OPINION
Whеn a primary insurer against tort liability refuses to settle and then loses at trial for amounts greater than its coverage limits, what recourse does an excess insurer have against the primary insurer? This case involves the issue of whether, under Kentucky law, an excess insurer can recover against a primary insurer pursuant to the doctrine of equitable subrogation, either for the primary insurer’s failure in good faith to settle a claim or for the primary insurer’s failure to investigate whether an insured has other insurance.
The excess insurer in this case, National Surety Corporation, argues that the primary insurer, Hartford Casualty Insurance Company, acted in bad faith by failing to settle a tort claim against their mutual insured, Sufix U.S.A., and thereby exposed Sufix to excess liability. 1 National *754 Surety seeks to step into Sufix’s shoes, pursuant to the doctrine of equitable sub-rogation, to assert this bad-faith claim. National Surety also seeks to assert a claim against Hartfоrd for Hartford’s failure to discover that Sufix was insured by National Surety. The district court held that National Surety did not have a cause of action under Kentucky law, and accordingly granted Hartford’s motion to dismiss.
We reverse the district court’s order because the Supreme Court of Kentucky would likely recognize a cause of action in this case. Kentucky law already permits an insured to sue a primary insurer for bad faith failure to settle a claim. Kentucky law alsо recognizes the doctrine of equitable subrogation, which permits an insurance company to “step into the shoes” of the insured and recover what the insured would have been able to recover against a tortfeasor. Combining these two principles to allow an excess insurer to recover from a primary insurer is a logical extension of these principles and furthers Kentucky’s policy goals of encouraging fair and reasonablе settlements and preventing third parties from profiting from an insured’s insurance coverage. However, the district court’s order properly dismissed National Surety’s failure-to-investigate claim because an insured does not have a cause of action under Kentucky law against its insurer for failing to discover an insured’s other sources of insurance.
National Surety’s complaint alleges the following facts, which this court must accept as true,
Evans v. Pearson Enters., Inc.,
.
In May of 1999, Cook filed suit against Sufix in Jefferson Circuit Court, alleging that the weed trimmer was defectively designed and that Sufix was grossly negligent in failing to discover the defect. Hartford assumed thе defense of Sufix pursuant to its insurance contract. Hartford, through its attorneys, engaged in settlement negotiations with Cook, and ultimately rejected Cook’s offer to settle for the limits of Hartford’s policy (i.e., $1 million).
National Surety did not receive notice of Cook’s action against Sufix from Sufix or Hartford until approximately two weeks before trial. National Surety alleges that because of the lack of timely notice, it was (1) unable to evaluate effectively its exposure to Cook under the excess policy, (2) unable to evaluate Cook’s settlement demand, (3) not given the opportunity to participate in or direct the preparations for the trial, and (4) unable to engage in informed settlement negotiations with Cook.
On May 21, 2002, a jury found Sufix liable to Cook and awarded Cook $6,486,588.44. After the trial, National Surety assumed the defense of Sufix and brought an unsuccessful appeal to the Court of Appeals оf Kentucky.
On February 24, 2005, National Surety filed suit against Hartford in the United States District Court for the Western District of Kentucky. National Surety sued Hartford for breach of contract and for violation of the common-law duty of good *755 faith. National Surety asserted in its complaint that Hartford failed “[t]o perform an adequate investigation of the allegations that form the basis of the Civil Action,” failed “[t]o provide Sufix with an adequate and competent defense of the allеgations contained in the Civil Action,” and failed “[t]o settle claims against Sufix within its policy limits so as not to expose Sufix and its assets to an excess judgment.” National Surety claimed that it is subrogated to Sufix pursuant to the terms of the excess policy and the doctrine of equitable subro-gation. Hartford filed a motion to dismiss, pursuant to Federal Rule of Civil Procedure 12(b)(6), on the grounds that Kentucky does not recognize the right of excess insurers to sue primary insurers in a situation like this one.
The district court granted Hartford’s motion to dismiss.
Nat’l Sur. Corp. v. Hartford Cas. Ins. Co.,
Second, the district court cоncluded that Kentucky would not follow the jurisdictions that have adopted the rule advocated by National Surety because excess insurers do not suffer an injury when a primary insurer, in bad faith, fails to settle a claim within its policy limits. Id. at 782-83. The district court reasoned that the excess insurer, National Surety, has received a premium in exchange for assuming the risk of an excess judgment and therefore suffered no wrong, while the insured, Su-fix, who has been fully indemnified, has suffered no loss. Id. at 783. Thе district court supported this reasoning with several hypotheticals. Id. at 783-85. Finally, the district court refuted the argument that failing to adopt the majority rule would raise excess insurance premium costs by raising the countervailing likelihood that adopting the majority rule would raise primary insurance premiums, thereby ultimately distributing costs unfairly. Id. at 785.
