Bad Faith as a Continuum:
From Claim to Trial
Thomas F. Segalla
I.
Introduction
The concept of bad faith can only be clearly understood if viewed as a continuum. This requires that the claims handler and defense counsel look forward and backward after receiving notice of a lawsuit. The claims handling field is fraught with dangers; if the claims professional does not understand the impact of action or inaction during the claims handling process, a bad faith claim may result. Similarly, potentially large verdicts can emerge if defense counsel does not fully understand the claims handling process. Specifically, the claims professional must look forward to assess how action or inaction will be viewed by a jury. Defense counsel must look backwards at the process, however, considering how to profile the claims professional before the jury. Counsel also must determine whether to adopt a proactive or reactive approach to the defense process.
This article is divided into three sections and highlights what the claims professional should know about the present bad faith environment, what defense counsel should consider when advising its client about the proper approach to defend a case, and what both should know about potential challenges at the time of trial. Each of these matters must be assessed separately, but should be viewed as interrelated. Absent that approach, bad faith litigation will continue to plague the industry.
II.
Bad Faith Avoidance: Who Set the Trap?
A. The Dilemma
Education, not insensitivity, cynicism or skepticism, is the principal tool in avoiding bad faith. However, even the most educated claims professional can be blind-sided in the claims handling and litigation processes, absent a clear understanding of the bad faith “setup,” and an actual awareness of who set the trap. The focal issue can be framed in the alternative: (1) was the trap set by the insured and its counsel and/or the third‑party claimant and its counsel, or (2) was it set by the claims handling professional at the adjuster level or at the management level of the insurance company? The purpose of this article is to help identify what prophylactic measures should be taken to prevent setting the trap at the outset; to identify what proactive measures are needed after the trap has been set; to identify who set the trap, and to provide some practical and tactical recommendations to remove the bait from the trap before it is sprung.
Bad faith has been variously described by courts and commentators. It abides many definitions:
1. irrational recalcitrance on the part of the insurer to pay what is due to the insured;
2. reprehensible conduct designed to redirect small amounts from all property damage claims;
3. evil mindedness of the adjuster, which results in a refusal to pay a claim;
4. “malicious intent” of the adjuster in investigating the claim; and
5. “conscious wrong doing” and “spite” towards the insured.
These descriptive words have been used to characterize the insurer’s actions within the context of both first‑party and third-party claims. It should be noted, however, that this article is not intended to provide a complete analysis of the legal standards applied within the first- and third-party context.[1]
One of the dominant goals of the education process is to prevent the insurer from entering the “Bad Faith Insurer Hall of Shame,” promoting its entry instead into the “Good Faith Insurer Hall of Fame,” as published by Fight Bad Faith Insurance Companies (“FBIC”) (a non-profit advocacy organization) at www.badfaithinsurance.org. Although reading such publications can be highly inflammatory from the insurance industry perspective, these publications serve to identify the existing climate under which the claims professional and defense counsel must operate. Recognizing where the problems and potential exposure lie, and taking proactive steps to prevent the bad faith claim constitute more realistic goals for the insurance industry to pursue. These goals can be achieved by educating the industry about acceptable claims handling procedures and analyzing how the industry’s actions or inactions will impact the insureds and be judged by the courts.[2]
B. Who Set the Trap?
1. The Right to be Wrong
While the claims professional should be ever vigilant to the bad faith setup or trap, the industry should also recognize that the insurance company does have the right to be wrong; an insurer is not compelled to pay a claim or settle a case just because a claim is made or a settlement demand issues from the claimant. Unfounded claims and exorbitant demands within the policy limits need not be paid and should not be paid.[3] Regardless of the specific standard applied in either the first- or third-party context, most courts agree that a “reasonableness” or “fairly debatable standard” should be applied. Not only does an insurer have the right to be wrong, some jurisdictions even recognize an insurer’s duty to verify that the claimant (i.e., either a third party or its own insured) did not cause the loss so as not to pay suspicious or collusive claims. Such a duty protects the insurer’s innocent premium-paying insureds. In Time Insurance Co., Inc. v. Harvey Burger,[4] the Florida Supreme Court noted: “Insurers have a right and a duty to other policyholders to contest illegitimate claims. This statute should not be given a construction which destroys that right or frustrates that duty. Payment of illegitimate claims raises the cost of insurance for all policyholders.”[5]
The claims professional, who often consults with counsel when determining its position with respect to a particular claim, will sometimes aver that he or she relied on the advice of counsel. Courts traditionally have held that an insurer’s failure to follow the advice of counsel is evidence of bad faith. More recently, the courts have held that reliance on the advice of counsel is but one factor in determining whether the insurer acted in bad faith, rather than an absolute defense to the claim.[6] It should be noted, however, that reliance on the advice of counsel must be reasonable, resulting from something more than wishful thinking on the part of the claims professional.[7] But what if the advice given by counsel is erroneous?
