The Liability Insurance project has attracted much attention from insurers, policyholders and their counsel, as well as academics and judges. As the project nears its end, The ALI Adviser will share several sections of the project, including Black Letter and Comments, detailing how Reporters have responded to concerns, and have worked with all sides on the project to restate the law.
This first post of the series deals with “The Insurer’s Duty to Make Reasonable Settlement Decisions.”
The project specifically uses the phrase “duty to make reasonable settlement decisions,” rather than “duty to settle.” The Reporters use this phrase to emphasize that “duty to settle” is not entirely accurate; rather, there is a duty to make reasonable decisions in relation to settlement.
The latest draft of the project, Council Draft No. 3, will be discussed at the Council meeting in January 2017. It has not been approved by ALI’s Council or membership.
From the Reporters:
This draft of § 24 differs from the version previously approved by Council in the Comments, which now make clearer that the standard is that of the “reasonable insurer.” In this regard, we have now adopted the position advocated by Mr. Cusumano in his proposed amendment at the May Meeting, which we opposed at the time. The change in position is the result of intense engagement with this topic in connection with preparing the Sections on bad faith, as well as continued discussion with Advisers and Members.
Black Letter and Comment from Council Draft No. 3:
- 24. The Insurer’s Duty to Make Reasonable Settlement Decisions
(1) When an insurer has the authority to settle a legal action brought against the insured, or the authority to settle the action rests with the insured but the insurer’s prior consent is required for any settlement to be payable by the insurer, and there is a potential for a judgment in excess of the applicable policy limit, the insurer has a duty to the insured to make reasonable settlement decisions.
(2) A reasonable settlement decision is one that would be made by a reasonable insurer who bears the sole financial responsibility for the full amount of the potential judgment.
(3) An insurer’s duty to make reasonable settlement decisions includes the duty to make its policy limits available to the insured for the settlement of a covered legal action that exceeds those policy limits if a reasonable insurer would do so in the circumstances.
a. A duty to make reasonable settlement decisions rather than the “duty to settle.” The duty set forth in this Section is a longstanding rule of insurance law that is frequently referred to in shorthand by commentators and some courts as the “duty to settle.” This Section uses a more accurate term, the “duty to make reasonable settlement decisions,” to emphasize that the insurer’s duty is not to settle every legal action, but rather to protect the insured from unreasonable exposure to a judgment in excess of the limits of the liability insurance policy. Although a strict-liability standard of the sort that might be suggested by the label “duty to settle” would eliminate the need for the reasonableness evaluation, a strict-liability standard has not found favor in the courts. Moreover, the reasonableness standard followed in this Section is more closely tailored to the conflict of interest that underlies the legal duty.
The insurer’s duty to make reasonable settlement decisions arose as a special application of the general contract-law duty of good faith and fair dealing in the context of insurance policies that granted the insurer discretion over the settlement of an insured liability action. As courts early recognized, when the insured faces a potential judgment in excess of the policy limit (an “excess judgment”), the insurer may have an incentive to undervalue the possibility of a loss at trial, since a portion of that loss will be borne by the insured rather than by the insurer, absent a legal rule assigning the risk of excess judgment to the insurer. For example, if an insurer receives a settlement offer that is equal to or just under the policy limits, the insurer has little financial incentive, other than reduction in defense costs, to accept that offer as long as there is some chance of a judgment at trial in favor of the defense. By going to trial in such cases, the insurer maintains the possibility of eliminating its own liability by winning the case against the claimant. Moreover, as long as the insurer’s liability is bounded by the policy limit, taking the case to trial imposes no added risk on the insurer, beyond the additional defense costs required to try the case. As courts have described this conflict-of-interest problem, an insurer that rejects a reasonable settlement offer in favor of going to trial is effectively “gambling with the insured’s money,” or gambling with the excess insurer’s money, since the insured or the insured’s excess insurer will have to pay any verdict in excess of the policy limit.
