According to conventional wisdom, a liability insurer’s duties to defend and indemnify are separate and are judged by different standards: an insurer must defend if there is a potential for coverage based on the allegations against the policyholder, but the insurer must indemnify only if the “actual facts” demonstrate that the claim against the policyholder is covered under the wording of the policy. In the unusual situation where the “actual facts” are determined by specific fact-finding by the jury in the underlying case against the policyholder, that distinction works.
But, in the real world, cases settle, and they often settle without any determination of the “actual facts.” So, what happens to the conventional wisdom in those situations? Courts sometimes allow insurers to examine the facts known at the time of settlement or even allow the insurers essentially to litigate the underlying case against the policyholder to develop the so-called “actual facts.” Insurers are especially eager to follow that approach in situations where some, but not all, of the allegations are potentially covered. In those situations, the insurer usually agrees to defend the action under a reservation of rights, which provides a defense to the policyholder, but still allows the insurer to try to avoid paying for any of the policyholder’s liability established in a judgment or settlement. Thus, the additional “fact-finding” approach allows the insurer to try to escape liability even though it has admitted the potential for coverage under its policy.
Permitting an insurance carrier to re-litigate facts in an underlying case is the wrong approach —especially when no facts have been developed in the underlying case beyond the complaint. Rather, in those situations, the insurer’s duty to pay the settlement should be judged by whether the allegations potentially fall within coverage. In other words, if there is a duty to defend, there is a duty to indemnify the settlement.
The Duty To Defend Is Determined by the Potential for Coverage
In nearly every jurisdiction, a liability insurer has a duty to defend its policyholder if underlying complaint alleges facts that potentially bring suit within policy coverage. This means that, if any part of the complaint is potentially covered, the insurer must defend the entirety of the lawsuit. See e.g. Montrose Chem. Corp. v. Superior Court, 861 P.2d 1153, 1157 (Cal. 1993). The rationale for this standard is that the policyholder paid for “litigation insurance” as part of its policy and is entitled to a defense against any covered allegation from the beginning of the case. See e.g. Id.; Internat’l Paper Co. v. Continental Cas. Co., 320 N.E.2d 619, 621 (N.Y. 1974).
The Duty To Indemnify Is Determined by “Actual Facts”
Courts usually state that the insurer’s duty to indemnify is determined by whether the actual facts, as opposed to the allegations, fall within the coverage of the policy. That duty is typically determined after the conclusion of the underlying case against the policyholder. During the course of the underlying case, the underlying plaintiff may be able to support certain allegations and establish liability, but not others. Those “actual facts” are considered the basis of the duty to indemnify, at least when they are established in the underlying case. See. e.g. C.H. Heist Caribe Corp. v. American Home Assur. Co., 640 f.2d 479, 483 (3d Cir. 1981).
How Courts Apply the “Actual Facts” Standard to Settlements
Even where the underlying case settles before trial, some courts have held that the insurer is entitled in coverage litigation to ascertain and litigate the merits of the underlying case against the insured, in order to determine which part of the settlement, if any, should be indemnified. See e.g. Enserch Corp. v. Shand Morahan & Co., 952 F.2d 1485 (5th Cir. 1992). That approach is unfair to the policyholder because it forces the policyholder to try the merits of a case that it just settled. It also is often unworkable, because the actual facts may be difficult or impossible to ascertain. For example, in a case brought by a government agency that alleges covered and uncovered damages that settles shortly after the complaint is filed, it usually is not possible to determine which allegations constituted which part of the settlement amount.
Other cases, however, have recognized these problems and have correctly used the “potential for coverage” standard to determine coverage for indemnity when the underlying case settles. See e.g. Pacific Indem. Co. v. Linn, 590 F. Supp. 643 (E.D. Pa. 1984), aff’d, 766 F.2d 754 (3d Cir. 1985) (“Linn”); Harold S. Schwartz & Associates, Inc. v. Continental Cas. Co., 705 S.W.2d 494 (Mo. App. 1986) (“Schwartz”).
In Linn, the policyholder doctor was sued by people who had read and followed his diet book. Those cases were resolved by settlement. The court held that the insurers had a duty to defend, despite the assertion of several exclusions, “because the underlying complaints stated causes of action on which there was potential liability.” 590 F. Supp. at 650. The court had waited until the underlying cases were resolved to determine the indemnity obligations based on the facts of those cases. “However, because those cases implicating the duty to indemnify were terminated by settlement rather than final judgment, it is now impossible to determine on what theories of liability, if any, the underlying plaintiffs would have prevailed. There are no factual findings to consider in determining which insurers are obligated to defend Dr. Linn. As a result, the duty to indemnify must follow the duty to defend.” Id. (emphasis added).
In Schwartz, a radio station was sued for allegedly defamatory statements, some of which pre-dated the policy period of the insurance at issue. The defamation suit was settled, with the consent of the insurer, but the insurer claimed it was not liable to indemnify the entire settlement amount because some or all of the defamation had occurred outside the policy period. The court held that the insurer was liable for the entire cost of the settlement, however, because the underlying case settled “prior to pleading refinement and full discovery, without an agreement with the insureds as to an allocation of the cost.” 705 S.W.2d at 498.
Courts Should Apply the Potential for Coverage Standard to the Duty To Indemnify Settlements
Where the duty to defend exists, there is a potential for coverage based on the allegations of the underlying complaint. If the underlying case then settles, especially at an early stage without significant discovery or factual development, then the settlement is based only on the exact allegations set forth in the complaint. In this situation, there is no development of facts that could support any insurer defenses, whether asserted in the insurer’s reservation of rights letter or not. As held in Linn and Schwartz, the standard for determining whether a settlement is covered by the policy is the same as the standard for determining whether or not there is a duty to defend, and the potential-for-coverage standard requires the insurer to pay for any reasonable settlement reached in the underlying case.
Conclusion
Policyholders should not accept insurers’ attempts to deny coverage for reasonable settlements when there is a potential for coverage. Insurance carriers should not be permitted to re-litigate “actual facts” not determined in the underlying litigation. Rather, if an insurer has agreed to defend, they must, in most situations, also pay for reasonable settlements.
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