This is one of a series of articles originally published in Mealey’s Litigation Report: Insurance Bad Faith, Vol. 23, #12, page 27 (October 22, 2009). © 2009
[Editor’s note: Steve Rawls is a partner with the law firm of Butler Weihmuller Katz Craig LLP in Tampa, Florida. He devotes his practice to third party bad faith, liability coverage, and liability defense. Ryan Hilton is a senior associate in the firm’s bad faith, liability coverage, and liability defense departments. Comments in this article are those of the authors and not their law firm. Responses to this commentary are welcome. Copyright 2009 by the authors.]
Many businesses are increasingly utilizing insurance policies with large self-insured retention endorsements in order to exercise better control over the defense of claims. In these circumstances, an issue may arise regarding whether an insured who is responsible for defense costs under a self-insured retention (“SIR”) owes a duty of good faith to its insurer.
Commercial general liability policies sometimes contain an SIR endorsement. SIRs generally require the insured to pay a certain amount before the policy responds. This amount requires payment by the insured for covered claims until exhaustion of the SIR. Some SIRs also require that the insured pay defense costs up to the exhaustion of the SIR.
Commercial general liability policies typically contain one of two types of SIR endorsements. One type makes payment of the SIR a condition precedent to coverage. The other type does not make payment of the SIR a condition precedent to coverage so that the policy may respond even if the SIR is not exhausted.
Some SIRs require the insured to pay defense costs until the SIR is exhausted. In policies that do not require exhaustion of the SIR as a condition precedent to coverage, the carrier has a duty to defend and indemnify in the same manner as if the policy contained a deductible. An SIR typically differs from a deductible in that an SIR provides a threshold for an insurer’s duty to both defend and indemnify, while a deductible provides a threshold only for an insurer’s duty to indemnify. Even though an SIR is a term of art with a technically different meaning from a deductible, many cases and commentators use the terms interchangeably.
An insurer’s duties under a general liability policy with an SIR generally do not arise until the insured pays the SIR. Courts will look to policy language to determine whether and when the insured or insurer has a duty to defend. Some SIR endorsements require the insured exhaust the SIR by payment of covered claims or by payment of defense costs (and/or covered claims if payment of defense costs has not exhausted the SIR). Certain SIR endorsements may not obligate the insurer to defend prior to the exhaustion of the SIR, but may provide for reimbursement to the insured of a pro rata portion of the insured’s defense costs after exhaustion. Other SIRs may require the insurer to defend and to indemnify for amounts in excess of the SIR regardless of whether the insured paid the SIR.
Courts, when considering SIRs, look to the policy language to determine whether the duty to defend falls upon the insured or the insurer. In General Star Indemnity Company v. Hard Rock Café America, an SIR endorsement provided that the insurer “shall have the right but not the duty to assume charge of the defense and/or settlement of any claim or ‘suit’ brought against the insured.” The SIR endorsement also provided that the duty to defend was “reinstated” only in the event that the “aggregate Retained Limit” was exhausted. The SIR endorsement contained other key provisions, such as (1) the insurer had no duty to defend, (2) if settlement of a claim exceeded the Retained Limit of $100,000, the insurer had to reimburse the insured for a pro rata portion of the insured’s defense costs, and (3) if settlement of a claim didn’t exceed the Retained Limit of $100,000, the insurer paid nothing. The California appeals court found: “General Star here was in the position of an excess carrier having no obligations until the SIR was exhausted.” 
Two cases, both decided by the same judge in a Florida federal bankruptcy court, addressed the effect of an SIR where one SIR acted as a primary policy while the SIR in the other case acted as a deductible. In the case of In Re Apache Products Company, the SIR endorsement in the policy at issue specifically stated that the duty to defend did not arise until the SIR had been exhausted. Apache Products applied Alabama law and provided an extensive discussion of issues accompanying an SIR. Ultimately, the court found that the insurer had no duty to defend or indemnify until the SIR had been exhausted.