In resolving an issue of state law in a diversity case, this court must “ ‘make [the] best prediction, even in the absence of direct state court рrecedent, of what the Kentucky Supreme Court would do if it were confronted with’ ” the same question of law.
Managed Health Care Assocs., Inc. v. Kethan,
The Kentucky Supreme Court would likеly adopt the majority rule because that rule naturally follows from two other Ken *756 tucky insurance rules: (1) that an insured may sue an insurer who, in bad faith, fails to settle a claim within policy limits, and (2) that an insurer may step into the shoes of the insured, pursuant to the doctrine of equitable subrogation. In addition, the majority rule furthers Kentucky policies of encouraging fair and reasonable settlements and preventing wrongdoers from piggybacking on an insured’s insurance.
Kentucky law рermits an insured to sue a primary insurer that, in bad faith, fails to settle a claim. Under Kentucky law, the insurance contract between an insured and insurer contains an implied covenant of good faith and fair dealing.
Manchester Ins. & Indem. Co. v. Grundy,
Kentucky also recognizes the doctrine of equitable subrogation. Although Kentucky courts note that equitable subro-gation “should be strictly limited in its application,”
United Pac. Ins. Co. v. First Nat’l Bank of Prestonsburg,
Considering these two principles together leads to the conclusion that an excess insurer is permitted to step into the shoes of the insured and sue a primary insurer pursuant to the doctrine of equitable sub-rogation to enforce the primary insurer’s duty to avoid excessive judgments against an insured. The overwhelming majority of jurisdictions that have considered the issue in this case have adoptеd such a rule.
2
*757
Only Alabama and Idaho adhere to the minority position.
See Fed. Ins. Co. v. Travelers Cas. & Sur. Co.,
The majority rule encourages the fair and reasonable settlement of lawsuits.
See, e.g., Am. Centennial Ins. Co. v. Canal Ins. Co.,
Such hypotheticals cannot be disposed of with the observation that they fail to take into account the litigation costs incurred by the insurer when the case goes to trial. Although the presence of litigation costs diminishes the incentive an insurer has to go to trial, the underlying problem still remains. For example, in the above hypothetical, suppose that if the case went to trial, Hartford would have incurred $100,000 in litigation costs. Then the tоtal weighted expected cost of going to trial would have been $2.35 million. But Hartford would have had to pay $1.1 million if Cook won and $100,000 if Cook lost, for a weighted expected cost of $600,000. Thus, it still would have been in Hartford’s interest to go to trial.
Similarly, Kentucky law values the fair and reasonable settlement of lawsuits. The Kentucky courts have repeatedly stated that “[t]he law always looks with favor upon an agreement between two or more persons who, to аvoid a lawsuit, amicably settle their differences on such terms as to them seem fair and reasonable.”
Dexter v. Duncan,
In addition, the majority rule’s goal of preventing a primary insurer from, in bad faith, failing to settle a claim comports with Kentucky’s insurance policy goals. As discussed above, a primary insurer has an incentive to fail to settle a claim within its policy limits even though the settlement offer is objectively fair and reasonable. Although the insured has a cause of action against a primary insurer who fails to settle in good faith, when the insured has excess insurance, the insured has little incentive to sue because the harm of the primary insurer’s refusal to settle falls completely on the excess insurer.
See, e.g., Twin City Fire Ins. Co.,
Adopting the rule that excess insurers can sue primary insurers in cases like this does not, as argued, conflict with the Kentucky Court of Appeals’ decision in
American Continental Insurance Co. v. Weber & Rose, P.S. C,
Other concerns with adoption of the majority rule do not, in the end, provide persuasive reasons for Kentucky to reject it. It is not enough to say, for instance, that an excess insurer’s premiums reflect the possibility that a primary insurer would, in bad faith, fail to settle a claim. Such an argument proves too much: it would do away with equitable subrogation altogether in thе insurance context. For example, a health insurance company will pay for hospital bills covering injuries that an insured suffers by reason of a third party’s negligence. The health insurance company may sue the third-party tortfea-sor, under the doctrine of equitable subro-gation, to recover the damages owed to the insured that the insurer covered, and only circular reasoning would preclude such subrogation on the theory that the insurancе company’s premiums reflect the possibility of tortiously inflicted injuries. Like any business, an insurer will factor many risks of loss into the cost of its goods (i.e., insurance premiums), but that does not mean that the insurer must absorb the costs when those risks come to fruition if a third party’s negligence or bad faith caused the insurer to suffer those costs. Moreover, from the perspective of the primary insurer, the primary insurer’s premiums reflect its duty to settle in good faith, and failing to impose thе duty on primary insurers provides them a windfall.
