Insurers often have a duty to settle underlying claims against their insureds. While that duty generally requires insurers to accept reasonable settlement offers, insurers and insureds alike face many other issues regarding settlement of the underlying case. For example, can an insurer be liable for a bad-faith failure to settle the underlying claim when the insurer never received a settlement demand within the policy limits of the applicable insurance policy? Must an insurer show prejudice when an insured enters into a settlement without first receiving the insurer’s consent? How does a claim of bad-faith failure to settle affect otherwise valid claims of attorney-client privilege and work-product protection over an insurer’s documents? As shown below, the answers to these questions and others are dependent on the applicable law governing the interpretation of the insurance contract and the law governing an insured’s claim of bad faith.

Because of the varying state laws on these questions, parties to disputes involving insurance coverage must act carefully and deliberately at all steps of the process. All parties, insurers and insureds alike, must remain aware of the realm of possibilities with respect to the settlement of the underlying claim and the potential bad-faith failure-to-settle litigation arising out of that settlement.

Settlement Demand Within Policy Limits and Bad Faith Failure to Settle
Suppose that a plaintiff sues an insured for personal injuries and seeks $10 million in damages. The insurer had issued a policy to the insured with limits of $2 million. During the underlying litigation, the plaintiff’s lowest settlement demand is $5 million, and she refuses to consider any lower amount. After the insured settles with the plaintiff for $5 million and the insurer does not contribute any of its limits to the settlement, can the insured sue the insurer for bad faith even though the insurer never received a settlement demand within the $2 million policy limits?

In some states, like Texas, such a bad-faith claim would fail because courts in those states have held a bad-faith claim cannot be maintained without a demand within the policy limits.[2] In American Physicians Insurance Exchange v. Garcia, the insurer’s policy limits were $500,000.[3] The underlying plaintiffs first demanded $600,000 and then demanded $1.1 million to settle the underlying claim against the insured.[4] The insurer responded that the limits of the applicable insurance policy were $500,000. The plaintiffs then raised their demand to $1.6 million on the day of the underlying trial.[5]

After the insurer refused that demand, the underlying trial proceeded and ultimately resulted in judgment of $2.2 million against the insured.[6] The insured assigned his rights against the insurer to the plaintiffs, and the plaintiffs filed suit in the insured’s name alleging that the insurer breached its duty to settle the underlying case.[7] The trial court found that the insurer breached its duty to settle and entered judgment against the insurer.[8]

The Supreme Court of Texas reversed because the insurer had never received a settlement demand within its policy limits.[9] The court explained that a rule that did not require a settlement demand within policy limits “would require the insurer to bid against itself in the absence of a commitment by the claimant that the case can be settled within policy limits.”[10] In light of the “negotiating incentives” for the insured and insurer, the court concluded that the public interest in quick resolution of disputes supported its decision “not to shift the burden of making settlement offers . . . onto insurers.”[11] Accordingly, the insurer was not liable for failure to settle the underlying claim because the insurer did not receive a settlement demand within the applicable $500,000 policy limits.

Other courts have taken a contrary view and determined that a settlement demand within policy limits is not a prerequisite to a bad-faith failure-to-settle claim.[12] For example, in State Auto Insurance Co. of Columbus, Ohio v. Rowland, the insurer contended that it could not be liable for bad faith for failure to settle because there was no settlement demand within the limits of the applicable insurance policy.[13] The Supreme Court of Tennessee rejected that argument.[14] It found that the requirement of a settlement demand within limits may “lead to inequitable results.”[15] The court was wary of an insurance company, “in a case where liability is certain and injury great, to simply decline negotiations with the injured party and later assert that there was no offer within the policy limits.”[16] The court explained, however, that it was not placing on insurers “an affirmative duty to negotiate with the injured claimant in all cases.”[17] Instead, the “refusal to discuss a settlement may be considered along with other evidence in determining the issue of bad faith.”[18]

As shown above, courts in different states have disagreed about whether a settlement demand within the limits of the applicable insurance policy is a requirement for a bad-faith failure-to-settle claim. The outcome of a bad-faith claim in a case in which an insurer does not receive a settlement demand within its policy limits may ultimately be dependent on the applicable law governing the bad-faith claim.