The same Florida bankruptcy court looked at a similar issue in the case of In Re OES Environmental, Inc., but Alabama law did not apply. It appears that the court applied New York law because of the policy’s choice-of-law provision, but it did not appear to make a difference as to whose laws applied because the court pointed out that there was little precedent from anywhere on the issue. The court noted that it had held that the insurer had no duty to defend or indemnify until the SIR had been satisfied in Apache Products.However, the court distinguished OES, noting that the SIR endorsement there did not appear to require exhaustion as a precondition to coverage, but simply provided that the SIR be “borne by” the insured. In that situation, the court held that the SIR was comparable to a deductible that simply provided a threshold for the duty to make payment. The court held that the insurer was liable to defend and indemnify for any amounts in excess of the SIR, regardless of whether the insured paid the SIR.
In Beloit Liquidating Trust v. Century Indemnity Company, the Northern District of Illinois dealt with a general liability policy where the SIR endorsement “expressly limit[ed] the defendant’s liability to ultimate net loss in excess of plaintiff’s retained limit.” The policy defined “ultimate net loss” to mean sums paid in settlement of losses for which the insured was liable after making deductions for all recoveries, salvages, and other insurance, whether recoverable or not, but did not include costs, such as taxed court costs and premiums on appeal bonds. The court held that the SIR endorsement there made it clear that no coverage began until the SIR’s exhaustion. Thus, the court held that the policy required exhaustion of the SIR not only with respect to the duty to indemnify, but also with respect to the duty to defend.
The Supreme Court of Appeals of West Virginia observed that businesses are increasingly utilizing insurance policies with large SIRs in order to exercise better control over the defense of claims asserted against them. The court in Camden-Clark Memorial Hospital Associates v. St. Paul Fire and Marine Insurance Company noted that the SIR provision in the policy allowed the insured to control the claims handling and defense of all claims asserted against it. While the policy provided the insurer the option to join in the defense of claims that may exceed the SIR limits, it imposed no duty upon the insurer to defend and the insurer had no obligation to do so until exhaustion.
If a court determines from the policy language that an insured has a duty to defend and an insurer alleges bad faith against its insured, courts will typically look to the policy language to determine if the insured owes a duty of good faith to its insurer. So far, no courts have imposed an implied duty of good faith upon an insured under an SIR.
Where a policy makes payment of the retained limit a condition of coverage, an SIR represents the amount of the loss for which the insured is responsible before the coverage is triggered. Some courts therefore analyze SIRs similarly to primary insurance. These courts interpret SIRs as, in essence, primary insurance coverage so that the insured may owe the insurer many of the traditional duties found in the primary/excess insurer relationship. The majority of jurisdictions, however, do not treat an SIR as insurance. In these jurisdictions, an insured owes no duty of good faith to its insurer as a result of an SIR.
Courts in California and Florida have described the duty of good faith as a “two-way street” between an insured and an insurer. Neither of these courts found that an insurer’s claim for bad faith against the insured was supported by the policy language. The courts did, however, indicate that such a duty might exist if the policy expressly describes that duty.
One of the first reported cases to address whether an insured under a self-insured retention owes a duty of good faith to its insurer is the case of Commercial Union Assurance Companies v. Safeway Stores, Inc. In Commercial Union, Travelers Insurance Company and Travelers Indemnity Company (hereafter Travelers) insured Safeway for the first $50,000 of liability. Safeway insured itself for liability between the sums of $50,000 and $100,000. Commercial Union Assurance Companies and Mission Insurance Company (collectively referred to as Commercial) provided insurance coverage for Safeway’s liability in excess of $100,000 to $20 million.
A claimant sued Safeway in San Francisco Superior Court and recovered judgment for $125,000. Thereafter, Commercial paid $25,000 of the judgment in order to discharge its liability under the excess insurance policy.
Commercial, as excess liability carrier, sued its insured, Safeway, and Safeway’s primary insurance carrier, Travelers, to recover $25,000 that Commercial had paid. Commercial alleged that Safeway and Travelers had an opportunity and a duty to settle the case for less than the underlying $100,000 limits, and knew or should have known that there was a possible and probable liability in excess of $100,000. Commercial’s complaint stated two causes of action against Safeway and Travelers, one in negligence and another for breach of the duty of good faith and fair dealing.