In Gordon v. Nationwide Mutual Insurance Co.,[8] an insurer relied on counsel’s advice that a policy could be validly canceled. The New York Court of Appeals responded that reliance on advice of counsel is an absolute defense, noting: “It would be an extraordinary result to hold a client guilty of breach of good faith, with large punitive damages, because it acts on advice of counsel -- even mistaken advice . . . .”[9] In contrast, the Court of Appeals for the Fifth Circuit determined in Blakely v. American Empoyers Insurance Co.[10] that the advice of counsel was irrelevant: “We do not hold to the view that an insurer can relieve itself of its duty to investigate, negotiate, settle or defend a claim by showing advices from its investigators, adjusters or legal counsel.”[11] There appears to be no consistency among the various jurisdictions; therefore, it is incumbent upon claims professionals and practitioners to review the law in the controlling jurisdiction.[12]
2. Claims Professional’s Conduct
Did the claims professional set his or her own trap within the context of the relevant action or inaction? Traditionally, in the claims adjustment process, the claims professional exercised nearly unfettered discretion in adjusting both the first‑party and third‑party claims. Within this context, bad faith claims focused on the actions or inactions of individual adjusters, asking whether those actions or inactions violated the bad faith standard as applied in a given jurisdiction. Within the first‑party context, claimants generally allege that the insurer committed bad faith because:
a. it arbitrarily and capriciously denied a claim;
b. it unscrupulously denied a claim, placing its own interests over those of the insured;
c. it denied a claim that was reasonable or fairly debatable;
d. it denied a claim where there was no bona fide dispute; or
e. it denied a claim without adequate investigation.
In the third-party context, claimants generally allege that the insurer:
a. failed to provide a defense for a third-party claim in good faith;
b. failed to properly settle the claim of a third party within the policy limits; or
c. failed to provide an adequate defense.
The gravamen of these allegations deals with the reasonable conduct of the insured or its counsel. Therefore, the conduct must be judged by the individual claims professional and his or her supervisor within the confines of the applicable bad faith standard. If claims professionals are not keenly aware of which claims adjustment activities and attitudes can be problematic, they are setting themselves up for a fall.
There are, however, certain claims handling do’s and don’ts that can help keep the claims professional out of trouble or out of the trap. One of the clearest cautions prevents the claims professional from becoming a B.U.M.; that is:
1) Biased
2) Unfair
3) Mean
This acronym was developed by Lee Craig, a partner with the law firm of Butler, Burnette & Pappas in Tampa, Florida.[13]
Evidence of a claims professional’s attitude and demeanor typically derives from oral comments or admissions made by the claims professional to the claimant. Such evidence can be found in the claims file, whether stored in hard or electronic copy, which generally is discoverable in most jurisdictions.[14]
Furthermore, any notation in the activity log is potentially discoverable and could make its appearance as a trial exhibit. The following are reported “lapses in judgment” as taken from the activity log notes of actual files:
· “The house is filthy and unsafe for habitation. I told the insured that before I would inspect the damage, she had to clean the place up and call an exterminator.”
· “I met with the tenant at the insured location. I told the tenant that the damage was caused by surface water and therefore, not covered. The tenant will explain to insured.”
· “I denied coverage for the extensive damage to the floor as the cause of loss is unknown. The insured requested an expert identify the source of water. I told her that I am the expert and the damage is not covered.”
· “The insured is stupid and does not speak English very well. I mailed him a denial letter in hopes he can read better than he speaks.”
· “The insured submitted notarized lightning affidavits for the damaged contents. I disagree with her expert and am therefore denying coverage for the loss.”
· “The insured is submitting a claim for water damage in dining room. I remember this house from a claim last year. The dining room is in the front of the house. There is no source of water near the dining room, so this must be caused by surface water, which is not covered. No inspection needed. I will send insured surface water denial letter.”
· “Attempted to contact the insured. I do not speak Spanish. I will close file at this time until the insured can get a translator for me to communicate with.”
· “It appears the damage is caused by foundation movement. The insured has hired an engineer who concluded the foundation damage is caused by a plumbing leak in the bathroom. The bathroom is about 40 feet away from the worst damage. A leak in the bathroom could not be causing this damage. No coverage extended.”
· “The insured became very upset with my explanation. I definitely do not want to cover this loss after the way she acted.”
· “After reviewing the insured’s inventory form, it is obvious she is lying. No one living in a house like hers could ever afford contents she is claiming. The insured stated she inherited most of her belongings from her mother who died last year. I don’t believe this. If the insured can’t produce purchase receipts, I will deny claim.”
· “My inspection of the roof indicated extensive damage. I do not know what caused the damage, so I won’t cover this loss.”
· “The insured will not call me back while I am at the office. He keeps leaving messages on my voice mail after hours while I am not here. I will close the file until he calls me back while I am in the office.”[15]
These “lapses” can be utilized by plaintiff’s counsel to establish a traditional bad faith claim, where the claims handler has no lawful basis on which to preclude the claim, and a non-traditional case, where there is an intentional or reckless failure to investigate whether a lawful basis exists on which to refuse payment.[16]
The attitude of the claims adjuster is important to the overall process because authorities have recognized that “[b]ad faith is a very contentious issue for both the policyholders and insurance companies. . . . Such claims elicit strong emotions from the parties and often intensify the adversarial nature of a law suit.”[17] To the extent that the insurer’s representatives add fuel to the fire by way of adverse attitudes and lapses, they subject themselves to emotional distress damages. While there appears to be no consistency among the various jurisdictions regarding whether emotional distress damages will be allowed in bad faith litigation, a number of issues can be determinative. These include whether the claim at issue is a third-party or first-party claim; whether the distress is severe, or differences between tort and contract law. In California, for example, emotional distress damages are recoverable only where the insured or third party has suffered some financial loss.[18]
Claims professionals should consider the following recommendations to defuse the bad-faith time bomb that potentially awaits the unwary claims professional. Each of the items mentioned in the checklists below should be assessed on a case-by-case basis, although no single recommendation presents a “cure” for bad faith litigation.
