2.2.3.1 Understanding Damron and Morris

• Jurisdiction: Arizona

Prior to the landmark decision of Damron v. Sledge,^[106] insurance carriers were historically faced with a Hobbesian's choice in deciding to defend their insureds in personal injury actions where there was doubt as to whether the insurance policy provided coverage for the claim being asserted. On the one hand, the carrier could refuse to defend its insured and risk a large judgment that the carrier might be obligated to pay if the carrier failed to establish a valid basis for denying coverage. On the other hand, the carrier could defend the lawsuit and use its best efforts to prevent an excess verdict, but in so doing, the carrier risked waiving its right to raise a policy defense or exclusion to coverage under its policy at a later date.

The court's holding in Damron allowed carriers to avoid the Hobbesian's choice that had previously confronted them in cases where coverage was questionable, by recognizing the validity of a carrier's defense of its insured under a reservation of rights to later contest coverage.^[107] The reservation of rights approach has allowed insurance carriers to defend their insureds, minimizing the risk that an unduly large verdict would result from a lack of cross-examination or rebuttal at trial,^[108] while preserving the carrier's right to challenge coverage.

The court in Damron also recognized the right of an insured to protect himself from the "sharp thrust of personal liability" in those cases where the carrier refused to defend the lawsuit. The court held that when a carrier refused to defend its insured, the insured was permitted to enter into an agreement with the tort claimant respecting liability, accompanied by an assignment to the claimant of any cause of action the insured had against the carrier, in exchange for a covenant not to execute the judgment against the personal assets of the insured. In reaching its decision to permit Damron-type agreements, the court observed that when a carrier has abandoned its insured by refusing to defend the lawsuit, an acute change occurs in the relationship between the insured and the carrier, creating a conflict of interest. While the insured was still obligated to testify truthfully should the matter proceed to trial, he did not need to indulge in financial masochism by expending significant resources on his defense.^[109]

The court's analysis in Damron was one-sided. Indeed, the supreme court has recently described the reservation of rights approach as allowing the carrier to have a "double bite at escaping liability."^[110]

While the Damron decision afforded protection to insurance carriers through the validation of reservation of rights defenses, the decision allowed the insured to protect himself only in those circumstances where the carrier refused to defend under its policy. This limited means of self-protection is eviscerated when the carrier defends under a reservation of rights because the carrier, which has the right to control the defense, will not allow Damron-type agreements to be made. Under such circumstances, the sharp sword of personal liability hangs over the insured's head like the ancient sword of Damocles. The insured can no longer protect his personal assets through a negotiated settlement with the tort claimant as a result of the carrier's qualified assumption of the defense, and at the same time, the insured must face the prospect that the carrier will prevail in its claim of no coverage, leaving the insured's personal assets exposed. With this in mind, it becomes evident that the "acute change" in the relationship between the insured and the carrier that was described in the Damron decision also occurs in those circumstances where the carrier defends under a reservation of rights.

The principles set forth in the Damron decision were widely accepted throughout the insurance community. The so-called "reservation of rights defense" became the standard approach to all defense matters where the carrier seriously questioned the availability of coverage to the insured. This established practice came under juridical scrutiny in a series of case rulings that have now substantially expanded the rights of insureds and resurrected the Hobbesian's choice that had confronted carriers before the Damron decision was penned by the court.

In McGough v. Insurance Co. of North America,^[111] the court held that an insured may not condition the carrier's right to defend upon the insured being given an agreement from the carrier wherein the carrier would waive its right to later litigate the question of coverage. In McGough the carrier offered to defend its insured under a reservation of rights. The insured refused the defense unless the carrier dismissed its pending declaratory judgment action challenging coverage. The insured further demanded that the carrier acknowledge, unequivocally, that its policy provided coverage for the claim. On the same day the insured notified the carrier of its rejection of the reservation of rights defense, he executed a Damron agreement with the tort claimant. The agreement provided for a stipulated judgment on liability and damages to be entered against the insured, accompanied by a covenant not to execute. An evidentiary hearing was scheduled on the damage judgment: the carrier sought to intervene. The trial court denied the carrier's intervention motion and entered judgment in accordance with the terms of the Damron agreement. On appeal, the insured argued that he had a right to demand an unconditional defense. The insured argued that the carrier lost the right to intervene when it refused to unconditionally defend the insured. The court of appeals disagreed.

