The Artificial Collective-Action Problem in Lawsuits Against Insured Defendants

Abstract

In lawsuits against defendants covered by liability insurance, the parties negotiate toward a single settlement amount that collectively binds the plaintiff and all defense-side parties (the defendant and its liability insurer). This settlement method produces a collective-action problem whenever the trial outcome is uncertain and the potential damages exceed the limit of the defendant’s liability policy. When such a suit settles, the insurer often pays more, and the defendant/policyholder pays less, than each expected to pay if the case had gone to trial. The insurer is thus biased against, and the policyholder toward, pre-trial settlement. This conflict could produce an unnecessary trial or a settlement that overcompensates the plaintiff, depending on which bias prevails. To prevent such results, courts (and some insurance policies) place settlement duties on liability insurers. But enforcing these duties entails additional litigation, compliance costs, and the risk of legal error. An alternative solution would be to replace collective settlements with “segmented” settlements. Each defense-side party would bargain separately with the plaintiff for a release of the plaintiff’s right to collect any damages which, if awarded at trial, would be that defense-side party’s contractual responsibility. The collective-action problem would then disappear, as would the need for settlement duties. The benefits would be greatest in lawsuits against corporate defendants, which often have multiple excess insurers in addition to a primary insurer. Why parties continue to follow a settlement method that produces an avoidable collective-action problem is an open question in the study of insurance law.

Keywords: liability insurance, duty to settle, litigation, tort law, duty to contribute

JEL Classification: K13, K41, G22