Settling Without Consent - A Perilous Route

An insured calls its E&O carrier, claiming it has recently committed an error that has damaged the insured’s client. Reportedly, the client is unhappy and wants to be paid for the mistake. The insured’s board of directors has just met and has resolved that the insured will issue a check in the amount of $200,000 to the client within the next 48 hours. The insured relays its expectation of receiving full reimbursement for this payment from its E&O insurer.

The insurer balks and urges the insured not to settle the claim. It issues a reservation of rights letter by fax citing, among other things, the following policy provision: The Insured shall not, except at the Insured’s own cost, make any payment, admit any liability, settle any claims, assume any obligation or incur any expense without the written consent of the Company...

The insured, pressured by its important customer, proceeds and issues the check. When demand is made upon the insurer for reimbursement, the claim is denied. The carrier contends that the insured has violated the above-quoted provision...

The insured and its insurance broker can’t believe it. They argue that the evidence shows that the insured was indeed liable and that the amount of damages is clear. Since the carrier was not prejudiced, goes the argument, it remains liable for the full amount of the settlement.

Generally, an insurer will be entitled to deny coverage for any such unilateral payments, with no need for a showing of prejudice. Courts typically enforce the policy’s requirement that insureds not settle cases without the consent of the carrier. This is a material part of the bargain struck by the insurer when issuing a policy, and claim denials should thus not come as a surprise to insureds and their insurance broker representatives.

What is at issue here is not mere late notice of a claim or occurrence. While the requirement of prompt notice and provisions relating to unauthorized settlements are usually found in the Conditions portion of an E&O policy, the consequences for failing to strictly comply with each of these provisions are not frequently the same. Because insureds and their brokers often times confuse the operation of these respective clauses, the goal of this article is to alert insureds and their brokers as to how E&O carriers and courts tend to view unauthorized settlements, so as to avoid uninsured losses and ill will between insureds, brokers, and insurers.

“Late Notice-Prejudice Rule”
The general purpose of a notice provision in a liability policy is to enable insurers to adequately investigate and respond to claims. As a majority rule, the late reporting of a claim (or occurrence) to a liability insurer will not compromise the insured’s coverage, unless the insurer can demonstrate that it has been somehow “prejudiced” by the late notice - that is, unless an insurer’s rights have been materially compromised, courts will look to make the call of “no–harm–no–foul” if at all possible, such that the insured does not lose its coverage.

This result is often justified by the notion that insurance contracts may be seen as contracts of adhesion – the policy is offered by the marketplace on a “take it or leave it basis” with no realistic opportunity to negotiate terms. Further, enforcement of a notice provision is seen as a “forfeiture,” where the insured loses its right to insurance without regard to its payment of premiums. Courts are also cognizant that loss of liability coverage can impact innocent third parties.

“Consent to Settlement” Clause
On the other hand, courts often require strict compliance with the Consent to Settlement clause. This type of clause is found in liability policies which forbid insureds from settling without the consent of the insurer. The purpose of this clause is to prevent collusion between the insured and the claimant and to give the insurer control over the settlement of the claim. While an insured that fails to provide timely notice to its insurer may be able to demonstrate that it has not compromised any of the insurer’s material rights under the policy, when an insured settles a claim without first procuring consent from its insurer, this action strikes more centrally to the insurer’s rights under the policy. The dynamics of the policy have been greatly altered, with the insurer’s rights substantially affected. It is important for insureds and brokers alike to appreciate this reality.

In the professional liability world, the desire to settle without the insurer’s consent is often engendered by a client of the insured that wants to be paid. While this is not always the case, it seems to comprise many of the claims scenarios. The client seeks recovery from the insured for an alleged mistake made by the insured. The client wants to be paid fast. The insured may be primarily interested in keeping its customer happy. The rapidity with which the client/claimant wants to be paid typically does not coincide with the normal and appropriate “adjustment” phase of a claim. The insurer will usually not be in a position to pay any indemnity moneys until it can satisfactorily conduct its investigation into liability and damages.

