By Jordan S. Stanzler

For more than thirty five years courts in California have held that insurance companies have a duty to settle claims prior to litigation. That principle is fundamental to insurance law and is recognized nationwide. Liability insurance is "litigation insurance" because it provides "peace of mind." It therefore follows that if an insurance company wrongfully refuses to settle a covered claim -- before the claim turns into a lawsuit -- then the insurance company may be held liable for its bad faith refusal to settle. The duty to settle -- and to avoid unnecessary litigation -- is based not only in the language of the insurance policy, but in the public policy of resolving disputes short of actual litigation.

These principles are now under attack by insurance companies who have been emboldened by the Supreme Court's decision in Foster-Gardner, Inc. v. National Union Ins. Co., 18 Cal, 4th 857 (1998) and Certain Underwriters at Lloyd's of London v. Superior Court (Powerine), 24 Cal. 4th 945 (2001). Those cases held, respectively, that there is no duty to defend claims that have not ripened into lawsuits; and that the duty to indemnify is limited to money ordered by a court. There is no question that these cases are a disaster for policyholders, adopting an extreme minority view of coverage that departs from the vast weight of authority nationwide, depriving policyholders of coverage that is granted in other states. Insurance companies now reason that those cases should be interpreted to mean that there is no duty to settle a claim prior to litigation. The argument goes that a claim is not a lawsuit requiring a duty to defend; and the settlement of a claim prior to litigation does not involve the payment of money by a court. Therefore, it is argued, there is no duty to settle claims prior to litigation. This logic is erroneous for several reasons. Despite the sweeping reach of Foster-Gardner and Powerine, those cases still did not eviscerate the duty to settle prior to litigation.

First of all, the duty to settle is imposed as a matter of public policy. "The implied obligation good faith and fair dealing requires the insurer to settle in an appropriate case although the express terms of the policy do not impose such a duty." Communale v. Traders and General Ins. Co., 50 Cal. 3d. 654, 659 (1958).

The policyholder reasonably expects that "a sum of money equal to the limits is available and will be used so as to avoid liability on his part with regard to any covered accident." Crisci v. Security Ins. Co., 66 Cal. 2d 425, 431(1967). The duty to settle is therefore implied in every liability policy: "Liability [for breach of the duty to settle] is imposed not for a bad faith breach of contract but for failure to meet the duty to accept reasonable settlement, a duty included within the implied covenant of good faith and fair dealing." Id. at 430. Accordingly, "an insurer's ‘good faith', though erroneous, belief in non coverage affords no defense to liability flowing from an insurer's refusal to accept a reasonable settlement offer." Johansen v. California State Auto Assn, 15 Cal. 3d 9, 12 (1975); Samson v. Transamerica Ins. Co., 30 Cal. 3d 220, 237 (1981) ("If an insurer honestly believes that its policy does not provide coverage and, therefore, chooses to reject a reasonable settlement offer, it must bear responsibility if coverage is found"). Thus, the duty to settle is fundamental to the protections afforded by liability insurance. That insurance is illusory if the insurance company does not have a duty to settle a covered claim (or lawsuit) when failure to do so would result in liability being imposed upon the insured.

Recognizing these principles, California courts have long held that the insurance company has a duty to settle claims prior to the filing of a lawsuit against the policyholder.

1. The duty to Settle Applies Prior to and Without Regard to Whether the Claimant Files Suit Against the Policyholder.

California courts have explicitly held that the insurance company has a duty to settle claims prior to the filing of a lawsuit by the claimant against the policyholder. In Critz v. Farmers Ins. Group, 230 Cal. App. 2d 788 (1964), for example, the court reinstated the policyholder's bad faith complaint alleging breach of the duty to settle, with leave to amend. The court observed that:

failure to settle may occur late or early in the game. Sometimes negotiations are held open almost to the time the jury returns with its verdict; sometimes the contending sides agree to disagree even before the accident suit is filed. Certainly, the extent of negotiations preceding the breakdown, the timing of the insurer's rejection in relationship to the sequence of accident, commencement of suit and trial are elements in the fact trier's individualized adjudication of good or bad faith. That rejection of the compromise offer happened early rather than late, that it preceded judgment or trial or even commencement of suit, does not preclude a finding of bad faith. Assuming bad faith, the breach of the insurance company's obligation occurs at the time when it indulges in the unwarranted rejection of a reasonable compromise offer within the policy limits.
Id. at 797 (emphasis added).

In Critz the claimant was injured in an accident involving Farmers Insurance Group's (Farmers) policyholder. Before suit was filed, Farmers refused the claimant's policy limits settlement offer. The court subsequently found that if Farmers' rejection of the settlement offer prior to the claimant's lawsuit was wrongful, then Farmers' would have breached its duties under the policy and policyholder's assignment of his rights against the insurance company to the claimant would be valid. Id. at 803-804.

