Pennsylvania’s Supreme Court recently ruled that where an insurer defends subject to a reservation of rights, the insured settles the underlying claim against the insurer’s wishes, and coverage is due, then the insurer can be required to indemnify the insured up to policy limits for that settlement, if the settlement was fair, reasonable, and non-collusive.  The Court’s July 21, 2015 decision in Babcock & Wilcox Co. v. American Nuclear Insurers establishes a clearly worded standard, but those words open the door to a new world of litigation over when a settlement is fair, reasonable, and non-collusive.  One thing the Court clearly eliminates from that future litigation, however, is the idea that an insured must prove that the insurer acted in bad faith in refusing to settle.  The Court was unequivocal that bad faith is not required.

On the burden of proof, the Supreme Court makes clear the burden of proof falls on the insured, or the underlying claimant, to make out a case for reimbursement on the basis that the settlement was reasonable.  In the Court’s words: “If an insurer breaches its duty to settle while defending subject to a reservation of rights and the insured accepts a reasonable settlement offer, the insured need only demonstrate that the insurer breached its duty by failing to consent to a settlement that is fair, reasonable, and non-collusive … rather than demonstrating bad faith by the insurer, as the damages sought are subject to the policy limits to which the insurer originally contracted.”  Factors to evaluate in determining whether a settlement is fair and reasonable include “consideration of the terms of the settlement, the strength of the insured’s defense against the asserted claims, and whether there is any evidence of fraud or collusion on the part of the insured.” The Supreme Court more generally stated that the “risks of going to trial” had to be evaluated in determining the case.

The Court did accept the insurer’s arguments on one issue that will undoubtedly become another fertile field for future litigation:  the difference between “soft” and “hard” reservations of rights.  A “soft” reservation of rights involves circumstances where an insured is reserving rights which are “unlikely to alter the interests of the parties”; whereas with a “hard” reservation of rights “the insurer views the claims as possibly covered, requiring a defense, but ultimately unlikely to be covered by the policy, such as when intentional actions are also pled in negligence.”

In acknowledging this distinction, and expressly stating that “not all reservations of rights are equal,” the Court sends a message that a reservation of rights letter by itself is not a carte blanche ticket for insureds to unilaterally settle an entire case, simply because some rights have been reserved.  Rather, the rights specifically reserved by the insurer in a particular case must be evaluated against the subject matter of the settlement at issue, to determine if that settlement can be the basis to seek indemnification from the insurer.  Again, this will certainly be a burgeoning field of litigation.

So, for example, an insured is sued in negligence, but the complaint includes a claim for punitive damages.  The insurer issues a reservation of rights solely as to the punitive damages claim, which is indisputably not covered under the policy.  The case is about to go to trial, and while the insurer and insured recognize any judgment is extremely unlikely to come close to policy limits, the insured is concerned the jury could still award punitive damages.  The claimant is willing to settle below policy limits, but at a number well in excess of a reasonable compensatory damages figure. The insurer refuses to settle at a sum unreasonably in excess of the potential compensatory damages award. The insured pays the full sum demanded, and then sues the insurer for that full sum.  Under B&W, the insurer should have an argument that the reservation of rights did not concern a covered claim, and the insured should not get the benefit of the fair, reasonable, and non-collusive standard to make its case, since there was no reservation of rights as to the covered negligence claim.

Or imagine a more black and white case, where a reservation of rights is issued solely based on late notice, but the insurer defends the case and is ready to go to trial.  Further, there is no risk to the insured that the insurer will pursue a claim that coverage is not due based on late notice. The claimant demands a sum that would be determined fair and reasonable under the B&W test, but the insurer refuses to settle as there is no risk of an excess verdict, and wants to test the case at trial.  The insured does not want to go to trial and unilaterally settles, over the insurer’s objection.  Under this scenario, where the specific reservation of rights is actually irrelevant to the insured’s risk of actually having to pay any of its own funds toward a judgment against it, then B&W indicates that the insured should not be indemnified for such a settlement.