3. Checklist: First-Party Claims
With regard to first-party claims, the claims professional should observe the following recommendations:
a. Accurately record the analysis of the insured’s proof of loss; do not editorialize any adverse or personal impressions.
b. Conduct a site investigation as soon as possible and record all facts, damages, and other information that impacts coverage.
c. Review all obligations of the insurer to the insured and comply.
d. Obtain timely coverage analysis where coverage issues are presented and advise insured of denial in a timely manner.
e. Pay any portion of the claim that may be owing.[19]
4. Checklist: Third-Party Claims
With respect to third-party claims, the recommendations are similar.
a. Failure to Settle
1. Investigate all liability aspects of the underlying claim.
2. Promptly evaluate both the liability and damage aspects of the case.
3. Keep the insured informed as to the liability assessment and value of the case.
4. Keep the insured informed of all settlement negotiations, any excess exposure, and the right to contribute.
b. Failure to Defend
1. Advise the insured of the insurance company’s coverage position, consistent with any obligation imposed by statute or case law (i.e., reservations of rights or denial of coverage).
2. Institute a declaratory judgment and attempt to resolve coverage issues in advance of the underlying liability claim.[20]
Superimposed across each of the foregoing obligations is the recommendation that the claims professional communicate in a direct, diplomatic, and professional fashion, articulating its position in a manner that can be easily understood by the claimant, the insured, and their counsel.[21] At least one court has observed that “[t]he portion of the claims file which explains how the company processed and considered Brown’s [the insured’s] claim and why it rejected the claim are certainly relevant to these issues.”[22] In the matter of Brown v. Superior Court, that court further noted: “The claims file is a unique, contemporaneously prepared history of the company’s handling of the claim; in an action such as this the need for the information on the file is not only substantial, but overwhelming.”[23] Other courts have indulged similar observations: “It seems evident to us that in a case of alleged bad faith refusal to settle, the circumstances and content of the various negotiations and communications between the involved individuals are clearly relevant . . . .”[24]
In light of these comments and because the documentation regarding negotiations and communications will become exhibits in any subsequent litigation, the claims handler must be sensitive to the tenor and manner in which these are recorded. Such awareness can forestall any trap, but equally important, it will prevent the trap from being sprung during the litigation.[25]
5. Insurer’s Corporate Policy
As noted earlier, the action or inaction of the claims handler traditionally forms the basis of a bad faith assault. According to some, however, the focus has changed:
Plaintiffs are broadening their assault against insurer’s corporate policies and procedures on two fronts: class action litigation and single or small multi-party plaintiff cases. What characterizes both forms of attack is that plaintiff all but ignores the adjuster’s claim specific decision. The trial bar’s assault is against the company at the management level because the issue in the case is the allegedly improper guidelines and procedures, promulgated by management, that have been consistently followed by its adjusters, which reap unfair profits from the insurer’s policyholders. The adjuster is portrayed almost as an ignorant pawn of corporate management.[26]
The comments of Attorney Arnold D’Angelo raise the specter of institutional bad faith. Succinctly defined, it occurs “[w]hen corporate structure or policies encourage bad faith claims handling.”[27] These comments were made eleven years after Leo Jordan, Associate General Counsel for State Farm Insurance, offered the following advice to members of the American Bar Association in 1979:
The most important advice I can leave you with, is that the time has come for the insurance industry to do its own laundry. If there are practices and procedures which are tinged with questionable motivation or proprieties, they must be eliminated. If changes are needed in the way we do business, let the industry and its well-trained lawyers lead the way in the reform. We cannot allow the trial bar and courts to establish our practices for us. We will be far better off to cleanse our own procedures and openly present them for public scrutiny. Justice Louis Brandeis said it well: Sunshine is the most powerful disinfectant.[28]
Over the past several years, insurers have adopted new claims handling guidelines in certain circumstances to address many of the issues raised by the challenge that claims adjusters had failed to properly investigate or process claims. Beyond these, changes in claims-handling guidelines were often dictated by economic factors affecting the insurance industry. However, it must be recognized that such procedures, practices and policies cannot be enacted in a vacuum; they should only be enacted “when the procedures have been adopted after a due diligence review which concludes that the practice fulfills the insurers’ contractual obligations and is otherwise in conformance with state law.”[29] It is evident, therefore, that the individual(s) charged with the drafting of claims‑handling policies, practices and procedures must be educated to the manner by which courts interpret existing policy language; they must clearly understand the impact of current and proposed statutory law. Furthermore, the insurer should be vigilant about proposed legislation and the sentiment expressed by the various state legislatures. After considering the impact of these variables, the insurer can determine whether to redraft its practices, policies and procedures and, in the right case, whether to redraft policy language. If an insurer does not develop its claims-handling and billing guidelines in this fashion, it is setting its own trap.
Representatives at the management level should also be aware that they may be joined as individual defendants in any litigation. If not specifically joined, they may be noticed for deposition.[30] In an institutional bad faith claim, the industry representative will be subject as well to an extensive request for production of documents.[31]
The obvious purpose of such discovery is to establish a “pattern and practice” of activity at upper management levels in order to bolster the punitive damage aspects of the bad faith claim.[32] In addition to using traditional discovery devices, counsel for bad faith plaintiffs have developed other proof of pattern and practice. In one case, an insured school district sent letters and questionnaires to other policyholders in order to determine whether its insurers had engaged in a pattern and practice of denying similar claims.[33] Defense counsel undoubtedly will challenge such evidence on grounds that it is prejudicial, confusing, and a waste of judicial time. However, it might be best to address and avoid bad faith claims by engaging a more realistic assessment of an insurer’s patterns and practices outside of the litigation process.
