Ending Duty To Defend: Exhaustion Of Policy Limits By Settlement Of Less Than All Suits

A liability insurer's duty to defend its insured against covered suits seeking damages is purely contractual. There is no common law duty to defend.1 Accordingly, courts will look to the language of the policy at issue to determine whether an insurer has a defense obligation and, if so, the extent of that obligation.

The present (and since 1986) Insurance Services Office (ISO) standard form Commercial General Liability policy (CGL) expressly provides that:

Our right and duty to defend ends when we have used up the applicable limit of insurance in the payment of judgments or settlements under Coverages A [Bodily Injury and Property Damage] or B [Personal Injury and Advertising Liability] or medical expenses under Coverage C.2 The prior ISO 1966 and 1973 CGL policies achieved the same result, but through the use of somewhat different wording — "the company shall not be obligated to pay any claim or judgment or to defend any suit after the applicable limit of the company's liability has been exhausted by the payment of judgments or settlements."3

While the ISO wording made the underwriting intent clear and unambiguous4 — there is no duty to defend after policy limits have been exhausted by payment of judgments or settlements — several important issues remained for the courts to weigh in one.

Is the insurer's duty to defend terminated by settlements that, while exhausting the applicable policy limits, do not settle all suits, or claims within a suit, against the insured? May the insurer terminate its duty to defend by paying its policy limits to get one insured out of the action, to the detriment of another insured who remains in the action? Must the insurer wait until all potential claims against its insured(s) have been filed before settling with any claimant? Does a non-settling claimant have a cause for complaint because the settlement will deplete or exhaust coverage otherwise available for his or her injuries? What constitutes an insurer's good faith in settling less than all suits or claims against the insured?

"First in time, first in right"

Where multiple claimants bring suits against one or more insured defendants seeking damages for bodily injuries or death arising out of a single occurrence and, on any reasonable evaluation, the policy limits are plainly insufficient to cover the insured's total potential exposure, the rule generally applied is "first in time, first in right."5 This principle "applies regardless of "whether the priority is by way of judgment or by way of settlement."6

A liability insurer "has discretion to settle whenever and with whomever it chooses, provided it does not act in bad faith."7 Absent an allegation of bad faith with respect to settlement negotiations, an insurer will not be precluded from entering into a settlement agreement releasing less than all of the insureds.8 The insurer "has no duty to pay out claims ratably and/or consolidate them,"9 and it can settle less than all claims, even if the settlement exhausts policy limits so that the insured and other claimants are left without coverage under the policy.10 When the insurer "has paid the full monetary limits set forth in the policy, its duties under the contract of insurance cease."11

Where a covered occurrence gives rise to multiple claims, it is not necessary for the insurer to wait until all potential claims against its insured(s) have been filed before settling with any particular claimant.12 "Whether multiple claims are to be treated one at a time or collected and evaluated together, is a choice solely within the discretion of the insurer."13 As long as the insurer does not act in bad faith, it is not required to notify non-settling third-parties of the proposed settlement.14 When "a presumptively valid and adequate award has been made to one of several claimants, the fact that the remaining claimants, or any one of them, have not been taken into the confidence of the settling parties falls far short of establishing an adequate ground for equitable relief."15 If an insurer cannot obtain a global settlement and settles less than all claims, it will be subject to a bad faith suit only if the settlement is found not to have been made in good faith.

The "first in time, first in right" rule is supported by the strong public policy of encouraging speedy settlements.16 If insurers were required to know of and evaluate all potential claims against their insureds before settling any individual claim, insurers could only settle if they were willing to assume the risk that their remaining coverage, if any, would be insufficient to cover any future claim arising out of the same occurrence. Such a rule would discourage insurers from accepting reasonable settlement offers at an early stage of the litigation. As the Texas Supreme Court said that

when faced with a settlement demand arising out of multiple claims and inadequate proceeds, an insurer may enter into a reasonable settlement with one of the several claimants even though such settlement exhausts or diminishes the proceeds available to satisfy other claims. Such an approach, we believe, promotes settlement of lawsuits and encourages claimants to make their claims promptly.17 As a general rule, non-settling third-party claimants have no ground for complaining that the settlement depleted or exhausted policy proceeds that otherwise would have been available to them, leaving them no recourse against the insurer.18 The insurer's duty "is to its insured. It owes no correlative contractual duty to third-party claimants."19 As the Supreme Court of Kansas explained:

The insurer certainly could not be enjoined by plaintiffs from settling with other persons injured in the same accident and thereby exhausting the fund to the exclusion of plaintiffs. . . . If we were to follow plaintiffs' theory it could lead us to a result where one injured person could enjoin the compromise and settlement by an insurer of the claim of another injured person in the same accident. This would be in direct conflict with what has just been stated. The better rule is that where, as here, an insurer settles two of five claims arising out of an automobile accident, such settlement is not contrary to public policy as against the remaining three claimants who reduced their claims to judgment.20 Similarly, a liability insurer may settle claims against one insured under a particular policy even if such settlement exhausts the policy proceeds to the detriment of another named insured or additional insured. An insurer is "free to settle suits against one of its insureds without being hindered by potential liability to co-insured parties who have not yet been sued."21

A Texas Court of Appeals was presented with a case in which a primary insurer, having settled up to its policy limits and obtained a release on behalf of its named insured, refused to defend an additional insured in a separate action arising out of the same accident. The additional insured's excess insurer assumed the defense and then sued the primary insurer to recover its costs. The Texas Court of Appeals found that the primary insurer had breached no duty in obtaining the settlement for its named insured, and its duties to the additional insured terminated when that settlement exhausted the policy limits.22

Good faith

An insurer has a duty to act in good faith with respect to the disbursement of the proceeds of a liability insurance policy and the insurer's "termination of its duty to defend, like all transactions between insurer and insured, requires the insurer to have acted in good faith."23 When an insured has surrendered all control over the handling of a claim to the insurer, the insurer assumes "a duty to exercise such control and make such decisions in good faith and with due regard for the interests of the insured."24 The duty of good faith requires the insurer to give "the interest of the insured" consideration "equal to that consideration given its own interest",25 or "to treat the claim as if it were alone liable for the entire amount."26 Where the policy limits are less than the insured's potential exposure, "the insurer cannot put its own interests first, but must negotiate as it would if its liability limits were unbounded."27

In Peckham v. Continental Cas. Ins. Co.,28 the court summarized the insurer's obligation in a multi-claim, limited coverage situation as follows:

The insurer has both the right and the duty to exercise its professional judgment in settling, or refusing to settle, such claims - but it must do so mindful of the insured's best interests and in good faith. The insurer's goal should be to try to effect settlement of all or some of the multiple claims so as to relieve its insured of so much of his potential liability as is reasonably possible, considering the paucity of the policy limits.. . . So long...