Sophisticated insureds looking for ways to reduce their insurance premiums often elect to purchase liability insurance that is subject to a deductible or self-insured retention. Typically, liability policies that contain deductibles still include language granting insurance companies the exclusive rights to control the defense, investigation, and settlement of claims and suits, and to seek reimbursement from named insureds of those amounts that fall within the policies' deductibles.

A typical deductible provision provides:

The company may pay any part or all of the deductible amount to effect settlement of any claim or suit and, upon notification of the action taken, you shall promptly reimburse the company for such part of the deductible amount as has been paid by the company.
Additionally, liability policies almost universally define “you” as “the 'named insured' listed in the policy declarations.” Thus, it is usually the named insured who is responsible for payment of a policy's deductible.

It is common in construction and commercial real estate settings, among others, for one party to the contract to require that the other party name it as an additional insured on the other party's general liability policy. For example, owners and general contractors commonly require each subcontractor to add the owner and general contractor as additional insureds under the subcontractor's liability policies. This usually is accomplished through an additional insured endorsement.

A potential dispute can arise if an insurance company settles a claim against an additional insured for an amount that substantially eats up the policy's deductible, and then seeks to collect the deductible amount from the named insured. The named insured may dispute whether the other party is an additional insured under the policy. Even when the other party's insured status is not in dispute, the named insured's interests may not be aligned with the additional insured's with regard to the settlement of claims against the additional insured.

In some situations, when there is a good defense to the claim, the named insured might prefer that the carrier not settle claims against additional insureds because such settlements would require it to pay its deductible. The additional insured, on the other hand, is likely to put immediate pressure on the insurance company to settle claims asserted against it, irrespective of the cost to the named insured and insurer.

Consequently, if the named insured did not agree with the deductible-consuming settlement, the named insured may later rebuff the insurance company's request for reimbursement and allege that the insurer breached the insurance contract by failing to obtain the named insurance's consent prior to settlement. Such a claim, however, is not likely to be supported by the actual terms of the policy, as the typical liability policy grants the insurer the exclusive right to control the defense and settlement of claims and suits.

Specifically, liability policies often contain the following provision:

The company shall have the right and duty to defend any suit against the insured seeking damages on account of such bodily injury or property damage…and may make such investigation and settlement of any claim or suit as it deems expedient.

Therefore, the named insureds may resort to the extra contractual defense of bad faith in order to avoid paying deductibles. Named insureds may argue that their insurers committed bad faith by settling claims that fall partially or entirely within the deductibles without first consulting with and obtaining the named insureds' consent.

Case Law

This is precisely the type of claim presented in Hartford Accident and Indemnity Co. v. U.S. Natural Resources, Inc., 897 F.Supp. 466 (D.Oregon 1995). In that case, the named insured, U.S. Natural Resources (USNR) entered into a contract with Temple-Eastex to sell and install certain machines at Temple-Eastex's sawmill. The contract required USNR to name Temple-Eastex as an additional insured under USNR's liability policy.

Some time later, a worker was injured at the site while under the direct supervision of USNR and using a ladder furnished by a division of USNR. The worker sued Temple-Eastex, but not USNR. Temple-Eastex tendered the suit to its own insurers and USNR's insurer, Hartford, which initially declined to accept the tender. Hartford and USNR took the position that Temple-Eastex was not an insured.

Temple-Eastex's own insurers settled the suit by paying the plaintiff $1.1 million. Hartford subsequently re-evaluated its position, determined that Temple-Eastex was an insured, and agreed to contribute $550,000 toward the settlement. Hartford then requested USNR to pay the $250,000 deductible under the Hartford policy. USNR refused and Hartford filed suit.

In the coverage action, USNR defended its failure to pay the $250,000 deductible on the basis that Hartford's settlement of the underlying suit, without first providing USNR notice and seeking its consent to the settlement, constituted bad-faith conduct and precluded Hartford from recovering the deductible. The district court noted that the policy gave Hartford the contractual right to settle claims as it “deemed expedient.” The court also found that the policy's deductible provision granted Hartford the right to “pay all or part of the deductible to settle a claim” and required the “named insured” to, “after notification of the action taken,” reimburse Hartford for the amount of the deductible paid to settle the claim. Consequently, the court held that there was no contractual basis for USNR's claim that Hartford was required to seek its consent prior to settling claims asserted against the additional insured.

The court also rejected USNR's alternative argument that the court should impose a duty of “good faith and fair dealing” with regard to Hartford's performance under the policy and require Hartford to first provide notice and obtain USNR's consent prior to expending any of USNR's money to settle claims against additional insureds. The court noted that both USNR and Hartford had cited cases from other jurisdictions to support their respective positions.