The Supreme Court of California recognized that an excess carrier may maintain an action against the primary carrier for wrongful refusal to settle within the latter’s policy limits. However, the court recognized that the rule is based on the theory of equitable subrogation: because the insured would have been able to recover from the primary carrier for a judgment in excess of policy limits caused by the carrier’s wrongful refusal to settle, the excess carrier, which discharged the insured’s liability as a result of this tort, stands in the shoes of the insured and should be permitted to assert all claims against the primary carrier which the insured himself could have asserted. Hence, the court stated that the rule does not rest upon the finding of any separate duty owed to an excess insurance carrier.
Commercial argued that the implied covenant of good faith and fair dealing is reciprocal, binding the insured as well as the carrier. Commercial also contended that the implied covenant of good faith and fair dealing applied separately to the insured (as well as the insurer), and thus the insured owed a duty to his excess carrier not to unreasonably refuse an offer of settlement below the amount of excess coverage where a judgment of liability above that amount was substantially likely to occur.
In light of these arguments, the court stated: “We have no quarrel with the proposition that a duty of good faith and fair dealing in an insurance policy is a two-way street, running from the insured to his insurer as well as vice versa.” But the court said that the scope of such a duty depends upon the nature of the bargain struck between the insurer and the insured and the legitimate expectations of the parties which arise from the contract.
The Supreme Court of California discussed that the essence of the implied covenant of good faith in insurance policies is that “‘neither party will do anything which injures the right of the other to receive the benefits of the agreement.'” At the same time, the insured owes no duty to defend or indemnify the excess carrier; hence, the carrier can possess no reasonable expectation that the insured will accept a settlement offer as a means of “protecting” the carrier from exposure. The protection of the insurer’s pecuniary interests is simply not the object of the bargain.
The court recognized that it had previously stated that “[t]he duty to settle is implied in law to protect the insured from exposure to liability in excess of coverage as a result of the insurer’s gamble on which only the insured might lose.” The court explained that similar considerations do not apply where the situation is reversed: where the insured is fully covered by primary insurance, the primary insurer is entitled to take control of the settlement negotiations and the insured is precluded from interfering. The court observed that, where the insured is self-insured for an amount below the beginning of the excess insurance coverage, the insured is gambling as much with his own money as with that of the carrier.
The court stated that the crucial point is that the excess carrier has no legitimate expectation that the insured will “‘give at least as much consideration to the financial well-being'” of the insurance company as he does to his “‘own interests’ ” in considering whether to settle for an amount below the excess policy coverage. The court described that the primary reason excess insurance is purchased is to provide an available pool of money in the event that the decision is made to take the gamble of litigating.
The court observed that the complaint made no reference to any language in the policy that supported any legitimate expectation by Commercial that its insured would settle a claim for less than the threshold amount of the policy coverage in the light of what the parties bargained for. Accordingly, the court asked:
Did Safeway, when it purchased excess coverage, impliedly promise that it would take all reasonable steps to settle a claim below the limits of Commercial’s coverage so as to protect Commercial from possible exposure? Further, did Commercial extend excess coverage with the understanding and expectation that it would receive such favorable treatment from Safeway under the policy?
The court summarily answered both questions: “We think not.”
The court acknowledged that equity requires fair dealing between the parties to an insurance contract. The court recognized that the insured status is not a license for the insured to engage in unconscionable acts which would subvert the legitimate rights and expectations of the excess insurance carrier. However, the court was unable to conclude that the covenant of good faith and fair dealing should be extended to include a duty which would require an insured contemplating settlement to put the excess carrier’s financial interests on at least an equal footing with his own. The court described that such a duty cannot reasonably be found from the mere existence of the contractual relationship between the insured and the excess carrier in the absence of express language in the contract so providing.
The Supreme Court of California held that a policy providing for excess insurance coverage imposes no implied duty upon the insured to accept a settlement offer which would avoid exposing the insurer to liability. The court further held that such a duty cannot be predicated upon an insured’s implied covenant of good faith and fair dealing. The court said that if an excess carrier wishes to insulate itself from liability for an insured’s failure to accept what it deems to be a reasonable settlement offer, it may do so by appropriate language in the policy. The court hesitated “to read into the policy obligations which are neither sought after nor contemplated by the parties.”