The duty to make reasonable settlement decisions creates an incentive for insurers to take into account this risk to insureds and excess insurers. Because the purpose of the duty to make reasonable settlement decisions is to align the interests of insurer and insured in cases that expose the insured to damages in excess of the policy limits, the duty is owed only with respect to the exposure to such excess damages. With respect to liability for damages within the policy limits, the insurer’s contractual liability for those damages already provides an incentive for the insurer to make reasonable settlement decisions.
b. Equal consideration and the “disregard the limits” rule. In the insurance context, the general duty of good faith and fair dealing is often described as requiring the insurer to give equal consideration to the interests of its insured. The duty to make reasonable settlement decisions can be similarly described as requiring the insurer to give equal consideration to the insured’s exposure in excess of the policy limits. When there is the potential for a judgment in excess of the policy limit, equal consideration requires managing the litigation and settlement process in a manner that neutralizes, to the extent possible, the conflict of interest described in Comment a. Courts and commentators use a variety of verbal formulas to articulate that requirement more precisely. The standard stated in subsection (2) implements the equal-consideration requirement in actionable terms. A reasonable settlement offer is one that would be accepted or made by a reasonable insurer that bears the sole financial responsibility for the full amount of the potential judgment. Courts and commentators sometimes refer to this formulation of the standard as the “disregard the limits” rule, because it requires the insurer to evaluate the reasonableness of a settlement offer without regard to the policy limits, or, to put it another way, in a manner that “disregards the limits” of the policy.
c. Relationship to the duty of good faith and fair dealing. Because of its origins in the duty of good faith and fair dealing, courts in some jurisdictions refer to the standard for breach of the duty in the settlement context as one of “bad faith.” That formulation suggests the need to prove some bad intent on the part of the insurer that goes beyond the reasonableness standard stated in this Section, and some courts do require such a showing. In most breach-of-settlement-duty cases, however, even those that invoke the language of bad faith, the ultimate test of liability is whether the insurer’s conduct was reasonable under the circumstances. To make clear that an insurer’s settlement duty is grounded in commercial reasonableness, this Section does not use the term “bad faith” to describe the insurer’s breach of the duty to make reasonable settlement decisions. Under the rule followed in this Restatement, an insurer is subject to liability for insurance bad faith only when it fails to perform its duties under a liability insurance policy without a reasonable basis for its conduct and with knowledge or in reckless disregard of its obligation to perform. See § 51. A liability insurer that breaches the duty to make reasonable settlement decisions is subject to liability for damages under § 27, but it is not thereby subject to liability for insurance bad faith unless the insured also satisfies the requirements of § 51. See Comment d to § 51. If the insured does satisfy the requirements of § 51, the insurer will be liable not only for the excess verdict and other damages under § 27 but also for the damages set forth in § 52 (including attorneys’ fees, any other loss proximately caused by the insurer’s bad-faith conduct, and, if the insurer’s conduct meets the applicable state-law standard, punitive damages).
d. Applying the reasonableness standard. The “reasonable insurer” referred to here is a legal construct, similar to that of the “reasonable person” in tort law. As such, it can be understood as an average or ordinary insurer that sells liability insurance of the kind and in the amounts of the liability insurance policy at issue. The duty to make reasonable settlement decisions includes the duty to accept a settlement offer that a reasonable insurer would accept and to make an offer to settle when a reasonable insurer would do so, if that reasonable insurer had sold an insurance policy with limits that were sufficient to cover any likely outcome of the legal action. See also Comment f (on the insurer’s failure to make settlement offers).
In determining whether a settlement decision was reasonable, the factfinder should view the settlement decision from the perspective of the parties at the time the settlement decision was made. A reasonable insurer is expected, at the time of the settlement negotiations, to take into account the realistically possible outcomes of a trial and, to the extent possible, to weigh those outcomes according to their likelihood. In a complex case, these evaluations are difficult, both for the insurer making the settlement decision and for the trier of fact in a subsequent suit challenging the reasonableness of the insurer’s settlement decision. This difficulty, however, cannot be avoided. If a reasonableness standard is to be applied, such qualitative evaluations are inevitable. The insurer will be liable for any excess judgment against the insured in the underlying litigation if the trier of fact finds that the insurer rejected a settlement offer that a reasonable insurer would have accepted (or failed to consent to a settlement to which a reasonable insurer would have consented).
In evaluating the reasonableness of an insurer’s settlement decisions, the trier of fact may consider, among other evidence, expert testimony as well as testimony from the lawyers and others involved in the underlying insured liability claim. The reasonableness of settlement offers may also take into account other facts, such as the amount of time that is given to evaluate an offer and the jurisdiction in which the case would be tried. It is also appropriate for the trier of fact to consider the procedural factors addressed in Comment e. It is important to note that this standard takes into account only the interests of the parties in relation to the legal action at issue, not the insurer’s interest in minimizing the overall size of the losses in its portfolio of claims. Otherwise, the insurer would not be giving equal consideration to the interests of the insured.