In Farmers Insurance Co. v. Vagnozzi,^[112] the court recognized that where a carrier defends its insured under a reservation of rights, a potential conflict of interest may arise.

A problem arises when investigation by the insurer reveals facts that tend to place the claim outside coverage of the policy, yet the question of coverage depends on facts to be litigated in the tort suit. The insurer's interest in defending the claim while restricting its obligation to the terms of the policy gives rise to a conflict of interest. The insured wants to prove either that he is not liable for the injury or that he was at most negligent, while the insurer wants to prove that the insured, if liable, is guilty of an intentional tort and therefore coverage is excluded under the policy.^[113]

Where a conflict of interest is present it "puts both the insurer and the insured in the untenable position of attempting to cooperate in the course of litigation when their interests are in fact adverse."^[114] Therefore, the court held that where there is a conflict of interest between the carrier and the insured in the underlying tort action, the carrier will not be collaterally estopped in a subsequent declaratory action from relitigating those factual issues central to the coverage question.

In Vagnozzi the tort claimant, Vagnozzi, was injured in a scuffle during a basketball game. Vagnozzi filed a suit against the insured alleging that his injuries were negligently caused. The carrier challenged coverage, arguing that the insured intentionally caused Vagnozzi's injuries. The insurance carrier retained an attorney to defend its insured in the tort suit under a reservation of rights. The carrier filed a declaratory judgment action challenging coverage. There was an ensuing "race to the courthouse," where the parties attempted to bind each other to facts favorable to their own respective sides. The tort claimant filed a motion for summary judgment in the tort action on the issue of negligence. The summary judgment motion on the negligence issue was unopposed by the insured's carrier-appointed defense counsel, and a judgment of negligence was entered. The carrier filed a motion to consolidate the tort case with its declaratory judgment action. The carrier also filed a motion for summary judgment seeking a determination that the insured intentionally injured Vagnozzi, vacating coverage. Vagnozzi attempted to derail the declaratory judgment proceedings by arguing that the carrier was bound by the finding of negligence in the tort suit, and, therefore, the carrier was bound by the doctrine of collateral estoppel from arguing an intentional act on the part of its insured.

In Arizona Property & Casualty Insurance Guaranty Fund v. Helme,^[115] the court held that where a party to an insurance contract repudiates its contractual obligations on the basis of an erroneous interpretation of the contract, that party has committed an anticipatory breach. The court held that "once an insurer breaches any duty to its insured, the insured is no longer fully bound by the cooperation clause."^[116] While the carrier's anticipatory repudiation may narrow the scope of the cooperation clause, it does not eliminate the insured's duty of cooperation. The court stated:

We do not hold that the insurer's anticipatory repudiation eliminates the insured's duty of cooperation so that the insured may enter into any type of agreement or take any type of action that may protect him from financial ruin. We hold only that once the insurer commits an anticipatory breach of its policy obligations, the insured need not wait for the sword to fall and financial disaster to overtake. The insurer's breach narrows the insured's obligations under the cooperation clause and permits him to take reasonable steps to save himself. Among those steps is making a reasonable settlement with the claimant.^[117]

The court in Helme concluded that the insured does not breach the cooperation clause by entering into a settlement agreement with the claimant so long as the settlement agreement is neither fraudulent, collusive, "nor otherwise against public policy."^[118]

In Helme, the state guarantee fund assumed the original carrier's obligations under the insolvent carrier's policy. The carrier became insolvent and was unable to...