settle.”

In United Services Automobile Assoc. v. Morris, supra, the Supreme Court of Arizona also considered an unauthorized settlement and a reservation of rights, but it saw things differently:

An insurer that … reserves the right to deny the duty to pay should not be allowed to control the conditions of payment.  The insurer’s insertion of a policy defense by way of reservation … narrows the reach of the cooperation clause and permits the insured to take reasonable measures to protect himself against the danger of personal liability.  Accordingly, we hold that the … prohibition against settling without the insurer’s consent forbids an insured from settling only claims for which the insurer unconditionally assumes liability …

Where the insurer continues to reserve its rights, the court held that insurer must provide coverage for an unauthorized settlement, if the settlement has been “made fairly, with notice to the insurer, and without fraud or collusion.”  To qualify for coverage, the settlement must be “reasonable and prudent under all the circumstances,” as measured against

what a reasonably prudent person in the insured’s position would have settled for on the merits of the claimant’s case.

It is this shift of perspective—from the insurer’s point-of-view to that of the insured—which marks the most significant difference between Cowden and Morris.  Under Cowden, an insurer may block a settlement where it believes in good faith it has a legitimate chance of winning the underlying case.  Even where those requirements are met, however, it can still be reasonable for a prudent insured to accept the settlement.  Consequently, the Morris approach severely reduces the insurer’s discretion with respect to settlement.

A third group of cases preserves both lines of authority, giving the insured the option of rejecting a defense that is offered under a reservation of rights. If the insured accepts the defense, then it may not settle without the insurer’s consent—unless the insurer has withheld its consent in bad faith.  If the insured conducts an independent defense, however, then it may settle the case, and the insurer will be liable for the settlement if its coverage defenses fail.  See, e.g., Taylor v. Safeco Ins. Co., 361 So.2d 743 (Fla. Dist. Ct. App. 1978).

Morris Variations

In Babcock & Wilcox, the trial court decided to follow Morris.  It conducted a jury trial on the issue of whether the settlements concluded by B&W and ARCO were “fair and reasonable” under the Morris standard.  The jury found for the insureds, and the court awarded $80 million, together with pre- and post-judgment interest.  But the Superior Court (an intermediate appellate court) opted for Taylor v. Safeco.  The Superior Court therefore remanded the case for a new trial, and both sides appealed

The Supreme Court concluded that Cowden “[did] not control in the case at bar,” because it did not involve an unauthorized settlement and a reservation of rights.  For the situation it confronted, the court adopted what it called “a variant of the Morris fair and reasonable standard“—a “more nuanced analysis” that is “based upon [the] observation that an insurer breaches its duty to its insured when it refuses to settle in the appropriate case.”  Following the lead of the Iowa Supreme Court in Kelly v. Iowa Mut. Ins. Co., 620 N.W.2d 637 (Iowa 2000), the Pennsylvania court declared that an insurer must provide coverage for an unauthorized settlement

[in] 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 … .

Although this statement offers a new rationale for its analysis, as a practical matter, it would represent a “variant” of Morris only if it applied a different standard for determining whether a settlement is “fair and reasonable”:  the bottom line in both cases, after all, is that insureds are entitled to coverage for “fair and reasonable” settlements.  In fact, however, Babcock & Wilcox appears to come out exactly where Morris did.  The trial court expressly adopted the Morris standard, and the Supreme Court ruled that the jury’s application of that standard was conclusive.

[T]he jury determined that the settlement was ‘fair and reasonable from the perspective of a reasonably prudent person in the same position of [Insureds] and in light of the totality of the circumstances,’ a standard which we adopt herein as the proper standard to apply in a reservation of rights case where an insured settles following the insurers’ refusal to consent to settlement. …

Accordingly, we … reinstate the judgment of the trial court.

In a footnote, the Supreme Court’s opinion also refers to the standard set forth in Cowden as “the higher burden of bad faith,” and it states that this “higher” standard applies only where (as in Cowden) the insured seeks coverage for a judgment in excess of policy limits.