The effect of this rule is that, once a claimant has made a settlement offer in the underlying litigation that a reasonable insurer would have accepted, an insurer that rejects that offer thereafter bears the risk of an excess judgment against the insured at trial. One practical effect of this rule is to give claimants an incentive during the pretrial phase to make reasonable settlement offers within the policy limits, since the insurer’s rejection of such an offer sets the stage for a subsequent breach-of-settlement-duty lawsuit in the event of a verdict that produces an excess judgment that is covered by the policy. In that subsequent lawsuit, it will not be sufficient for the policyholder to simply demonstrate that the amount of the offer was reasonable; the policyholder must also demonstrate that a reasonable insurer would have accepted the offer. Nevertheless, evidence that the amount of the offer was reasonable would ordinarily be enough to make the reasonableness of the insurer’s decision to reject the offer a question of fact.
- A claimant files a personal-injury lawsuit against the insured seeking damages. The insured has a duty-to-defend liability insurance policy that assigns settlement discretion to the insurer. The policy contains a policy limit of $75,000 and no deductible. The claimant offers to settle for $45,000. The insurer rejects the offer. The case proceeds to trial and a judgment of $175,000 is entered against the insured. In a subsequent action for breach of the duty to make reasonable settlement decisions, the insured introduces evidence supporting the conclusion that, at the time of the settlement negotiations, $45,000 was a reasonable settlement value of the case, based on the judgment that it was reasonable to conclude that the plaintiff had a 30 percent chance of success and likely damages of $150,000. Based on this evidence a trier of fact could conclude that a reasonable insurer would have accepted the offer and, thus, the insurer breached its duty.
- Same facts as Illustration 1, except that the insurer makes a counteroffer of $35,000 and, in the subsequent breach-of-settlement-duty case, the adjuster managing the claim for the insurer testifies that, based on her extensive experience managing similar claims, she believed that the claimant would eventually accept the counteroffer. The parties offer conflicting expert testimony regarding the reasonableness of the adjuster’s decision to reject an offer that represented a reasonable settlement value of the suit in these circumstances. Even if the trier of fact concludes that the adjuster had made every reasonable effort to become informed about the suit and honestly held the opinion to which she testified and, accordingly, that the rejection of the settlement offer was in good faith, the trier of fact could nevertheless conclude that a reasonable insurer would have accepted the initial offer, and, thus, the insurer breached its duty. Based on this evidence, the trier of fact could also conclude, however, that the insurer did not breach its duty.
e. Procedural factors may be considered. The reasonableness standard requires the trier of fact in the breach-of-settlement-duty suit to evaluate the expected value of the underlying legal action at the time of the failed settlement negotiations. That inquiry may be complex and difficult in some cases. Because of the difficulty of determining, in hindsight, whether a settlement offer was reasonable, it is appropriate for the trier of fact to consider procedural factors that affected the quality of the insurer’s decisionmaking or that deprived the insured of evidence that would have been available if the insurer had behaved reasonably. Factors that may affect the quality of the insurer’s decisionmaking include: a failure to conduct a reasonable investigation, a failure to conduct negotiations in a reasonable manner, a failure to follow the recommendation of its adjuster or chosen defense lawyer, and a failure to seek the defense lawyer’s assessment of the settlement value of the case. Factors that may deprive the insured of evidence include: a failure to conduct a reasonable investigation, a failure to follow the insurer’s claims-handling procedures, a failure to keep the insured informed of within-limits offers or the risk of excess judgment, and the provision of misleading information to the insured.
Such factors are not enough to transform a plainly unreasonable settlement offer into a reasonable offer, but they can make the difference in a close case by allowing the jury to draw a negative inference from the lack of information that reasonably should have been available or from the low quality of the insurer’s decisionmaking and fact-gathering processes. Just as reasonable investigation and settlement procedures cannot guarantee that an insurer will make a decision that is substantively reasonable, however, the failure to employ reasonable procedures does not necessarily mean that the insurer’s decision was substantively unreasonable. In breach-of-settlement-duty cases in which the facts do not make clear that the insurer’s settlement decision was substantively reasonable, however, the factfinder may decide based on these other procedural factors that the settlement decision was unreasonable. In an extreme case, the insurer may be subject to liability for bad-faith breach. See § 51.
