When Does an Insurer Not Owe Duties to the Purchaser of the Policy?

December 15, 2008

The Seventh Circuit recently held that, in Illinois, an insurer owes a duty of good faith and fair dealing only to the insureds under a policy, and not to a business that purchased the policy. In Iowa Physicians’ Clinical Medical Foundation v. Physicians’ Ins. Co. of Wisconsin, No. 08-1297 (7th Cir. Oct. 31, 2008) the court applied Illinois law and found that an insurer’s obligations in responding to offers to settle within policy limits do not extend to the entity that purchased the policy unless that entity is an insured.

In Iowa Physicians, the Estate of Dennis Goetz sued a physician, Dr. Mullen, and his employer, Iowa Health Physicians (Iowa Health) for failing to vaccinate properly and treat Goetz for malaria, which caused Mr. Goetz’s death. Physicians’ Insurance Company of Wisconsin insured Mullen and his employer under a professional liability insurance policy with limits of $1 million. Physicians’ Insurance had issued the policy in the name of Iowa Health, and Iowa Health had paid the premiums on behalf of Dr. Mullen. Although Iowa Health was listed as the policyholder, the policy itself made clear that Iowa Health was not an insured and, in fact, Iowa Health declined to pay the additional premium that would have entitled it to coverage under the policy, instead arranging for insurance through another carrier.

The Goetz Estate offered to settle the case prior to trial for $900,000. Despite the opinions of several experts that Mullen had provided substandard care to Goetz and that damages were significant, Physician’s Insurance failed to respond to the offer. After a defense expert testified that Goetz had received inadequate treatment, the Estate withdrew its $900,000 offer and demanded $1.5 million instead. Physician’s Insurance eventually countered with an offer of $200,000. Ultimately, the case went to trial and resulted in a verdict of $3.5 million against Mullen and Iowa Health.

Iowa Health and Mullen sued Physician’s Insurance, claiming that the carrier had breached its duty of good faith and fair dealing by failing to accept the demand of $900,000. The district court held that Mullen could pursue a claim for damage to his reputation and for emotional distress even though Iowa Health had paid the $2.5 million excess judgment over the $1 million policy limit. The district court also held, however, that Iowa Health had no cause of action because it was not an insured under the policy.

Under Illinois law, an insurer has a good faith obligation to settle within policy limits and may be liable for the entire judgment against its insured if it fails to act in good faith in responding to offers to settle. See, e.g. Haddick v. Valor Ins. Co., 763 N.E.2d 299 (Ill. 2001) In its opinion, the Seventh Circuit observed that Dr. Mullen himself had a strong argument against his insurer. The issue before the court, however, was whether the district court had properly held that the insurer owed a duty of good faith to Iowa Health, the non-insured policyholder.

Iowa Health argued that it should be treated as an insured because of its customer relationship to the carrier and its status as a policyholder. The Seventh Circuit disagreed, noting that what was important was not the mere existence of a contractual relationship, but rather the substance of the insurance contract itself. The court emphasized the fact that Iowa Health had chosen not to purchase insurance coverage, and explained that:

The duty to settle is meant to protect the bargained-for insurance coverage, not extend it. An insurer who acts in bad faith may end up paying above the contracted policy limits but only when doing so protects the insured’s legitimate expectation of coverage under the policy. . . .

The Seventh Circuit also explained that that the Illinois Supreme Court’s analysis of this issue in cases such as Haddick rested on the duty to settle as arising out of the insurer’s exclusive control over the duty to defend, including the right to settle. In Iowa Physicians, however, the court noted out that although Physician’s Insurance had exclusive control over Dr. Mullen’s defense, Iowa Health had arranged its own defense.

Many businesses purchase liability insurance for employees who in turn work for third parties as “outsourced” employees or independent contractors, which is similar to the situation in Iowa Physicians. In these situations, the entity purchasing the policy should become a named insured or ensure that the policy gives it the same rights as a named insured in order to preserve its rights to make decisions concerning the management of potential litigation and to assert claims against the insurer if the insurer does not act in good faith in handling the case.