In numerous other cases California courts have similarly applied the duty to settle to pre-lawsuit claims. In Chodos v. Insurance Co. of North America, 126 Cal. App. 3d 86 (1981), the policyholder settled a claim arising from an auto accident without waiting for the claimant to file suit. Id. at 92. When the insurance company then refused to pay its policyholder the full amount of the settlement, the jury in a subsequent bad faith action found that the insurance company breached its duty of good faith. The appellate court did not specifically mention the duty to settle, but held that in light of evidence that the insurance company failed to investigate the claim, the jury, with little difficulty, could conclude that the insurance company had not done its duty when it failed to pay the amount of the pre-litigation settlement. The court also observed that in settlement of the claim the insurance company's and policyholder's best interests were identical: to avoid a lawsuit by settling expediently and economically. Id. at 99.

Similarly, in Hulett v. Farmers Ins. Exchange, 10 Cal. App. 4th 1051 (1992), an insurance company prior to suit submitted a low settlement offer to settle a claim against its policyholder. The matter did not settle, and the policyholder's liability to the claimant was established to be much greater. In the policyholder's subsequent suit for policy benefits against the insurance company, the appellate court found that the amount of the award supported an inference that the insurance company's much lower settlement offers were made in bad faith, defendant making no attempt to effectuate a fair and equitable settlement, and that the presence of inferences supporting a judgment in favor of plaintiff was sufficient to defeat the insurance company's motion for summary judgment. Id. at 1060. Other cases include Palmer v. Financial Indem. Co., 215 Cal. App. 2d 419 (1963), in which the insurance company was found to be in bad faith for not including a party in a pre-lawsuit settlement, Id. at 430, and Hightower v. Farmers Ins. Exch., 38 Cal. App. 4th 853 (1995), in which the court held that an insurance company may have tort liability for bad faith handling of an uninsured motorist claim, including failures to settle or investigate prior to arbitration where liability is clear. Id. at 862-863.

When an insurance company has denied coverage, the policyholder may settle the claim, prior to litigation, rather than wait for the claim to metastasize into litigation. In Walters v. American Ins. Co., 185 Cal. App. 2d 776, 786 (1960), for example, the court held that the insurance company was bound to reimburse the policyholder for a settlement of threatened litigation:

Although there was no action instituted her, defendant had denied coverage. The record clearly indicates that the filing of suit would have impaired plaintiff's credit and that such credit would not have been impaired had defendant admitted coverage. Moreover, in making the settlement under the circumstances here present, plaintiff acted reasonably and as a result of defendants' denial of coverage

2. The Decision in Shade Foods Shows Application of the Duty To Settle to Protect a Business's Interests Under the Policy.

Application of the duty to settle a "claim" prior to and irrespective of whether the claimant filed a lawsuit is shown by the decision in Shade Foods, 78 Cal. App. 4th 847 (2000). The policyholder's primary insurance company was found in bad faith for failing to participate in the settlement of a "claim" prior to its maturation into a "suit." The insurance company was under a duty to settle even though there was no lawsuit brought by the claimant, and no attendant duty to defend. Shade Foods later affirmed a bad faith judgment against the insurance company that refused to settle the claim against its policyholder even though the claimant never filed a lawsuit against the policyholder. Id. at 905-910. General Mills had filed a claim asserting that Shade Foods had damaged General Mills' nut cluster cereal, by selling almonds which contained wood splinters.

Shade notified Royal that it intended to assume full responsibility for the loss, yet Royal failed to engage in meaningful settlement discussions. Id. at 901. Therefore in April and May 1995 Shade paid General Mills the amount of its claim without waiting for General Mills to file a lawsuit, and in fact General Mills never filed a lawsuit against Shade arising out of the almond claim. Id. at 904-905. In June, 1995 Shade instead filed its lawsuit against Royal, alleging various claims of bad faith. Id. at 862.

The First District affirmed the jury's finding that Royal breached its duty of good faith when Royal failed to make good faith efforts to negotiate a settlement of General Foods' pre-litigation claim.

3. Powerine Did Not Abrogate The Duty To Settle Pre-Litigation

It is inconceivable that the Supreme Court intended to overrule this line of authority in either Foster-Gardner or Powerine, without even mentioning it. Justice Kennard's dissent in Powerine made a point of emphasizing that if an insurance company refuses to settle a claim, prior to litigation, the policyholder may still sue "for breach of the duty to accept a reasonable settlement." 24 Cal. 4th at 979. The majority opinion grudgingly acknowledged this point, while not accepting Justice Kennard's dissent, that the duty to indemnify is not limited to judgments entered by a court but also extends to settlements entered into outside of court. The majority recognized in a footnotes that the standard insurance policy contains a provision recognizing the duty to pay for settlements. Id. at 962, n.4. That duty is set forth obliquely in the "no action" clause, which states that "no action" shall be brought against the insurance company unless there has been a judgement or a settlement to which the insurance company "agrees." In discussing this provision, the Court seemed to make a distinction between the duty to fund a settlement and the duty to indemnify: "This provision implies that the insurer may owe a duty to fund such a settlement. It also implies that the insurer may owe a duty to indemnify." Id.