The views expressed by the Supreme Court of California in Commercial Union provide a good example of the historically protective attitude California courts have taken with respect to an insured in litigation with its insurance carrier. Following Commercial Union, a California appeals court acknowledged that a self-insured owed a duty of good faith to its insurer under the policy language, but the court did not enforce the provision because the insurer did not preserve this issue. While the majority of courts, including California, do not regard an insured under an SIR as a primary insurer or an SIR as “other insurance,” California presumably might do so if the policy language defines an SIR as such. For instance, in Nabisco, Inc. v. Transport Indemnity Company,< a primary policy expressly made its coverage excess “if ‘there is other insurance or self-insurance.'”
In The Vons Companies, Inc. v. United States Fire Insurance, the insurer contended that the SIR there could not be paid by other insurance. The California appeals court disagreed, finding there was no policy provision to that effect. The court pointed out that the policy expressly imposed a duty of good faith upon both parties to the contract, requiring each “to consider the interests of the other equally with its own to evaluate settlement offers as though it was liable for the full amount of the claim or suit.” The court noted that if the insurer believed that the insured had breached its duty of good faith, the insurer could have raised the issue by way of affirmative defense or cross-complaint. The insurer waived that argument because the record showed that the insurer had not raised an affirmative defense or filed a cross-complaint alleging bad faith.
California courts have also considered reporting requirements contained in SIRs. In Service Management Systems, Inc. v. Steadfast Insurance Company, the insured conceded that it had violated the reporting requirements in the SIR endorsement to its commercial general liability policy. However, the court pointed out that the insurer did not contend that it could demonstrate prejudice from the insured’s violations. Therefore, the question of whether the insurer had a duty to defend and indemnify, and thus whether it breached the insurance contract, centered upon whether California’s notice-prejudice rule applied to the policy SIR. The Ninth Circuit Court of Appeals agreed with the district court that the rule applied. California’s notice-prejudice rule provides “that breach by an insured of a cooperation or notice clause may not be asserted by an insurer unless the insurer was substantially prejudiced thereby.” An SIR endorsement may add notice and reporting requirements as a condition precedent to coverage, but California courts have applied the rule “even though compliance with the notice provisions is made a condition of the policy or specified as a condition precedent to the liability of the insurer,” and even where the policy otherwise subjects the insured to specific reporting requirements. The insurer argued that the language of the SIR endorsement, stating that the insurer “shall not be required to establish prejudice resulting from noncompliance,” demonstrated that the notice-prejudice rule did not apply to the policy. Despite the seemingly plain language of this clause, the Ninth Circuit Court of Appeals agreed with the district court that this clause was insufficient to defeat California’s strong public policy behind the notice-prejudice rule.
In North American Van Lines, Inc. v. Lexington Insurance Company, the express language of the policy stated that the insured was solely responsible for the investigation and defense of any claim or suit brought or proceedings against the insured to which the policy would apply. The Florida appellate court pointed out that the policy of insurance at issue was not a true liability policy but it was similar to a contract for indemnity insurance. Under indemnity policies, the court explained that the insured defends the claim and the insurance company simply pays a claim against the insured after the claim is concluded. The court noted that while the policy had some provisions which may not appear in true indemnity policies, the important feature was that under the policy terms, the insured had the duty to defend itself and prudently settle claims.
The court discussed that the concept of bad faith arose in connection with liability policies, but a good faith obligation is implied in all insurance contracts. The court further stated: “[t]he duty of good faith and fair dealing in an insurance policy ‘is a two way street,’ running from the insured to his or her insurer as well as vice versa.”
The court discussed that the duty of good faith is also present in an indemnity-type policy. Often, excess insurance policies take the form of indemnity policies because they leave the duty to defend and settle a claim against the insured to the primary insurer, or in the policy at issue, the insured. The court therefore concluded that an excess insurer can hold a primary insurer responsible for improper failure to settle a claim against the insured, because the primary insurer’s position is analogous to that of the insured.Similarly, the duty of good faith attending the contractual obligations of such excess policies requires that the insured exercise diligence and good faith in conducting the defense for the benefit of both the insured and the insurer who each have a financial stake in the proceedings.
