When it is likely that a policyholder will be liable for more than policy limits, an insurance company generally still has a duty to accept a reasonable settlement for less than the policy amount should such an opportunity arise. If a court finds that the insurer declined a reasonable settlement offer and the insured ultimately is liable for more than the policy limit, the insurer could be on the hook for the entire judgment.
While this rule is fairly simple in theory, its application has created a wide range of problems for insurance companies. One particularly difficult situation arises when there are multiple potential claimants under a policy but insufficient limits to cover everyone. In this situation, an insurer faces a Hobson’s Choice: risk a bad faith ruling if it refuses to settle one claimant’s case in order to preserve the pot for every policyholder, or risk a bad faith ruling by settling for one claimant and hanging the others out to dry.
Courts across the country have developed various legal frameworks for insurance companies to follow when confronted with this problem. Unfortunately, the rules are not always straightforward, though they do provide some guidance on how an insurance company can avoid bad faith liability when there are multiple claimants vying for a limited pot. Below is a summary of the law in the six largest states in the country.
California
California follows the minority rule where an insurer that settles the liability of one insured without leaving enough money under the policy for the others can be exposed to a claim of bad faith. Conversely, an insurer will not be found to have acted in bad faith if it rejects a settlement offer that potentially could leave one or more policyholders without coverage.
In Strauss v. Farmers Insurance Exchange, the courted noted, “[A]n insurer may, within the boundaries of good faith, reject a settlement offer that does not include a complete release of all of its insureds.” California case law gives little guidance as to how an insurance company should attempt to handle a case in which multiple insureds are likely to be exposed to liability above the policy limits other than to say it cannot settle for one if doing so would leave others without coverage.
Texas
Texas law will not subject an insurance company to a bad faith claim if it accepts settlement of a claim against one insured, even if it potentially exposes another insured to liability over the policy limits.
In Texas Farmers Ins. Co. v. Soriano, the court concluded that an insurance company “faced with a settlement demand arising out of multiple claims and inadequate proceeds…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.” The reasoning is that this rule will encourage prompt reporting of insurance claims and any settlement would benefit every insured because it would decrease the total amount of liability in the underlying lawsuit.
New York
New York law gives an insurance company discretion to settle on a first-come, first-served basis, even when doing so could affect the ability of other insureds to be covered under the policy limits—as long as it acts in good faith. An insurer has no obligation to interplead the other potential claimants, though it is encouraged to do so and it would be seen as an act of good faith. In Hartford Ins. Co. v. Methodist Hospital, the court stated that, to show bad faith, the insured must show that the insurance company acted in “gross disregard” of the insured’s interest.
Florida
Florida law provides the most comprehensive framework for an insurance company faced with multiple claimants within a limited pot. An insurance company has a certain degree of discretion, though there are limits. It must (1) fully investigate all the claims to determine how to best limit the insureds’ liability, (2) seek to settle as many claims as possible within the policy limits, and (3) avoid indiscriminately settling select claims and leaving some insureds at risk of excess judgments that otherwise could have been minimized. To avoid a finding of bad faith, the insurer is obligated to advise the insured of settlement opportunities, advise as to the probable outcome of the litigation, warn of the possibility of an excess judgment, and advise the insured of any steps he might take to avoid an excess judgment.
Illinois
In Illinois, an insurer does not necessarily act in bad faith when it settles for the policy limits for some insureds without releasing all insureds from liability. Bad faith will be found only where the insurer has engaged in vexatious, unreasonable, or outrageous conduct toward the insured parties. However, an insurance company might not satisfy its duty of good faith if it attempts to interplead all insureds, deliver the policy limits to the court, and then walk away from the litigation.
Pennsylvania
Under Pennsylvania law, an insurer is not prevented from accepting a settlement offer when doing so might expose other insureds to excess liability, as long as the settlement is reasonable. If the settlement is unreasonable, the insurer is subject to a bad faith claim from the other insureds. In Anglo-American Ins. Co. v. Molin, the court cited that if an insurer “cannot obtain a global settlement, then it may arrange a less comprehensive settlement and will be subject to a bad faith suit only if the process used in reaching the settlement was in bad faith.”
To avoid a bad faith claim where insureds who didn’t settle are left exposed, the insurer should not enter into a dubious release to quickly exhaust its policy limit. Additionally, it should time its withdrawal from litigation to not prejudice the insured. Finally, it may not exhaust its policy limit in order to avoid its duty to defend. Like Texas, this rule is partly based on the reasoning that a settlement by one defendant in the underlying action benefits all defendants.