Insurer's Duty to Defend its Insureds
Refusal To Defend Or Settle And Reservation of Rights
Generally, liability insurers owe three separate duties to their insureds. The duty to defend, to settle claims against the insured in good faith and to indemnify and pay coverage claims against their insureds. Arizona Property & Cas. Ins. Guar. Fund v. Helme, 153 Ariz. 129, 735 P.2d 451 (1987).
Standard liability policies require the insurer to defend the insured against all actions brought against them which are, judging by the allegations of such actions, potentially within coverage of the policy. Similarly, an insurers duty to defend is independent of and not limited to its duty to pay. Generally, only three options are available to a liability insurer requested to defend an insured against claims which the insurer believes are beyond policy coverage. The insurer can: (1) seek a declaratory judgment; (2) defend under a reservation of rights; or (3) refuse either to defend or to seek a declaratory judgment (at the insurer's peril that it might later be found to have breached its duty to defend.)
Liability insurers must be careful when voluntarily assuming the duty to defend. An insurers voluntary assumption of the duty to defend may give rise to a cause of action for dereliction in that defense even when there is no actual coverage. Lloyd v. State Farm Mut. Auto. Ins. Co., 176 Ariz. 247, 860 P.2d 1300 (1993).
The duty to defend may be shared. One insurer may be compelled to contribute its share of defense costs where both insurers had a duty to defend and one company failed. Home Indem. Co. v. Mead Reinsurance, 166 Ariz. 59, 800 P.2d 46 (1990).
Arizona has specifically determined when a duty to defend terminates. In Continental Cas. Co. v. Farmers, 180 Ariz. 236 53, 883 P.2d 473 (1994), Farmers Insurance, the primary insurer, was found to have no "ongoing duty" to defend once having paid its policy limits and secured a covenant not to execute in favor of its insured. Previously it was unknown what an Arizona court would do to ensure the duty to defend where policy limits had been exhausted. Other jurisdictions had held that an insurer's tender of policy limits does not end the duty to defend absent judgment, settlement or complete release. It should be noted that the Farmers's policy specifically included language which terminated the duty to defend after having paid its liability limits.
Similarly, the Court of Appeals in a split decision, held that an insurer's duty to defend terminates when the insurer tenders the policy limits and obtains from the claimant either a complete release or a covenant not to execute against the insured's assets. California Cas. Ins. v. State Farm Mut. Auto. Ins. Co., 211 Ariz. Adv. Rptr. 19 (February 19, 1996).
As a result, the mere fact that the primary insurer had paid or at least tendered its policy limits, did not extinguish the duty to defend and ongoing defense costs.
In Arizona, a claim by an insured against his insurer for failure of the insured to defend may be assigned to the injured party. Thus, if the insurer breaches its contract with its insured, its insured may assign any claim against the insurer to a third party, including an injured plaintiff.
In Damron v. Sledge, 105 Ariz. 151, 460 P.2d 997 (1969), the insured's insurance company failed to defend or indemnify the insured for a personal injury claim made against him. The insured then entered into a "Damron agreement" as follows:
- The plaintiff s attorney executed a covenant not to execute against the insured.
- The plaintiff gave a note to the attorney for the insured as payment of attorney's fees.
- The insured then assigned to the plaintiff whatever claims he had against the insurer for bad faith in failing to defend the lawsuit by the plaintiff.
The trial court has the power to dismiss a case which is collusive. In order to do so, however, the court must hold a hearing and take evidence to prove or disprove the presence of collusion. It cannot be held as a matter of law that collusion exists merely because the defendant chooses not to defend when he can escape all liability by such an agreement and must take large financial risks by defending. If the insured withdraws the answer and accepts a default, the insurer will normally be allowed to intervene in the default hearing on its own behalf in order to protect itself and ensure good faith between the parties and prevent collusion.
The insurer may file a declaratory action in order to determine its rights and duties under the insurance contract. If the insurer fails to file such a declaratory action, the injured plaintiff, to whom the insured's rights have been assigned, may file a declaratory action against the insurer or may attempt to garnish the insurance company for the amount of the judgment the injured plaintiff has secured. If, by the declaratory action, it is determined that the insurer wrongfully refused to indemnify or defend its insured, the insurer will be liable for the amount of the judgment secured by the injured plaintiff, up to the policy limits. If the injured plaintiff is able to prove bad faith, the insurer will be liable even if the amount of the judgment secured by the injured plaintiff is in excess of the policy limits. In addition, damages may be awarded for the bad faith.
