Gambling With Coverage: Primary Insurers and the Bad Faith Failure to Settle
A recent Illinois opinion of the 7th Circuit has explored the extra contractual liability of a primary insurer that failed to give timely notice to its policyholder of the possibility that the claims against it would exceed its $1 million limit. In so holding, the esteemed panel (Easterbrook, Posner, Tinder) held that primary insurer's not only have a fiduciary duty to give notice of the risk of an excess verdict but this risk creates a conflict of interest entitling the insured to appoint its own defense counse.
In R.G. Wegman Construction Co. v. Admiral Ins. Co., 09-2022 (7th Cir. January 14, 2011), a worker at a construction site managed by Wegman Construction was injured in a fall and sued Wegman as an additional insured on the subcontractor’s policy. The policy in question had a One Million Dollar limit. The claim was duly tendered to Admiral which appointed defense counsel and controlled the defense thereafter.
On the eve of trial, the insured learned inadvertently that there was a substantial risk that the case, if it resulted in a plaintiff’s verdict, would exceed the $1 million limit. At that point, Wegman hired his own defense counsel. He also gave notice for the first time to his excess insurer but coverage was denied on the basis of late notice.
The case proceeded to trial and resulted in a $22 million judgment. Worse, even though defense counsel had hoped that the insured’s liability would be 25% or less such that the plaintiff could only recover its proportional damages from the insured under Illinois’ “joint and several” rules, Wegman was held liable for 27% and thus became responsible for the entire judgment.
Reviewing this unhappy set of facts, the Seventh Circuit declared that a conflict of interest had arisen once Admiral became aware that there was a risk of an excess judgment. In this case, the court found that such facts should have become apparent by the time that the underlying plaintiff's deposition was taken, two years before trial and certainly by the date that the plaintiff demanded $6 million in settlement.
The court refused to find that this conflict was eliminated merely because the settlement demand was inflated or because the likelihood was that the case would not result in an excess judgment. The court observed that even if there was a 90% likelihood of the case being resolved within limits, these disparate outcomes create entirely different attitudes on the part of the insured and insurer with respect to whether to settle or not.
The Court rejected Admiral’s argument that there was no actual conflict of interest requiring notice to the insured until actual settlement negotiations had begun. Rather, the Court held that, having controlled the defense, Admiral had a duty to warn its insured when that control created a conflict of interest. The Court also rejected Admiral’s argument that it was the obligation of its appointed defense counsel to give notice to the policyholder holding that the duty to notify of a conflict of interest is the responsibility of the insurer and cannot be contracted away without the policyholder’s consent.
In light of the existence of this conflict, it is incumbent on the insurer to give notice to its policyholder of the risk of an excess judgment once that risk becomes apparent. Otherwise, in the view of the court, the insurer breaches its fiduciary obligations by "gambling with the insured's money." Once notified, the insured may take appropriate steps to protect its own interests, including hiring independent counsel of the insured's own choosing, whose fees must be paid by the insurer as Peppers counsel. The Seventh Circuit therefore found that the Illinois District Court had erred in granting summary judgment to Admiral and remanded the case back to the trial court to determine whether there was merit to Wegman's bad faith claims. The court made clear, however, that the insured's burden of proof in this case will not be as onerous as would ordinarily be the case. Although in most cases the policyholder would have the additional obligation of proving not only that the insurer breached its obligations but that the case could have settled within the $1 million primary limit, in this case such proof was likely not essential as the late notice that the insured gave to its umbrella carrier had resulted in a denial of coverage by that insurer. There are some interesting takeaways from this new opinion. The first is the suggestion that the mere risk of an excess judgment creates a right to independent counsel in Illinois. Second, the dicta in this case places significant pressure on insurers to not take cases to trial. If an insurer elects to try rather than settle, it should certainly document its file carefully to ensure that the risks of trial have been fully explained to the insured.
Another example of the minefield that is the risk of excess exposure! The Mississippi Court of Appeals in the recent case of Great American E & S Ins. Co. v. Quintairos, Prieto, Wood & Boyer, reversed a 12(b)(6) dismissal of a legal malpractice claim, brought by the excess insurer for a nursing home against the defense counsel retained by the primary insurer. Traditionally, the lack of a direct attorney-client relationship between counsel and the excess carrier would have protected the attorneys against that risk, but not any more! The Court held that the excess insurer could proceed against counsel under the theory of equitable subrogation - standing in the shoes of the Insured, which had no interest in pursuing the malpractice claim itself(since it had insurance for the loss, it bore no direct risk).