This is one of a series of articles under the by line “Butler on Bad Faith” originally published in Mealey’s Litigation Report: Bad Faith, Vol. 12, #16, p.18 (Dec. 15, 1998). Copyright Butler 1998.
Please also see the Supplement to this article published in January, 1999 following the U.S. Third Circuit Court of Appeals reversal of its decision on rehearing in Van Holt v. Liberty Mutual Fire Insurance Co.
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During the past year, numerous areas in the United States have experienced severe and, at times, unprecedented flooding. Whether the flooding occurred as a result of the active Atlantic hurricane season or the effect of “El Nino” on national weather patterns, the result for insurers is the same: an increase in the number of claims under flood insurance policies. With this comes a corresponding increase in the likelihood of extracontractual or bad faith claims.
This article discusses the right of an insured to sue for extracontractual damages based on the handling of a claim under the flood insurance program of the National Flood Insurance Act (the “NFIA”). As will be seen, in many, but not all jurisdictions which have decided the question, the NFIA preempts state law. For those jurisdictions that have not decided the question, this article will provide an overview of how preemption principles apply to state common law claims and statutory remedies, including bad faith and other “extracontractual” claims, under flood policies.
The federal system of flood insurance is a bit complicated. In 1968, Congress enacted the NFIA.(1) The NFIA provides for the issuance of flood insurance policies pursuant to the National Flood Insurance Program (the “NFIP”)(2). The NFIPis a guaranteed insurance program administered by the Federal Emergency Management Agency (“FEMA”).(3) Congress established the NFIP, in part, as “areasonable method of sharing the risk of flood losses.”(4) It provides flood insurance coverage to all persons, especially persons in high risk areas who need such protection, at or below actuarial rates.(5)
Initially, under the NFIA, private insurance companies formed a pool andcontracted with the Department of Housing and Urban Development to administer the NFIP and issue policies.(6) Over the years, the program evolved. The Department of Housing and Urban Development terminated its contractual relationship(7) with the private insurers and FEMA became the Program Administrator. Eventually, under FEMA’s administration of the NFIP, the “Write Your Own” (“WYO”) Program was created which allowed private insurance companies to write their own flood insurance policies.(8) These policies are issued by the insurer as the insurer’s own, but the document itself is a standard form approved by FEMA. The insurer cannot deviate from the approved policy.
So, WYO insurance companies issue standard government policies, collectpolicy premiums, adjust claims and pay on them.(9) However, WYO insurers keep only the minimum premium fund necessary to meet claim costs.(10) They hand over the rest to the Flood Insurance Administration.(11) When an insurance company depletes the premium fund that was “held back” from the Flood Insurance Administration, the company draws money from FEMA to cover claims.(12) WYO insurers are responsible for defending suits on claims made under flood policies.(13) FEMA reimburses the defense costs.(14)
Under this system, private insurance companies become “fiscal agents of the United States.”(15) They are not general agents.(16) Although WYO insurers issue the policies, collect premiums, adjust claims and disburse settlements, FEMA alone bears the risk for the program. United States Treasury funds ultimately are used to pay claims.(17) And, as stated above, Treasury funds are used also to reimburse insurers for defense costs.(18) Thus, FEMA bears the financial responsibility for lawsuits, regardless of whether FEMA or the insurer is named as the defendant.(19)
Federal preemption of state law occurs in one of six ways.(20)
Few federal statutes preempt state laws applying to insurance companiesand insurance policies.(27) The most prominent example is the Employee Retirement Income Security Act(28) (“ERISA”). ERISA preempts state law by express statutory language.(29) A state law which “relates to” an employee benefit plan is preempted by ERISA.(30) Courts have interpreted this preemption broadly to encompass both tort and contract claims for alleged improper claim handling.(31) ERISA preempts state claims for breach of contract, bad faith, unfair dealing and intentional infliction of emotional distress.(32)
Unlike ERISA, the NFIA does not contain express preemption language. Nonetheless, most courts examining the preemption issue have found that the NFIA preempts state common law and statutory claims based on the following NFIA language:(33)
[I]nsurance company’s and other insurers……may adjust and pay all claims for approved losses covered by flood insurance in accordance with the provisions of this chapter and, upon the disallowance by anysuch company or other insurer of any such claim, or upon refusal ofthe claimant to accept the amount allowed upon any such claim, the claimant, within one year after the date of mailing notice ofd isallowance or partial disallowance of the claim, may institute an action on such claim against such company or other insurer in United States District Court for the district in which the insured property or the major part thereof shall have been situated, and original exclusive jurisdiction is hereby conferred upon such court to hear and determine such action without regard to the amount in controversy.
