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Vol. 4, Iss. 12
December 16, 2015

American Western Home Insurance Co. v. Donnelly Distribution,
No. 14–797, 2015 WL 505407 (E.D. Pa. Feb. 6, 2015)

Court Allows Insurer To Settle And Then Seek Recovery Of Uncovered Damages


I know. It seems curious that an unpublished decision, from a federal District Court, could be one of the year’s ten most significant coverage cases. But when a court provides a solution to one of the toughest issues of them all for insurers, not to mention one sorely lacking in guidance, it is worthy of a lot of attention.

The insurer is defending its insured under a reservation of rights. There are strong coverage defenses. The underlying case is getting close to trial. There is a demand to settle within limits. It is a settlement that should be accepted based on liability and damages considerations. But the insurer does not believe that coverage is owed. So it is not pleased at the prospect of settling. But if it accepts the demand, it could lose its coverage defenses. If it does not accept the demand, because of the coverage defenses, it may be liable for the verdict – excess or otherwise. And, of course, a declaratory judgment is unlikely to solve the problem as trial is probably approaching and a DJ could never be resolved in time.

An issue along these lines played out not long ago in the Eastern District of Pennsylvania in American Western Home Insurance Co. v. Donnelly Distribution, Inc. The case is not the exact scenario that I described -- but it certainly provides real guidance to an insurer confronting it.

Donnelly Distribution was named as a defendant in a slip and fall action. The plaintiff alleged that her foot became entangled in the loop of a plastic tie used to wrap papers allegedly distributed or used by Donnelly. Donnelly was defended by its insurer, American Western Home Ins. Co., under a reservation of rights. For whatever reason, American Western did not believe that it owed coverage, for defense or indemnity, and filed a declaratory judgment action.

The District Court in the declaratory judgment action ruled that Donnelly was entitled to defense and indemnity. Shortly before trial the action was settled for $150,000. American Western was to pay $125,000 toward the settlement. American Western appealed the decision in the declaratory judgment action and the Third Circuit reversed -- ruling that American Western was not obligated to defend or indemnify Donnelly. American Western then filed an action seeking reimbursement of the $125,000 that it paid to settle the personal injury suit.

The court in the reimbursement action held that American Western was entitled to the recovery of the amount paid. The court did not announce any general rule governing an insurer’s right to reimbursement of a settlement following a judicial determination that no coverage was owed for it. And the court acknowledged that the procedural posture of the underlying case “is an important piece of the right-to-reimbursement analysis.” However, how the court reached its decision, permitting reimbursement, provides some lessons, and possible assistance, for an insurer that is confronted with a settlement demand for a claim that it does not believe is covered.

First, the court’s decision makes clear that the insurer will be in the best posture to seek reimbursement, of an uncovered claim, if it filed a declaratory judgment action seeking a determination of the lack of coverage. The filing of such declaratory judgment action is also likely to be more effective if it was filed as far in advance of the trial as possible. But, admittedly, even when that is done, there may still not be a ruling on coverage in time to guide the insurer’s response to the settlement demand. This is where American Western v. Donnelly comes in.

American Western argued that it was entitled to reimbursement of the settlement on an unjust enrichment theory. The insurer acknowledged that its policy contained no right of reimbursement and that it was not proceeding on a contract theory. The court’s reasons for allowing reimbursement of the settlement were several and tied to certain Pennsylvania case law. But the take-aways are as follows.

While Pennsylvania courts have endorsed the general doctrine, prohibiting recovery for voluntary payments made due to a mistake of law, this was a different kind of “mistake in law” situation: “American Western did not make the payment under a mistake of law. American Western has consistently disputed its obligation to pay under the insurance policy through a reservation of rights letter and a letter disclaiming coverage. Additionally, American Western clearly communicated to Donnelly its dispute over its obligation[.]”

Second, the court observed that “[w]hile the settlement payment certainly benefitted American Western, the Court concludes that it greatly benefitted Donnelly as well. This case was settled well within policy limits. Thus, the Court thinks it unlikely that Donnelly faced a situation in which it would be hit with an excess verdict. However, the settlement guaranteed a fixed settlement amount and capped costs, whereas a trial could have led to a verdict greater than the settlement in a case in which it was ultimately decided that American Western owed no duty to indemnify Donnelly.”

Lastly, the court noted a practical aspect of its decision to allow reimbursement. The Third Circuit was aware that a settlement had been reached in the personal injury action when it issued its decision that no coverage was owed. Based on this, the court observed: “It therefore seems unlikely that American Western would have no duty to indemnify but would be barred from receiving reimbursement once its duties and obligations were litigated in this forum. If such a distinction existed, it would provide an incentive for the insurer to not settle, hoping that it owed no duty to indemnify, or stall on litigating and paying a settlement, hoping that its duties would be clarified before it made any payments. This Court does not wish to encourage either of those responses.”

Based on these rationales, an insurer that is undertaking its insured’s defense, under a reservation of rights, and has filed a coverage action, but that is not resolved before a demand to settle is made, has an argument that any settlement it makes is one for which it is entitled to reimbursement, following any judicial determination that no coverage was owed for such settlement. [Of course, the insured’s financial ability to actually reimburse the settlement payment is a key practical issue.]

Having filed the declaratory judgment action, it cannot be said that the insurer’s settlement payment was voluntarily made due to a mistake of law. To the contrary, in fact. Filing the coverage action evidences the insurer’s clear belief that no coverage is owed. Second, the settlement benefits the insured. Since coverage may not be owed, the settlement prevents a verdict greater than the settlement amount, for which the insured may have no coverage, as was the case in Donnelly.

Donnelly makes an important point. By filing a declaratory judgment action, even if it is not resolved in time before a settlement demand is made, an insurer has more options when an underlying action gets down to the wire and it faces two choices – both difficult: settle and possibly lose coverage defenses or not settle and face liability for the verdict – excess of the settlement amount or policy limits. American West filed a coverage action and thereafter had an option after being confronted with the settlement demand.

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