This article was published in For the Defense Vol. 42, No. 1, January 2000. © Copyright 2000 DRI, Inc.
Claimants sometimes seek bad faith damages from their insurer even when there is no coverage for the loss or claim. Courts have split on the issue of whether a carrier can be held liable for bad faith when there is no coverage. Courts often analyze this issue differently for first party and third party claims. Whether a claim involves both covered and non covered claims also affects the analysis of this issue.
This article looks at some of the critical issues courts have considered when determining whether bad faith can exist in the absence of coverage. Please note that the authors do not intend for this article to serve as an exhaustive study. We recommend that you refer to your state’s statutes and case law when faced with similar issues.
First party bad faith actions often stem from one of the following scenarios: (1) an insurer’s alleged failure to pay a claim asserted by its own insured without a reasonable basis for the denial; (2) untimely payment to the insured; and/or (3) payment or offer of payment less than the amount demanded by the insured.
When an insured asserts a bad faith claim against his or her insurer, but the insurer successfully proves a coverage defense, any remaining action between the two necessarily proceeds in tort. That is, absent coverage, the dispute is no longer about benefits as contemplated in the insurance contract. Instead, the dispute involves the allegedly tortious conduct of the insurer in one or more aspects of its claims handling procedures.
Courts around the country dealing with first party bad faith generally acknowledge the contract law principle that “a covenant of good faith and fair dealing [is implied] in every contract.” See Rawlings v. Apocada, 151 Ariz. 149, 726 P.2d 565, 569 (1986). An insurance contract is said to “create more than the company’s bare promise to pay certain claims when forced to do so; implicit in the contract and the relationship is the insurer’s obligation to play fairly with its insured.” 726 P.2d at 570.
The specific nature of an insurer’s first party duty of good faith and fair dealing was addressed in Deese v. State Farm Mutual Automobile Insurance Co., 172 Ariz. 504, 838 P.2d 1265 (1992). The insured was injured in an automobile accident and sought recovery of benefits for payment of her accident related medical expenses under her policy with State Farm. State Farm reduced the amount of the bill submitted for chiropractic treatment after it was independently reviewed by another chiropractor; the insurer then paid the discounted amount to Deese.
Although State Farm agreed to defend Deese if the medical service provider attempted to sue her for recovery of the reduced amount, Deese refused and paid the reduced amount out of pocket, stating that she did not wish to allow litigation to disrupt her lifelong relationship with her chiropractor. Thereafter, Deese filed suit against State Farm, alleging breach of contract and bad faith. The jury returned a verdict in favor of State Farm on the breach of contract question and in favor of Deese on the bad faith question, awarding Deese $3,000 in compensatory damages and $75,000 in punitive damages.
State Farm then challenged the judgment on appeal. The Arizona appellate court found that a breach of an express term of the insurance contract was a necessary prerequisite to a claim for bad faith. The Arizona Supreme Court then reviewed this issue. Citing its earlier decision in Rawlings v. Apocada, the court held that an actual breach of the insurance contract was not essential in order to establish breach of the implied covenant of good faith and fair dealing. The Deese court quoted from Rawlings: “The implied covenant is breached, whether the carrier pays the claim or not, when its conduct damages the very security which the insured sought to gain by buying insurance.” 838 P.2d at 1269.
The court explained that the quoted language from Rawlings did not mean that insurer conduct was only subject to a bad faith claim when it rises to the level of precluding the specific type of insurance protection that was expected by the insured. Id. Rather, the quoted language meant that insurer bad faith could arise where the insurer’s conduct effectively denies the insured the “security of knowing that she will be dealt with fairly and in good faith.” Id.
In White v. Unigard Mutual Insurance Co., 112 Idaho 94, 730 P.2d 1014 (1986), the insured homeowner brought a first party bad faith claim against her insurance company after the insurer denied coverage for fire damage loss. The Idaho Supreme Court examined the question of whether its state recognized a tort action, distinct from an action on the contract, for an insurer’s bad faith in settling first party claims of its insureds. In an opinion that carefully explored the source and scope of an insurer’s duty of good faith and fair dealing in the first party context, the court held that such duty was greater than the duty imposed by the terms of the insurance policy, and that the breach of that greater duty may give rise to an independent tort action. 730 P.2d at 1017.
The court cited to its 1980 opinion that “it might be shown that in denying [a] claim the company committed some independently tortious act, which would give rise in itself to an award of punitive damages.” Id. Although its opinion opened the door for first party bad faith actions in Idaho in the absence of coverage, the court imposed some limits upon the type of conduct that might expose an insurer to liability for breach of the duty of good faith and fair dealing:
[T]he mere failure to immediately settle what later proves to be a valid claim does not of itself establish “bad faith.” As indicated earlier, the insured must show the insurer “intentionally and unreasonably denies or delays payment. . .” (citation omitted). An insurer does not act in bad faith when it challenges the validity of a “fairly debatable” claim, or when its delay results from honest mistakes.
Id. at 1020.
The cases cited above typify the widening scope of potential liability for first party bad faith facing insurers today. Conversely, several states hold fast to a narrower view and refuse to lower the threshold requirements for an insured to assert a first party bad faith claim. For instance, Texas adheres to the notion that “there can be no claim for bad faith when an insurer has promptly denied a claim that is not covered.” Lemke Concrete Construction v. Employers Mutual Casualty Co., 1997 Westlaw 78917, 1997 Tex. App. LEXIS 857, citing Republic Insurance Co. v. Stoker, 903 S.W.2d 338 (Tex. 1995). However, even Texas has recognized an exception to this rule by leaving open the possibility that the absence of coverage may not preclude a bad faith claim where “the insurer [commits] some act, so extreme, that would cause injury independent of the policy claim.” Id. at *5, n.4.