- A claimant files a tort suit against the insured seeking compensatory damages of $500,000. The insured has a duty-to-defend liability insurance policy that assigns settlement discretion to the insurer, with a policy limit of $100,000. Early in the litigation the claimant makes a time-limited settlement offer for the policy limits directly to the insurance claims manager, giving the insurer 60 days to investigate and either accept or reject the offer. The insurer immediately rejects the offer without conducting a reasonable investigation. The claim goes to trial and results in a jury verdict against the insured of $500,000. In the subsequent breach-of-settlement-duty lawsuit brought by the insured against the insurer, the trier of fact may, but need not, properly conclude from the insurer’s failure to investigate and failure to inform the insured of the offer that the insurer’s settlement decisions were unreasonable. If the trier of fact concludes that the $100,000 offer was above the range of reasonableness and that the claimant was unwilling to accept any reasonable settlement offer from the insurer or insured, the insurer will not be held liable for the excess judgment.
f. The insurer’s failure to make settlement offers and counteroffers. There is no hard and fast rule regarding the insurer’s obligation to make offers. It is a question of what a reasonable insurer would do in the circumstances. In the absence of a reasonable offer by the plaintiff, there can be circumstances in which an insurer has a duty to make a settlement offer, such as, for example, a suit in which the policy limits are significantly less than the reasonable settlement value of the case. In such circumstances, the insurer is obligated to attempt to protect its insured from an excess judgment. By making a reasonable settlement offer, the insurer can avoid potential liability for an excess judgment, even if that offer is rejected. It is important to emphasize, however, that the insurer has no obligation to make an offer unless a reasonable insurer that bore the sole financial responsibility for the full amount of the judgment would do so, and there may be good reasons not to.
g. The causation difference between rejecting a settlement offer and choosing not to make an offer. An insurer’s decision to reject a reasonable settlement offer made by a claimant potentially has different consequences than an insurer’s decision not to make its own reasonable settlement offer, even in those situations in which a reasonable insurer would have made such an offer. The difference comes from the causation requirement in an action for breach of the duty. When an insurer breaches the duty by failing to accept a settlement offer (in situations in which failing to accept such an offer constitutes a breach of the duty), and the case goes to trial resulting in an excess judgment against the insured, the causation requirement is satisfied: had the insurer accepted the settlement offer, there would have been no trial and no possibility of an excess judgment. By contrast, when the insurer breaches the duty by failing to make its own settlement offer (in situations in which failing to make its own settlement offer constitutes a breach of the duty), and the case goes to trial and an excess judgment ensues, causation remains in question. The insurer’s failure to make an offer caused the excess judgment only if the claimant would have accepted a reasonable offer from the insurer. Proving causation is difficult. Before the trial, the claimant would have been in the best position to answer the question whether he or she would have accepted the settlement offer, but after the trial the claimant’s interests will often be too closely aligned with those of the insured defendant to be objective. Other good sources of objective evidence on the matter will be scarce. Nevertheless, a trier of fact may conclude that an insurer’s decision not to make a settlement offer or counteroffer constitutes an unreasonable settlement decision.
- A claimant files a personal-injury lawsuit against the insured seeking damages. The insured has a duty-to-defend liability insurance policy that assigns settlement discretion to the insurer. The policy contains a policy limit of $100,000 and no deductible. As found by the trier of fact in a subsequent action for breach of the duty to make reasonable settlement decisions, reasonable estimates of the value of the underlying claim range between $30,000 and $45,000. The claimant makes no settlement offers during the period leading up to the trial. The insurer, however, makes a settlement offer of $35,000, which is rejected by the claimant. The jury in the personal-injury lawsuit finds for the claimant and awards damages of $150,000. The insurer is not subject to liability for the amount of the judgment in excess of the policy limits. By making a reasonable settlement offer in a circumstance in which the claimant did not make a reasonable settlement offer, the insurer satisfied its duty to make reasonable settlement decisions.
- Same facts as Illustration 4, except that the insurer, rather than making a $35,000 settlement offer, makes a $5000 settlement offer, well below the minimum reasonable offer. The claimant rejects the offer. The insurer makes no other settlement offers. The case then goes to trial, resulting in a jury verdict of $150,000 for the claimant, which includes an excess judgment of $50,000. The trier of fact in a subsequent action alleging breach of the duty to make reasonable settlement decisions may take into account that the insurer, having received no reasonable settlement offer from the insured, failed to make a reasonable settlement offer of its own. Indeed, the trier of fact may conclude from this fact, in the absence of compelling reasons to the contrary, that the insurer acted unreasonably and thus breached its settlement duty. Whether the insurer is subject to liability for the amount in excess of the policy limits for any breach, however, will depend on whether the trier of fact determines that the claimant would have accepted a reasonable offer.