The court's distinction between the two duties -- settlement and indemnification -- evokes (without citation) the principle that the duty to settle is a special, independent duty that arises apart from the duty to indemnify. This is an important distinction, which reaffirms the importance of the duty to settle. A settlement may take place outside of court, before or after litigation, and typically involves no money ordered by a court. Therefore, the majority decision -- that the duty to indemnify is limited to money ordered by a court -- could not stand unless some explanation was given about the duty to settle out of court. Taken together, the footnote and the dissent recognize that the duty to settle was not addressed or affected by the Powerine decision; and still survives, independently of the duty to indemnify.

4. Pitfalls of the "No Action" Clause

Nevertheless, insurance companies may invoke the "no action" clause to avoid paying for settlements. Buried in the find print of most insurance policies is a provision that the policyholder cannot make "voluntary payments"; and that no action can br brought against the insurance company unless there has been a judgment or unless there has been a settlement which the insurance company agreed to in writing. This provision provides the insurance company with protection in the event that a policyholder settles a claim without giving notice to the insurance company. There are untold cases in which the policyholder settled a case and then gave notice to the insurance company.

Can an insurance nevertheless refuse to give its consent after being given notice that the policyholder intends to settle a covered claim? The answer is no, if the insurance company has denied coverage. If an insurance company denies coverage, then it has breached the contract, leaving the policyholder no alternative but to strike the best deal possible with the adversary. See, e.g., Samson v. Transamerica Ins. Co., 30 Cal. 3d 220, 240 (1981). The insurer can no longer rely upon its right to approve a settlement where it has rejected coverage. See, e.g., Pruyn v. Agricultural Ins. Co., 36 Cal. App. 4th 500, 509 (1995) (when "a liability insurer wrongfully denies coverage or refuses to provide a defense, then the insured is free to negotiate the best possible settlement . . . including a stipulated judgment accompanied by a covenant not to execute"); Diamond Heights Homeowners Ass'n v. National American Ins. Co., 227 Cal. App. 563, 581 (1991) (insurer waives "no action clause" and right to control settlements where it wrongfully denies coverage); Walters v. American Ins. Co., 135 Cal. App. 2d 776 (1961); Phoenix Ins. Co. v. United States Fire Ins. Co., 189 Cal. App. 3d 1511, 1526 (1987)

A more problematic situation takes place when the policyholder gives notice of a proposed settlement, but the insurance company does nothing. Can the insurance company withhold its consent? The answer again is no. The insurance company cannot deny coverage where it has not responded at all to notice of a settlement, but then argues that it never gave its consent to the settlement. See, e.g., National American Ins. Co. v. Certain Underwriters at Lloyd's London, 93 F.3d 529 (9th Cir. 1996) (lack of response to notice of settlement prevents insurer from invoking no action clause); Fisher v. USAA Casualty Ins. Co., 973 F. 2d 1103, 1107-1109 (3rd Cir. 1992)( insurance company cannot unduly delay coverage decision after notice of a settlement proposal).

Recently, the Fourth Appellate District invoked the "no action clause" in County of San Diego v. Ace Property & Casualty Co., No. D038707 (December 2, 2002). The County settled groundwater contamination claims after its excess insurance company denied coverage. The insurance company invoked the "no action" clause, saying the settlements had been entered into without its consent. Surprisingly, the court agreed and did not follow the Pruyn-Diamond Heights line of authority. The court distinguished those cases on grounds that they dealt with primary insurance companies, not excess policies. That distinction is dubious. There is no indication in the case law that there is a different, lesser duty to settle for excess insurance companies. There is no reason why there should be such a distinction between primary and excess policies. The court, indeed, never recognized the duty to settle. The case seems wrongly decided.


In conclusion, the duty to settle claims prior to litigation is a vital aspect of coverage. Policyholders obviously need to give notice to insurance companies before doing so. Should an insurance company wrongfully deny coverage, the policyholder is free to settle the claim under the best circumstances available, including the assignment of its rights against the insurance company. The insurance company, whether primary or excess, remains liable for breach of the duty to settle.

Jordan Stanzler is a partner in Stanzler Funderburk & Castellon with offices in Los Angeles & San Francisco and co-author of "Insurance Coverage Litigation" (Aspen 2002). The firm represents policyholders in disputes with insurance companies.


All materials copyright 1999-2004 by Stanzler Funderburk & Castellon LLP. All rights reserved.

Disclaimer: These materials have been prepared by Stanzler Funderburk & Castellon LLP for informational purposes only and are not legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Internet subscribers and online readers should not act upon this information without seeking professional counsel.