In North American Van Lines, the insured undertook the defense by contract. The court found that the language of the insurance policies at issue made the insured obligated to the primary and excess insurer to adequately defend their interests in the litigation. The insured also had the duty to negotiate a prudent settlement. Both the primary insurer and the excess insurer had a corresponding duty of good faith in evaluating any settlement offers, considering each other’s and the insured’s interests. Neither the primary insurer nor the excess insurer could arbitrarily reject a reasonable settlement. If they could, the contract would be illusory. If they arbitrarily rejected a reasonable settlement, they breached their policy provisions, entitling the insured to settle the case and to seek reimbursement. The court observed thhttps://www.butler.legal/blog/does-an-insured-owe-a-duty-of-good-faith-to-its-insurer-when-the-insured-is-responsible-for-defense-costs-in-a-self-insured-retention/at the insured must prove at trial that the settlement was reasonable and made in good faith.
In Royal Surplus Lines Insurance Company v. Coachmen Industries, Inc., an unpublished case, the SIR provision in the primary policy gave the insured the ability to control the defense of any action within the SIR. The contract further provided that the insurer had the right to assume the defense in any action that could exceed the SIR amount. The amount of the SIR included any costs incurred by the insured in defending or investigating the claim.
The insurer sued its insured alleging that it breached it duties to defend and prudently settle, investigate the claim, and keep the insurer informed. In finding that the insured did not breach its duties under the policy, the Middle District of Florida, applying Florida law, did not agree that the SIR at issue turned the insured into an insurer by observing that the weight of the authority “establishes that a retained limit does not generally convert an insured into a primary insurer.” Additionally, the court looked at other jurisdictions and stated that at least one court had held that the insured does not have an obligation to accept an offer within the SIR amount. The court noted that there was no provision in the policy requiring the insured to accept a reasonable offer within the SIR amount. Moreover, the court observed, there was no evidence that the insured was presented with an offer within the SIR.
In Employers Mutual Casualty Company v. Key Pharm, Inc. the federal district court found that there is no duty running from the insured to the excess carrier. The court observed that policyholders are not primary carriers because they pay premiums to excess carriers to have protection against the risks of litigation while primary carriers do not. The court found no basis in law for concluding that, apart from the premiums it pays, an insured also assumes a fiduciary duty of care toward its insurer in the context of settlements.
An insurer’s duties under a general liability policy with an SIR generally do not arise until the insured pays the SIR. Courts will look to policy language to determine whether and when the insured or insurer has a duty to defend. A majority of courts do not view an SIR as insurance. In those jurisdictions, an insured owes no duty of good faith to its insurer because of the SIR. However, courts seem willing to review the policy language to determine whether the SIR is considered insurance and whether an insured owes a duty of good faith to its insured as contracted between the parties. Courts have declined to extend an implied, reciprocal duty of good faith upon an insured to its insurer under an SIR.
See, e.g., In Re Apache Products
See, e.g., In Re OES Environmental, Inc., 319 B.R. 266, 268 (Bankr. M.D. Fla. 2004).
See, e.g., OES Environmental, Inc., 319 B.R. at 268.
In re Feature Realty Litigation, 634 F. Supp. 2d 1163, 1169 n.5 (E.D. Wash. 2007).
General Star Indem. Co. v. Hard Rock Café America, 47 Cal. App. 4th 1586 (Cal. Ct. App. 1996).
Id. at 1594.
Apache Products Company, 311 B.R. at 288.
Id. at 293.
Id. at 297.
 OES Environmental, Inc., 319 B.R. at 266.
 Id. at 269.
Id. at 268.
 Id. at 269.
 2002 WL 31870525 (N.D. Ill. Dec. 20, 2002).
 Id. at *2.
 Camden-Clark Mem’l Hosp. Ass’n v. St. Paul Fire and Marine Ins. Co., 2009 WL 1835016, at *9 (W. Va. June 25, 2009).
 William T. Barker, Combining Insurance and Self Insurance: Issues for Handling Claims, 61 Def. Counsel J. 352, 359 (1994).
