SAN FRANCISCO-A policyholder's own bad faith can't be used as a defense by insurers that are sued for bad faith, a California appellate court said in a decision that could encourage insurers to settle claims within policy limits more quickly.

Insurers complain that they will lose an important legal defense in bad faith cases if the May 7 decision is upheld by the state Supreme Court.

The appellate court in San Francisco ruled in Kransco et al. vs. American Empire Surplus Lines Insurance Co. that policyholders' bad faith cannot be used by insurers as a separate defense in bad faith cases. Juries, however, still would be able to consider evidence of policyholders' behavior in evaluating bad faith cases brought against insurers.

Policyholder attorneys hailed the decision.

"It means that insurance companies cannot avoid their obligation to settle within policy limits by pointing the finger at something the insured did wrong during the lawsuit," said Stuart Parsons, a policyholder attorney with Milwaukee-based Quarles & Brady who represented San Francisco-based Kransco in the case.

Insurer attorneys say it heightens the risks for their clients.

Robert N. Schiff, an insurer attorney with San Francisco-based Fisher & Hurst, said: "I think as long as it stays on the books, it takes away a defense that insurers have, namely the claimant's own conduct, own unreasonable behavior. And to the extent it takes a away a defense, it increases the insurers' exposure to such claims."

American Empire plans to petition the appellate court to reconsider the 2-1 ruling. If that petition is denied, the insurer will ask the California Supreme Court to review the case, said Bertrand L. LeBlanc II, an attorney with San Francisco-based Carroll, Burdick & McDonough who represented American Empire in the case.

Some policyholder attorneys say they are optimistic the case will go no further. But insurer attorneys and some policyholder attorneys say they expect the decision to be either depublished, so that it cannot be used as a precedent, or reviewed by the California Supreme Court.

Reasons making it likely the state's high court would review the decision are that it conflicts with an earlier appellate decision and that there was a dissenting opinion.

Otherwise, it "leaves everybody in doubt as to what the state of the law is," said James Boedecker, an insurer attorney with Haines & Lea in San Francisco.

The complex litigation had its origins in a June 1987 accident, when 35-year-old Michael Hubert jumped head first onto his Wisconsin neighbor's backyard water slide toy, the Kransco-manufactured Slip 'N Slide, and broke his neck, making him a quadriplegic.

Kransco was insured by Cincinnati-based American Empire Surplus Lines Insurance Co., with which it had liability coverage with a $1 million limit above a $100,000 self-insured retention. Additional excess insurance provided Kransco with a total of $5 million in coverage.

AES provided the defense in the case, which was tried in 1991. During that trial, Mr. Hubert offered to settle his suit for $750,000, almost $1 million less than his pretrial demand. But AES rejected the offer and tried unsuccessfully to settle it for $450,000.

The jury subsequently returned a verdict against Kransco for more than $12.3 million, including $2.3 million in compensatory damages and $10 million in punitive damages.

While post-verdict motions were pending, Kransco settled with Mr. Hubert for $7.5 million. The company also agreed to prosecute a bad faith action against AES and to split equally with Mr. Hubert any proceeds from that litigation.

In 1995, a San Francisco jury found that AES had breached its duty of good faith and awarded compensatory damages of more than $14 million. That amount reflected the approximately $12.5 million jury verdict as well as an additional settlement in another case that Kransco had to pay part of because its insurance had been partially exhausted by the Hubert case.

However, according to the appellate court decision, the jury also found Kransco itself had breached its duty of good faith and fair dealing in its handling of Hubert's claim before the verdict, and attributed fault for the Hubert verdict at 90% to Kransco and only 10% to AES.

The verdict was in response to AES-requested instructions directing the jury to consider Kransco's comparative bad faith and negligence in the underlying case. The decision notes that AES said the original jury was angry because Kransco initially disclaimed knowledge of previous Slip 'N Slide accidents during pretrial discovery in the Wisconsin action.

The San Francisco trial court, however, then reconsidered its acceptance of American Empire's theory of comparative fault and entered a "judgment notwithstanding the verdict" in favor of Kransco for the full amount of damages.

In its decision, which upholds the trial court's action, the appellate court disagrees with American Empire's position that it is not liable for the full amount of the judgment because Kransco's own conduct led to the $10 million punitive damage verdict.

The decision says AES urges that the policyholders' comparative bad faith be used as an affirmative defense, citing in support a 1985 California appellate case, California Casualty General Insurance Co. vs. Superior Court.

In disagreeing with the California Casualty decision, the appellate court said: "The doctrine of comparative bad faith is marked by inconsistencies and complexities in application because it is founded on the faulty premise that the obligations of insurer and insured-and thus their bad faith-are comparable. They are not.

"In short, we respectfully disagree with the California Casualty Court's extension of tort comparative fault principles to an insured's contractual breach of the covenant of good faith and fair dealing.

"An insurer may not, as AES did here, fail to settle a case within policy limits when there is a substantial risk of an excess judgment and then later fault an insured's litigation conduct for contributing to the amount of the verdict."

In addition, says the court, an insurer is not shielded from full responsibility for its bad faith failure to settle a case "even if the insured's mishandling of the claim may have inflated the size of the verdict."

The decision notes also that "rejection of comparative bad faith does not leave the insurer without redress for an insured's misconduct." The conduct "can still be used to disprove the insurer's liability for bad faith, or may provide grounds for contractual and equitable defenses."

Turning to the issue of recovery of punitive damages, the decision says the $10 million punitive damages portion of the award is recoverable even though California prohibits punitive damage awards, because Wisconsin law, where the insured event occurs, applies.

In considering the measure of damages, the decision says American Empire argues Kransco will make an "unconscionable profit" if the jury's award is affirmed, because that award totals about $12.5 million, while the actual settlement was for $7.5 million.

This does mean that Kransco "will gain $2.5 million from its half share of the net proceeds of the insurance litigation in addition to recovering the money it actually spent in settling Hubert," acknowledges the decision. But this argument has "deceptive force," says the decision, because the settlement also includes the agreement to split proceeds from the bad faith action.

In addition, though Kransco's financial gain from the action is an "unpleasant consequence," says the decision, "a contrary determination would impede settlements and the expeditious compensation of injured parties."

Kransco, International Insurance Co. et al. vs. American Empire Surplus Lines Insurance Co., First Appellate District in California; No. A070954