In states that resist expanding the boundaries of first party bad faith claims beyond covered claims, such as Texas, Alabama, and Nevada, the claimant must usually allege and prove that there was either no reasonable basis for denial of a claim, or a failure on the part of the insurer to determine whether any reasonable basis for the denial or delay existed. See Viles v. Security National Insurance Co., 788 S.W.2d 566, 567 (Tex. 1990). This line of reasoning appears to be adopted mainly by those states that use a “fairly debatable” standard of bad faith liability, as opposed to a “totality of the circumstances” standard. The “fairly debatable” standard usually favors insurers who can point to and substantiate some reasonable basis for their denial of coverage; more likely than not in these cases, if coverage does not exist, bad faith damages are prohibited. This is not a hard and fast rule, however.
In Alabama, for instance, if the insured is not entitled to a directed verdict on the coverage question, e.g., where the insurer creates a genuine issue of material fact by raising at least some “arguable” reason for denying coverage, the insurer is presumed to have a reasonable basis for the denial and the first party bad faith claim cannot be presented to the jury. King v. National Foundation Life Insurance Co., 541 So. 2d 502, 504—05 (Ala. 1989). See also, O’Malley v. United States Fidelity & Guaranty Co., 776 F.2d 494, 500 (5th Cir. 1985) (describing Mississippi law which precludes a first party bad faith claim if the insured does not establish coverage and that the insurer had no “arguable reasons” for denying coverage). This so called “directed verdict on the contract claim” standard applies in every first party bad faith claim in Alabama, with the exception of four situations: “the insurer (1) intentionally or recklessly failed to investigate the plaintiff’s claim; (2) intentionally or recklessly failed to properly subject the plaintiff’s claim to a cognitive evaluation or review; (3) created its own debatable reason for denying the plaintiff’s claim; or, (4) relied on an ambiguous portion of the policy as a lawful basis to deny the plaintiff’s claim.” State Farm Fire & Casualty Co. v. Slade, 1999 Westlaw 667291, at *11 (Ala.).
In Wyoming, by contrast, courts have expressly rejected the “arguable” or “fairly debatable” basis for denying coverage. Thus, even if a claim for benefits is fairly debatable, the insurer may be liable for breach of the duty of good faith and fair dealing through the manner by which it investigates, handles, or denies the claim. State Farm Mutual Auto Insurance Co. v. Shrader, 882 P.2d 813, 828 (Wyo. 1994), citing Hatch v. State Farm Fire & Casualty Co., 842 P.2d 1089, 1099 (Wyo. 1992).
Several court opinions describe insurer conduct that has resulted in liability for first party bad faith in the absence of coverage. Although the courts appear justified in permitting bad faith damage awards to stand in several of these cases, the opinions do show a foundation materializing from what once seemed to present a mere mirage. Many of the factual scenarios involved do not initially appear so egregious as to permit an award of bad faith damages in the absence of coverage.
Timing of notice of denial in relationship to proof of loss
For example, in Viles v. Security National, supra, the insureds, the Viles, were contemplating the sale of their home. The purchasers postponed the closing of the sale on the condition that the cost to repair recently discovered moisture damage to the foundation of their home$33,500be placed in escrow. The Viles filed a claim with their insurer to obtain the funds for the repair of the foundation damage. However, they did not submit a sworn proof of loss within 91 days of the loss as required by their homeowners policy. Prior to the expiration of the 91day period, the insurer made several inspections of the home and shortly thereafter denied the bulk of the claim, offering $3,000 as a compromise settlement. The insurer’s asserted basis for the denial was that the moisture damage was due to a cause that predated coverage under the subject policy.
In response, the Viles brought an action for breach of contract and breach of the duty of good faith and fair dealing. In addition to the coverage term exclusion, the insurer argued that the insureds failed to comply with the 91day proof of loss requirement. A jury found for the Viles on the bad faith claim, but the court of appeals reversed, finding that the jury never determined that the insurer waived its entitlement to insist on the proof of loss as required in the insurance contract. Therefore, the court held the insurer had a reasonable basis for the denial of the claim as a matter of law. 788 S.W.3d at 567.
The Texas Supreme Court reversed. It first noted that while the failure to file a proof of loss would be detrimental to a claim for coverage under the insurance contract, it was “not controlling as to the question of breach of the duty of good faith and fair dealing.” Id. Secondly, and more importantly, the court noted that an insurer could avoid bad faith where there was a reasonable basis for a denial of coverage, but such reasonable basis for denial “must be judged by the facts before the insurer at the time the claim was denied.” Id. Because the denial was made before the time for the Viles to file their proof of loss expired, the court held that the failure to file the form within the 91day period could not have been a reasonable basis for denial at the time of denial. Id. at 568.
This holding illustrates that the timing of the notice of denial should be reasonable, and that the insurer should have sufficient time in which to conduct a good faith investigation of the claim. Additionally, insurers should be careful not to violate the time frames for allowing insureds to file claims that may be expressed or implied from the terms of the insurance contract. Viles also serves as a reminder that insurers must make decisions with an eye toward potential bad faith exposure when denying first party claims. The benefits of quickly denying the claim and closing the file may pale in comparison to the blistering bad faith judgments that are becoming more common. If done haphazardly, closing a file after providing the insured with notice of denial may be only the beginning of a costly first party bad faith action.
