The court in Yan Fang Du v. Allstate Insurance Co., No. 10-56422 (9th Cir. June 11, 2012), held that an insurer’s implied covenant of good faith and fair dealing imposes a duty to attempt to settle an underlying action when the liability of its insured has become “reasonably clear,” even where the underlying claimant has not made a settlement demand.  The appellate court held that although the particular facts before it did not support a finding of bad faith, the trial court erred when it rejected a proposed jury instruction stating that in determining whether the insurer acted in bad faith, the jury could consider whether “the defendant did not attempt in good faith to reach a prompt, fair and equitable settlement . . . .”

Prior to the Yan Fang Du decision, California courts had not directly addressed the issue of whether an insurer can face bad faith liability for failing to initiate settlement negotiations before the underlying claimant has made a settlement demand within policy limits.  However, California courts and a majority of courts across the country have held that an insurer is liable for the amount of a judgment or settlement against its insured in excess of policy limits if the insurer, in bad faith, refuses to accept a settlement demand made by an underlying claimant for an amount less than the remaining policy limits if, at the time the demand is made, there is a reasonable probability that the insured could be held liable at trial for damages in excess of the policy limits.  The Yan Fang Du holding is consistent with this rule, which is based on an insurer’s obligation to treat the interests of its insured equal to or greater than its own interests deciding whether to settle. 

The Yan Fang Du decision also is consistent with the nature of the protection from liability provided by the duty to defend itself.  Given that the sole purpose of the duty to defend is to minimize or eliminate liability, the duty to timely negotiate a settlement when liability is clear is an integral component of the duty to defend.  See, e.g.,  SwedishAmerican Hospital Association of Rockford v. Illinois State Medical Inter-Insurance Exchange, 395 Ill. App. 3d 80, 916 N.E.2d 80 (2d Dist. 2009) (observing that “the good-faith duty to settle is . . . an extension of the duty to defend”).  It is reasonable for an insured that purchases “litigation insurance” to expect that its insurer will take all measures to protect it from liability, including effectuating settlements of claims.  Moreover, imposing an obligation on an insurer to initiate settlement negotiations when liability is reasonably clear addresses the concern that insurers have much less of an incentive to settle claims than their insureds, even when liability is clear, due to the substantially disparate financial impacts that the failure to negotiate a settlement could have on an insurer and insured.  Liability that exceeds policy limits could drive an insured out of business.  A liability insurer’s business model, on the other hand, expressly contemplates absorbing judgments.  As one court explained:   

[I]t is more important to an individual, who is only a casual, sporadic, and infrequent litigant, whether he wins or loses a lawsuit which may eat up his life's savings than it is to a professional litigant, such as an insurance company, which is in the business of litigation, collects premiums and sets up reserves for the purpose of paying verdicts, and can set off against each other the lean and fat verdicts, so that the wins and losses average out over the long pull.

Ripepi v. American Insurance Companies, 234 F. Supp. 156, 158-59 (W.D. Penn. 1964).