See Centennial Ins. Co.,
Nor can it be persuasively argued that the excess insurer does not really “step into the shoes” of the insured because the insured’s cause of action against a primary insurer presupposes the lack of excess insurance. As noted above, the insured still has a cause of action under Kentucky law even when the insured’s loss is indemnified by insurance.
Taylor,
It could be argued that the interests of the excess insurer and the insured are not truly the same, but we are persuaded by the Seventh Circuit’s rejection of the argument:
It is true that the harm to the insured (when there is no excess insurer) is apt to be even greater than the harm to the excess insurer (when there is one in the picture), because the insured, at least if an individual, will be risk averse — that is why he buys insurance — while the insurance company eliminates risk by pоoling the risks of many insureds. But the excess insurer is hurt, nonetheless, if the primary insurer takes steps that increase the probability that the excess insurer will be liable, as in our hypothetical example [see n. 3, supra], where the conduct of the primary insurer converts a zero probability of liability to the excess insurer into a 50 percent probability that the latter will lose $1 million. No court has ever suggested that the difference in attitudes toward risk between an insured and an insurance company should alter the measure of recovery when an excess insurer is subrogated to an insured’s claim of bad faith.
Twin City Fire Ins. Co.,
Finally, the Kentucky courts are unlikely to reject the majority rule because it might raise premiums for primary insurers. The risk of liability for an insurance company’s own bad faith is doubtless included in the cost of primary coverage premiums, just as the cost of committing torts is built into the price of doing business generally. The cost of bad faith refusal to settle is presumably built into the primary insurance premiums where an insured has no excess insurance, and there is no good reason not to have the cost of bad faith refusal to settle included in the premiums for insureds who do have excess insurance. Bad faith costs, in other words, are a cost of doing business. There is no clear economic efficiency derived from shifting them to other insurers who have not acted in bad faith.
National Surety, however, may not assert a claim against Hartford for Hartford’s purported failure to investigate whether Sufix had other insurance. Such a claim does not sound in subrogation because Sufix, who presumably knows from whom it has obtained insurance, would have had no such claim against Hartford. Instead, such a claim would presume a direct obligation of the primary insurer to the excess insurer, a concept rejected by most of those jurisdictions accepting subrogation of the primary insurer’s obligation to its insured. As the Seventh Circuit said in
Twin City Fire Insurance Co., supra,
“the arguments in favor of the direct duty are not so compelling that we could responsibly predict that the Supreme Court of Illinois would buck the national trend and declare that under the common law of Illinois a primary insurer has a direct duty, actionable in tort, against the excess insurer.”
For the foregoing reasons, we affirm the dismissal of the claim against Hartford to the extent it relied on the failure to investigate whether its insured had other insurance coverage, but otherwise reverse the district court’s order granting Hartford’s motion to dismiss, and remand for further proceedings consistent with this opinion.
Notes
. A primary insurer insures against liability risk from $0 up to the policy limits. An excess insurer insures against liability above the limits of primary insurance. For exam- *754 pie, here, the insured had a primary insurance policy with Hartford that covered liability up to $1 million and an excess insurance policy with National Surety that covered any liability above $1 million, up to $10 million.
.
See Hartford Accident & Indem. Co. v. Aetna Cas. & Sur. Co.,
. Judge Posner used a similar hypothetical in explaining the Seventh Circuit's anticipation of Illinois law on the subject:
Suppose the claim was for $2 million, the policy limit was $1 million, the plaintiff was willing to settle for this amount, but the defendant’s insurer believed that if the case was tried the plaintiff would have a 50 percent chance of winning $2 million and a 50 percent chance of losing. The insurer's incentive would be to refuse to settlе, since if it lost the trial it would be no worse off than if it settled-in either case it would have to pay $1 million — but if it won it would have saved itself $1 million. It is in order to quench this kind of temptation that the liability insurer's duty to settle in good faith was read into liability insurance contracts. When by virtue of an excess insurance policy the victim of the behavior that we have described is the excess insurer rather than the insured, the former is permitted to step into the shoes of the latter and assert the *758 latter’s implied contractual right against the misbehaving insurer.
Twin City Fire Ins. Co. v. Country Mut. Ins. Co.,