In State Farm Mut. Auto. Ins. Co. v. Peaton, 168 Ariz. 184, 812 P.2d 1002 (App. 1990), the court held that an insured is not absolutely entitled to enter into a Damron agreement unless the insurer breaches a duty, either express or implied, in the insurance contract. The court rejected the argument that an insured should be allowed to settle with an injured party simply because the insurer declines to pay more than the amount of coverage that the insured purchased. Only when an insurer breaches its contract obligations will an insured be excused from his obligations under a cooperation clause.
The Arizona Court of Appeals upheld this position in the case of H.B.H. v. State Farm Fire and Cas. Co., 170 Ariz. 324, 823 P.2d 1332 (App. 1992). In H.B.H., the plaintiff brought an action against the insured seeking damages incurred when the insured sexually molested the plaintiffs child on numerous occasions. The parties entered into a Damron Agreement which provided that the insureds would withdraw their answer to the complaint and allow a default judgment to be entered against them in agreement not to contest plaintiff s damages. State Farm moved to intervene at the hearing on damages. However, the trial court denied State Farm's motion and allowed a judgment to be entered.
On appeal, the Court of Appeals reversed the judgment and remanded the case to allow State Farm to intervene at the damages hearing.
The appellate court recently addressed this issue in Purvis v. Hartford Accident and Indem. Co., 179 Ariz. 254, 877 P.2d 827 (1994). In Purvis the court held that an insurer loses its right to intervene if the insurer has breached its contract by refusing to provide a defense to its insured. Before an insurer can be found to have refused its duty to defend, the insured must show that the insurer received sufficient notice that the defense was being tendered to the insurer. The insured must make an unequivocal and explicit demand for the insurer to undertake the defense. A demand for indemnification does not constitute an express demand to undertake a defense.
An insurer with a coverage defense must defend its insured under a properly communicated reservation of rights, or it will lose its right to later litigate coverage. The insurer does not need to reserve its rights immediately upon learning of the lawsuit and may subsequently reserve its rights upon learning new information that would provide a coverage or a policy defense. When an insurer performs its contractual obligation to defend, an insurance policy "cooperation clause" requires the insured to cooperate with the insurer, and the insured must aid the insurer in the defense and may not settle with the insured plaintiff without breaching the cooperation clause, unless the insurer first breaches one of its contractual duties. Thus, if the insurer performs its obligations, the cooperation clause remains in full force, and settlement by the insured constitutes a breach of the insurance policy. United Service Auto. Ass'n . Morris, 154 Ariz. 113, 741 P.2d 246 (1987).
The cooperation clause prohibition against the insured settling without the insurer's consent forbids the insured from settling all claims for which the insurer unconditionally assumes liability under the policy. A settlement agreement between the injured plaintiff and the insured, where the insurer has raised a coverage defense and is defending under a reservation of rights, does not constitute a breach of the cooperation clause. Stipulation by the parties to a Morris agreement, to facts essential to establishing coverage, are not enforceable. In fact, insurers are not even bound by litigated issues if there was a conflict of interest. The insured's settlement agreement may not be used to obtain coverage that the insured did not purchase.
The courts recognize that an insured being defended under a reservation of rights might settle for an inflated amount or agree to a frivolous case merely to escape exposure or annoyance. Accordingly, the amount of liability to the injured plaintiff is binding on the insurer only if the insured or the injured plaintiff can show that the settlement was "reasonable and prudent." The test is what a reasonably prudent person in the insured's position would have settled for on the merits of the plaintiff s case. This involves evaluating the facts bearing on the liability and damage aspects of the plaintiffs case, as well as the risks of going to trial:
When the insurer breaches its obligation of good faith settlement, it exposes its policyholder to the sharp thrust of personal liability. At that point, there is an acute change in the relationship between policyholder and insurer. The change does not or should not affect the policyholder's obligation to appear as the defendant and to testify to the truth. You need not indulge in financial masochism, however. Whatever may be his obligation to a carrier, it does not demand that he bear his breast to the continued danger of personal liability. By executing the assignment, he attempts only to shield himself from the danger to which the company has exposed him. He is doubtless less friendly to his insurer than he might otherwise have been. The absence of cordiality is attributable not to the assignment, but to his fear that the insurer has callously exposed him to extensive personal liability.
Damron, 105 Ariz. at 153, 460 P.2d at 999.
The previous cases indicate the serious effect of issuing a reservation of rights letter and denying indemnification in the defense of tort claims in Arizona. Any time a dispute arises regarding coverage under an insurance contract, an insurer should do the following:
- Send a reservation of rights letter immediately to the insured identifying exactly the factual issues and the language in the policy which give rise to the reservation of rights.
- Do an immediate investigation to determine the validity of the reservation of rights.
- Continue to provide a defense while investigating the reservation of rights.
- If denying coverage, file a declaratory action immediately to resolve the coverage issues.
- Intervene in any damages hearing based on Damron or Morris Agreements.