With respect to pattern and practice claims, commentator Arnold D’Angelo suggests several solutions for avoiding institutional bad faith claims:
Suits are always being brought attacking insurance practices and, when successful, should form the basis of an internal dialogue within the insurance company. If the practice under attack is critical to an insurer’s strategy, the insurer should determine whether the policyholder assault is meritorious. If so, the policy should be modified or sacrificed. On the other hand, if the practice is critical to the success of the business, the company may be able to preserve the practice by changing the policy language. By doing so, any policyholder’s suit which is brought will only be able to attack the insurer’s past practices, and liability will be thereby limited.[34]
6. Claimant’s Setup
It is generally recognized that an actual offer within the policy limits is prerequisite to a bad faith claim. However, there are situations where a settlement demand is made by the claimant’s counsel in order to set a trap for the claims professional.[35] Thus, the claims professional should be wary when:
a. Settlement demand is patently unreasonable, yet within the policy limits.
b. Settlement demand is made with the specific intent not to settle the case.
c. Terms and conditions (i.e., length of time the demand remains open) are so unreasonable that they cannot be met.
This bad faith setup has been described as follows:
Creative plaintiffs’ attorneys often seek to expand the insurer’s policy limits by staging facts that would give rise to bad faith liability. Sometimes these attorneys play “dirty pool” in their attempts to set insurers up for bad faith claims, using such techniques as making policy limits offers with unreasonable time limits, making offers before there has been adequate time for investigation or discovery and backing out of settlement agreements under pretexts they blame on the insurer.[36]
When confronted by such situations, the claims professional should document all negotiations and maintain a log of all critical dates, noting what transpired on each date (i.e., noting the date and who said what regarding settlement). This documentation will assist defense counsel in alleging and proving the “setup defense.”[37] A review of existing case law clearly indicates that when faced with such settlement demands, the claims professional should develop a time line of critical dates. As noted in DeLaune v. Liberty Mutual Insurance Co., an offer to settle made less than two months after the accident and ten months before trial, which was open only for ten days, “made it virtually impossible to make an intelligent acceptance.”[38] Not only should the claims professional be prepared to document these critical dates, he or she must also document what was being done from a claims-handling standpoint during this time frame. This documentation will establish that the settlement demand could not be reasonably and realistically assessed, and that the claims handler’s reaction was reasonable.
7. Other Warning Signs
The claims professional should be aware of other warning signs that identify potential claims handling problems and occur on a daily basis. The National Insurance Crime Bureau has developed and published indicators that alert the insurance industry to potentially fraudulent claims. It has also published methods for assessing these claims. These types of claims often lend themselves to bad faith allegations. The following checklist may prove helpful when assessing whether a first-party claim carries the potential for bad faith:
a) Claim is a large one.
b) Claim is excessive in relation to the type of harm suffered or evidence submitted to support the claim.
c) Insured has made frequent claims against this and other policies.
d) Insured has retained an attorney to deal with the insurer immediately after the loss.
e) Additional limits were placed on the insured item before the loss.
f) Insured had been refused coverage by other carriers and is keenly aware of the claims process.
g) Insured exhibits a cavalier attitude towards the loss and merely wants to be paid.
h) Insured’s financial condition changed immediately before the loss.
i) Insured makes inconsistent statements and is uncooperative.
j) With respect to a fire policy, insured has absented itself from the property prior to the loss.
While factors of this nature do not conclusively identify all suspicious/fraudulent claims or predict that a bad faith claim will develop, they should put the claims handler on notice that his or her best practices should be followed. Such practices will also provide a strategy (substantiated by documentation) by which to proactively challenge the setup.
When dealing with a third-party claim, the claims handler should be sensitive to the possibility of collusion between the insured and the injured party when settlement has been effectuated without involving the insurer. It has been noted that a settlement:
[B]ecomes collusive when the purpose is to injure the interests of an absent or nonparticipating party, such as an insurer or non‑settling defendant. Among the indicators of bad faith and collusion are unreasonableness, misrepresentations, concealment, secretiveness, lack of serious negotiations on damages, attempts to affect the insurance coverage, profit to the insured, and attempts to harm the interest of the insurer. They have in common unfairness to the insurer, which is probably the bottom line in cases in which collusion is found.[39]
When faced with such indicators, the claims professional should document critical elements without reacting negatively, which might jeopardize the defense of any subsequent bad faith claim.
C. Proactive Claims Handling
The threat of a potential bad faith claim does not mean that the claims professional cannot or should not do what is expected in the position. The following are claims-handling pointers, some of which may seem obvious. However, the failure to follow many of these often results in bad faith claims.
1. Keep in mind that the ultimate goal is to commit no act (nor fail to perform some act) that can be utilized by plaintiff’s counsel as evidence of bad faith.
2. Be sensitive to the allegations made by the insured, the claimant or counsel in correspondence, and identify strategies.
3. Document responses to any correspondence, communication, or allegations made by plaintiffs. Do not ignore phone calls or written communications.
4. Treat the plaintiff and/or insured with the utmost courtesy, even if the insurer believes the insured is attempting fraud.
5. Be aware of all applicable claims-handling practices and procedures; document how these have been followed or explain why they have not.
6. When the insured or plaintiff’s counsel presents evidence of the claim, be receptive and careful in responding. Follow all leads.
7. When evaluating liability and damages, and responding to the insured or plaintiff’s counsel, do not act in an arbitrary manner or abruptly supply comment.
8. Follow all leads both for and against the plaintiff’s or the insured’s claim. Do not focus exclusively on denying the claim.
9. With respect to the claims file:
a. Avoid any verbiage that provides an appearance of unreasonableness.
b. Where a decision has been made, include supporting documentation in the file.
c. Make sure the file is thorough and well organized, containing only information that pertains to the claim in question.
d. Avoid verbiage pertaining to racial, sexual or religious orientation.