 See, e.g., St. John’s Reg’l Health Ctr. v. American Cas. Co., 980 F.2d 1222, 1227-28 (8th Cir. 1992) (applying Missouri law); Wake County Hosp. Sys., Inc. v. Nat’l Cas. Co., 804 F. Supp. 768, 774-75 (E.D.N.C. 1992); Underwriters Ins. Co. v. Marriott Homes, Inc., 238 So. 2d 730, 732 (Ala. 1970); Hillsborough County Hosp. and Welfare Bd. v. Taylor, 546 So. 2d 1055, 1057 (Fla. 1989); Ponder v. Fulton DeKalb Hosp. Auth., 353 S.E.2d 515, 517 (Ga. 1987); State v. Continental Cas. Co., 879 P.2d 1111, 1117-18 (Idaho 1994); Morgan v. City of Ruleville, 627 So. 2d 275, 280-81 (Miss. 1993); American Nurses v. Passaic Gen. Hosp., 471 A.2d 66, 71 (N.J. Super. Ct. App. Div. 1984); In re Mission Ins Co., 816 P.2d 502, 505 (N.M. 1991); Cone Mills Corp. v. Allstate Ins. Co., 443 S.E.2d 357, 360-61 (N.C. Ct. App. 1994); Physicians Ins. Co. v. Grandview Hosp. & Med. Ctr., 542 N.E.2d 706, 707 (Ohio Ct. App. 1988).
 North American Van Lines, Inc. v. Lexington Ins. Co., 678 So. 2d 1325, 1331 (Fla. Dist. Ct. App. 1996); Diamond Heights Homeowners Ass’n v. National Am. Ins. Co., 227 Cal. App. 563, 578 (Cal. Ct. App. 1991).
 Commercial Union Assurance Companies v. Safeway Stores, Inc., 610 P.2d 1038 (Cal. 1980).
Id. at 1041 (citing Northwestern Mut. Ins. Co. v. Farmer’s Ins. Group, 76 Cal. App. 3d 1031 (Cal. Ct. App. 1978); Valentine v. Aetna Ins. Co., 564 F.2d 292 (9th Cir. 1977); Estate of Penn v. Amalgamated Gen’l Agencies, 148 N.J. Super. 419 (N.J. Super. Ct. App. Div. 1977)).
 Commercial Union at 1041 (citing Northwestern Mut. Ins. Co. v. Farmers’ Ins. Group, 143 Cal. Rptr. 415 (Cal. Ct. App. 1978)).
Id. at 1041 (quoting Murphy v. Allstate Ins. Co., 553 P.2d 584, 586 (Cal. 1976)).
 Commercial Union at 1042.
 Id. (quoting Murphy v. Allstate Ins. Co. 553 P.2d at 586.)
 Commercial Union at 1043.
 Hall F. McKinley, III, Issues in the Selection of Counsel and Control of Litigation When the Insured has a Self-Inured Retention, 32 Tort & Ins. L.J. 769.
 Aerojet-General Corp v. Transport Indem. Co., 17 Cal. 4th 38, 72 n.20 (Cal. 1997).
 Nabisco, Inc. v. Transport Indem. Co., 17 Cal. App. 3d 831 (Cal. Ct. App. 1983).
 The Vons Companies, Inc. v. U.S. Fire Ins., 92 Cal. Rptr. 2d 597, 605 (Cal. Dist. Ct. App. 2000).
 Service Mgmt. Sys., Inc. v. Steadfast Ins. Co., 216 F. App’x. 662 (9th Cir. 2007).
 Id. at 664.
 North Am. Van Lines, Inc. v. Lexington Inc. Co., 678 So. 2d 1325 (Fla. Dist. Ct. App. 1996).
 Id. at 1329.
 North Am. Van Lines at 1330-31.
 North Am. Van Lines at 1331 (quoting Diamond Heights Homeowners Ass’n v. National Am. Ins. Co., 277 Cal. Rptr. 906, 914 (Cal. Ct. App. 1991)).
 Id. at 1331.
 North Am. Van Lines at 1332.
 North Am. Van Lines at 1332-33.
 North Am. Van Lines at 1333.
 Royal Surplus Lines Ins. Co. v. Coachmen Indus., Inc., 2002 WL 32894915 (M.D. Fla. 2002).
 Id. at *10 (citing Diversified Services, Inc. v. Avila, 606 So.2d 364, 366 (Fla. 1992); State Farm Mut. Auto. Ins. Co. v. Universal Atlas Cement Co., 406 So.2d 1184, 1187 (Fla. Dist. Ct. App. 1982)).
 Id. at *11.
 Employers Mut. Cas. Co. v. Key Pharm., Inc., 871 F. Supp. 657, 665 (S.D.N.Y. 1994).