When an Insured Settles without the Insurer’s Consent
Insurance policies often contain clauses providing that the insurer will not cover any payment or obligation that an insured voluntarily makes or assumes. What happens, then, when an insured settles an underlying claim without the insurer’s consent? As above, different states have different rules for this situation.

Some states require an insurer to show that the insured’s action in settling without the insurer’s consent actually prejudiced the insurer. For example, in Public Utility District No. 1 of Klickitat County v. International Insurance Co., the insureds were sued in 29 separate lawsuits involving plaintiffs that held bonds issued by the insureds. [19] Those lawsuits were consolidated into a multidistrict litigation proceeding (MDL).[20] Ultimately, the insureds entered into a settlement for $580 million for bonds with a face value totaling $2.25 billion.[21]

Two insurers refused to make payments under their policies, in part because the insured did not receive the insurers’ consent to the settlement of the MDL.[22] The policies provided that “the insured shall not, except at his own cost, voluntarily make any payment, assume any obligation or incur any expense . . . .”[23] The policies also provided that the insured could take “no action” against the insurers unless the insured “fully complied with all the terms” of the policies.[24] Because the insured entered into a settlement without the insurers’ consent, the insurers argued that the insured breached these provisions in the insurance policies, thereby releasing the insurers from any duty to pay under the policies.[25]

The Supreme Court of Washington found that the trial court correctly denied the insurers’ motion for summary judgment on this issue. The court held that an insurer must show that an insured’s voluntary settlement without the insurer’s consent prejudiced the insurer.[26] It stated that “[t]o release an insurer from its obligations without a showing of actual prejudice would be to authorize a possible windfall for the insurers.”[27] And because the insurers were unable to show as a matter of law that they were prejudiced by the insured’s failure to receive consent from the insurers, summary judgment was inappropriate.[28]

Conversely, other states have found that an insured’s failure obtain its insurer’s approval of an underlying settlement prohibited the insured from recovering from its insurer amounts it paid in settlement, without requiring the insurer to demonstrate any prejudice resulting from that failure.[29] In Vigilant Insurance Co. v. Bear Sterns Cos., Bears Sterns agreed to pay $80 million to settle underlying claims related to “potential conflicts that could arise from the relationship between research functions and investment banking objectives” at financial services firms such as Bear Sterns.[30] Bear Sterns did not request that its insurers consent to the settlement until three days after Bear Sterns executed the settlement agreement.[31]

Contending that Bear Sterns breached the consent-to-settle clause in the applicable insurance policy, the insurers argued they were not liable under the policy.[32] That clause provided Bear Sterns “agrees not to settle any claim . . . without the Insurer’s consent” and that “the insurer shall not be liable for any settlement . . . in excess of a settlement authority threshold of $5,000,000 . . . to which it has not consented.”[33] The New York Court of Appeals noted that Bear Sterns was a “sophisticated business entity” but nevertheless entered into a settlement without its insurers’ consent.[34] Accordingly, the court found that Bear Sterns breached the consent-to-settle clause, and the court concluded that the insurers were not liable under the policy.[35] It is important to note that the court did not require the insurers to demonstrate prejudice resulting from Bear Sterns’ decision to settle without the insurers’ consent.[36]

The enforcement of provisions such as those in the cases above varies from state to state. Because the applicable state law can affect an insured’s ability to recover from its insurer, when considering whether to enter into a settlement of an underlying case without their insurers’ consent, insureds should remain aware of the potential consequences of such action.