Federal courts sitting in Florida,(34) Louisiana,(35) and Mississippi(36) all have found that state common law and statutory causes of action are barred in disputes arising from policies issued pursuant to the NFIP. These courts have interpreted the above language to only authorize suits based on “disputes in coverage, or breach of contract . . . deriving from a denial of insurance claims.”(37) They have relied on the intent of Congress to create a national unified program for flood insurance. These courts correctly recognize the need for uniformity of decisions in the application of the law to policies issued pursuant to the NFIA.(38) The courts note the federal government’s extensive participation in the NFIP.(39) They highlight the government’s administrative and financial responsibilities under the NFIA.(40) Further, they find it significant that Congress failed to include language that provides for state law claims under the NFIA.(41)
A small number of courts have addressed directly the issue of whether the NFIA bars an action for bad faith. In Stock v. State Farm Insurance Company,(42) the United States District Court for the Eastern District of Louisiana addressed the issue of whether a claim for bad faith brought under La. Rev. Stat. § 22:1220 is governed by federal law. The issue was raised in the context of a motion forremand.(43) The Court denied the motion for remand of the bad faith claim because the NFIA completely preempted state insurance law, and thus, federal law controlled all coverage disputes arising out of flood insurance policies.(44)
The Stock Court reasoned that, since Plaintiff first must demonstrate that heis entitled to coverage before he can be successful in an action for bad faith, the claim for bad faith must be brought “in connection with” the policy claim.(45) The Court noted that Congress provided exclusive jurisdiction to the federal courts over actions relating to the adjustment and payment of flood insurance claims.(46) Accordingly, the Court concluded that federal law controlled the action for bad faith and the action was within the exclusive jurisdiction of the federal courts.(47) The Court did not announce the effect of exclusive federal jurisdiction on the viability of the statutory bad faith claim.
Six months after the Stock decision, the United States District Court for the Eastern District of Louisiana published the opinion in Oppenheim v. Leone.(48) That decision went further than Stock. It ruled specifically that actions for bad faith under La. Rev. Stat. § 22:1220 are barred by the NFIA.(49)
In Oppenheim, Plaintiff made a claim under his mother’s flood insurance policy for damage to his house in New Orleans.(50) State Farm denied Plaintiff’s claim on the ground that the damage was not caused by a storm, and therefore,was not covered under the policy.(51) After the denial, Plaintiff filed a complaint containing a state law claim for bad faith.(52) State Farm moved to strike this claim, and for partial summary judgment.(53) State Farm argued that the flood insurance policy was governed by federal law under the NFIA.(54) Thus, state law governing insurance policies was preempted by the statute.(55) Plaintiff, on the other hand, argued that, while the policy was governed by federal law, State Farm’s conduct was not.(56) Plaintiff asserted that, since he was alleging negligent conduct on the part of State Farm’s agent in denying coverage, such conduct was governed by state law including the penalties of § 22:1220.(57)
The Court granted State Farm’s motion finding that the NFIA alone is applicable to questions of coverage, penalties and attorney’s fees.(58) The Court cited the earlier Fifth Circuit decision in West v. Harris(59) wherein a Plaintiff prevailing in a claim under a flood insurance policy was not entitled to statutory penalties under state insurance law for denial of coverage.(60) Based on the Fifth Circuit’s interpretation of the NFIA, the Oppenheim Court concluded that federallaw does not recognize a cause of action under § 22:1220.(61)
Another cause of action used by insureds to import state law into claims arising from a NFIA flood policy is alleged fraud. Plaintiffs assert that a fraudulent misrepresentation by the WYO insurer or its agent misled them about some aspect of coverage. Because such assertions involve conduct, rather than policy content, the “preemption language” of the NFIA should not apply.