In Judah v. State Farm Fire & Casualty Co., 227 Cal. App. 3d 1133, 266 Cal. Rptr. 455 (1990), the California appellate court addressed somewhat egregious conduct in determining whether the insurer could be held liable for bad faith damages in the absence of coverage. Although depublished (268 Cal. Rptr. 541, 281 Cal. Rptr. 766), this opinion has been referenced by other courts following California’s lead on this issue.
In Judah, the insured filed a claim with her insurer, seeking recovery for damage to her house that resulted after a nearby landslide. After an initial visit to the site, State Farm informed Judah that the loss might not be covered because the policy excluded losses due to earth movement and water damage. Later, the insurer suggested that the damage may have been attributable to a design defect in the foundation of the house. It ultimately denied coverage, asserting that the damage was due to earth movement. Remarkably, however, “State Farm had already filed a subrogation suit against the contractor,. . . alleging that he negligently designed and constructed the foundation of Judah’s house.” 266 Cal. Rptr. at 458.
Not surprisingly, Judah filed suit, alleging breach of contract and bad faith. The jury returned a $953,270 verdict, which included $15,000 for emotional distress and $750,000 as punitive damages (the latter award was reversed because of an erroneous jury instruction). On appeal, the court clarified that a first party claim for breach of the duty of good faith and fair dealing could be made, even if it was determined on remand that coverage did not exist.
Although insurers do not want to risk waiver of a known coverage defense, the timing of the notice of potential denial must be calculated to coincide with other substantial findings that result from the insurer’s investigation. When dealing with its insureds, an insurer aware of potential first party bad faith claims should take a conservative approach when advising of a potential denial, i.e., asserting a denial only if the investigation actually indicates the coverage defense. This conservative approach is essential in those states that permit first party bad faith claims to proceed regardless of coverage.
Although the court did not analyze the specific conduct that formed the basis for the alleged bad faith in Judah, State Farm’s notice of potential denial was perhaps a bit premature. Additionally, its conduct in denying third party negligence while pursuing the very third party builder in a separate subrogation suit suggested misrepresentation or dishonesty.
As a result of the depublishing of Judah, the current law in California rejects the notion of first party bad faith where the insurer has properly denied coverage. However, Judah offers guidance to insurers in those states that affirmatively recognize bad faith even in the absence of coverage.
California’s current position on the issue is set forth in Brodkin v. State Farm Fire & Casualty Co., 217 Cal. App. 3d 210, 265 Cal. Rptr. 710 (1989). Plaintiff homeowners brought a claim against their insurer based on several cracks they discovered in the floor and foundation of the house. State Farm denied coverage under an exclusion in the policy. The plaintiffs subsequently filed suit against the insurer, claiming that the asserted cause for the denial was improper under the terms of the contract since the cause asserted by the plaintiffs was a concurrent proximate cause of the damage and, therefore, should have been covered. Plaintiffs also alleged that State Farm breached its duty of good faith and fair dealing by “failing to pay benefits when it knew the claim was covered under the policy, refusing to conduct a geological survey to discover the nature and extent of the problem, and selectively denying the claim while paying benefits to other homeowners similarly situated.” 265 Cal. Rptr. at 711.
State Farm prevailed on summary judgment, citing California law which decides first party coverage questions not on the basis of whether an asserted cause was a concurrent cause, but rather on the basis of whether the asserted cause was the “efficient cause” or “the one that sets the others in motion.” Id. at 713. Because the bases for coverage asserted by the plaintiffs did not satisfy the efficient cause standard, State Farm succeeded on the coverage issue as a matter of law. The court went on to declare that “[e]ven if there was evidence the claim was improperly handled, there could be no cause of action for breach of the covenant of good faith or of any statutory duty since State Farm correctly denied the claim.” Id. at 714.
The “creation” of coverage by waiver or estoppel is another method by which insureds attempt to obtain bad faith damages against insurers. For example, in Coventry Associates v. American States Insurance Co., 136 Wash. 2d 269, 961 P.2d 933 (1998), the coverage question was ultimately resolved in favor of the insurer, but the plaintiff still sought damages. Coventry involved a claim for first party bad faith where the insurer conceded that it made a bad faith investigation into a loss. The trial court granted summary judgment for the insurer on the coverage question and granted its motion to dismiss the bad faith claim. The court of appeals affirmed, but the Washington Supreme Court reversed.
One of the issues resolved by the Coventry court was the nature of the remedies available to an insured who succeeded in proving the insurer’s breach of the duty of good faith and fair dealing through a bad faith investigation, where coverage did not exist under the policy. The insured had sought to impose coverage by estoppel. This remedy may be extended to the insured where coverage was wrongfully (or sometimes rightfully) denied by the insurer, based on the insurer’s bad faith claims handling conduct. The court explained that while policy reasons support the availability of coverage by estoppel in third party bad faith actions, such reasons did not support the remedy in first party bad faith actions. 961 P.2d at 939. It described that it was appropriate to permit coverage by estoppel in the third party context because the insurer, by failing to honor some contractual obligation to protect the threatened interests of the insured, “contributes” to the harm suffered by the insured. Id.
The Coventry court distinguished Safeco Insurance Co. of America v. Butler, 118 Wash. 2d 383, 823 P.2d 499 (1992), a third party reservation of rights case where it was held that coverage by estoppel was available to an insured. In contrast, in the first party bad faith context, the loss occurs before the insurer is even aware that a claim exists; the insurer does not contribute to the loss. The facts that result in noncoverage are usually independent of any actions by the insurer. Id.
