On July 21, the Supreme Court of Pennsylvania announced a rule that frees policyholders to settle claims without insurer consent when the insurer seeks both to retain the right to deny coverage for the claim and also refuses to consent to an objectively reasonable and non-collusive settlement.  This case, arising out of hundreds of bodily injury and property damage claims alleging harmful effects from nuclear facility emissions, strikes a balance between the insurer's election to defend under a reservation of rights, and the policyholder's concern for liability that might not be covered by its policy.  In a thoughtful opinion written by Justice Baer, the Court placed a limit on the insurer's reservation of rights that is combined with a refusal to settle claims.  The Court acknowledged that there are legitimate interests that favor permitting insurers to reserve a right to deny coverage, but held that a reserving insurer does not have free reign to refuse consent to reasonable settlements.  The Court reviewed the competing approaches applied in other states but declined to make a choice based on a simple "tally" of jurisdictions.  Instead, the court carefully considered the interests at stake for both the insurer and policyholder, including the substantial uncertainties that arise when the interests of the policyholder and insurer are not aligned.  Adopting a version of the rule set out in the Supreme Court of Arizona's opinion in United Services Auto Ass'n v. Morris, 741 P.2d 246 (Ariz. 1987), the Court held:

"[I]f 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. . . ."  The Court also would require the policyholder to establish that the settled liabilities were, in fact, covered by insurance.

By reserving the right to deny coverage, insurers must relinquish the power to force the policyholder to forego reasonable settlement opportunities  for covered claims.  A key rationale for the Court's decision was that the policyholder otherwise would be bound to pass up reasonable settlement prospects while at peril of having to pay the full claim (potentially at a much larger amount than the proposed settlement) if ultimately the claim is not covered.

The Pennsylvania approach is consistent with the current draft of the Restatement of the Law of Liability Insurance being prepared by the American Law Institute, which provides:

§ 25. The Effect of a Reservation of Rights on Settlement Rights and Duties

(3) When an insurer has reserved the right to contest coverage for a claim, the insured may settle the claim without the consent of the insurer and without violating the duty to cooperate or other restrictions on the insured's settlement rights contained in the policy, provided the following requirements are met:

(a) The insurer is given the opportunity to participate in the settlement process;

(b) The insurer declines to withdraw its reservation of rights after receiving prior notice of the proposed settlement;

(c) A reasonable person that bore the sole financial responsibility for the full amount of the potential covered judgment would have accepted the settlement; and

(d) If the settlement includes payments for damages that are not covered by the liability insurance policy, the portion of the settlement allocated to the insured component of the claim is reasonable.

Restatement of the Law, Liability Insurance at § 25(3) (Discussion Draft April 30, 2015).

Pennsylvania now has two separate but related rules of law regarding settlements refused by insurers:

(1)  The rule announced in Babcock, above, under which the policyholder can recover up to the policy limits in the case of a reasonable settlement that is refused and the insurer maintains a reservation of the right to deny a claim that ultimately is determined to have been covered; and

(2) The rule of Cowden v. Aetna Cas. & Sur. Co., 134 A.2d 223 (Pa. 1957), under which the policyholder can recover amounts in excess of policy limits when an insurer refuses a settlement in bad faith.

Justice Eakin (joined by Justice Saylor) submitted a concurring and dissenting opinion, in which he wrote that he would have imposed a bad faith standard such as that described in Cowden.  A principal rationale for the dissent is that the parties have bargained to give the insurer control over settlement when it is defending a claim.  A point not addressed by the dissent, however, is that the insurer's "reservation of rights" to deny coverage is a court-sanctioned practice rather than a right that appears in the policy text, and the rule announced in Babcock simply places a limitation on insurer's rights once it invokes such a reservation.  In this case, the insurers had maintained a reservation of the right to deny coverage for approximately two decades.

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