Liability Insurance: The Risks of Denying a Duty to Defend

By Greg Johnson. Deciding whether to defend the insured in a third-party lawsuit (which generally involves a comparison between the allegations of the complaint and the policy), can be simple, complex or somewhere in between.  Regardless, insurers should always factor in the potential risks (and associated costs) associated with denying a defense before making its decision.  Those risks (which are the subject of this post and not found in any policy provisions) may militate in favor of extending a defense, at least in “questionable” coverage cases.

A Minnesota “insurer assumes two duties to its insured: the duty to defend and the duty to indemnify.” St. Paul Fire & Marine Ins. Co. v. Nat’l Chiropractic Mut. Ins. Co., 496 N.W.2d 411, 415 (Minn. Ct. App.1993), review denied (Minn. Apr. 29, 1993). The duty to defend is distinct from and broader in scope than the insurer’s duty to indemnify. Wooddale Builders, Inc. v. Maryland Cas. Co., 722 N.W.2d 283, 301-302 (Minn. 2006). “The duty to defend is broader than the duty to indemnify in three ways: (1) the duty to defend extends to every claim that ‘arguably’ falls within the scope of coverage; (2) the duty to defend one claim creates a duty to defend all claims; and (3) the duty to defend exists regardless of the merits of the underlying claims.” Wooddale, 722 N.W.2d at 301-302 (Minn. 2006).

In Minnesota, an insurer that fails to defend its insured against a third-party lawsuit faces several risks. One or more of the following general rules will come into play:

First, the non-defending insurer forfeits its right to control the defense and strategy, including the right to compel the insured’s cooperation in the defense of the lawsuit.

Second, the non-defending insurer will probably be involved in a “duty to defend” declaratory judgment action and will obviously have to pay its coverage counsel to prosecute or defend that action.

Third, if the court determines the insurer was required to defend, the breaching insurer will be obligated to reimburse all “reasonable” defense fees and costs incurred in defending the underlying litigation. See, Lanoue v. Fireman’s Fund Am. Ins. Co., 278 N.W.2d 49, 50 (Minn.1979).

Fourth, if the court determines the insurer was required to defend, the breaching insurer will be required to pay the “reasonable” fees and costs incurred in the declaratory judgment action which established the duty to defend. See, Morrison v. Swenson, 142 N.W.2d 640 (Minn. 1966); American Standard Ins. Co., v. Le, 551 N.W.2d 923 (Minn.1996) (restating rule that attorney fees are recoverable in a declaratory judgment action if there is a breach of a contractual duty, “usually by wrongfully refusing to defend the insured”).

Some jurisdictions have recognized that in a claim of equitable indemnification or contribution (e.g., where a participating insurer paid the insured’s defense costs and seeks reimbursement from the non-participating insurer), the non-participating insurer waives any right to contest the reasonableness of the defense costs. See, e.g., Safeco Ins. Co. of America v. Superior Court,  140 Cal.App.4th 874, 877-882, 44 Cal.Rptr.3d 841, 842 – 846 (Cal. App. 2 Dist. 2006) (by “its refusal to participate [in the defense of the insured], the recalcitrant co-insurer waives the right to challenge the reasonableness of the defense costs . . .”).  This rule makes sense inasmuch as the participating insurer monitored the defense costs and paid the costs as they were incurred — at a time when it did not know whether it would obtain reimbursement of any part of the defense costs it was paying. Further, the “need” to review the defense costs would not have been necessary had the non-defending insured agreed to participate in the defense of the underlying litigation.

Fifth, the non-defending insurer will likely be involved in a “coverage” action (or garnishment proceeding) relating to a settlement (or judgment) between the insured and claimant and the insurer will obviously have to pay its coverage counsel to defend that action.