In the first party context, the only recovery to which the insured is entitled is the consequential tort damages suffered by the insured as a result of the insurer’s bad faith. The Washington court’s conclusion emphasized the need for first party insureds to be able to prove consequential damages or harm as a result of the alleged bad faith of their insurers. But one can still legitimately question the logic of permitting insureds to seek recovery for “harm” based on the insured’s claim processing mistakes or blunders, where the insured’s loss is appropriately denied under the terms of the contract. In the standard case of denial for lack of coverage, what true damages exist?
To the extent that first party bad faith claims arising in the absence of coverage sound in tort, the insured must prove the basic elements necessary to proceed in any tort claim: (1) duty; (2) breach; (3) causation; and, importantly, (4) harm or damages. But what are the real damages that may be attributed to the insurer when denial was appropriate? Where the significant portion of an insurer’s relationship with an insured arises from and is based in the insurance contract, how are courts managing insurer liability for bad faith and related damages in the absence of any liability arising from that significant contractual relationship? Many question the appropriateness of “going beyond the contract” to find first party bad faith in the absence of coverage and wonder how far the damage(s) will extend.
In a critique of both Deese and Rawlings (discussed supra), Professor Roger C. Henderson examined the implication that, under Arizona law, no distinction appears to exist between “wrongful” conduct and “harmproducing” conduct on the part of an insurer; liability for the tort of bad faith exists even where it is ultimately determined that the insurer in no way violated its original contractual duties (i.e., coverage was properly denied). “The Tort of Bad Faith in First Party Insurance Transactions After Two Decades,” 37 Ariz. L. Rev. 1153, 1167 (1995). Recall that, under the language used by the Arizona Supreme Court in Deese and Rawlings, an insurer can be liable in tort for breach of the duty of good faith and fair dealing, absent coverage, if its conduct somehow denies the insured the knowledge that he or she will be dealt with fairly and in good faith.
This test for bad faith conduct is contradictory because it acknowledges that the insured is owed nothing under the terms of the insurance contract, but permits the insured to recover damages if somewhere during the insurer’s coverage analysis the insured feels “insecure” or loses the peace of mind that usually accompanies the knowledge that a loss will be covered by insurance. The Arizona standard seems to invite claims by insured parties that may eventually be based wholly on the alleged emotional distress which would normally be experienced in any denied claim situation.
Insurers are fortunate that, among the reported cases of first party bad faith in the absence of coverage, plaintiffs have proven or were required to prove on remand consequential damages flowing from the insurer’s alleged bad faith. In Deese and Rawlings, for instance, the insureds incurred actual expenses, such as independent investigation costs. However, under the framework established by the Arizona Supreme Court in these two cases, one must wonder how far reaching the range of actionable harm suffered by first party plaintiffs will ultimately become.
On the other hand, the opinion in Viles v. Security National, supra, contained elements that demonstrated the kind of insurer breach of duty and resulting harm that might logically support a claim of first party bad faith in the absence of coverage. Viles gives dimension to the earlier discussion of Texas law which permits bad faith to proceed against an insurer in the absence of coverage, especially when the insurer acts in an extreme manner that causes some injury to the insured independent of the insurance contract.
In Viles, the extreme conduct seemed to be the insurer’s decision to settle the claim prior to the expiration of its time period for filing a proof of loss, suggesting that the denial decision was made first and meaningful investigation, if any, would come later. The extracontractual harm suffered by Viles resulted because the insureds ultimately had to sell their house for an amount that was $27,400 less than the amount contemplated in the contract with the original prospective buyer, and the facts indicated that the insurer’s agent was made aware of the pending sale around the same time that the premature decision to deny the claim was made. 788 S.W.2d at 567. These facts suggest that the insurer’s decision to prematurely deny coverage, with the knowledge of the pending sale of the home, represented a kind of reckless disregard of the economic harm that the Viles would suffer.
The idea of comparative bad faith is based on the notion that an insurer should not be liable to an insured for damages resulting from the insurer’s alleged bad faith where the conduct of the insured “contributes to an insurer’s failure to pursue or delay in pursuing the investigation and payment of a claim.” California Casualty General Insurance Co. v. Superior Court (Gorgei), 173 Cal. App. 3d 274, 283, 218 Cal. Rptr. 817, 822 (1985).
Comparative bad faith may proceed as a defense for insurers because, as one court explained, the “duty of good faith and fair dealing in an insurance policy is a two way street, running from the insured to his insurer, as well as vice versa.” Commercial Union Assurance Cos. v. Safeway Stores, Inc., 26 Cal. 3d 912, 918, 164 Cal. Rptr. 709, 712 (1980). The idea of comparative bad faith is not new because it mirrors the defense used by insurers to argue that their insureds have colluded with third parties in breach of a policy’s cooperation clause and in breach of the duty of good faith and fair dealing. See Richmond, “An Overview of Insurance Bad Faith Law and Litigation,” 25 Seton Hall L. Rev. 74, 131 (1994). However, there are not many cases which directly address the application of the comparative bad faith defense.