Muddy Waters

Babcock & Wilcox does introduce “nuance” to other areas—but in a way that is likely to result in confusion and unfairness.  In a footnote, for example, the court stated that some reservations of rights will not trigger the new, lower standard for measuring the “fairness” of a settlement:

[N]ot all reservations of rights are equal.  The mere fact that an insurer restates that it will not cover what the insurance policy does not cover, where it arguably might be part of the damages sought, does not automatically result in allowing the insured to settle the entire suit.  Parties and courts may need to consider whether a particular reservation of rights justifies diverging from the contract’s cooperation clause, a question which is not squarely before this court.

Notwithstanding the court’s disclaimer, the insurer in Babcock & Wilcox argued expressly that its reservation of rights created “no plausible risk of [the insureds’] being left without any coverage.”  And the disclaimers of coverage for damages unrelated to a “nuclear energy hazard,” or outside the policy period, certainly sound like “restatements” that the insurer would “not cover what the … policy does not cover.”  The insurer might have had a less solid basis for arguing that its second reservation of rights—based on alleged breach of the duty to cooperate—”posed no serious threat to B&W at the time of” the settlement, and had “largely become irrelevant with the passage of time.”  But those arguments were nevertheless before the court, and the court never explained its basis for rejecting them.  Consequently, the court’s opinion offers little in the way of meaningful guidance about which reservations of rights do or do not “justif[y] diverging from the cooperation clause.”  Parties and courts will have to work out those issues on their own.

The court’s decision to distinguish Cowden, rather than to overrule it, is also problematic—especially given the court’s ostensible focus on the duties of the insurer.  If a consumer purchases an automobile policy with minimal limits, and she becomes involved in an accident in which a child is permanently disabled, she will have a strong incentive to settle for an amount that is as close to the policy limit as possible—even if she has valid defenses on the issue of liability.  In other words, her interests will conflict with those of her insurer to at least the same extent that B&W’s interests diverged from those of its carriers.

In the consumer’s case, however, the insurer’s duty to approve a settlement would be governed by Cowden:  a “real and substantial” chance to win on liability is all the insurer needs to take the case to trial.  Whereas in a case involving a reservation of rights—even one where there is no risk of an excess judgment—the insurer must approve any settlement that a prudent insured would accept.

The Supreme Court explained this discrepancy by invoking the different types of risk facing the insurer.  In the automobile scenario, the insurer’s breach of duty exposes it to extra-contractual liability; in the reservation of rights case, policy limits still apply, and the insurer may still assert its coverage defenses.  Thus, the rules established by Babcock & Wilcox give insurers greater leeway when the stakes are higher—for those insurers.

But this approach also means that insureds who face similar types of litigation risks may receive different degrees of consideration from their insurers.  In Babcock & Wilcox, the insurer argued that the policyholder’s risk of liability for an excess judgment is “part of the bargain assumed by the parties to a liability insurance contract,” and the court’s decision implicitly accepts that argument.  Yet the court made no attempt to explain why the risks associated with a reservation of rights are not also part of the bargain that is set forth in an insurance contract containing an express consent-to-settlement clause.  (In a concurring and dissenting opinion, which argued for application of the Cowden standard, two justices asserted that “[t]he majority’s rationale allows an insured to alter the nature of the bargain it struck with its insurer.”)  Nor did the court assert that those risks are meaningfully different from those confronted by consumers facing excess judgments.

Conclusion

The gist of Babcock & Wilcox is fairly clear: insureds that are being defended under a reservation of rights now have significantly greater leverage for getting settlement approval from their insurers.  But the majority opinion still leaves substantial room for disputes over whether its rule applies to particular reservations of rights, and it institutes a set of rules that appear to be theoretically incoherent.

Image source: C. D. Arnold; H. D. Higinbotham (Wikimedia)