Sixth, although a non-defending insurer generally retains the right to dispute coverage for the judgment or settlement, it waives its right to approve any settlement the insured may reach with the claimant. The insured is entitled to negotiate a good faith settlement with the claimant and the settlement serves as presumptive evidence of the breaching insurer’s liability. Butler Bros. v. American Fidelity Co., 120 Minn. 157, 139 N.W. 355 (Minn.1913). In an action to enforce the settlement and recover settlement payments, the insured is not required to prove that it was actually liable to the claimant. IdSee, also, Pietras v. Sentry Ins. Co., 513 F. Supp. 2d 983, 986 (N.D. Ill. 2007) (the fact that the insureds “might have been able to dispute the plaintiffs’ claims . . . . does not mean that it was imprudent for them to settle, given the prospect of lengthy, expensive, and time-consuming litigation that they would have had to finance out of pocket”). To require claims to be actually tried in an action to enforce a settlement would defeat the purpose of settlement agreements. In addition, the non-defending insurer may have no right to object to the amount of the settlement unless it can establish bad faith, collusion or fraud. Id. (to require the insured to prove that “the amount paid was not excessive [does] not appeal to our idea of equity or law”); Motors Ins. Co. v. Auto-Owners Ins. Co., 251 Ga. App. 661, 664, 555 S.E.2d 37, 39 (Ga. Ct. App. 2001) (non-defending insurer cannot avoid liability unless it can establish the amount paid in settlement was so excessive as to show evidence of bad faith, or there was other evidence that the settlement was made in bad faith). This is a corollary to the rule that an insurer, which usually has the right to control the litigation, owes the insured a good faith obligation in considering settlement offers. By not defending the insured or acknowledging any obligation to protect the insured against a resulting judgment, the insured is likewise free to enter into a good faith settlement with the claimant. Under this view, the insured is placed in the same position it would have occupied had the policy provided that the insured (as opposed to just the insurer) had the right to make a good faith settlement.

(Note that in a Miller-Shugart settlement — where the insured pays nothing to the claimant in exchange for a release of personal liability and, thus, is “quite willing to agree to anything as long as plaintiff promise[s] them full immunity,” Miller v. Shugart, 316 N.W.2d 729 (Minn. 1982) – the claimant (judgment creditor) is required to prove the settlement was reasonable and prudent.  The settlement will be deemed reasonable in amount where it approximates the amount the insured/tortfeasor “could have been liable for” as opposed to the amount the insured/tortfeasor “would have been liable for.” Osgood v. Medical, Inc., 415 N.W.2d 896, 903 (Minn. Ct. App. 1987), rev. denied (Minn. Feb. 12, 1988).  In Alton M. Johnson Co. v. M.A.I. Co., 463 N.W.2d 277 (Minn. 1990), the Minnesota Supreme Court rejected the argument that an unreasonable Miller-Shugart settlement should exonerate the insurer from liability.  Instead, the Court held that if a Miller‑Shugart settlement is set aside because it is unreasonable in amount, the settlement is unenforceable, but the claimant’s tort action against the insured is reinstated for jury trial.

Some jurisdictions recognize, in a claim of equitable indemnification or contribution (e.g., where a participating insurer defended the insured and settled the claim against the insured) that the non-participating insurer cannot contest the reasonableness of the settlement amount. See, e.g., Safeco Ins. Co. of America v. Superior Court,  140 Cal.App.4th 874, 877-882, 44 Cal.Rptr.3d 841, 842 – 846 (Cal. App. 2 Dist. 2006) (by “its refusal to participate [in the defense of the insured], the recalcitrant co-insurer waives the right to challenge the reasonableness of the . . . amounts paid in settlement”). This rule makes sense inasmuch as the participating insurer, unsure about its prospects of recovering any portion of the settlement, sought to minimize its payment. Further, it is well known that when settling a lawsuit, the settling insurer will take into consideration the prospect of having to pay the future costs of defense, which may be quite large. Had the recalcitrant insurer agreed to contribute to the insured’s defense during the litigation, the insurers may have decided not to settle the lawsuit. The recalcitrant insurer should not be permitted to challenge the reasonableness of the settlement amount in such a case because its breach of contractual obligations probably played some role in the need to settle the case in the first instance.

Thus, assuming there is coverage for the settlement, the non-defending insurer will likely be required to indemnify the insured against a settlement that is greater in amount than that which the insurer could have secured had it participated in the underlying litigation.

Seventh, although the insurer can challenge its liability for the insured’s settlement, it likely has no right to a jury trial. Alton M. Johnson Co. v. M.A.I. Co., 463 N.W.2d 277 (Minn. 1990).

