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A respected cosmetic surgeon gives advice to his patient who has just undergone a laser-assisted radical facelift, but the patient ignores the advice. The patient then visits another doctor and learns that a post-operative infection has developed in his ears, which results in him going deaf. The California Medical Board holds that the surgeon did not commit malpractice. Nevertheless, the patient sues the doctor, seeking $5 million in damages. The doctor’s malpractice carrier assumes the defense under a complete reservation of rights. The policy excludes coverage for injuries caused by lasers during surgery. The insurer therefore seeks a separate declaratory judgment affirming its laser exclusion. The doctor and patient are both adamantly opposed to settlement of the malpractice action within the $1 million policy limits so the patient never makes a demand within the limits. Based upon the Medical Board’s findings, the doctor’s wishes, the absence of a demand within policy limits and the policy’s laser exclusion, the insurer does not settle the case. A jury trial results in a $3 million judgment against the doctor, who in turn sues her insurer for the entire judgment based on the insurer’s inadequate settlement efforts. Meanwhile, the insurer is denied declaratory relief when the laser exclusion is found to be inapplicable. In a case like the hypothetical one described above, many would say that the doctor should have purchased a policy with higher limits and that she simply gambled and lost. How could the insurer have settled considering the doctor’s strong liability defenses and opposition to settlement, no policy limits demand and a reasonable coverage defense? Unfortunately, questions like this are almost impossible to answer. Indeed, bad faith litigation is on the rise and insurers are caught in the middle. In cases like the one presented above, hindsight isn’t even 20/20, as most experts would agree that the company would not have made a different decision given the evidence it had. But as bad faith litigation proliferates, insurers must grapple with such conundrums. Even as they do, however, they also have options that can reduce the risk of bad faith exposure. Even if the insured is opposed to settlement and panel defense counsel has identified strong liability defenses, insurers should consider retaining separate coverage counsel to impress upon the insured the significance of settlement demands over policy limits and the effect of coverage defenses. The insured’s settlement position should then be thoroughly documented. Further, even if an insurer’s “no coverage” position is reasonable, the insurer will be liable for the full amount of any ensuing judgment regardless of policy limits if that position is held to be erroneous. In other words, the insurer is said to “act at its own risk.” ( Samson v. Transamerica (1981) 30 Cal.3d 220; Johansen v. California State Auto. Ass’n Inter-Ins. Bureau (1975) 15 Cal.3d 9.) This rule resulted from the injustice of allowing an insurer (with full control over the defense) to reject a policy limits demand and gamble that there is no coverage, thereby exposing its insured to personal liability. It does seem anomalous, however, to impose tort liability in cases where the insurer acted reasonably but erroneously in denying coverage. Some courts have rejected tort liability under those circumstances. ( American Cas. Co. of Reading, Pa. v. Krieger (9th Cir. 1999) 181 F.3d 1113.) But in a case involving sexual molestation claims, the California Court of Appeal has affirmed that an insurer who refuses a reasonable settlement offer on the grounds of “no coverage” does so at its own risk and has no defense that its refusal was in good faith if coverage is ultimately found. However, an insurer has no obligation to settle any claim that may be asserted but is not covered by the insurance contract. ( Marie Y. v. General Star Indemnity (2003) 110 Cal. App. 4th 928) Where there are no coverage issues, the insurer’s refusal to settle is commonly based on its evaluation of the settlement demand. In effect, the insurer concludes that it should at least be able to obtain a judgment for less than the demand. In such cases, the question of whether the insurer’s refusal to settle constitutes bad faith is measured by the “prudent insurer” standard. This means that there will be no bad faith liability unless the insurer’s refusal to settle was unreasonable under all circumstances. The applicable standard is whether the carrier would have settled if it alone was exposed to a potential judgment. If it is shown that the carrier fell below that standard, the insurer assumes the full liability of its insured even in excess of policy limits. ( Hulett v. Farmers Ins. Exch. (1992) 10 Cal.App.4th 1051.) However, an insurer is not obligated to accept a demand within policy limits unless it is also reasonable. The reasonableness of a settlement offer depends on facts known or available to the insurer at the time of the proposal. “The reasonableness of a settlement offer is to be evaluated by considering whether, in light of the victim’s injuries and the probable liability of the insured, the ultimate judgment is likely to exceed the amount of the settlement offer.” ( Isaacson v. California Ins. Guar. Ass’n (1988) 44 Cal.3d 775.) Unfortunately, under the “hindsight rule” the entry of an excess judgment provides evidence of the likelihood of such result, furnishes an inference that the value of the claim was the amount of the judgment and indicates “that acceptance of an offer within those [policy] limits was the most reasonable method of dealing with the claim.” ( Crisci v. Security Ins. (1967) 66 Cal.2d 425.) Of course, based on its conclusion that a claim is meritless, a carrier may simply refuse to settle and agree to pay any judgment without regard to policy limits. Such a waiver of limits should be clear, unequivocal and in writing. But this tactic makes sense only in cases in which the insurer is very confident that the insured will prevail. Under such an arrangement, the insured would not be exposed to uninsured liability, which should preclude any bad faith liability for the carrier. The maxim that communication is everything is especially true during litigation involving insurers and insureds. If the insured feels that the carrier is keeping her informed of the decision-making process regarding settlement negotiations, the insured is much less likely to file a bad faith lawsuit. As a result, an insurer should send all such communications to its insured. If the insurer does not wish to accept a settlement offer, its reasons should be thoroughly explained to the insured. If the insured and the insurer both agree that the case should not be settled, that strategy should be thoroughly documented. If there is a demand in excess of limits and the insurer is willing to pay its limits, the insured should be advised of his right to contribute the excess portion of the demand. This avoids a later argument by the insured that he would have agreed to contribute if he had only been given an opportunity to do so. If the plaintiff fails to initiate settlement discussions, the insurer should open negotiations with the insured’s knowledge. If a settlement demand is uncertain — for example, when it does not address the release of a workers’ compensation lien — the insurer should promptly seek clarification. Should the insurer refuse to settle and a judgment is entered against its insured in excess of policy limits, the carrier may often avoid a bad faith lawsuit by proceeding with an appeal. In fact, under Jenkins v. Ins. Co. of No. America (1990) 220 Cal.App.3d 1481, the duty to defend includes the duty to appeal whenever reasonable grounds exist. However, if the judgment is in excess of policy limits, the insurer is only obligated to secure the covered portion of the judgment up to those limits. The insured is obligated to secure the remainder with her own assets. However, if the insured does not have sufficient assets to do so, the insurer may decide to secure the entire judgment pending appeal. In that way, the appellate court is given an opportunity to reverse the judgment, which could result in an outright reversal or retrial and, ultimately, a defense verdict. At the very least, an appellate reversal may position the case for a settlement within policy limits. The risk, of course, is that the appellate court affirms the judgment. In that case, the insurer may end up funding the entire judgment because it will likely never be able to recover the excess portion of the judgment from its impecunious insured. Ultimately, no matter what the insurer does it may still be sued for bad faith if the insured is unhappy with the outcome of the underlying lawsuit or is faced with personal exposure. However, if the carrier has followed the common sense suggestions outlined above, it should be able to present evidence that it acted reasonably in refusing to settle an underlying lawsuit. That will go a long way toward defending against any extra-contractual claims. Marta B. Arriandiaga and Kim Karelis are partners in the Los Angeles office of Ropers, Majeski, Kohn & Bentley, where they represent insurance companies in coverage disputes and bad faith litigation.

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