10. Conduct all investigations in a timely and reasonable fashion, documenting the reasons for any delay.
11. Make sure all communications and documentation evidence an open mind in assessing the claim.
12. Do not react adversely to the aggression, rudeness or adverse and negative comments made by the insured or plaintiff’s counsel. Do not be lulled into making statements that can be utilized as admissions of bad faith.
13. Move the file through the claims process in a proactive and orderly fashion.
14. Seek advice from co-employees, supervisors, and counsel where necessary; do not handle the claims file in a vacuum.
15. Be aware of all applicable legal standards by which your activities will be judged.
16. Attend continuing legal education programs to remain abreast of current obligations and dangers.
17. Do not conduct a pretextual investigation.
18. Never be perceived as placing company interests above the insured’s.
19. Retain experts who will provide an independent assessment of the claims.
20. Do not utilize computerized evaluation programs in a rigid manner; be flexible and realistic in assessing liability and damage potential.
21. Assume that all statements, documents, letters, e-mails, and claims files will be exhibits in any bad faith case and prepare accordingly.
22. Retain defense counsel who is familiar with the company’s claims-handling process. Consistency between good claims handling and defense strategies is important.
23. Keep the insured informed.
Observing the foregoing recommendations will educate claims handlers and provide evidence to counter unwarranted bad faith allegations or the contention that the claims handler is a B.U.M.
Education is awareness, information, and communication coupled with an attitude of reciprocity, e.g., “do unto others as you would like them to do onto you.” The educated insurance representative will enable defense counsel to properly evaluate and successfully litigate bad faith cases. While the insurance company controls the claims and litigation process contractually through policy language, that ability should not create the perception that company interests predominate over those of the insured. At all levels of the process, the representatives of the insurance industry and defense counsel must be aware of the atmosphere surrounding litigation of bad faith claims. They must clearly understand judicial standards and legislative intent as well. Absent a clearly defined and proactive educational program, the trap will be set and sprung before the bad faith letter leaves the insured’s hands. A properly educated claims staff can assist defense counsel in assessing the case and handling the claim.
III.
“Proactive” or “Reactive:”
What Message should be given to Insurers in Today’s Bad Faith Climate?
A. The Problem
Without specific dictionary definition, proactive is the term that generally describes an affirmative approach to a situation. Reactive is defined as tending to be responsive to a situation.[40]
In today’s insurance climate,[41] an insurer who faces either a troublesome first‑party or third‑party claim that holds potential for developing into a bad faith claim should immediately assess its options and determine whether to be proactive or reactive.[42] It is generally recommended that the insurance industry develop an internal program that prescribes proper claims‑handling and litigation techniques. However, a program to identify such claims early in the process is equally important. Similarly, once a bad faith claim is threatened, it is critically important to immediately define the defense strategy. This should include utilizing traditional breach of contract defenses and a creative approach to other defenses that may be available but untested in the particular jurisdiction. This section analyzes not only the traditional defenses available to insurers in a bad faith situation, but also assesses the current status of the comparative bad faith and reverse bad faith defenses. It also discusses recent decisions where the insurer has confronted and successfully recovered damages from the insured (i.e., return of benefits paid, sanctions and fees, and costs). Finally, this section explores claims made by insurers against defense counsel.
Practitioners who litigate in the bad faith arena and claims professionals who are faced with potential bad faith or extra‑contractual exposure must not be “gun shy.” While the potential for bad faith exposure can be significant and often affects the insurer’s public image through adverse publicity,[43] the message of good faith must be projected to the public at large, as well as to judges and juries. Specifically, the duty of good faith and fair dealing implied in every insurance contract “is a two‑way street, running from the insured to his insurer and vice‑versa.”[44] Recognizing that the implied covenant of good faith and fair dealing is a “two‑way street,” one court noted that “the fact finder, in its search for the truth, should be able to look at the whole forest and not just a few of the trees. This should include a view of the insurer’s conduct as well as the insured’s.”[45] Whether relying on traditional defenses or attempting to stem the tide that favors insureds by invoking the defenses of comparative bad faith and reverse bad faith, the practitioner and claims professional must be prepared to argue that the duty of good faith is a “two-way street.” If successful, the following headlines will attain a greater level of prominence:
· “Insured Who Inflated Loss Must Return $1.5 Million to General Accident”[46]
· “Jury Awards Allstate $3 Million in Damages for Inflated Invoices”[47]
· “Insurance Company Wins $800,000 in Punitives Against Fraudulent Policyholder”[48]
Furthermore, any proactive or reactive approach to an insured’s misconduct must underscore the concept that the insurance industry and the state insurance agencies are committed to eliminating insurance fraud. Such misconduct affects society as a whole; it undermines the insurer’s obligation to its other policyholders — to pay legitimate claims that should be paid and deny the false and fraudulent claims that should not. Only this approach will guarantee that the insurer can meet its obligations to all insureds.[49] To that end, the analysis below identifies components of the basic dilemma.