Bad Faith-Claims and an Insurer’s Privileged Documents
States also differ on issues that arise once an insured sues an insurer for bad-faith failure to settle. One relevant consideration in bad-faith failure-to-settle litigation is the effect a bad-faith claim may have on an insurer’s ability to withhold material on the basis of the attorney-client privilege. Insurers and insureds may be surprised to learn that under some states’ law, a bad-faith failure-to-settle claim can provide an avenue for insureds to access insurers’ otherwise privileged material. Indeed, under Ohio law, in a bad-faith action, an insured may discover documents that are otherwise protected by the attorney-client privilege and that were created prior to the insurer’s denial of coverage.[37]

In Boone v. Vanliner Insurance Co., the plaintiff, Richard Boone, was a truck driver injured in an accident.[38] Vanliner Insurance Company had issued an insurance policy to Boone and separately to Boone’s employer.[39] After a third party’s insurer paid out its $100,000 limits to Boone, Boone sought $1,000,000 in underinsured motorist benefits under the policy Vanliner had issued to Boone’s employer.[40]

Vanliner denied the claim.[41] Boone then sued Vanliner, claiming that the policy issued to Boone and the policy issued to his employer each provided him with $1 million in underinsured motorist coverage.[42] Boone also brought a claim for bad faith against Vanliner.[43] In connection with that claim, Boone sought documents from Vanliner’s claim file including documents protected by the attorney-client privilege and the work-product doctrine.[44]

The Supreme Court of Ohio determined that “in an action alleging bad-faith denial of insurance coverage, the insured is entitled to discover claims file materials containing attorney-client communications related to the issue of coverage that were created prior to the denial of coverage.”[45] The court reasoned that material that shows a lack of good-faith effort to settle was “undeserving of protection.”[46]

The Boone decision applies to communications between an insurance company and its outside counsel. Thus, in a bad-faith action governed by Boone, an insured may obtain otherwise privileged communications that are related to coverage issues even if those communications were exchanged between an insurer and its outside attorney.

Similarly, the Supreme Court of Washington, in Cedell v. Farmers Insurance Co. of Washington, recently found a presumption “that there is no attorney-client privilege relevant between the insured and the insurer in the claims adjusting process, and that the attorney-client and work product privileges are generally not relevant.”[47] Thus, under Cedell,in a first-party bad-faith claim, there is a presumption that an insured is entitled to access the insured’s entire claims file, including otherwise privileged material.[48]

Although the Boone and Cedell decisions represent a minority view,[49] the decisions provide an important example of the significance of the applicable state law. Where Washington or Ohio law applies to an insurer’s privilege claims, bad-faith failure-to-settle litigation can unfold in vastly different ways than in litigation governed by the majority view.

Punitive Damages in a Bad-Faith Failure-to-Settle Action
The availability of punitive damages in a bad-faith failure-to-settle case is another issue on which states differ. Because the availability of punitive damages can be a function of whether an insured can bring a tort claim, a key consideration in determining the availability of those damages is the question of whether a state allows for an independent tort of bad faith or only recognizes bad faith as part of a contractual claim.

Some states do not recognize an independent tort of bad faith. Instead, those states hold that a bad-faith claim is simply a claim that the insured has breached the implied contractual obligation to act in good faith, and those states therefore limit “insured’s remedies for breach of the duty to the traditional remedies for breach of contract.”[50]

For example, as interpreted by the Fourth Circuit, a bad-faith claim under Virginia law is properly considered a breach of contract claim; therefore, punitive damages are not available in an action for bad faith.[51] Thus, in Virginia, an insured may not be able to recover punitive damages against an insurer in a bad-faith failure-to-settle action.

Many other states recognize an independent claim in tort for bad faith.[52] For example, Ohio recognizes an independent tort of bad faith.[53] Thus, in Ohio, insureds may recover punitive damages in bad-faith failure-to-settle claims against insurers.[54]

Punitive damages can be an important component of bad-faith failure-to-settle cases. Because the availability of those damages is dependent on which state’s law will apply to the bad-faith claim, choice of law can be a hotly contested issue in cases involving allegations of a bad-faith failure to settle.

