Insurance bad faith
Encyclopedia
Insurance bad faith is a legal
term of art that describes a tort
claim that an insured person may have against an insurance company for its bad acts. Under the law of most jurisdictions in the United States
, insurance
companies owe a duty of good faith
and fair dealing
to the persons they insure. This duty is often referred to as the "implied covenant of good faith and fair dealing
" which automatically exists by operation of law in every insurance contract. If an insurance company violates that covenant, the insured person (or "policyholder") may sue the company on a tort
claim in addition to a standard breach of contract
claim. The contract-tort distinction is significant because as a matter of public policy, punitive or exemplary damages are unavailable for contract claims, but are available for tort claims. The end result is that a plaintiff in an insurance bad faith case may be able to recover an amount larger than the original face value of the policy, if the insurance company's conduct was particularly egregious.
industry in the U.S. are state
-specific. In 1869, the Supreme Court of the United States
held, in Paul v. Virginia (1869), that United States Congress did not have the authority to regulate insurance under its power to regulate commerce.
In the 1930s and 1940s, a number of U.S. Supreme Court decisions broadened the interpretation of the Commerce Clause
in various ways, so that federal jurisdiction over interstate commerce could be seen as extending to insurance. In March 1945, the United States Congress
expressly reaffirmed its support for state-based insurance regulation by passing the McCarran-Ferguson Act
(found at 15 U.S.C. §§ 1011-15) which held that no law that Congress passed should be construed to invalidate, impair or supersede any law enacted by a State regarding insurance. As a result, nearly all regulation of insurance continues to take place at the state level.
Such regulation generally comes in two forms. First, each state has an "Insurance Code" or some similarly named statute which attempts to provide comprehensive regulation of the insurance industry and of insurance policies, a specialized type of contract. State insurance codes generally mandate specific procedural requirements for starting, financing, operating, and winding down insurance companies, and often require insurers to be overcapitalized (relative to other companies in the larger financial services sector) to ensure that they have enough funds to pay claims if the state is hit by multiple natural and man-made disasters at the same time. There is usually a Department of Insurance or Division of Insurance responsible for implementing the state insurance code and enforcing its provisions in administrative proceedings against insurers.
Second, judicial interpretation of insurance contracts in disputes between policyholders and insurers takes place in the context of the aforementioned insurance-specific statutes as well as general contract law; the latter still exists only in the form of judge-made case law in most states. A few states like California and Georgia have gone farther and attempted to codify all of their contract law (not just insurance law) into statutory law.
Early insurance contracts were considered to be contracts like any other, but first English (see uberrima fides
) and then American courts recognized that insurers occupy a special role in society by virtue of their express or implied promise of peace of mind, as well as the severe vulnerability of insureds at the time they actually make claims (usually after a terrible loss or disaster).
In turn, the development of the modern cause of action for insurance bad faith can be traced to two landmark decisions of the Supreme Court of California
: Comunale v. Traders & General Ins. Co., 50 Cal. 2d 654, 328 P.2d 198, 68 A.L.R.2d 883 (1958) (third-party liability insurance), and Gruenberg v. Aetna Ins. Co., 9 Cal. 3d 566, 108 Cal. Rptr. 480, 510 P.2d 1032 (1973) (first-party fire insurance). Other state courts began to follow California's lead and held that a tort
claim exists for policyholders that can establish bad faith on the part of insurance carriers. According to Stephen S. Ashley's treatise, Bad Faith Actions: Liability and Damages, 2nd ed. (Eagan, MN: Thomson West, 1997), §§ 2.08 and 2.15, courts in nearly thirty states recognized the claim by the late 1990s. In nineteen states, state legislatures became involved and passed legislation that specifically authorized bad faith claims against insurers.
or life insurance
, but those cases tend to be rare. Most of them are preempted by ERISA.
