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Posted on behalf of Valerie Rojas

DRI’s Insurance Bad Faith and Extra-Contractual Liability Seminar scheduled for June 17-19, 2015, in Chicago, will include a discussion on how uninsured exposures can create extra-contractual liability for liability insurers.

The right of an insurer to control litigation carries with it the correlative duty to exercise good faith in considering offers to compromise an injured party’s claim against the insured. Whenever an insurer is presented with a settlement offer within policy limits, a conflict arises between the insurer’s interest in minimizing its payments and the insured’s interest in avoiding liability beyond the policy limits. This conflict is complicated in situations where an insured is exposed to liability for both insured and uninsured risks. 

An insurer has a duty to accept a reasonable settlement offer within policy limits rather than unreasonably risk an adverse judgment substantially over the policy limits. An insurer may be held liable for the failure to settle where the insurer is presented with a reasonable settlement demand, or opportunity to settle within policy limits, but fails to do so, and a judgment is rendered against the insured in excess of the policy limits. When this occurs, courts have held that the insurer is liable for extra-contractual damages, including the payment of the entire judgment. An insurer’s rejection of a settlement offer for less than the full amount of its policy does not by itself establish the insurer’s bad faith, even when the insured later suffers a judgment greater than the policy limit. The claimant’s settlement demand must be within policy limits and for an amount that is reasonable. Determining whether a settlement demand is reasonable requires an evaluation of the probable liability of the insured and the amount of that liability; but the fact that a claim may not be covered does not impact whether a settlement demand is reasonable.

However, when presented with a settlement demand for both insured and uninsured claims, the duty of an insurer to settle an underlying claim applies only to insured claims. Therefore, in determining the reasonableness of settlement offers, a liability insurer is only obligated to pay a reasonable settlement for covered claims. For example, where the policy does not cover punitive damages, or where it is against public policy to insure against punitive damages, an insurer may properly disregard its insured’s exposure to punitive damages in evaluating a settlement demand. 

If an insurer refuses to accept a reasonable settlement offer and it is subsequently determined that there is no coverage, the insurer obviously has no liability. However, the insurer bears the risk that a court will later determine that the entire claim is covered. In most jurisdictions, an insurer’s reasonable, but mistaken beliefs concerning coverage do not excuse the failure to settle where the settlement offer is reasonable. An insurer that is reluctant to risk having a court later disagree with its coverage position and find that the insurer acted in bad faith, may choose to ask its insured to contribute to the settlement of uninsured claims, or if not successful in this regard, settle the entire underlying claim while properly reserving its right to later seek contribution from its insured. These options may demonstrate the insurer’s reasonableness, and help avoid a claim for breach of the duty to settle in good faith.

When an insurer does breach its duty to settle, the insured has been allowed to recover the entire excess compensatory damage award over the policy limits.  In addition, when an insurer breaches its duty to settle, some courts have allowed insureds to recover damages for emotional distress, economic loss, physical impairment and, when the insurer’s conduct is in bad faith and egregious, punitive damages.  Thus, an insurer’s breach of its obligation to settle in good faith can result in substantial extra-contractual exposure.