- Same facts as Illustration 4, except that the claimant makes a settlement offer of $45,000, which is at the high end of the reasonableness range. The insurer rejects that offer and makes a counteroffer of $35,000 in circumstances in which a reasonable insurer would have accepted the $45,000 offer. The claimant rejects the insurer’s offer, and the settlement negotiations break down. The case goes to trial, resulting in a $150,000 judgment against the insured, which is $50,000 more than the policy limits. In the subsequent breach-of-settlement-duty case against the insurer, the insurer is subject to liability for the full amount of the judgment, because the insurer rejected a settlement offer in the underlying litigation that a reasonable insurer would have accepted.
h. Settlement offers in excess of policy limits. In some cases the expected value of the underlying legal action is greater than the limits on coverage contained in the policy. In such cases a reasonable insurer that bore the risk of the entire liability would settle the case for an amount in excess of the policy limits. The duty to make reasonable settlement decisions, however, does not obligate the insurer to accept or make such settlement offers in excess of its policy limits. In such cases the insurer may satisfy the duty by informing the insured that the insurer is prepared to offer the policy limits toward a reasonable settlement. The insurer may also make the insured aware of the option to pay the amount of the settlement in excess of the policy limits and explain why the insurer has concluded that settlement would be reasonable (for example, by pointing out the high likelihood of an excess judgment in the event of a trial). If the insured opts not to pay to settle in excess of the policy limits, the insurer is not thereby excused from its obligation to defend the claim. See § 18 (terminating the duty to defend). This duty to make the policy limits available to the insured in response to reasonable settlement offers in excess of the policy limits is sometimes referred to as the “duty to contribute.” The duty to contribute does not apply to settlement offers that are unreasonable.
- A claimant files a tort suit against the insured seeking compensatory damages of $500,000 and punitive damages of $700,000. The insured has a duty-to-defend liability insurance policy that gives settlement discretion to the insurer and provides coverage for punitive damages, which are insurable in the jurisdiction. The policy also contains a policy limit of $500,000 and no deductible. At the time of settlement negotiations in the underlying tort action, the reasonable settlement value of the case ranges between $525,000 and $600,000. The claimant makes a settlement offer of $545,000. A reasonable insurer—a rational insurer who is the sole holder of the full $1.2 million potential liability—would accept the offer. The insurer satisfies its obligations under the duty to make reasonable settlement decisions by notifying the insured of the offer and by offering to contribute the policy limits in support of the settlement. The insurer has no obligation to pay more than the policy limits to settle the claim.
i. No direct duty owed to excess insurers. The duty stated in this Section is owed to insureds, not to excess insurers. Excess insurers nevertheless may recover through equitable subrogation for damages incurred as a result of a breach of the duty to make reasonable settlement decisions. Excess insurers’ subrogation rights are addressed in § 28.
j. No duty owed to third parties. The duty to make reasonable settlement decisions is owed to insureds, not to the third-party claimants that bring tort suits against insured defendants. A claimant has no independent common-law right to recover against the insurer for breach of the duty to make reasonable settlement decisions. The courts in a few states have interpreted state insurance consumer-protection statutes to grant tort claimants an implied statutory private right of action against insurers for unfair settlement practices in individual cases. The majority of states that have addressed this question have found no such implied right of action in individual cases. This Section follows the majority rule. Imposing a direct duty to tort claimants in individual cases could distort the market for liability insurance, because insurers would be subject to liability for conduct that would be permissible for an uninsured defendant. An insured may assign its rights under a liability insurance policy, including for breach of the duty to make reasonable settlement decisions, to a third-party claimant. See § 37.
k. Mandatory rules. Insurers may avoid the rules stated in this Section by structuring insurance policies that do not give the insurer the kind of control over settlement that leads to the conflict of interest that these rules address. As long as insurance policies grant insurers that control, however, the duty to make reasonable settlement decisions is a mandatory rule that is properly understood as an application of the general contract-law duty of good faith and fair dealing.