Does a Primary Carrier Owe a Duty to Settle to an Excess Carrier?
Splits among courts with regard to the duty to settle are not limited to the relationship between an insurer and its insured. Courts also come to different results regarding the duty to settle and the relationship between a primary insurer and an excess insurer. In particular, courts have differed on whether an excess carrier may maintain a direct cause of action against a primary carrier for bad-faith failure to settle.

A federal court in New York has stated that “under New York law, the insurer’s duty to act in good faith is also owed directly to any excess insurers.”[55] Thus, in that case, the court allowed two excess insurers’ cross-claims for bad faith against the primary insurer to be tried to the jury. Similarly, a federal court in Louisiana opined that the Louisiana Supreme Court would “hold that under Louisiana law a primary carrier owes a duty to the excess carrier to act reasonably and in good faith.”[56]

On the other hand, the Supreme Court of Michigan found that “the primary carrier does not owe a direct duty to the excess carrier to act in good faith to defend and settle a claim within the former’s policy limits.”[57] However, the excess insurer could still bring an action as a subrogee against the primary insurer for bad-faith failure to settle.[58] This subrogation cause of action is different than a direct cause of action because, in the subrogation cause of action, the excess insurer “acquires no lesser or greater rights than those held by the insured.” Thus, the primary insurer may advance the same defenses against the excess insurer as it could have advanced against the insured; for example, a failure by the insured to cooperate.

Like the issues above, whether a primary insurer owes direct good-faith duties to an excess insurer is determined state by state. Thus, the applicable law governing an excess insurer’s claim against a primary insurer can prove outcome-determinative in these cases.

Conclusion
The issues examined above are only a few that underlying plaintiffs, insureds, primary insurers, and excess insurers may encounter in navigating the settlement of an underlying claim, coverage disputes, and bad-faith litigation. Given the different rules in different states, all of the parties must cautiously consider their options for each decision throughout the settlement process.

Keywords: litigation, bad faith, failure to settle, contract law, tort law, subrogation

Walter Andrews, Syed Ahmad, and Patrick McDermott are with Hunton & Williams LLP in McLean, Virginia.

