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Pennsylvania Superior Court Issues Significant Ruling Regarding Insurer's Duty To Indemify Unauthorized Settlement Made By Insured Being Defended Under A Reservation Of Rights

In what is certainly going to prove to be a significant decision that affects the landscape for insurers and insureds alike, the Pennsylvania Superior Court recently issued an opinion addressing the legal standard to be applied when evaluating an insurer's duty to indemnify an insured for an unauthorized settlement made by the insured while being defended under a reservation of rights. In Babcock & Wilcox Co. v. Am. Nuclear Insurers & Mut. Atomic Energy Liab. Underwriters, 2013 Pa. Super. LEXIS 1630 at *6-7 (Pa. Super. June 10, 2013), the court was called on to decide whether the settlement should be evaluated under the "bad faith" standard articulated in Cowden v. Aetna Casualty and Surety Co., 134 A.2d 223 (Pa. 1957), or the "fair and reasonable" standard formulated in Alfiero v. Berks Mutual Leasing Co., 500 A.2d 169 (Pa. Super. 1985).

At the trial court level, the insurer argued that the Cowden standard should apply because the insured, not the insurer, breached its obligations under the policy when it settled without the insurer's consent. Id. at 6-7. The Honorable Stanton Wettick rejected this argument because the insurer was defending the insured under a reservation of rights under which the insurer could later deny coverage. Id. at 13-16. According to Judge Wettick, because the reservation of rights pitted the insurer's interest against the interests of the insured, the insured had a right to protect its interests and be indemnified as long as the settlement was "fair and reasonable." Id. at 14-16. In essence, Judge Wettick found that a defense provided under a reservation of right exposed the insured to the same risks that it would face if the insurer had outright denied coverage and a defense. Id. at 15. In support of his conclusion, Judge Wettick looked to the decisions of other courts that had resolved the issue similarly, including the Arizona Supreme Court's decision in United Servs. Auto. Ass'n v. Morris, 741 P.2d 246 (Ariz. 1987). Id. at 16-17.

On appeal, the Pennsylvania Superior Court reversed Judge Wettick's decision. The court began its analysis by discussing Pennsylvania caselaw that recognizes that an insurer who defends under a reservation of rights does not breach its duty to its insured and the insurer's corresponding right to control the defense. Id. at 28-30. Moreover, in rejecting the line of reasoning in cases like Morris, the court called attention to the fact that an insurer who defends its insured under a reservation of rights has not breached any duty to the insured under the policy. Id. at 38-39. Consequently, the court concluded that it was improper to adopt a "fair and reasonable" standard that was predicated upon the concept of an insurer's breach of its duty to its insured. At the same time, however, the court also found unavailing the reasoning in cases that cursorily dismissed the risks to an insured being defended under a reservation of rights. Id. at 40-42.

To resolve the perceived shortcomings in the reasoning in these lines of cases, the court looked to a third approach, which had not been advanced by either of the parties. Id. at 43-44. The third approach adopts a framework that the court believed balances the competing interests of the insurer and the insured in the reservation of rights context by allowing the insured to reject a defense made under a reservation of rights. If the defense is rejected by the insured, then the "fair and reasonable" standard set forth in Alfiero should apply to determine the extent to which the insurer is obligated to indemnify the insured for the unauthorized settlement. Id. at 57-58. Conversely, if the insured accepts the insurer's tender of a defense under a reservation of rights, then the insurer's duty to indemnify should be evaluated under the "bad faith" standard articulated in Cowden. Id. at 57.

The dissent in the case was critical of the majority's approach. Although it concurred in the result, it believed that Cowden resolved the issue. In addition, the dissent expressed its concern that the majority's approach "will disturb the settled expectations of both insureds and insurers alike."

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