One of the few cases addressing comparative bad faith, California Casualty v. Superior Court, supra, involved an insured that sought recovery of uninsured motorist coverage benefits after suffering an allegedly compensable injury under the terms of her policy. The insurer denied coverage. The insured brought suit, alleging breach of contract, breach of the duty of good faith and fair dealing, and the insurer’s breach of its statutory duties under California law. The insurer sought leave to amend its initial answer, which already contained three affirmative defenses, to add a fourth affirmative defense alleging comparative bad faith on the part of the insured and her attorney. Her allegation read (218 Cal. Rptr. at 819):
The plaintiff and her former attorney are guilty of bad faith conduct in the prosecuting, handling and management of the uninsured motorist claim referred to in the plaintiff’s First Amended Complaint and as a proximate cause of their bad faith acts, omissions and failure to provide full and complete information to the defendants and their insuror [sic], these defendants request that any damages awarded against them for bad faith be reduced by the amount of the bad faith conduct of plaintiff and her former attorney.
After noting that the insurer’s proposed affirmative defense might be attacked because of its conclusory language and its attempt to impute conduct by plaintiff’s former attorney to plaintiff, the court agreed with the insurer that, in certain cases, an insurer who relies on an insured’s conduct that contributed to the insurer’s bad faith can use it as at least a partial defense to the plaintiff’s claim for damages arising from the insurer’s alleged bad faith. Id. at 822. Under the comparative bad faith principles announced in California Casualty, the trier of fact must balance any bad faith by the insured against the insurer’s bad faith while reducing any damage award in direct proportion to the assessed fault of the insured. Richmond, supra.
Though unavowed in many courts, another avenue for insurer relief may come in the form of an affirmative action by the insurer under a theory of “reverse” bad faith. Reverse bad faith refers to an insurer’s attempt to sue its insured in tort for his or her breach of the duty of good faith and fair dealing. If the duty of good faith and fair dealing is as much a two way street as the court implied in Commercial Union v. Safeway Stores, supra, 164 Cal. Rptr. at 712, it seems that courts would readily acknowledge an insurer’s right to pursue claims against unscrupulous insureds that make first party bad faith claims in violation of their own duties of honesty and cooperation.
Nonetheless, most cases dealing with the issue either dismiss reverse bad faith claims by insurers without any real discussion, or simply assert, as the court did in Tokles & Son, Inc. v. Midwestern Indemnity Co., 65 Ohio St. 3d 621, 605 N.E.2d 936, 945 (1992), that insurers are “holder[s] of the purse strings. . . [with] certain builtin protection from [the evils of bad faith by their insureds]. On the other hand, the insured, who often finds himself in dire financial straits after the loss, must have the equal footing which is provided by the ability to sue the insurer for bad faith.” Other cases echoing the sentiments of the Ohio Supreme Court include Agricultural Insurance Co. v. Superior Court (MKDG/Rhodes SC), 70 Cal. App. 4th 385, 82 Cal. Rptr. 2d 594 (1999), and Johnson v. Farm Bureau Mutual Insurance Co., 533 N.W.2d 203 (Iowa 1995).
Extracontractual duties regarding indemnity in third party cases are often similar to the duties imposed in first party cases. Carriers must use fair and honest claims handling and settlement practices. Because third party liability insurance contracts also impose a duty to defend, a carrier’s extracontractual duties also encompass the defense obligation.
Some courts have found that a carrier can be liable for bad faith even in the absence of a covered claim. In these cases, courts have observed that the benefits due to an insured are not limited solely to those expressly set out in the insurance contract. Insureds are also entitled to receive the security of knowing that they will be dealt with fairly and in good faith. For instance, one court held that a carrier must make reasonable efforts to disclaim all liability under the policy when valid coverage exclusions exist. Another court noted that a carrier is required to acknowledge an insured’s communications with reasonable promptness, and the failure to do so would constitute bad faith even when no coverage exists. Further, if a carrier assumes the defense and through mishandling causes actual harm to the insured, a bad faith claim may be presented even though the carrier did not have a duty to defend in the first place.
In Tadlock Painting Co. v. Maryland Casualty Co., 322 S.C. 498, 473 S.E.2d 52 (1996), the Supreme Court of South Carolina notes that benefits due to an insured are not limited solely to those expressly set out in the insurance contract. The insured, Tadlock, held a CGL policy with Maryland. While painting at Cargill, the insured oversprayed and inadvertently painted several of Cargill’s employees’ vehicles. The employees sued the insured.
A dispute over the amount of the deductible arose between the carrier and the insured. Ultimately, the carrier told the insured that it would not proceed further until the insured acknowledged that the carrier’s interpretation of the deductible was correct. The insured would not comply, and personally settled each claim. It then sued the insurer in federal court for bad faith.
The trial court granted summary judgment to the carrier on the deductible issue. It then certified the following question to the Supreme Court of South Carolina: “May an insured assert a cause of action on an implied covenant of good faith and fair dealing against his insurance company for consequential damages he allegedly suffered because of the insurance company’s bad faith handling of third party claims?” The state court answered yes, and stated that breach of an express contractual provision was not a prerequisite to bringing the action. 473 S.E.2d at 55.
The state court, citing to several first party cases, held that a carrier could be liable for bad faith even in the absence of a contractual duty to pay. Id. at 54. It commented in a footnote that the distinction between bad faith handling of a first party claim as opposed to a third party claim was of no significance. Id.
The Tadlock court cited several cases from other jurisdictions that held that an action for bad faith can proceed despite any liability arising out of breach of contract. Benefits due to an insured are not limited solely by those expressly set out in the contract. The court found that whether the claims were ultimately settled for an amount less than the applicable deductible was irrelevant to whether the insured performed its duties in good faith. Id. at 55. Thus, the court rejected the carrier’s contention that an insured can only bring a bad faith action if the insurer has breached some express contractual provision. Id. at 54.