If the insured ultimately acquiesces to the demands of its client by making payment, it should expect a denial from its E&O carrier. However, when these claims are denied, it is not unusual for the response from the insured and/or its broker to be quite cavalier, expressing disbelief that the insurer is so troubled by the unilateral acts of the insured. The position taken is that nothing the insured has done has prejudiced the insurer; that the facts demonstrate clear liability of the insured; that the insured has saved defense costs on the claim; and that the quantum of damages are equally clear. According to the insured, there is nothing left to do but for the insurer to issue a check in settlement on the insured’s behalf.

When a third-party has made a claim against the insured (and for which the insurer may be responsible), during the investigation and adjustment phase of a claim, it is imperative that the insurer has the full cooperation and fidelity of the insured. In essence, during this phase, its the claimant v. the insured (and the insurer). This is the nature of a liability insurance policy, as it must be. The “Consent to Settlement” clause allows the insurer to properly protect its interests.

This important dynamic is seriously undermined when an insured settles without the consent of the insurer. Once a claim is paid, there is no longer any incentive for the insured to assist the insurance company in marshaling evidence in support of the defense of the claim; on the contrary, the insured’s only objective incentive becomes to prove the claimant’s case. The nature of the policy is turned on its head. Since the insured’s actions so compromise the fundamental procedural safeguards built into a liability policy for the insurer’s benefit, the insured will face a real possibility of losing its coverage.

Frequently, what the insured really wants (consciously or unconsciously) is some form of protection from losing a valued customer. This is not, however, what an E&O policy covers. It covers the insured’s legal liability. The case of Charter Oak Fire Ins. Co. v. Color Converting Indus., 45 F. 3d 1170 (7th Cir. 1995) is an instructive case in this regard.

In Charter Oak, the insured paid its biggest customer, without the consent of its insurer. While there was evidence that the insurer undertook an investigation as soon as practicable and otherwise acted in good faith towards its insured, this was not good enough for the insured, given what was rapidly becoming a precarious business relationship.

The issue to be decided by this case was whether the insurer had an implied obligation to settle in order to minimize the insured’s business risk– the risk of the insured losing a valued customer. The insured argued that since this was part of the insurer’s obligation, it could thus circumvent the provision of the policy which the insurer argued precluded settlements without the consent of the insurer. The court did not agree. The court then sets forth its rationale as to why this is not part of the bargain between an insurer and its insured. As part of this explanation, the court talks about the fact that this breach, all by itself, whatever its genesis, so compromises the insurer’s rights found in a liability policy, that it cannot be countenanced. The court continued:

Such insurance would be foolhardy to write, at least without an enormous premium...[Insureds] do not want to harm their customers. If they do so by accident, as happened here, they are eager to make amends, especially when they can do so at no cost to themselves, or at least no greater than the possible increase in insurance premiums that impends whenever an insurer has to pay a claim. They do not want to anger valued customers (and [the claimant] appears to have been [the insureds] most valued customer) by questioning the accuracy or honesty of the claim, or by trying to shift the fault to the customer, or by failing to pay the claim promptly. If the insurance company has an implied duty to cooperate with its insured to the extent necessary to avoid offending powerful customers, the opening for collusive and exaggerated claims...will be immense. It would be unrealistic to suppose that, in the absence of any language in the policy suggestive of such an undertaking, the parties had agreed that the insurance company would shoulder this duty. The danger of collusion between an insured and its customers, just as between an insured and the members of the insured’s family, is one against which insurance companies assiduously endeavor to protect themselves...

To all this, [the insured] might reply that the danger of collusion is exaggerated. If the insured does settle and then turns around and seeks reimbursement from the insurance company, it will have to prove that the settlement was reasonable...

But as insurance companies are not popular litigants, they want to manage the settlement process themselves rather than have to persuade a court that the insured acted precipitately (citation omitted). We can imagine a liability insurance contract that entitled the insured to settle any claim without consulting the insurer, provided only that the settlement was reasonable. That is not this contract, however, and we daresay the insured would have had to pay a higher premium if it had wanted this additional freedom of action that it might use to safeguard its customer relations.

Compliance with the “Consent to Settlement” clause is thus vital to protecting coverage. It is also important to understand the legal application of such clauses, so that parties to the insurance contract (and any intermediaries) can have reasonable expectations. A clearer understanding of the issues can go a long way in avoiding unhappy conflicts between and amongst insurers, their brokers and insurers, as well as reducing the costs of coverage litigation which is likely to ensue in the event of a breach of this clause.