B. Insured versus Insurer, or Insurer versus Insured?
1. Basic Elements of Bad Faith
For many reasons, the elements of bad faith are extremely difficult to assess. This difficulty is due perhaps to the changing nature of the claims, the inability of courts to agree on the standard of conduct to be used as a benchmark, the fact that some jurisdictions provide a statutory cause of action, or whether the cause of action is viewed as tort or contract within the jurisdiction. While a complete survey of the various states is beyond the scope of this article, each jurisdiction recognizes that a claim of bad faith emanates from the relationship between an insurance company (insurer) and its policyholder (insured).[50] Based on that relationship, the courts recognize that an implied covenant of good faith and fair dealing exists in every insurance contract. A bad faith cause of action generally arises when an insurer fails to provide an insured with a recognized right provided by the policy and the insurer’s failure violates the standard of conduct imposed by case law or statute. The standard of conduct differs from jurisdiction to jurisdiction. For example, an unreasonable standard or wrongful denial standard is used in California.[51] However, a gross disregard or egregious conduct standard is used in New York.[52] Other jurisdictions, such as Arizona, require an intentional denial without a reasonable basis.[53] These differences illustrate the difficulty in assessing the particular elements of a bad faith claim and the need for the claims professional and practitioner to become familiar with the standard applied in the particular jurisdiction.[54] Once the standard is determined, the strategy for defense of the case can be designed and implemented based upon that standard.
2. Contract versus Tort
Critical to any analysis of bad faith litigation is the question whether a particular jurisdiction bases the cause of action on breach of contract or tort theory. The particular theory adopted by the courts of a given jurisdiction can impact the nature and extent of damages, the length of the statute of limitations, and the types of defenses available. A majority of jurisdictions that have considered this issue have determined that the cause of action for breach by the insurer of the implied covenant of good faith and fair dealing sounds in tort.[55] In Kransco v. American Empire Surplus Lines Insurance Co.,[56] the California Supreme Court considered the matter but issued a decision that involved a majority opinion, a concurring opinion by one judge, a concurring and dissenting opinion by one judge, and a dissenting opinion by another judge. The majority opinion noted the following:
Because the covenant is a contract term, in most cases compensation for its breach is limited to contract rather than tort remedies. But “an exception to this general rule has developed in the context of insurance contracts where, for a variety of policy reasons, courts have held that [an insurer’s] breach of the implied covenant will provide the basis for an action in tort.” The availability of tort remedies in the limited context of an insurer’s breach of the covenant advances the social policy of safeguarding an insured in an inferior bargaining position who contracts for calamity protection, not commercial advantage.[57]
The two dissenting judges also agreed that an action by an insured for an insurer’s breach of the implied covenant sounds in tort.[58] As noted below, the Kransco decision went beyond this issue to consider an insurer’s bad faith claim against an insured.
As a result of the determination that the insured’s right to sue the insurer sounds in tort, the insurer who breaches an implied duty of good faith and fair dealing is liable for extra‑contractual damages (i.e., the full amount of any judgment against the insured in excess of its policy limits).[59] The rationale for extra‑contractual damages has been described as follows: “The policy limits restrict the amount the insurer may have to pay in the performance of the contract, not the damages that are recoverable for its breach.”[60] The insurer’s liability in the third‑party context is triggered when there is an excess verdict in the underlying action.[61]
Within the first‑party context, a majority of courts have similarly determined that because an insured’s cause of action against an insurer sounds in tort, the insured is entitled to tort damages. These can include punitive damages as well, provided the insurer’s action or inaction warrants the imposition of extra‑contractual damages.[62] In this regard, courts have utilized the following standards to justify the imposition of punitive damages:
· insurer’s conduct was intentional or made without a reasonable basis;
· insurer’s conduct is egregious in nature; or
· insurer’s actions were wanton and willful.[63]
The insured must allege and prove that the insurer’s conduct met one of these standards and that the insurer knew or should have known that it was acting unreasonably.[64]
3. Insurer Defenses and Causes of Actions
When faced with first- or third-party complaints that allege bad faith in violation of the applicable standard, seeking to establish extra‑contractual damages, the practitioner representing the insurer must immediately assess all available defenses and potential affirmative claims. Many of the defenses are fact-driven. Thus, the ultimate goal should seek to review all action or inaction of both the insurer and the insured in order to strategize dismissal of the complaint or reduction in compensatory (contract) and extra‑contractual (tort) damages. To this end, it is important to investigate any defenses available in the particular jurisdiction whose laws will control the litigation. Before discussing any available contractual defenses, the defenses of comparative bad faith and reverse bad faith should be considered in light of recent case law and other commentary.
a. Comparative Bad Faith
Simply stated, comparative bad faith is an affirmative defense based upon the standards of comparative fault; it is designed to apportion damages between the insurer’s and the insured’s bad faith conduct.[65] However, this defense was rejected recently by the California Supreme Court in Kransco, despite earlier legal speculation that “California courts would reduce punitive damages awards when the insurer submits a proper special issue calling for an allocation of the percentages of fault based on the insured’s and the insurer’s malicious, oppressive or fraudulent behavior.”[66] Prior to the Kransco decision, many legal commentators had endorsed this affirmative defense.[67] These discussions are still instructive in those jurisdictions which have not yet addressed the issue. Thus, practitioners who represent insurers should be familiar with the arguments supporting this defense.
When rejecting comparative bad faith, the Kransco majority left no room for doubt that such a defense is not viable within the third-party context:
We agree with the Court of Appeals below that the jury should not have been instructed at all within principles of comparative bad faith. . . . We observe that rejection of comparative bad faith in this context does not leave the insurer without remedies for an insured’s breach of the covenant of good faith and fair dealing.[68]
As noted, however, the court clarified that its determination would not diminish the insurer’s ability to defend these bad faith cases, specifically noting that the insurer’s remedy would lie with the following contract defenses:[69]
· Insured’s conduct may be used to disprove allegations that the insurer’s conduct meets the applicable bad faith standard.[70]
· A breach of the cooperation clause of the policy may result in a dismissal of the complaint.[71]
· A material misrepresentation by the insured voids coverage altogether.[72]
· Fraudulent misconduct provides a separate, distinct defense and is separately actionable.[73]
Each of these defenses is separate and distinct, requiring a specific factual analysis unique to the particular defense.