In Lloyd v. State Farm Mutual Automobile Insurance Co., 189 Ariz. 369, 943 P.2d 729 (Ariz. App. 1996), the court addressed whether a third party bad faith claim could arise in the absence of coverage. Mrs. Lloyd sustained catastrophic injuries after being struck by a midget race car owned by the Lanes. The Lanes had an automobile policy with State Farm.
The Lloyds sued the Lanes. Because of various instances of miscommunication, neither the insured nor the insurer responded adequately to the suit, and a default became effective. While the plaintiff’s settlement demand had been $50,000, the default judgment was for $10 million; the plaintiff sued State Farm for this amount.
State Farm argued that it could have no liability for the assumption of a duty to defend in the absence of an insurance policy covering the accident. The trial court granted summary judgment for State Farm and the appellate court reversed. The court noted that the issues in this case specifically arose out of questions concerning the insurance contract. The contract imposed two express responsibilities: the duty to indemnify and the duty to defend. 943 P.2d at 736. Although the court further noted that a carrier need not defend when the complaint does not trigger a duty to defend, the court specifically provided that a carrier could be held liable for bad faith even when it did not violate any express provision of the insurance contract. Id. (Emphasis added).
The core of the duty of good faith and fair dealing requires a carrier to act reasonably to its insured. While financial security is the primary goal of motivating the purchase of insurance, an insured is also entitled to receive the additional security of knowing she will be dealt with fairly and in good faith. That security does not come from express contractual provisions but instead from the implied covenant of good faith and fair dealing. Thus, a covenant of good faith and fair dealing can be breached even if a policy does not provide coverage.
In Hagen v. United States Fidelity & Guaranty Insurance Co. 138 Ariz. 521, 675 P.2d 1340 (Ariz. App. 1983), the court addressed whether the failure to timely deny coverage was bad faith when there was no coverage at the outset. Hagen was struck by a truck driven by Glen High. USF&G insured High and disclaimed coverage on the basis of an employee exclusion. The insured’s assignee (the plaintiff below) obtained a judgment against USF&G in a garnishment proceeding. The Hagen court reversed.
The court stated that the carrier had an implied duty to notify its insured that the carrier intended to assert that there was no coverage, due to the employee exclusion. It noted a long line of cases standing for this proposition, and pointed out that the failure to provide notice to all insureds of an assertion that there is no coverage may waive the right to deny the coverage or estop the carrier’s ability to assert an exclusion. While the court found the permissive driver to be an insured, it held that even if the exclusion were valid, the carrier would still have an extracontractual duty to make reasonable efforts to notify persons that it would disclaim all liability under the policy. According to the Hagen court, this duty persists even when valid coverage exclusions are present.
Similarly, in Snydergeneral Corp. v. Century Indemnity Co., 907 F. Supp. 991 (N.D. Tex. 1995), the court addressed whether bad faith could result from a late denial of coverage when there was no coverage. Century wrote umbrella coverage for Snydergeneral. Snydergeneral was sued for environmental cleanup costs and turned to Century to respond. Century refused to pay based on its pollution exclusion.
Snydergeneral sued for coverage, also claiming that Century had breached its duty of good faith and fair dealing in violation of the Texas Insurance Code. Century obtained a summary judgment on the coverage issue and asserted that it was entitled to dismiss the bad faith claim on that basis. The court noted that the Texas Insurance Code required the carrier to acknowledge an insured’s communications with reasonable promptness and the failure to do so would constitute an unfair claims practice. Century had failed completely to respond during a five year period to three letters requesting coverage. Snydergeneral presented sufficient evidence for a reasonable jury to find that Century’s failure to acknowledge communications with reasonable promptness and its failure to undertake a reasonable investigation of Snydergeneral’s claim constituted bad faith. Moreover, the court accepted Snydergeneral’s claims that the attorneys’ fees incurred, that it would not otherwise have expended, were the proper measure of damages.
In Delmonte v. State Farm Fire & Casualty Co., 90 Hawaii 39, 975 P.2d 1159 (1999), the Supreme Court of Hawaii held that a carrier had a duty to conduct a defense in good faith when it undertook the defense despite the absence of a duty to defend. State Farm insured the Delmontes with a homeowners policy. The house had many problems. The Delmontes conducted superficial repairs that hid the evidence of these problems and sold the house. After the buyers moved in, they found many of the problems the sellers had not disclosed and they sued the sellers.
The insureds’ personal counsel began defending, but later they tendered the defense to State Farm, which defended under a reservation of rights. It refused to hire the lawyer requested by its insureds. It did not authorize its retained trial counsel to prepare a memorandum specifying key issues and trial memos on such issues, despite the specific request of the insured for this information. At trial, the jury returned a verdict of $160,000 in compensatory and $500,000 in punitive damages.
The insureds and their personal lawyer wanted to pursue an appeal. The insurer was not so eager, and eventually refused to provide a lawyer for the appeal. The insureds said they could not afford the bond to stay execution and therefore paid the judgment, plus interest. They sued State Farm and its retained counsel. The complaint alleged that the insurer was estopped to deny coverage based on its assumption of the defense and that it acted in bad faith in handling the matter. The trial court granted State Farm’s motion for summary judgment, commenting that the carrier had no duty to appeal and had no initial duty to defend.