Third party situations break down into at least two distinct duties, both of which must be fulfilled in good faith. First, the insurance carrier usually has a duty to defend a claim (or lawsuit) even if some or most of the lawsuit is not covered by the insurance policy. Unless the policy is expressly structured so that defense costs "eat away" at the policy limits, the default rule is that the insurer must cover all defense costs regardless of the actual limit of coverage. In one of the most famous decisions of his career, Justice Stanley Mosk
wrote: "[W]e can, and do, justify the insurer's duty to defend the entire 'mixed' action prophylactically, as an obligation imposed by law in support of the policy. To defend meaningfully, the insurer must defend immediately. [Citation.] To defend immediately, it must defend entirely. It cannot parse the claims, dividing those that are at least potentially covered from those that are not."
Second, the insurer has a duty of indemnification, which is the duty to pay a judgment against the policyholder, up to the limit of coverage, but only if the judgment is for a covered act or omission. As a result, most insurance companies exercise a great deal of control over litigation.
Bad faith can occur in either situation—by improperly refusing to defend a lawsuit or by improperly refusing to pay a judgment or settlement of a covered lawsuit.
In some jurisdictions, like California, third party coverage also contains a third duty, the duty to settle a reasonably clear claim against the policyholder within policy limits, in order to avoid the risk that the policyholder may be hit with a judgment in excess of the value of the policy (which a plaintiff might then attempt to satisfy by writ of execution on the policyholder's assets). If the insurer breaches in bad faith its duties to defend, indemnify, and settle, it may be liable for the entire amount of any judgment obtained by a plaintiff against the policyholder, even if that amount is in excess of policy limits. This was the holding of the landmark Comunale case.
Bad faith is a fluid concept and is defined primarily by court decisions in case law
. Examples of bad faith include undue delay in handling claims, inadequate investigation, refusal to defend a lawsuit, threats against an insured, refusing to make a reasonable settlement offer, or making unreasonable interpretations of an insurance policy.
In some cases, the tort or the governing state statute allows punitive damages
against insurance companies as a mechanism to prevent future behavior.
In California, the plaintiff in a bad faith action may be able to recover some of its attorneys' fees separately and in addition to the judgment for damages against a defendant insurer, but only up to the extent that those fees were incurred in recovering tort damages (for breach of the implied covenant) as opposed to contractual damages (for breach of the terms of the insurance policy). The allocation of attorneys' fees between those two categories is usually a question of fact (meaning it usually goes to the jury).
The first situation is where an insured abandoned in bad faith by its liability insurer makes a special settlement agreement with the plaintiff. Sometimes this occurs after trial, where the insured has attempted to defend himself or herself by paying for a lawyer out of pocket, but went to verdict and lost (the actual situation in the landmark Comunale case); other times it occurs before trial and the parties agree to put on an uncontested show trial
that results in a final verdict and judgment against the insured. Either way, the plaintiff agrees to not actually execute on the final judgment against the insured in exchange for an assignment of the assignable components of the insured's causes of action against its insurer.
The second situation is where the plaintiff does not need to obtain a judgment first, but instead proceeds directly against the insured's insurer under a state statute authorizing such a "direct action." These statutes have been upheld as constitutional by the U.S. Supreme Court.
. Bad faith cases may also be slow, at least in the third party context, because they are necessarily dependent upon the outcome of any underlying litigation. For example, the 2003 Campbell decision involved State Farm's handling of litigation resulting from a fatal car accident in 1981, 22 years earlier.
Toxic mold is a common cause of bad faith lawsuits, with about half of the 10,000 toxic mold cases in 2001 being filed against insurance companies on bad faith grounds. Before 2000 the claims were uncommon, with relatively low payouts. One notable lawsuit occurred when a Texas jury awarded $32 million (later reduced to $4 million). In 2002 a suit was settled for $7.2 million.
Law
Law is a system of rules and guidelines which are enforced through social institutions to govern behavior, wherever possible. It shapes politics, economics and society in numerous ways and serves as a social mediator of relations between people. Contract law regulates everything from buying a bus...
term of art that describes a tort
Tort
A tort, in common law jurisdictions, is a wrong that involves a breach of a civil duty owed to someone else. It is differentiated from a crime, which involves a breach of a duty owed to society in general...
claim that an insured person may have against an insurance company for its bad acts. Under the law of most jurisdictions in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
companies owe a duty of good faith
Good faith
In philosophy, the concept of Good faith—Latin bona fides “good faith”, bona fide “in good faith”—denotes sincere, honest intention or belief, regardless of the outcome of an action; the opposed concepts are bad faith, mala fides and perfidy...
