Cleaning Up the Mess in Texas: Insurer Funding Payment of Liability Claims When Coverage Is Doubted

In May 2005, the Texas Supreme Court unanimously held that a liability insurer that voluntarily settles a claim against an insured may recover the payment against its own insured if it proves that the claim is uncovered and it reserved its right to seek recoupment. The Texas Supreme Court, while unanimous in result, was badly splintered in rationale.
Two years ago, the Court granted rehearing. Yesterday, the Court changed course, with a majority ruling that an insurer does not have a unilateral right or an equitable claim to recover a settlement payment. Excess Underwriters v. Frank’s Casing (Tex. Feb. 1, 2008). The court reaffirmed its prior decision in Matagorda County, which barred a primary insurer from seeking recoupment of defense cost. Recent case law in other jurisdictions have split on the issue, but the more robust recent opinions (Illinois, Massachusetts, Wyoming) line up with Texas.

I analyzed the Supreme Court’s original opinion from May 2005 at some length previously, criticizing it fairly strongly on a number of its points and approaches. In the new iteration issued yesterday, the three opinions (majority and two dissents) adopt three approaches: (i) the contract is silent and insurers should fix the drafting omission; (ii) the contract is silent but equity should balance out the resolution (and generally permit recoupment); and (iii) in this particular instance, the contract is not so silent that when combined with the facts there was created a new implied in fact or new implied in law agreement to reimburse.
The Frank’s Casing case was challenging in that an undeserving insured stood before the court – the insurer owed no obligation to pay. Had the insurer refused to pay, it would not have breached its contract and would not (on this basis) be liable for any bad faith or extra-contractual obligation. And the policyholder did not settle the case in reliance on the insurers forfeiting whatever claim they may have possessed at the time to obtain reimbursement.
The majority, per Justice O’Neil, found there was no fundamental unfairness in allowing the insured to reap the benefit of the settlement even when the claim is shown not to be covered. Settlement paid by the insurer is a welcome relief for the policyholder – unless the “other shoe” drops and the carrier seeks to prove in a separate suit both (i) the tort plaintiff was right and the insured-defendant truly was liable, (ii) the insured’s liability was such that it was entirely excluded from coverage and (iii) the insurer alleges the insured must reimburse it for all the money it paid. This result is essentially worse for the insured than is “rolling the dice” at trial, because if the case is triable then a reasonable jury could rule in favor of the insured. By the insurer’s settling, the insured loses the opportunity to have an outcome whereby it walks scot free.
Faced with a reasonable settlement offer from the tort plaintiff, what is the carrier to do? An insurer surely has a privilege to reject an unreasonable settlement offer, but a reasonable settlement offer cast against doubtful coverage places the insurer in a difficult situation. If the insurer doubts the existence of coverage but later is proven wrong, and the settlement offer was reasonable but spurned, the insurer is at risk of being held liable for the entirety of the verdict against the insured even if the verdict exceeds policy limits. This is a consequence of the law of “third party” bad faith or what is called in Texas “Stowers.” An insurer that unreasonably fails to settle a third-party claim that results in a verdict adverse to the insured is potentially liable for all the damages stemming from its unreasonable conduct, i.e., the value of the verdict that could have been averted had the settlement been accepted.
The insurers and their backers in the Texas Supreme Court found it unfair that the insurer could be set up or pressured to make payment on behalf of an insured yet be unable to prove that coverage was not properly owed. The split between the majority and dissent might be thought of as a difference in opinion whether the insurers are required to put into the policy some sort of provision addressing the situation of a reasonable settlement that might or might not be covered. The majority holds the insurer that fails to clarify its contract on this point bears the consequences, that is, if it makes the payment to extinguish the insured’s liability it does so without recourse against the insured (unless the insured expressly agrees to a right of reimbursement). The articulate dissent by Justice Hecht reasons that because the policy is silent the insurer should be able to pay under protest (i.e., with a reservation) such that it can mount an equitable claim to recover the benefit conferred on the insured that was never owing to begin with (assuming that coverage does not apply).
Justice Hecht’s dissent argues cogently that principles of equity generally permit a party that doubts performance is owed to tendered performance subject to a reservation; the dissent then argues that there is no distinction between insurance companies and other contracting parties. Assuming Justice Hecht is right in his premise on what equity generally provides, policyholders need to fashion a persuasive response as to why insurance is different.
I think the difference lies in the fact that other kinds of contracting parties do something else in the world other than make contracts. If I make widgets and you are a supplier, and you then think that you don’t owe me some delivery, equity (apparently) will permit you to provide performance to me, subject to straightening it all out later. No doubt the parties’ contract does not address this situation, that is, of uncertain obligations to perform, and the law or equity seeks to ensure a fundamentally fair outcome and does not blame the parties for not accounting for this situation ex ante.
That widget makers and their suppliers do not lay out in their contracts what happens in these circumstances is understandable. They are in the business of widgets, and their making a contract is ancillary to what they do. But insurance companies are different.
Insurers are professional contract-writing companies; what they sell are not widgets but contracts. Insurers have the knowledge that there are many circumstances where coverage may be uncertain but a reasonable settlement will be presented. What the insurer may do or may be required to do might be deemed to be something in the insurer’s superior knowledge vis a vis a prospective insured, such that an omission in the contract can be considered to be deliberate by the insurer. Under this approach, an insurer’s failure to clarify what might happen in a situation that is not altogether unlikely to arise can be considered a species of sharp practice such that Justice Hecht’s equitable remedy will not lie. It is well established that he who seeks equity must do equity, and that doctrines such as unclean hands will preclude the exercise of equity power. Accordingly, while the dissent makes a powerful argument that in an ordinary circumstance payment under protest is allowable and equity will reallocate, an insurer that finds itself in this situation and has not clarified its intentions in its contract has only itself to blame, such that equity should not intervene.
Instead, insurers should write out how such claims will be handled, and allow insurance regulators and market forces to scrutinize and differentiate among insurance products. This is the essence of the holding of the new majority opinion in Frank’s Casing:

We resolved this quandary in Matagorda County, determining that the risk of coverage uncertainties was best placed with the insurer. Id. We reasoned that “[r]equiring the insurer, rather than the insured, to choose a course of action is appropriate because the insurer is in the business of analyzing and allocating risk and is in the best position to assess the viability of its coverage dispute.” Id. at 135. An insurer in this situation has a number of options. If the insurer assesses its coverage position as strong, it may refuse to participate in settlement and rely on its coverage action, leaving the insured to negotiate a settlement with its own resources. Or, an insurer may seek prompt resolution of its coverage dispute, a course we have encouraged insurers in this position to take. Id. at 135 (citing State Farm Fire & Cas. Co. v. Gandy, 925 S.W.2d 696, 714 (Tex. 1996); Farmers Tex. County Mut. Ins. Co. v. Griffin, 955 S.W.2d 81, 84 (Tex. 1997)). Or, if an insurer’s coverage position is difficult to assess, as is sometimes the case, the insurer can leverage the coverage dispute during settlement negotiations to lower the claimant’s demand; by paying the negotiated claim, the insurer eliminates its own potential bad-faith liability, saves defense costs, and avoids protracted coverage litigation with its insured. Or, at the outset, the insurer may include a reimbursement right in the policy, which may yield a lower premium than a policy that does not contain such a right.

Slip op. at 7. Texas joins the high courts of Massachusetts and Illinois, among others, in placing the initial onus on insurers to state their intentions ex ante and not to permit case by case adjudication after the tort claim is settled. An insurer that has a contract that is silent on the point can choose to settle the claim against the insured and fund the settlement, can arrange with the insured to provide it with a loan to fund a settlement while the coverage issues are worked out, or can refuse to pay for a settlement and hope to prove there is no coverage or that its refusal to perform at least was reasonable. There is no reason for courts to create one further remedy for insurers when they are well-positioned to protect themselves at the point of contract. The Texas Supreme Court in its majority opinion contributes to stability in contract relationships and cleans up what had been a real mess conceptually in the initial opinion in Frank’s Casing.

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