[1] Walter Andrews is a partner, Syed Ahmad is counsel, and Patrick McDermott is an associate at Hunton & Williams LLP in McLean, Virginia. The opinions expressed in this article are solely those of the authors and may not necessarily reflect those of Hunton & Williams LLP or its clients.
[2] See Am. Physicians Ins. Exch. v. Garcia, 876 S.W.2d 842, 850 (Tex. 1994); Wierck v. Grinnell Mut. Reinsurance Co., 456 N.W.2d 191, 195 (Iowa 1990) (finding that a “bad faith claim cannot be based on settlements never presented to the liability insurance carrier”); Davis v. Home Indem. Co., 659 S.W.2d 185, 189 (Ky. 1983) (finding that one requirement of a bad-faith failure-to-settle claim is that “there has been an offer from the victim to settle within the policy limits”); Van Vleck v. Ohio Cas. Ins. Co., 471 N.E.2d 925, 928 (Ill. App. Ct. 1984) (upholding trial court’s dismissal of bad-faith claim where there was no allegation that insurer had opportunity to settle within the limits of the policy).
[3] Garcia, 376 S.W.2d at 843–44.
[4] Garcia, 376 S.W.2d at 845.
[5] Garcia, 376 S.W.2d at 845.
[6] Garcia, 376 S.W.2d at 845.
[7] Garcia, 376 S.W.2d at 845.
[8] Garcia, 376 S.W.2d at 845–46.
[9] Garcia, 376 S.W.2d at 849–50.
[10] Garcia, 376 S.W.2d at 851.
[11] According to the Garcia court, “[r]equiring the claimant to make settlement demands tends to encourage earlier settlements” because the claimant “stands to benefit substantially and increase the assets available to satisfy any judgment by committing to settle for a reasonable amount within policy limits if the insurer rejects the demand.” Garcia, 376 S.W.2d at 852 n.18. On the other hand, the court concluded that requiring the insurer to make settlement offers may delay settlement. The court explained that “if the insurer offers less than the policy limits, the claimant can reasonably anticipate that the offer will increase as trial approaches,” which would delay settlement. And the court said that even if the insurer offered its policy limits prior to the trial, the claimant would have little incentive to accept those limits because the insurer had established a “floor” for negotiations and could not withdraw its settlement offer without further potential exposure to bad-faith claims.
[12] See State Auto. Ins. Co. of Columbus, Ohio v. Rowland, 427 S.W.2d 30, 35 (Tenn. 1968); Rova Farms Resort, Inc. v. Investors Ins. Co. of Am., 323 A.2d 495, 504–7 (N.J. 1974) (insurer can be liable for bad-faith failure to settle in the absence of a settlement demand within limits, but that absence is one factor to consider in determining whether the insurer acted in bad faith); Badillo v. Mid Century Ins. Co., 121 P.3d 1080, 1095 (Okla. 2005) (“[A] legally binding, unconditional offer of settlement from the claimant is not a prerequisite to maintaining an action of this type where the insured has been exposed to an excess verdict.”); City of Hobbs v. Hartford Fire Ins. Co., 162 F.3d 576, 586 (10th Cir. 1998) (predicting that New Mexico would find that “a cause of action for bad-faith failure to settle can exist in the absence of a firm [settlement] offer”).
[13] 427 S.W.2d at 428.
[14] Rowland, 427 S.W.2d at 428.
[15] Rowland, 427 S.W.2d at 433.
[16] Rowland, 427 S.W.2d at 433–34.
[17] Rowland, 427 S.W.2d at 434 .
[18] Rowland, 427 S.W.2d at 434.
[19] 881 P.2d 1020, 1028 (Wash. 1994).
[20] Public Utility District No. 1, 881 P.2d at 1028.
[21] Public Utility District No. 1, 881 P.2d at 1028.
[22] Public Utility District No. 1, 881 P.2d at 1028.
[23] Public Utility District No. 1, 881 P.2d at 1028.
[24] Public Utility District No. 1, 881 P.2d at 1028.
[25] Public Utility District No. 1, 881 P.2d at 1028.
[26] Public Utility District No. 1, 881 P.2d at 1029.
[27] Public Utility District No. 1, 881 P.2d at 1020.
[28] Public Utility District No. 1, 881 P.2d at 1030.
[29] See, e.g., Vigilant Ins. Co. v. Bear Stearns Cos., Inc., 884 N.E.2d 1044, 1046 (N.Y. 2008); Low v. Golden Eagle Ins. Co., 110 Cal. App. 4th 1532, 1544 (Cal. Ct. App. 2003) (recognizing that California law allows an insurer to enforce provision providing that “no insureds will, except at their own cost, voluntarily make a payment . . . without our consent” without showing prejudice).