and fair dealing
Fair dealing
Fair dealing is a limitation and exception to the exclusive right granted by copyright law to the author of a creative work, which is found in many of the common law jurisdictions of the Commonwealth of Nations....
to the persons they insure. This duty is often referred to as the "implied covenant of good faith and fair dealing
Implied covenant of good faith and fair dealing
In contract law, the implied covenant of good faith and fair dealing is a general presumption that the parties to a contract will deal with each other honestly, fairly, and in good faith, so as to not destroy the right of the other party or parties to receive the benefits of the contract...
" which automatically exists by operation of law in every insurance contract. If an insurance company violates that covenant, the insured person (or "policyholder") may sue the company on a tort
Tort
A tort, in common law jurisdictions, is a wrong that involves a breach of a civil duty owed to someone else. It is differentiated from a crime, which involves a breach of a duty owed to society in general...
claim in addition to a standard breach of contract
Contract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
claim. The contract-tort distinction is significant because as a matter of public policy, punitive or exemplary damages are unavailable for contract claims, but are available for tort claims. The end result is that a plaintiff in an insurance bad faith case may be able to recover an amount larger than the original face value of the policy, if the insurance company's conduct was particularly egregious.
Historical background
Most laws regulating the insuranceInsurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
industry in the U.S. are state
U.S. state
A U.S. state is any one of the 50 federated states of the United States of America that share sovereignty with the federal government. Because of this shared sovereignty, an American is a citizen both of the federal entity and of his or her state of domicile. Four states use the official title of...
-specific. In 1869, the Supreme Court of the United States
Supreme Court of the United States
The Supreme Court of the United States is the highest court in the United States. It has ultimate appellate jurisdiction over all state and federal courts, and original jurisdiction over a small range of cases...
held, in Paul v. Virginia (1869), that United States Congress did not have the authority to regulate insurance under its power to regulate commerce.
In the 1930s and 1940s, a number of U.S. Supreme Court decisions broadened the interpretation of the Commerce Clause
Commerce Clause
The Commerce Clause is an enumerated power listed in the United States Constitution . The clause states that the United States Congress shall have power "To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes." Courts and commentators have tended to...
in various ways, so that federal jurisdiction over interstate commerce could be seen as extending to insurance. In March 1945, the United States Congress
United States Congress
The United States Congress is the bicameral legislature of the federal government of the United States, consisting of the Senate and the House of Representatives. The Congress meets in the United States Capitol in Washington, D.C....
expressly reaffirmed its support for state-based insurance regulation by passing the McCarran-Ferguson Act
McCarran-Ferguson Act
The McCarran–Ferguson Act, 15 U.S.C. §§ 1011-1015, is a United States federal law that exempts the business of insurance from most federal regulation, including federal anti-trust laws to a limited extent. The McCarran–Ferguson Act was passed by Congress in 1945 after the Supreme Court ruled in...
(found at 15 U.S.C. §§ 1011-15) which held that no law that Congress passed should be construed to invalidate, impair or supersede any law enacted by a State regarding insurance. As a result, nearly all regulation of insurance continues to take place at the state level.
Such regulation generally comes in two forms. First, each state has an "Insurance Code" or some similarly named statute which attempts to provide comprehensive regulation of the insurance industry and of insurance policies, a specialized type of contract. State insurance codes generally mandate specific procedural requirements for starting, financing, operating, and winding down insurance companies, and often require insurers to be overcapitalized (relative to other companies in the larger financial services sector) to ensure that they have enough funds to pay claims if the state is hit by multiple natural and man-made disasters at the same time. There is usually a Department of Insurance or Division of Insurance responsible for implementing the state insurance code and enforcing its provisions in administrative proceedings against insurers.
Second, judicial interpretation of insurance contracts in disputes between policyholders and insurers takes place in the context of the aforementioned insurance-specific statutes as well as general contract law; the latter still exists only in the form of judge-made case law in most states. A few states like California and Georgia have gone farther and attempted to codify all of their contract law (not just insurance law) into statutory law.
