In Babcock & Wilcox Co. v. American Nuclear Insurers, a divided Supreme Court of Pennsylvania, deciding an issue of first impression under Pennsylvania law, recently held that when an insurer defends its insured subject to a reservation of rights, the insured may accept a settlement over the insurer’s refusal where the settlement is fair, reasonable, and non-collusive. This is a significant statement of policyholder rights in an area that regularly generates litigation.

In 1994, a federal class action was brought against Babcock & Wilcox Co. (“B&W”) and Atlantic Richfield Co. (“ARCO”) (together, “Insureds”) by plaintiffs who claimed to have suffered bodily injury and property damage caused by emissions from nuclear facilities owned by Insureds. The class eventually included over 500 named plaintiffs, and a 1998 jury trial of eight test cases resulted in a $36 million verdict. Insureds, however, obtained a retrial due to evidentiary issues.

During the underlying litigation, American Nuclear Insurers and Mutual Atomic Energy Liability Underwriters (together, “ANI”) defended under a reservation of rights. However, ANI refused to consent to any settlement offers it was presented. It believed that plaintiffs’ claims lacked medical and scientific support, and because the court had issued favorable decisions on certain procedural and evidentiary issues during the retrial, a defense verdict was likely. Nevertheless, Insureds ultimately settled the class action for a total of $80 million, which – even when adding $40 million in defense costs they incurred – fell far short of the $320 million of total potential coverage available under the policies. When Insureds sought reimbursement, ANI refused to pay, invoking policy language prohibiting Insureds from making any payments, assuming any obligations, or incurring any expense without ANI’s consent.

In the coverage action, the trial court held that an insurer defending under a reservation of rights is required to reimburse an insured for a settlement reached in violation of the consent to settle clause if coverage exists and if the settlement is fair, reasonable, and made in good faith without collusion. After a two-week trial, a jury concluded that the Insureds’ settlement met this test. ANI appealed.

The appellate court, relying on an out-of-state case for a standard that neither party advocated, ordered a new trial, holding that where an insurer defends subject to a reservation of rights, the insured must choose between accepting the defense (and be bound by the consent-to-settle provision) or decline it, pay for its own defense, and recover its costs of settlement to the extent that they are found fair, reasonable and non-collusive. The Pennsylvania Supreme Court then granted review, reversed, and reinstated the judgment of the trial court.

The high court made short work of the intermediate appellate court’s “insured’s choice” standard, finding it had no basis in Pennsylvania law and was “unworkable” inasmuch as many policyholders would not have the funds to pay for their own defense. Instead, the court concluded that the correct standard was a variant of the “fair and reasonable” standard that the Insureds advocated. Under the standard, “if an insurer breaches its duty to settle while defending subject to a reservation of rights and the insured then accepts a reasonable settlement offer [within the policy limits], the insured need only demonstrate that the insurer breached its duty by failing to consent to a settlement that is fair [and] reasonable.” Determining whether the settlement was fair and reasonable entailed consideration of the terms of the settlement, the strength of the insured’s defense, and whether there was any fraud or collusion. Applying a higher standard urged by ANI, namely, a showing of bad faith by the insurer, was not appropriate, according to the court, as the remedy for bad faith may require an insurer to pay in excess of policy limits. The lower “fair and reasonable” standard is more appropriate where the insurer’s liability is confined to the policy limits.

The Babcock decision is attractive on its facts: in a case where the underlying action lasted more than a decade and produced one jury verdict that suggested that Insureds were potentially exposed to significant losses, ANI’s rejection of the settlement Insureds accepted, which was well under policy limits, left Insureds in a truly unenviable position. As the Babcock court noted, courts in other jurisdictions have applied standards less favorable to policyholders. Companies, therefore, at a minimum, need to review carefully their policies before settling claims brought against them to understand what may be required. They also should understand these requirements when purchasing insurance or negotiating renewal if they hope to avoid provisions that might lead to forfeiting coverage in some jurisdictions.