Although the court observed that Oregon recognizes that the covenant of good faith and fair dealing is implied in every insurance contract, it noted that Oregon law does not allow the duty of good faith and fair dealing to operate to alter the express terms of the parties' contract. The court held, therefore, that Oregon law did not allow a de facto amendment of the policy by reading a notice and consent requirement into the policy that was inconsistent with the express terms of the insurance contract.

At least three other jurisdictions have refused to broaden bad faith law to include situations in which insurers' settlements of claims against named insureds substantially consumed the insured's deductible. In Casualty Insurance Company v. Town & Country Pre-School Nursery, Inc., 498 N.E.2d 1177 (Ill. App. 1st Dist. 1986), the court ruled that, because the insurer had the contractual right to settle the case within the deductible limits, the insurer's good faith was not an issue. Similarly, in American Home Assurance Co. v. Hermann's Warehouse Corp., 563 A.2d 444 (N.J. 1999), the court held that the doctrine of bad faith does not extend to cases in which the insured has bargained away any rights that would arise out of conflicts of interest involving settlements that erode the policy's deductibles. Finally, in Aetna Cas. & Sur. Co. v. Dow Chemical, 883 F.Supp. 1101 (E.D. Mich. 1995), the district court noted that, although Michigan law has recognized the implied covenant of good faith and fair dealing in situations involving failure to settle and claim handling, the court refused to extend the implied duty to disputes to an insurer's alleged bad faith assignment of a claim to a particular policy that contained a deductible.

It should be noted, however, that some jurisdictions have been willing to recognize potential bad faith claims resulting from insurers' failure to obtain the insureds' consent to settlements that implicate insureds' deductibles. For example, in The Orion Ins. Co. v. General Electric, 493 N..S.2d 397 (N.Y. Sup. Ct. 1995), the court found that the insured only could prevail on its bad faith claim if no reasonable observer could have viewed the settlement as prudent in light of the posture of the case. Similarly, in Commerce & Industry Ins. Co. v. North Shore Towers Management, 617 N.Y.S.2d 632 (1994), the court ruled that, in order to establish bad faith, the insured must demonstrate that the insurer's settlement constituted a gross disregard of insured's interests and/or a deliberate or reckless failure to place the insured's interests on equal footing with its own. In another case, United Capitol Ins. Co. v. Bartolotta's Fireworks Co., 536 N.W.2d 198 (1996), the court found that, in order to establish bad faith, the insured must prove that the insurer's actions in settling a claim were “outside the bounds of the broad power” granted under the policy. Finally, in Nationwide Mut. Ins. Co. v. Public Service Co. of North Carolina, 435 S.E.2d 561 (N.C. App. 1993), the court stated that the insurer could not act with impunity in settling a case within the insured's deductible and that settlement must be made in good faith.

Avoiding Disputes

Insurers can take a number of steps to thwart potential bad faith claims arising out of settlements with additional insureds. The first of these is to confirm that the named insured, and not the additional insured, is the party responsible for payment of the deductible.

After receiving notice of a claim, the insurance company should consider advising the named insured in writing that the claim against the additional insured is subject to a deductible. This should make it harder for the named insured to argue later that it was unaware that it would be required to pay to a deductible to settle claims asserted against the additional insured. Also, if the named insured disputes whether the other party qualifies as an additional insured, the named insured is more likely to speak up at this time.

In the event that the named insured disagrees with the insurance company's position that coverage exists for the additional insured, and that the named insured will be responsible for payment of the deductible, the company should consider filing a declaratory judgment action to secure a judicial determination of the insurance company's rights before any settlement is finalized. Before settling a claim against an additional insured that falls within the named insured's deductible, the insurance company should confirm that the policy terms grant the insurer complete settlement authority.

Throughout the case, the claim handler and defense counsel should carefully document their files as to why the insurance company elected to settle the claim against the additional insured. A discussion of the exposure, including the merits of the claim and the verdict potential, should help deflect any later assertion that the insurer paid too much or settled too quickly with the use of the named insured's funds.

After the settlement is consummated, the carrier immediately should bill the named insured for the deductible amount. Significant delays in seeking reimbursement will only increase the likelihood that the named insured will attempt to avoid its reimbursement obligation.

Although existing case law in most jurisdictions makes it difficult for policyholders to succeed with this type of bad faith claim, insurers still should be cognizant of these potential claims and take steps to prevent these types of disputes from arising in the first place. An ounce of prevention can save significant litigation costs later.

Jim Murray is a partner in the Chicago office of the law firm Tressler Soderstrom Maloney & Priess, where he is a member of the Bad Faith and Insurance Service practice groups. He can be reached at jmurray@tsmp.com.

Special Reports /

Bad Faith Quandaries

Related Stories

Recommended For You