Early insurance contracts were considered to be contracts like any other, but first English (see uberrima fides
Uberrima fides
Uberrima fides is a Latin phrase meaning "utmost good faith" . It is the name of a legal doctrine which governs insurance contracts. This means that all parties to an insurance contract must deal in good faith, making a full declaration of all material facts in the insurance proposal...
) and then American courts recognized that insurers occupy a special role in society by virtue of their express or implied promise of peace of mind, as well as the severe vulnerability of insureds at the time they actually make claims (usually after a terrible loss or disaster).
In turn, the development of the modern cause of action for insurance bad faith can be traced to two landmark decisions of the Supreme Court of California
Supreme Court of California
The Supreme Court of California is the highest state court in California. It is headquartered in San Francisco and regularly holds sessions in Los Angeles and Sacramento. Its decisions are binding on all other California state courts.-Composition:...
: Comunale v. Traders & General Ins. Co., 50 Cal. 2d 654, 328 P.2d 198, 68 A.L.R.2d 883 (1958) (third-party liability insurance), and Gruenberg v. Aetna Ins. Co., 9 Cal. 3d 566, 108 Cal. Rptr. 480, 510 P.2d 1032 (1973) (first-party fire insurance). Other state courts began to follow California's lead and held that a tort
Tort
A tort, in common law jurisdictions, is a wrong that involves a breach of a civil duty owed to someone else. It is differentiated from a crime, which involves a breach of a duty owed to society in general...
claim exists for policyholders that can establish bad faith on the part of insurance carriers. According to Stephen S. Ashley's treatise, Bad Faith Actions: Liability and Damages, 2nd ed. (Eagan, MN: Thomson West, 1997), §§ 2.08 and 2.15, courts in nearly thirty states recognized the claim by the late 1990s. In nineteen states, state legislatures became involved and passed legislation that specifically authorized bad faith claims against insurers.
Bad faith defined
An insurance company has many duties to its policyholders. The kinds of applicable duties vary depending upon whether the claim is considered to be "first party" or "third party." A common first party context is when an insurance company writes insurance on property that becomes damaged, such as a house or an automobile. In that case, the company is required to investigate the damage, determine whether the damage is covered, and pay the proper value for the damaged property. Bad faith in first party contexts often involves the insurance carrier's improper investigation and valuation of the damaged property (or its refusal to even acknowledge the claim at all). Bad faith can also arise in the context of first party coverage for personal injury such as health insuranceHealth insurance in the United States
The term health insurance is commonly used in the United States to describe any program that helps pay for medical expenses, whether through privately purchased insurance, social insurance or a non-insurance social welfare program funded by the government...
or life insurance
Life insurance
Life insurance is a contract between an insurance policy holder and an insurer, where the insurer promises to pay a designated beneficiary a sum of money upon the death of the insured person. Depending on the contract, other events such as terminal illness or critical illness may also trigger...
, but those cases tend to be rare. Most of them are preempted by ERISA.
Third party situations break down into at least two distinct duties, both of which must be fulfilled in good faith. First, the insurance carrier usually has a duty to defend a claim (or lawsuit) even if some or most of the lawsuit is not covered by the insurance policy. Unless the policy is expressly structured so that defense costs "eat away" at the policy limits, the default rule is that the insurer must cover all defense costs regardless of the actual limit of coverage. In one of the most famous decisions of his career, Justice Stanley Mosk
Stanley Mosk
Stanley Mosk was an Associate Justice of the California Supreme Court for 37 years , and holds the record for the longest-serving justice on that court. Before sitting on the Supreme Court, he served as Attorney General of California and as a trial court judge, among other governmental positions...
wrote: "[W]e can, and do, justify the insurer's duty to defend the entire 'mixed' action prophylactically, as an obligation imposed by law in support of the policy. To defend meaningfully, the insurer must defend immediately. [Citation.] To defend immediately, it must defend entirely. It cannot parse the claims, dividing those that are at least potentially covered from those that are not."
Second, the insurer has a duty of indemnification, which is the duty to pay a judgment against the policyholder, up to the limit of coverage, but only if the judgment is for a covered act or omission. As a result, most insurance companies exercise a great deal of control over litigation.