[30] 884 N.E.2d at 1046.
[31] Vigilant Insurance Co., 884 N.E.2d at 1046.
[32] Vigilant Insurance Co., 884 N.E.2d at 1046.
[33] Vigilant Insurance Co., 884 N.E.2d at 1047.
[34] Vigilant Insurance Co., 884 N.E.2d at 1048.
[35] Vigilant Insurance Co., 884 N.E.2d at 1048.
[36] Vigilant Insurance Co., 884 N.E.2d at 1048.
[37] Boone v. Vanliner Ins. Co., 744 N.E.2d 154, 158 (Ohio 2001).
[38] Boone, 744 N.E.2d at 155.
[39] Boone, 744 N.E.2d at 155.
[40] Boone, 744 N.E.2d at 155.
[41] Boone, 744 N.E.2d at 155.
[42] Boone, 744 N.E.2d at 155.
[43] Boone, 744 N.E.2d at 155.
[44] Boone, 744 N.E.2d at 155–56.
Boone, 744 N.E.2d at 158. The court also stated that prior to the denial of coverage, “the claims file materials will not contain work product, i.e., things prepared in anticipation of litigation, because at that point it has not yet been determined whether coverage exists.”
[46] Boone, 744 N.E.2d at 158.
[47] 295 P.3d 239 (Wash. 2013).
[48] The insurer may rebut that presumption “by showing that its attorney was not engaged in the quasi-fiduciary tasks of investigating and evaluating or processing the claim, but instead in providing the insurer with counsel as to its own potential liability; for example, whether or not coverage exists under the law.”
[49] See Spiniello Cos. v. Hartford Fire Ins. Co., No. 07-cv-2689, 2008 WL 2775643 (D.N.J. July 14, 2008) (stating that “Boone is the minority rule” and collecting cases “declin[ing] to adopt a per se exclusion to the attorney-client privilege in a bad faith insurance case”).
[50] Marquis v. Farm Family Mut. Ins. Co., 628 A.2d 644, 652 (Me. 1993).
[51] Bettius & Sanderson, P.C. v. Nat’l Union Fire Ins. Co. of Pittsburgh, Pa., 839 F.2d 1009, 1015 (4th Cir. 1988); see also A & E Supply Co., Inc. v. Nationwide Mut. Fire Ins. Co., 798 F.2d 669, 670 (4th Cir. 1986) (finding that Virginia law would not recognize tort of bad faith because “liability for bad faith conduct is a matter of contract rather than tort law”); Adolf Jewelers, Inc. v. Jewelers Mut. Ins. Co., No. 3:08-cv-233, 2008 WL 2857191 (E.D. Va. July 21, 2008) (rejecting insurer’s argument that Virginia recognized bad-faith tort thereby making punitive damages available).
[52] See Canal Indem. Co. v. Greene, 593 S.E.2d 41, 46 (Ga. 2003) (“A claim for bad-faith failure to settle sounds in tort.” (quoting S. Gen. Ins. Co. v. Ross, 489 S.E.2d 53, 58 (Ga. 1997)); Bibeault v. Hanover Ins. Co., 417 A.2d 313, 319 (R.I. 1980) (“An insurer’s bad-faith refusal to settle an insurance claim can give rise to an independent tort action that can result upon a proper showing of an award of both compensatory and punitive damages.”).
[53] See Hoskins v. Aetna Life Ins. Co., 452 N.E.2d 1315, 1320 (Ohio 1983) (“bad faith refusal to settle a claim is a breach of that duty and imposes liability sounding in tort”).
[54] See id.; Zoppo v. Homestead Ins. Co., 644 N.E.2d 397, 402 (Ohio 1994).
[55] Schwartz v. Twin City Fire Ins. Co., 492 F. Supp. 2d 308, 329 (S.D.N.Y. 2007) (citations omitted), aff’d sub nom. Schwartz v. Liberty Mut. Ins. Co., 539 F.3d 135 (2d Cir. 2008).
[56] Nat’l Union Fire Ins. of Pittsburgh, Pa. v. Liberty Mut. Ins. Co., 696 F. Supp. 1099, 1101 (E.D. La. 1988).
[57] Commercial Union Ins. Co. v. Med. Protective Co., 393 N.W.2d 479, 486 (Mich. 1986).
[58] A majority of states follow the view that an excess insurer may bring a cause of action against a primary insurer based on equitable subrogation principles. See, e.g., Twin City Fire Ins. Co. v. Superior Court of State of Ariz. In & For County of Maricopa, 792 P.2d 758, 759 (Ariz. 1990) (recognizing that Arizona allowed excess insurer to sue primary insurer for bad-faith failure to settle under the equitable subrogation doctrine but declining to find that primary insurer owed direct good faith duty to excess insurer); Am. Centennial Ins. Co. v. Canal Ins. Co., 843 S.W.2d 480, 483 (Tex. 1992) (holding “that an excess carrier may bring an equitable subrogation action against the primary carrier”).