The Supreme Court of Hawaii stated that the fact that State Farm did not have a duty to defend did not foreclose the possibility of a bad faith claim. A carrier may be liable for any improper conduct of the defense even though it ultimately determined that it had no duty to defend or indemnify. Thus, if the carrier assumes the defense and through mishandling causes actual harm to the insured, a bad faith claim may be presented despite a later declaration that the carrier did not have a duty to defend in the first place. Once assuming the defense, the carrier is under a duty to pursue the defense in good faith until such time as clear grounds for withdrawal arise.
Other courts have found that a carrier cannot be liable for bad faith when there are no covered claims. Many such cases simply hold that extracontractual actions cannot proceed when there is no contractual breach upon which to base them. One court has noted that the covenant of good faith and fair dealing exists to prevent the contracting party from acting in a manner that frustrates the other party’s rights to the benefits of the contract (acts such as delayed payment based on inadequate or tardy investigation, impassive conduct by claims adjusters, and other tactics). Without an applicable insurance contract, however, an implied covenant is not a supplement to anything and should not be endowed with existence independent of its contractual base. One case relies upon the insured’s rejection of certain coverage to hold that the carrier could not act in bad faith with regard to settlement demands seeking damages under the rejected coverage (although there is contrary state trial court authority).
In Thom v. State Farm Lloyds, 10 F. Supp. 2d 693 (S.D. Tex. 1997), State Farm assumed the defense of its insured, Thom, in a case alleging negligent misrepresentation, subject to a reservation of rights based on the business pursuits exclusion. The insured sued State Farm seeking a declaration of coverage under his homeowners and umbrella policy and asserted a claim for bad faith.
The trial court granted summary judgment in favor of the carrier on the coverage issue based upon the business pursuits exclusion. The court also found that the insured’s bad faith claims against State Farm failed because there was no coverage. Thus, because the causes of action were based upon wrongful denials of defense and indemnification and because the denial of coverage was justified, the causes of action against State Farm could not prevail. Id. at 702.
In Waller v. Truck Insurance Exchange, Inc., 11 Cal. 4th 1, 44 Cal. Rptr. 2d 370 (1995), the Supreme Court of California held that a carrier cannot be found liable for statutory or common law bad faith, in the absence of coverage, when it refuses to provide a defense in a third party action. Truck Insurance had issued a CGL policy to its insured, Marmac, Inc. The policy also insured Mr. Amey, a Marmac employee. Amey later sued Marmac after being demoted. The carrier determined that the policy did not provide coverage for the allegations in the complaint.
Marmac then sued Truck Insurance, alleging bad faith. The trial court concluded that the carrier had a duty to defend, which it had breached, and granted plaintiff’s motion for partial directed verdict on the issue of good faith and fair dealing. The jury awarded in excess of $20 million in punitive damages against the carrier.
The appellate court reversed, stating that the lawsuit set forth nothing more than a business dispute such that only economic loss was claimed. The damages claimed for emotional and physical distress were derivative, caused by the economic loss suffered by Amey and did not trigger the bodily injury coverage of the CGL policy. The Supreme Court of California affirmed. 44 Cal. Rptr. 2d at 376.
The Waller court stated that the damages alleged flowed from intangible property losses that could not be considered covered occurrences and that the derivative claims for emotional distress were not covered because they flowed from the same noncovered acts. The court held that if there was no potential for coverage and hence no duty to defend, no action for breach of the implied covenant of good faith and fair dealing could stand because the covenant itself was based on the contractual relationship between the parties. Id. at 390.
In Rodriguez v. American Ambassador Casualty Co., 4 F. Supp. 2d 1153 (M.D. Fla. 1998), a federal court considered whether a carrier had a duty to convey settlement offers with regard to noncovered claims. Rodriguez had purchased property damage liability and personal injury protection coverage from American Ambassador. The insured specifically rejected bodily injury liability coverage and later severely injured a pedestrian. The carrier told the claimant’s lawyer that the policy did not cover bodily injury. Nonetheless, the plaintiff’s lawyer sent the carrier a demand for settlement of the property damage claim that also offered to release Rodriguez from all claims if the carrier paid less than $600 in property damage.
The carrier did not inform its insured of the settlement offer and failed to meet the deadline. The insured settled the lawsuit for $2 million and assigned his bad faith rights to the plaintiff, who then sued the carrier for bad faith for failing to forward the settlement offer. The Rodriguez court granted summary judgment to the carrier. It held that the carrier had no duty to convey the settlement offer because the policy did not cover bodily injury. It noted that the insured should not expect the carrier to act on his behalf with regard to the bodily injury claims when it had rejected such coverage and the carrier, therefore, owed no duties in this regard.
Unfortunately, under virtually identical facts, a trial court in Florida recently reached an opposite result. It held that a carrier had a duty to inform its insured with regard to settlement offers pursuant to the claims handling practices incorporated into Florida’s bad faith statute, which requires a carrier to notify an insured of settlement demands. Thus, because the settlement demand was extended for partially covered damages, the carrier had a good faith duty to convey the settlement offer. Hillery v. Connecticut Indemnity Co., 6 Fla. Supp. 2d 427 (Fla. Cir. Ct. 1999).
One of the more attenuated arguments attempting to create bad faith in the absence of coverage occurred in Hessley v. Travelers Indemnity Co., 468 So. 2d 456 (Fla. App. 1985). Plaintiff had sued, seeking coverage by estoppel and for bad faith refusal to settle, arising out of Travelers’ alleged failure to timely deny coverage. The jury found in favor of Travelers and the Florida appellate court affirmed. It observed that the basis of the claim was that Travelers, in not denying insurance coverage at the outset of the case and in proceeding to defend when there was no coverage, prejudiced the insured by “blowing” a settlement opportunity because plaintiffs would have settled the case with the putative insured for an amount less than the limits of the primary insurance carrier’s policy. Plaintiff then claimed that Travelers had refused in bad faith to settle the claim within the limits of the policy on which Travelers should have denied coverage at the outset. The court characterized this approach as “creative” but noted that this theory had no basis in Florida law.