Bad faith can occur in either situation—by improperly refusing to defend a lawsuit or by improperly refusing to pay a judgment or settlement of a covered lawsuit.
In some jurisdictions, like California, third party coverage also contains a third duty, the duty to settle a reasonably clear claim against the policyholder within policy limits, in order to avoid the risk that the policyholder may be hit with a judgment in excess of the value of the policy (which a plaintiff might then attempt to satisfy by writ of execution on the policyholder's assets). If the insurer breaches in bad faith its duties to defend, indemnify, and settle, it may be liable for the entire amount of any judgment obtained by a plaintiff against the policyholder, even if that amount is in excess of policy limits. This was the holding of the landmark Comunale case.
Bad faith is a fluid concept and is defined primarily by court decisions in case law
Case law
In law, case law is the set of reported judicial decisions of selected appellate courts and other courts of first instance which make new interpretations of the law and, therefore, can be cited as precedents in a process known as stare decisis...
. Examples of bad faith include undue delay in handling claims, inadequate investigation, refusal to defend a lawsuit, threats against an insured, refusing to make a reasonable settlement offer, or making unreasonable interpretations of an insurance policy.
In some cases, the tort or the governing state statute allows punitive damages
Punitive damages
Punitive damages or exemplary damages are damages intended to reform or deter the defendant and others from engaging in conduct similar to that which formed the basis of the lawsuit...
against insurance companies as a mechanism to prevent future behavior.
In California, the plaintiff in a bad faith action may be able to recover some of its attorneys' fees separately and in addition to the judgment for damages against a defendant insurer, but only up to the extent that those fees were incurred in recovering tort damages (for breach of the implied covenant) as opposed to contractual damages (for breach of the terms of the insurance policy). The allocation of attorneys' fees between those two categories is usually a question of fact (meaning it usually goes to the jury).
Assignment or direct action
In some U.S. states, bad faith is even more complicated because under certain circumstances, a liability insurer may ultimately find itself in a trial where it is being sued directly by the plaintiff who originally sued its insured. This is allowed through two situations: assignment or direct action.The first situation is where an insured abandoned in bad faith by its liability insurer makes a special settlement agreement with the plaintiff. Sometimes this occurs after trial, where the insured has attempted to defend himself or herself by paying for a lawyer out of pocket, but went to verdict and lost (the actual situation in the landmark Comunale case); other times it occurs before trial and the parties agree to put on an uncontested show trial
Show trial
The term show trial is a pejorative description of a type of highly public trial in which there is a strong connotation that the judicial authorities have already determined the guilt of the defendant. The actual trial has as its only goal to present the accusation and the verdict to the public as...
that results in a final verdict and judgment against the insured. Either way, the plaintiff agrees to not actually execute on the final judgment against the insured in exchange for an assignment of the assignable components of the insured's causes of action against its insurer.
The second situation is where the plaintiff does not need to obtain a judgment first, but instead proceeds directly against the insured's insurer under a state statute authorizing such a "direct action." These statutes have been upheld as constitutional by the U.S. Supreme Court.
Litigation
Bad faith lawsuits may result in large awards of punitive damages. A famous example is State Farm Mutual Auto. Ins. Co. v. Campbell, in which the U.S. Supreme Court overturned a jury verdict of $145 million in punitive damages against State Farm InsuranceState Farm Insurance
State Farm Insurance is a group of insurance and financial services companies in the United States. The company also has operations in Canada....
. Bad faith cases may also be slow, at least in the third party context, because they are necessarily dependent upon the outcome of any underlying litigation. For example, the 2003 Campbell decision involved State Farm's handling of litigation resulting from a fatal car accident in 1981, 22 years earlier.
Toxic mold is a common cause of bad faith lawsuits, with about half of the 10,000 toxic mold cases in 2001 being filed against insurance companies on bad faith grounds. Before 2000 the claims were uncommon, with relatively low payouts. One notable lawsuit occurred when a Texas jury awarded $32 million (later reduced to $4 million). In 2002 a suit was settled for $7.2 million.