The Kransco case is not the only recent decision to consider accepting or rejecting the defense of comparative bad faith. The United States District Court for the Virgin Islands, Division of St. Croix, recently considered the application of this defense as well. In the matter of In re Tutu Water Wells Contamination Litigation,[74] that Virgin Islands district court made a similar determination:
Although there is existing case law which supports the adoption of comparative bad faith, the clear weight of authority holds to the contrary. . . . Thus the Court concludes, consistent with the mandates of Virgin Islands Code, that the common law as understood throughout the United States does not recognize the affirmative defense of comparative bad faith.[75]
In reaching its decision, the court refused to align itself with those jurisdictions that allow the defense.[76]
The Virgin Islands district court also declined to follow Eastman Kodak Co. v. Traveler’s Indemnity Co.[77] In that case, the Superior Court of New Jersey allowed the defendant insurers to amend their answers and counterclaims to include common law fraud and a breach of the duty of good faith and fair dealing by the insured (a violation of the New Jersey Insurance Fraud Protection Act). The basis for the claims in the Eastman case was the insured’s failure to provide critical information to the insurer regarding its coverage position.[78]
There is little doubt that Kransco will have significant impact on the defense of comparative bad faith. As one commentator speculated prior to the decision,
[t]he decision that will be issued by the California Supreme Court in Kransco is likely to have a great deal of influence on courts across the country with respect to their willingness to accept comparative bad faith defenses by insurance carriers. It may also affect the New York courts, which have not yet addressed the comparative bad faith doctrine.[79]
Another commentator also surmised that recognition of the defense was the next logical step: “[T]he mere fact that Texas has consistently followed California in the area of insurance bad faith law supports adoption of the defense.”[80] However, his surmisal predated Kransco.
It should be noted that the Kransco decision is not without criticism. Notwithstanding Kransco, some case law and legal commentaries continue to support the defense:
Ultimately, some will explain Kransco as a case of bad facts making bad law, at least for insurers. . . . Unfortunately, rather than affirm the Court of Appeal’s decision on the facts of the case, the majority eliminated the defense of “comparative bad faith” as a matter of law.[81]
In fact, one court has even suggested that bad faith law would be improved by a comparative bad faith defense.[82]
The concurring opinion authored by Judge George in Kransco argued that the majority should not have rejected the comparative fault doctrine, noting that “the court should rest its decision in this case solely upon the narrower, and fully dispositive ground that the insured’s conduct here at issue negligently providing an incorrect answer to a discovery request does not constitute the type of misconduct that properly may reduce an insured’s liability or damage resulting from its failure to accept a reasonable settlement.”[83] Notwithstanding his rationale, a majority of the court overturned the state’s prior law, which had determined that an insurer could raise as a defense the tort concept of comparative fault (i.e., comparative bad faith) in a bad faith action.
While the concurring and minority opinions indicate the fallacy of entirely rejecting the comparative bad faith defense, the majority appears to have reasoned from a faulty premise. Specifically, the majority rejected the principle that the obligations of insurer and insured are comparable and mutual in the insurance relationship. To the contrary, the court observed that “[a] fundamental disparity exists between the insured, which performs its basic duty paying the policy premium at the outset, and the insurer, which, depending on a number of factors, may or may not have to perform its basic duties of defense and indemnification under the policy.”[84] The court went on to conclude that since the insurer and the insured held different financial interests, “[a]n insured is . . . not on equal footing with its insurer — the relationship between the insured and insurer is inherently unequal, the inequality resting on contractual asymmetry.”[85] Historically, of course, various commentators have noted that well‑established public policy considerations are contradicted by the comparative bad faith concept. Specifically, one commentator has observed:
A major public policy consideration in insurance litigation is the concept of fairness between the insurer and insured “that is equalization of the contenders’ strategic advantages.” The superior advantage an insurance carrier has over its individual insured in all aspects of the insurer‑insured relationship is most prevalent when it comes time for the insurers to “pay up” under the contract. Due to their advantageous position over the insureds, this idea of fairness and equalization impliedly leads the courts to treat insurance policies as adhesion contracts.[86]
Although the implied duty of good faith and fair dealing traditionally protected against this superior bargaining position,[87] several commentators have questioned whether this “superiority” continues within the current climate, or whether insureds have increased their bargaining positions.[88] In fact, it has been suggested that one size does not fit all and that all insureds are not created equal — at least with respect to commercial insureds.[89] These insureds have greater sophistication, often have self-retained limits, employ risk managers, and have access to legal counsel and other professional advisors. Following this analysis, some have noted:
The implied duty of good faith and fair dealing originally served to protect against the unequal bargaining power held by the insured. Many insureds now enjoy greater bargaining power. The large disparity in bargaining power is a thing of the past. This has led to the development of comparative bad faith as an affirmative defense to offset the damages caused by an insured’s own bad faith conduct.[90]
Other justifications by which to apply the comparative bad faith defense have surfaced as well:[91]
· The defense of comparative bad faith is connected with the comparative responsibility system enacted in the jurisdictions.[92]
· The defense is compatible with contractual liability theories within the jurisdiction.[93]
· The concept of fundamental fairness is promoted by the defense by shifting the responsibility back to the insureds for their misconduct.[94]
The defense of comparative bad faith clearly suffered a blow from the California precedent. At least in that state, the defense of a bad faith claim can be an all or nothing proposition. In defending both third‑ and first‑party claims, a California insurer can avoid bad faith in two ways. By pleading and proving that the insurer acted appropriately under the circumstances without violating the good‑faith standard, the insurer’s counsel can utilize the insured’s conduct to establish the overriding atmosphere and demonstrate how the insured’s actions or inactions affected the insurer’s ability to act. In the alternative, if the insured’s conduct amounts to a breach of contract, misrepresentation, fraud, the failure to mitigate damages or the failure to cooperate, these defenses should be raised separately.