Eighth, several jurisdictions have recognized that by electing not to participate in the defense of the underlying litigation, the insurer can be estopped from requesting any allocation between covered and non-covered damages. See, e.g., Servidone Const. Corp. v. Security Ins. Co. of Hartford, 102 A.D.2d 59, 477 N.Y.S.2d 725, 728 (3d Dep’t 1984), order rev’d, 64 N.Y.2d 419, 488 N.Y.S.2d 139, 477 N.E.2d 441 (1985) (when “insurer breaches its duty to defend, it must indemnify the insured for a reasonably arrived-at settlement because it is impossible to determine on what theory of liability plaintiff might have prevailed”); Prudential Property and Cas. Ins. Co. v. Lawrence, 45 Wash. App. 111, 724 P.2d 418, 423 (Div. 1 1986) (insurer that breaches duty to defend in lawsuit alleging covered and non-covered claims is estopped from denying coverage for a portion of the settlement if the settlement is not itself allocated between covered and non-covered claims); St. Paul Fire & Marine Ins. Co. v. Vigilant Ins. Co., 724 F. Supp. 1173, 1183 (M.D. N.C. 1989), aff’d, 919 F.2d 235 (4th Cir. 1990) (insurer was liable for settlement because the insurer had breached its duty to defend and the “settlement (should be) viewed as a cost of defending the suits”); Pacific Indem. Co. v. Linn, 590 F. Supp. 643, 650-51 (E.D. Pa. 1984), judgment aff’d, 766 F.2d 754 (3d Cir. 1985) (where insurer breached duty to defend and it was “impossible to determine on what theories of liability, if any, the underlying plaintiffs would have prevailed,” the “duty to indemnify must follow the duty to defend” and insurer was liable for the settlement even though only a portion of the injured party’s claims was covered); American Motorists Ins. Co. v. Trane Co., 544 F. Supp. 669, 690 (W.D. Wis. 1982), judgment aff’d, 718 F.2d 842 (7th Cir. 1983) (“I am not prepared to impose upon an insured which has conducted its own defense, negotiated its own settlement, litigated the insurer’s duty to defend, and prevailed in that action, the additional burden of allocating the settlement before it can collect any damages for the insurer’s breach. The insurer had the opportunity to participate in the settlement discussions. Its refusal to do so should not add to the insured’s burden”). Minnesota does not appear to have resolved the issue outside the context of a Miller-Shugart settlement which due to the lack of bona fides in the settlement process, imposes the allocation obligation upon the claimant/judgment creditor).

Ninth, if the insurer failed to communicate all policy defenses to the insured, it may be estopped from raising those defenses that were not disclosed to the insured.  See, SCSC Corp. v. Allied Mut. Ins. Co., 536 N.W.2d 305, 316 fn. 3 (Minn. 1995) (insurer could not rely on pollution exclusion where the insurer failed to assert this defense to the insured: an insurer “cannot . . . rely on its prior silence to defeat its duty to defend”).

In short, a liability insurer who elects not to defend the insured against a third-party lawsuit subjects itself to numerous risks and potential costs. Thus, before making  a determination that the insured is not entitled to a defense, the insurer should make absolutely sure that the complaint and facts known to the insurer at the time it is notified of the suit do not present any set of facts (either directly or inferentially) which, if proven, would subject the insured to a liability which could potentially be covered by the insured’s policy. Crum v. Anchor Cas. Co., 264 Minn. 378, 390‑392, 119 N.W.2d 703, 711 ‑ 712 (Minn. 1963) (where facts alleged in complaint “present a potential liability on the part of the insured covered by the insurance contract, the insurer is obligated to undertake the defense”); Meadowbrook, Inc. v. Tower Ins. Co., Inc.,  559 N.W.2d 411, 415 (Minn. 1997) (insurer’s duty to defend exists unless it “can be concluded as a matter of law that there is no basis on which the insurer may be obligated to indemnify the insured”).  As the above summary indicates, the risks (and costs) associated with making a wrong decision on the “defense” question are quite considerable.

This blog is for informational purposes only.  By reading it, no attorney-client relationship is formed.  The law is constantly changing and if you want legal advice, please consult an attorney licensed in your jurisdiction. © All rights reserved. 2010.

This entry was posted in ADCF Policy, Bad Faith, Coverage, Duty to Defend, Duty to Indemnify and tagged , , , , , , , , , , , . Bookmark the permalink.

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