The term “bad faith” is one of the most disparaging terms risk managers can level against their insurers. Bad-faith allegations are made after a claim has been poorly handled in the eyes of the risk manager, with a lawsuit often following.

Successfully proving a bad-faith allegation requires proof of more than mere negligence. The insurer must have knowingly acted in an unreasonable manner.

The damages facing an insurer found guilty of bad-faith dealings are more than financial. The insurer's reputation also can be seriously damaged.

The stakes are so high, in fact, that some insurers have sued their policyholders for reverse bad faith, alleging that because the policyholder also acted in bad faith, the insurer's actions should be negated.

With so much on the line, it's important to know what really constitutes “bad faith.” At its heart, it is the intentional failure by an insurer to perform the duties of good faith and fair dealing that are implied in law.

An insurer may be acting in bad faith when it refuses to pay a claim and has no reasonable basis for doing so; or has intentionally failed to determine whether it had a reasonable basis for so refusing.

This area of insurance law has been developed by case law and legislative or regulatory action in almost all jurisdictions. Additionally, many states have recognized the tort of bad faith in insurance transactions.

Bad-faith cases have arisen around an insurer's failure to handle property-insurance claims in good faith; its failure to reasonably settle liability claims within policy limits; and its failure to tender a defense under the duty to defend.

All contracts have an implied promise of good faith and fair dealing. Generally, however, damages for the breach of the requirement of good faith and fair dealing are contractual in nature.

In other words, the amount of possible damages that will be paid for breaching the contract are defined in the contract. In a typical contractual claim, consequential and punitive damages are rarely, if ever, available to the aggrieved party.

In insurance transactions, the requirements of good faith and fair dealing are more stringent, with broader damages. This more stringent requirement arises out of the importance of insurance to society and the general concept that the bargaining power of the policyholder and the insurance company are not equal.

Unlike typical contractual claims, consequential and punitive damages are often available to parties that can prove the insurer in some way acted in bad faith.

Courts have defined bad faith in various ways, but the definitions often have synonymous meanings. As noted by the court in Zilisch v. State Farm Mutual Automobile Insurance Company, “The appropriate inquiry is whether there is sufficient evidence from which reasonable jurors could conclude that in the investigation, evaluation and processing of the claim, the insurer acted unreasonably and either knew or was conscious of the fact that its conduct was unreasonable.”

DEVELOPMENT OF BAD FAITH

The tort of bad faith is a fairly recent one that arose in the second half of the 20th century. In liability settings, extra-contractual damages have been available to insureds since the 1940s, when the courts began to hold insurers responsible for excess judgments over policy limits in cases that the insurer refused to settle.

In other words, the insurer could have reasonably settled a liability claim within policy limits but decided, at the insured's expense, to “try their luck” at trial.

The development of bad-faith principles in the handling of first-party claims and the awarding of punitive damages originated more recently—during the 1980s in most jurisdictions.

California was the first state to hold that there is an independent tort action for the bad-faith handling of claims in a first-party context. In California's Gruenberg v. Aetna Ins. Co., the insured owner of a cocktail lounge became involved in an argument with a firefighter at the scene of a fire at the insured's premises. The owner was arrested and subsequently charged with arson and defrauding an insurer.

After the fire the insurance company demanded in writing that the insured submit to sworn examination. The insured's lawyer informed the insurer that no statements would be made until the resolution of the arson charge.

The insurer refused to delay the sworn examination and denied the loss for failure to comply with policy conditions. The court dismissed the charges against the insured for lack of probable cause, and the insured informed the insurer that he would now comply with the examination request. The company reaffirmed the denial of coverage.

Subsequently, the insured brought an action, stating that as a result of the outrageous conduct and bad faith of the insurer, he suffered economic damage, emotional distress, loss of earnings and other damages. He sought compensatory and punitive damages.

The insured prevailed. The court held that Aetna's refusal (without proper cause) to pay the covered claim gave rise to a tort cause of action for breach of an implied covenant of good faith and fair dealing.

EVOLUTION OF THE CONCEPT

Generally, the evolution of the doctrine in various jurisdictions has been a three-step process:

â–ª Recognition that insurance contracts contain a duty of good faith and fair dealing. If that duty is breached, the law recognizes extra-contractual damages. Such extra-contractual damages include amounts the insured has to pay in excess of policy limits when the insurer refuses to settle within the limits of liability; attorney's fees; and other consequential damages.

â–ª Policyholders have a tort action for bad faith dealing on the part of insurance companies which involves malice or fraud.

â–ª Extra-contractual damages, up to and including punitive awards in some jurisdictions, are available for actions not amounting to fraud or malice by the insurer (i.e., when an insurer knows that it does not have a reasonable basis to deny a claim but denies it anyway).

FURTHER REFINING OF BAD FAITH FOR FIRST-PARTY CLAIMS

The standards used to prove or disprove bad-faith allegations arising from first-party claims have been refined with time. Typical arguments include:

Good faith error. An insurance company may make a good faith erroneous decision, or at least a decision that is later disagreed with by a fact finder, without subjecting itself to bad-faith liability.

Prolonged investigation without cause. An Alabama court held that an insurer might open itself to bad-faith damages for prolonging an investigation beyond reasonable limits.

Placing extra-contractual limitations on coverage. A Tennessee court of appeals held that placing a limitation on coverage that is not contained in the policy gives rise to bad-faith damages under the state's “refusal to pay in good faith” insurance statute.

Nonrenewal or policy termination. The Alabama Supreme Court has held that the tort of bad faith does not apply to the insurer's alleged bad-faith nonrenewal of a policy.

REVERSE BAD FAITH

Insurers have recently begun to sue their customers for “reverse bad faith,” which may be defined as the “tortious breach of the covenant of good faith and fair dealing by the insureds.”

In other words, insurers are holding their insureds to the same standards that insurers must meet. At least two states, California and Ohio, have declined to allow such actions.

In Stephens v. Safeco Ins. Co., adjudicated in Montana, both the insured and the insurer were held to have acted in bad faith in the settlement of a property claim. The jury had assessed the insured's mental-distress damages under his bad-faith claim as $38,000.

However, the jury had allocated the insured's wrongful conduct at 53 percent, and the insurer's at 47 percent. The insurer argued that the insured could recover nothing on the bad-faith claim, as the insured's wrongful conduct exceeded that of the insurer's.

The court disagreed. The court held that the tort of bad faith serves to discourage oppression in contracts that necessarily give one party a superior position (such as insurance contracts) and that the action is not available to the party in the superior position. Therefore, the insurer could not use the insured's bad faith to off-set its own bad-faith conduct.

Special Reports /

Bad Faith: Wronged Insureds Can Collect Punitive, Consequential Damages

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