In other jurisdictions that either allow a comparative bad faith defense or have not yet ruled on the issue, the practitioner should plead the defense with specificity. These pleadings should aver generally that the defense of comparative bad faith is sought and request a reduction in the damages assessed, if any, in the insured’s underlying bad faith claim against the insurer. Similarly, the practitioner in these jurisdictions should allege any applicable contract defenses. In addition, the practitioner should be aware that if the defense is not raised affirmatively in the answer, it can be waived.[95]
b. Reverse Bad Faith
The issue presented by this defense is whether an insurer has the affirmative right to proactively sue an insured for breach of the good faith covenant of fair dealing. As one commentator has observed, “If the duty of good faith and fair dealing truly is a ‘two-way street,’ the answer to the question should be yes.”[96] One court has held that the doctrine of reverse bad faith “creates an independent tort that allows an insurer to seek affirmative relief for an insured’s breach of good faith and fair dealing.”[97] If recognized as a tort, it appears that extra-contractual damages would be allowed, whereas only compensatory damages would lie if the court recognizes that the cause of action is viable only in contract.[98]
While many courts and commentators interchange the concepts of comparative bad faith and reverse bad faith, they are distinct.[99] Comparative bad faith, as noted above, allows the court to apportion damages and reduce the bad faith compensatory and punitive damages awarded against the insurer in an appropriate case. Reverse bad faith involves an affirmative action against the insured, either as a direct cause of action in a complaint or a counterclaim, allows an affirmative dollar recovery in favor of the insurer against the insured,[100] and places the action or inaction of the insured before the judge or jury.
The elements of a reverse bad faith claim have been identified as follows:
· The insured owes the insurer a duty to meet a specific standard of conduct with respect to the claim‑handling and litigation process (i.e., duty of good faith and fair dealing);
· The insured breached that duty, and that breach interfered with the claim‑handling and litigation process; and
· The insurer’s ability to adjust or defend the case was affected, causing damage or prejudice to the insurer.[101]
Given these elements, the practitioner representing the insurer should peruse the claims-handling and litigation processes to determine whether the insured’s conduct during the “adjustment, investigation, negotiation phases of the first-party or third-party claims”[102] violated the covenant of good faith and fair dealing.
Whether a reverse bad faith claim constitutes a viable alternative to insurers is still an open question in many jurisdictions. The availability of reverse bad faith was recently considered in the case of In re Tutu Water Wells Contamination Litigation.[103] The court there reviewed existing common law throughout the United States. At issue in Tutu Water Wells was the insurer’s contention that “its investigatory efforts, coupled with the plaintiff’s [insured’s] failure to provide the insurer with the relevant policy terms and conditions prior to Cigna’s denial of coverage”[104] constituted reverse bad faith. In order to determine the law of the Virgin Islands, absent guidance from the Restatement of Torts, the district court examined the common law throughout the United States. The court concluded its analysis as follows: “Since an examination of the current state of the law reveals that ‘reverse bad faith’ has not been recognized by any jurisdiction in the United States, the Court must dismiss Cigna’s counterclaim for reverse bad faith.”[105] The court specifically had reviewed the following authority:
· Tokles & Son, Inc. v. Midwestern Indemnity Co.,[106] where the court rejected the defense, recognizing that an insurer has other avenues by which to pursue an insured for a fraudulent claim, and noting that the insurer holds the purse strings.
· First Bank of Turley v. Fidelity & Deposit Insurance Co.,[107] where the court refused to acknowledge that an insured’s nonperformance of a contractual duty amounted to a free-standing breach of contract or a tort.
· Johnson v. Farm Bureau Mutual Insurance Co.,[108] where the insurer claimed that the insured failed to closely examine the policy before alleging bad faith, and that this constituted reverse bad faith; the court rejected the defense since there were other remedies available.
To be candid, the court’s analysis appears to be incomplete; however, under the laws of the Virgin Islands, it was required to search for existing common law. The insurer had argued that “the refusal to recognize reverse bad faith would permit tortious conduct to result in damages for which the victim of the tortious conduct — the insurer — has no other remedy,”[109] and the court recognized that this was a good argument. However, because the insurer did not cite a single jurisdiction that recognized reverse bad faith, the court declined to recognize the defense. The court thus felt compelled to ignore the insurer’s good argument, but it conducted no independent analysis of case law indicating that a reverse bad faith defense could exist.[110] Thus, it ignored the following significant implications:
· First Bank of Turley v. Fidelity & Deposit Insurance Co.,[111] where the court considered the nonfeasance of the insured, but did not rule that a reverse bad faith action should be precluded where malfeasance existed.
· Parker v. D’Avolio,[112] where the court noted that “indeed, case law suggests, in the context of insurance claims, that courts be vigilant to ensure that plaintiffs not engage in ‘reverse bad faith’ conduct.”[113]
· Snap‑on Tools Corp. v. First State Insurance Co.,[114] where the court refused to consider a reverse bad faith cause of action on procedural grounds, but affirmed an award of compensatory and punitive damages against an insured.
· Garvey v. National Grange Mutual Insurance Co.,[115] where the court allowed the bad faith claim against the insured to go to the jury based upon the insured’s misconduct.
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