Sometimes complaints combine allegations for some claims that are covered with other claims that are not covered. Some courts have addressed bad faith under these circumstances. One court has held that the duty of good faith requires a carrier to advise the insured of settlement opportunities, warn of uninsured claims, and negotiate for settlement in good faith if the insured’s interest diverged from those of the carrier. While the duty of good faith does not include a payment to settle an uninsurable punitive damage claim, the duty of good faith does include working cooperatively with an insured in both defending and attempting to settle the entire case with fair consideration given to the insured’s concerns because of their personal exposure to punitive damage claims.
In Ging v. American Liberty Insurance Co., 423 F.2d 115 (5th Cir. 1970), the court addressed a carrier’s good faith duties when defending a complaint seeking punitive damages. American Liberty’s insured, Martin, was involved in an automobile accident. Settlement negotiations proved unsuccessful and plaintiff sued seeking compensatory and punitive damages.
The insurer and the counsel it retained to defend the insured did not keep the insured apprised of the progress of the suit, including various offers to settle and the possibility of punitive damages. Because the insured was not aware that the eventual verdict included a punitive award, it failed to appeal in time and became personally liable for the punitive award. It sued the insurer for bad faith. On appeal of a summary judgment for the carrier, the Fifth Circuit reversed.
The appellate court acknowledged the public policy that generally did not permit a carrier to pay for punitive damages. Nonetheless, the carrier did assume good faith duties even before suit when it undertook claim settlement negotiations. These good faith duties continued through judgment up to the time the possibility of an appeal expired. Once having undertaken the defense of a noncovered claim, the insurance company was under an obligation to act in good faith towards its insured with regard to the entire extent of its undertaking.
In Camelot by the Bay Condominium Owners Association, Inc. v. Scottsdale Insurance Co., 27 Cal. App. 4th 33, 32 Cal. Rptr. 2d 354 (1994), the court considered whether a carrier acted in bad faith by rejecting a settlement offer when plaintiff sought recovery of covered and noncovered claims. The condo association sued the developer for construction defects. Scottsdale defended its insured, the developer, under a reservation of rights. After failure of settlement efforts, the plaintiff sued the insurer.
The Camelot court found that the carrier did not breach its duty of good faith in failing to settle because the case did not present policy limits exposure to the insured. In fact, the total of both the covered and noncovered claim were less than policy limits. In the absence of policy limits exposure, there could be no breach of the duty of good faith and fair dealing. 32 Cal. Rptr. 2d at 365.
At least one case has found that bad faith cannot exist when some claims are covered and some claims are not covered. In Republic Insurance Co. v. Stoker, 903 S.W.2d 338 (Tex. 1995), the Supreme Court of Texas found that no bad faith existed when a noncovered claim was promptly denied, even for an invalid reason, when at the time a valid reason did exist for denial. In this case, the insured, Stoker, was involved in a rear-end motor vehicle accident. The insured sought to recover under his UM policy with the carrier, Republic. The carrier denied coverage initially on the basis that the insured was more than 50 percent at fault. Subsequently, the carrier relied upon a statutory provision requiring actual physical contact with an identified hit and run vehicle. This reason for the denial served as the basis for the bad faith suit against the carrier.
The Stoker court rejected the argument that because the claim was premised upon breach of the policy independent of a bad faith claim, an insured may recover for bad faith even if the claim is not covered by the policy. Id. at 340. The court agreed that a claim for benefits under the policy is independent of a bad faith claim, but found no cases that hold a carrier liable for denying the claim not covered by a policy. Id. at 341. Because an element of bad faith is an absence of a reasonable basis for denying payment of benefits, the carrier’s conduct did not reach this level; its decision was right but simply for the wrong reason.
The opinions expressed by several courts suggest that the goal of expanding the boundaries of first party bad faith law will encourage insurers to increase their level of respect for insureds and to further balance the difference in bargaining power between insurers and insureds. But as many people are already aware, and one commentator wrote, “[B]ad faith litigation has become the judicial equivalent of the Wheel of Fortune, with disastrous results for insurers, and [the] policyholders. . . ultimately bear the cost.” Richmond, “An Overview of Insurance Bad Faith Law and Litigation,” 24 Seton Hall L. Rev. 74, 140.
Extracontractual duties regarding indemnity in third party cases are similar to the duties imposed in first party cases. Carriers must use fair and honest claims handling and settlement practices. Because third party liability insurance contracts also impose a duty to defend, a carrier’s extracontractual duties also encompass the defense obligation.
As noted above, some courts have found that a carrier can be liable for bad faith in the absence of any covered claim. In these cases, courts have observed that the benefits due to an insured are not limited solely to those expressly set out in the insurance contract. Insureds are also entitled to receive the security of knowing they will be dealt with fairly and in good faith. Other courts have found that a carrier cannot be liable for bad faith when there are no covered claims. Many such cases simply hold that extra contractual actions cannot proceed when there is no contract upon which to base them. Other complaints allege damages for both covered and non covered claims. As in all attempts to present bad faith actions, the courts remain somewhat split regarding the duties owed and the resultant liability in the absence of coverage.