One such case is Stapleton v. State Farm.(62) In Stapleton, the United States District Court for the Middle District of Florida held that the NFIA preempts state law claims for fraud in the inducement. In that case, the Plaintiffs alleged that State Farm’s agent fraudulently misrepresented to them that their elevated home would have full coverage for flooding on the lowest level of the premises.(63) They alleged further that the agent told them this before they bought the house.(64) They would not have bought it had they known there was no coverage.(65)
A flood damaged the lowest level of the house.(66) State Farm, as provided inthe policy, afforded limited coverage to the damage on that level.(67) Following State Farm’s denial of full coverage, Plaintiffs filed suit for fraud in the inducement and unfair trade practices.(68) State Farm moved to dismiss, asserting that these state law causes of action were preempted by the NFIA.(69) After a detailed analysis of the NFIA, the Court agreed and dismissed both claims.(70)
In ruling on the motion to dismiss, the Court relied on the plain language of the NFIA.(71) The Court found the NFIA specifically provided for review only of “cases involving disputes in coverage, or breach of contract causes of action deriving from a denial of insurance claims.”(72) The Act did not provide for state law causes of action arising out of claims investigations or placement of insurance coverage.(73) The Stapleton Court concluded that Congress chose narrow language to preempt those state common law and statutory causes of action.(74)
Conversely, in the case of Spence v. Omaha Indemnity Insurance Company(75) the United States Court of Appeals for the Fifth Circuit distinguished between state law claims alleging breach of contract and those alleging fraudulent misrepresentation. Plaintiff had made a claim for damage to his basement under a flood insurance policy issued by Omaha Indemnity as a WYO insurer.(76) Omaha Indemnity denied the claim based on a “finished basement” exclusion.(77) Plaintifffiled suit for breach of contract and fraudulent misrepresentation.(78) Plaintiff contended that he bought the policy in reliance on representations made by Omaha Indemnity’s agents that the basement would be covered for flood.(79)
In the lawsuit, Omaha Indemnity asserted Plaintiff’s claims were timebarred.(80) Omaha Indemnity argued that the one year statute of limitations under the NFIA(81) and its associated regulations(82) applied rather than the four year limitations period under Texas law for breach of contract and fraud actions.(83) The trial court denied Omaha Indemnity’s motion for summary judgment.(84) At trial, the jury found Omaha Indemnity liable on both theories.(85)
On appeal, the Fifth Circuit found the breach of contract action time barred, but not the state law claim for fraud.(86) The Court distinguished between a breach of contract action (which arises from the partial or complete denial of coverage under a flood policy) and an action for fraud (which is outside the policy itself and, therefore, attenuated from federal interest).(87) The Court found it significant that the insurer must issue the policy without alteration and with the required endorsements.(88) This demonstrates the federal interest in the contract. Moreover, an action against the insurer under the policy is, in effect, an action against FEMA.(89) FEMA ultimately is responsible financially for the claim and its defense.
In an action for fraud, on the other hand, the WYO-FEMA agreement doesnot permit the WYO insurer to receive indemnity from FEMA for its own fraud liability.(90) Further, FEMA allows WYO insurers almost complete autonomy in the marketing of policies and the adjustment of claims.(91) Lastly, regulatory language states, “WYO companies shall not be agents of the federal government.”(92) For all those reasons, the federal interest in the alleged fraud of the WYO insurer is lessened.
As stated above, the United States District Court for the Middle District of Florida has determined that the NFIA preempts a claim for unfair trade practices under Florida’s Deceptive and Unfair Trade Practices Act (§§ 501.201—501.213,Florida Statutes).(93) The Court based this on “the large administrative role of the federal government” in the NFIP under the NFIA.(94) The Court relied also on the lack of congressional intent to allow state law causes of action under the NFIA.(95) The Stapleton court stated, “[n]owhere in the Act is there any mention of the statutory law of the forum state on any issue.”(96)
Federal law does not provide for recovery of damages based on emotional ormental distress.(97) Thus, only state common law or statutory law can support such recovery. Naturally, courts which interpret the NFIA as preempting state law have concluded that claims for emotional or mental distress are barred.(98) There are two rationales. First, once state law is preempted, there is no theory for recovery of damages resulting from emotional or mental distress.(99) Second, as discussed below, damages available under the NFIA are pecuniary only.(100)
Generally, if the NFIA preempts state law claims, damages in actions arising out of NFIP policies must be based on the readily ascertainable value of services and property; that is, pecuniary damages.(101) The reasoning is that the federal government operates as the guarantor for all claims and, thus, payment on any claim is made out of Treasury funds.(102) Allowing recovery for damages that are personal or are punitive would frustrate congressional intent and defeat the purposeof the NFIA. Increasing the cost of insurance likely would make it less affordable topersons in high risk areas.(103)
Likewise, the awarding of attorney’s fees is prohibited under the NFIA.(104) Some plaintiffs have tried creatively to obtain attorney’s fees in NFIA cases throughthe Equal Access to Justice Act.(105) But the courts have rejected this approach because WYO insurers are not actual agents of the federal government for NFIA purposes.(106)
A practitioner pursuing or defending claims arising out of a denial of coverage under a flood policy issued pursuant to the NFIP should not overlook the NFIA preemption issue. The issue can result in dismissal of state law extracontractual claims including bad faith, fraud and unfair trade practices. In addition, the Act may limit the prospect of damages that are not pecuniary, such as punitive damages, attorney’s fees and compensation for emotional or mental distress.