For years, I have been calling this one of the most challenging of all coverage issues.  An insurer is defending an insured under a reservation of rights.  A demand is made to settle within limits.  Based on the insured’s potential liability and plaintiff’s damages, and considering the applicable state standard for whether a claim should be settled, to avoid an insurer’s potential liability for an excess verdict, this one should be.

But here’s the rub.  As I said, the insured is being defended under a reservation of rights.  If the insurer settles, it could lose the ability to assert the coverage defense.  If it declines to settle, because it does not wish to settle an uncovered claim, and the case goes to trial, and there is an excess verdict, the insurer could be liable for the excess verdict.  And, if the insurer files a declaratory judgment action, it often-times won’t get an answer before the trial in the underlying action.

In other words, a demand is made to settle.  Even though the insurer has a coverage defense, the result may be, at best, the insurer’s coverage defense is lost.  At worst, the insurer is liable for an excess verdict.            

Despite it being such a significant, confounding, frequently occurring and challenging issue, there is not a significant amount of case law addressing the impact of a coverage defense on an insurer’s obligation to settle and possible liability for an excess verdict.  There is some, but there could be more.

The Tenth Circuit addressed this issue in Owner’s Insurance Co. v. Dockstader.  It was not a paradigm excess verdict situation.  But, given the importance of the issue, and limited case law, the court’s decision is worthy of being called one of the ten most significant coverage cases of the year.

The coverage issue at the heart of Dockstader is about as simple as it gets.  Jacob Dockstader hit Thomas Brooks in the head with a dumbbell at a gym.  Brooks was left permanently disabled.  Dockstader pleaded guilty to aggravated assault.

Brooks sued Dockstader for assault and battery and negligence.  Owner’s Insurance undertook Dockstader’s defense, under a homeowner’s policy issued to his parents, and did so under a reservation of rights.  The policy limit was $500,000. 

Not surprisingly, Owner’s Insurance asserted defenses based on no “occurrence” and an “expected or intended” exclusion.  Owner’s filed a declaratory judgment action seeking a determination that it had no duty to defend or indemnify Dockstader for these reasons.

Brooks made three settlement demands for the policy’s $500,000 limit.  He noted that his actual damages far exceeded the policy limit. In the court’s words, Owners “conditionally accepted” Brooks’ offer. “It referenced the declaratory judgment action and said, ‘[i]f there is coverage, [Owners] will pay the policy limit of $500,000 to Mr. Brooks.’”

Shortly after the third settlement offer, Owner’s filed a motion for summary judgment in the coverage action.  While that was pending, and without notice to Owner’s, Dockstader and Brooks reached a settlement for $5,000,000.  Brooks agreed not to execute against Dockstader and Dockstader assigned the rights under his policy to Brooks. 

Brooks intervened in the coverage action and filed a third-party complaint alleging that Owners was in bad faith for failing to settle within policy limits, when Dockstader faced a significant likelihood of judgment in excess of limits.

The federal district court in the coverage action concluded that no coverage was owed, finding that “the average adult would expect the probability of nontrivial harm as a result of swinging a dumbbell close enough to someone’s head to scare them.”  [This had been Dockstader’s argument as to his intent.] The court also concluded that there was no basis for a bad faith claim for Owner’s refusal to accept the policy limit demand.

Brooks appealed the bad faith finding.  He argued that “the district court erred in holding Owners had no duty to accept Brooks’ settlement offers. In effect, Brooks asks us to establish a rule holding that insurers who have accepted a defense must also accept settlement offers within the policy limits—even where the insurer has filed a declaratory judgment action disputing coverage and the district court ultimately finds none.”

The Tenth Circuit declined to adopt such a rule.  The court described its decision this way:  Here, Owners embraced its rights under Utah law in seeking declaratory relief. And with the declaratory judgment action pending, Owners conditionally accepted Brooks’ settlement offer. It said, ‘[i]f there is coverage, will pay the policy limit of $500,000 to Mr. Brooks.’ Owners did not gamble in deciding whether to accept an offer or take the case to trial. If the Policy covered Dockstader’s conduct, Owners agreed to pay Brooks the Policy limit—trial was never a consideration. Moreover, in pursuing a declaratory judgment action, Owners bore the risk that the district court would determine coverage existed and it might be on the hook for any judgment in excess of Brooks’ settlement offers—even if the excess exceeded the Policy limits. So the risks associated with Owners’ conditional acceptance of Brooks’ settlement offers were borne by Owners not Dockstader. Owners’ risk paid off as it later received a court judgment, which Dockstader did not appeal, declaring that the policy at issue provided no coverage.”

As I mentioned, as the case did not involve an excess verdict, following an insurer’s failure to settle within limits, Dockstader is not a paradigm bad faith failure to settle scenario.  However, it still offers some important take-aways:

First, an insurer that has a coverage defense, and one that it feels so strongly about that it will not want to accept a settlement demand within limits, should file a coverage action.  That the insurer had done so here was a key to the court’s decision and why the insurer prevailed.  Without doing so, the insurer can expect an argument that, if it knew it was not going to accept a settlement demand within limits, because of its coverage defense, then it should have taken steps to get the issue judicially resolved.

Second, as this court saw it, an insurer’s conditional agreement to settle within limits, subject to a later coverage determination, does not constitute bad faith failure to settle.  It is not a situation where the insurer gambled in deciding whether to accept an offer or take the case to trial.