10th Circuit Case Reinforces Limits of Insurer’s Duty to Settle Disputed Claims

A recent federal appeals court case applying Utah law goes to the heart of the conflict that arises between a policyholder and insurer when an insurer defends a policyholder under a reservation of rights and receives a settlement offer. The case is Owners Ins. Co. v. Dockstader, No. 19-4156 (10th Cir. June 29, 2021).

The facts are straightforward. A third-party claimant suffered a brain injury during a fight in a gym. The tortfeasor’s liability insurer, Owners Insurance Company, agreed to defend the tortfeasor under a reservation of rights, and filed a declaratory judgment action for a ruling that its policy did not cover the policyholder’s conduct. The third-party claimant made a settlement offer for the policy limit of $500,000. Owners accepted the offer, but only on the condition that coverage was found to exist in the declaratory judgment action. The third-party claimant entered into a settlement with the policyholder in excess of policy limits but agreed not to execute the judgment against the policyholder personally in exchange for an assignment of the policyholder’s rights. The third-party claimant subsequently intervened in the declaratory judgment action, alleging that Owners breached its fiduciary duties and the implied covenant of good faith and fair dealing by failing to settle within policy limits, even though the policyholder faced a significant likelihood of judgment in excess of those limits. The district court granted Owners summary judgment on its declaratory judgment action and on the third-party complaint.

The Tenth Circuit affirmed the judgment of the District Court. The Tenth Circuit reasoned that the duty to defend does not include an absolute duty to settle, even where the insurer has filed a declaratory judgment action disputing coverage and the district court ultimately finds none. The crux of the opinion was that an insurer cannot have acted in bad faith by refusing to settle a non-covered claim. To a casual observer, this seems like an obvious proposition: an insurer should not have to pay an uncovered claim. But the issue is more complicated because, when an insurer assumes the defense of its policyholder and the policyholder’s exposure appears likely to exceed policy limits, a conflict of interest arises between the policyholder and its insurer. While the insurer’s liability is generally capped at the policy limits, the policyholder could be held liable for amounts in excess of policy limits. To protect the policyholder in these situations, most jurisdictions impose a duty on an insurer to accept a settlement offer that is reasonable and within policy limits when a substantial likelihood exists that the verdict will exceed policy limits. When an insurer breaches this duty, it can be held liable for the full verdict against the policyholder, including amounts in excess of policy limits.

The drama often occurs because insurers almost always receive a settlement demand before a court has decided coverage. As Dockstader explains, these situations present a classic case of risk, pitting the policyholder against the insurer. If an insurer refuses to settle within policy limits, it may later be on the hook for any judgment in excess of policy limits. Conversely, if an insurer refuses to settle within policy limits and it is later found there is no coverage, the policyholder may be fully liable. But, this is exactly the situation that would unfold had no settlement offers been made, and this is exactly what happened in Dockstader. As the Court explained, Owners “bet” that there was no coverage, and in doing so, potentially exposed itself to a bad-faith claim and exposure in excess of its policy limits. This risk to Owners is what made the “bet” meaningful. All that happened in Dockstader was that the insurer’s gamble paid off. The court’s decision was merely the money in the pot.

Dockstader produced a curious dissent siding with the policyholder. The dissent focused exclusively on the fact that an insurer who assumes the defense of a policyholder controls the disposition of the claim and therefore must zealously guard the policyholder’s interests as it would its own. The dissent would have judged Owners’ actions by only the facts that existed at the time the offers were made, which in Dockstader’s case, preceded the finding of no coverage. The dissent’s observation – that an insurer defending a policyholder must guard the policyholder’s interest as it would its own – is true insofar as it goes. The fiduciary duty an insurer owes to its policyholder in these situations does not preclude an insurer from betting with its own money that a claim is not covered and exposing itself to a judgment in excess of policy limits. It’s one thing to say that an insurer should be penalized when it loses that bet. It’s an entirely different thing to say that an insurer should be punished when it wins the bet, as Owners did in Dockstaders. Under the dissent’s view, an insurer would have to pay an uncovered claim so long as a third-party claimant made a settlement offer before a court rendered a decision about coverage.

Still, the dissent in Dockstader correctly pointed out that an insurer’s liability for an excess judgment (even if there is a finding of coverage) is not automatic, and there was a possibility that Owners was betting with the policyholder’s money. It is true that an insurer can avoid liability for the amounts of an excess judgment if the insurer’s refusal of a settlement offer within policy limits was reasonable. But this is not a pro-insurer loophole. It is simply a reflection of a sensible rule that an insurer should not be liable for more than it contractually agreed to pay (its policy limits) except in those circumstances where it has been found to have acted unreasonably or in bad faith.