This is one of a series of articles under the by line “Butler on Bad Faith” originally published in Mealey’s Litigation Report: Insurance Bad Faith, Vol. 17, #8, p. 17 (August 13, 2003). © Copyright Butler 2003.
It has long been accepted that parties to an insurance contract have an obligation to deal with each other fairly and in good faith.(1) As early as 1914, this obligation was found to be grounded within an implied covenant within the contract between the insurer and its insured.(2) If a denial of benefits under the policy was ultimately resolved by a suit on the contract of insurance, a policyholder who prevailed would receive the amount due plus interest.(3) The recognition of a cause of action for the tortious breach of the duty of good faith and fair dealing in the context of the first-party contract of insurance(4) is relatively recent.
As early as 1958, the Supreme Court of California had recognized that an insured could sue for damages in contract and tort when an insurance company fails to settle a third party claim against their insured and that refusal resulted in an award in excess of policy limits.(5) Not until 1973, in Gruenberg v. Aetna Ins. Co., did the court expand its earlier decisions and held that an insured could also sue for damages in contract and tort when the insurer breached the contract by failing to pay insurance proceeds due the insured.(6)
The impact of the new cause of action and its underlying rationale has had a fundamental and, after thirty years, still evolving, impact on the relationship between the parties to an insurance contract(7) and those who practice in this area of the law. In the thirty years since the decision, most of the courts in other states have begun their analysis of the issues with a brief discussion of the reasoning in Gruenberg. Some have adopted it, and others have rejected it in preference for more traditional contract principles.(8) While insurance is a specialized area of the law, the complexity of the issues surrounding the tort of bad faith has occupied the attention of courts and commentators as few issues before or since.
At times, the discussion of the remedies available for a breach of an insurance contract has mirrored the larger controversy concerning the continued blurring of lines between contract and tort in American jurisprudence.(9) Some states have taken the position that, as the relationship between the parties is contractual, the remedy for the breach of contract remains the traditional contractual expectations of the parties.(10) Even then, in some states, an expansive analysis of what those expectations are has strained the usual understanding of contractual relations.(11) Following the rationale for the decision in Gruenberg, some states have followed the California court and fashioned a new tort of bad faith premised on the perceived inadequacies of traditional contract remedies in the first-party insurance context. Regardless of their approach, the majority of states now permit insureds to seek extra-contractual remedies when the insurer is found to have committed what the courts perceive as culpable conduct.(12)
A complete analysis of each jurisdiction’s approach is beyond the scope of this brief article. Instead, the discussion below will focus on what the rules have become in the thirty years since the Gruenberg decision,(13) address some of the consequences of extra-contractual damages on the insurance industry and touch on some of the implications for attorneys who devote their practice to resolving insurance disputes. Lastly, the article will note some recent developments that have an impact on what the future may hold for litigation of these issues.
From its inception, the concept of liability for the breach of a duty of good faith in the context of a first-party insurance contract was that the action sounded in tort rather than contract. As the California Supreme Court stated:
That responsibility is not the requirement mandated by the terms of the policy itself – to defend, settle, or pay. It is the obligation, deemed to be imposed by the law, under which the insurer must act fairly and in good faith in discharging its contractual responsibilities. Where in so doing, it fails to deal fairly and in good faith with its insured by refusing, without proper cause, to compensate its insured for a loss covered by the policy, such conduct may give rise to a cause of action in tort for breach of an implied covenant of good faith and fair dealing.
Proceeding from pure tort analysis, some courts have found liability for bad faith in the absence of coverage.(14) Other courts have adhered to the expansive language of the Gruenberg court, but nonetheless limited the tort to narrow situations.
A good example of this latter course can be found in the decision of the Idaho Supreme Court in Selkirk Seed Co. v. State Insurance Fund.(15) In Selkirk,(16) the court explained that insurance companies had a duty to act in good faith with their insureds, and that the duty existed independently of both contract and state regulatory statutes. The court noted, “Such a duty is beyond that which the policy imposes by itself – the duty to defend, settle, and pay – but is a duty imposed by law on an insurer to act fairly and in good faith in discharging its contractual responsibilities.”(17) The court made it clear that the cause of action existed in first-party actions, where the insured is personally filing a claim for benefits against the insurer under the policy.(18) However, despite its expansive language, the court then asserted that an independent action in tort arises only where the insured can show that the insurer intentionally and unreasonably denied or withheld payment and as a result of the insurer’s conduct, the plaintiff was harmed in a way not fully compensable by contract damages.(19)
Some states have expressly limited the independence of the tort of bad faith by holding that, while the tort is based on the implied covenant of good faith and fair dealing, there can be no breach of that covenant if there was not a breach of the contract’s express terms. The decision of the United States District Court for the Eastern District of Louisiana in First National Bank of Louisville v. Lustig(20) is instructive. Interpreting Kentucky law, the Federal District Court agreed that Kentucky recognized a cause of action for the bad faith refusal to pay the insured’s claim.(21) According to the court, the insured had to prove the following elements to prevail against an insurance company for bad faith:
- the insurer must be obligated to pay the claim under policy terms;
- insurer must lack a reasonable basis in law or fact for denying the claim; and
- the insurer must have either known that no reasonable basis existed for denying the claim or have acted with reckless disregard for whether such a basis existed.
The plaintiff argued that the basis for the tort of bad faith in the insurance context is the bad conduct of the insurer in its dealings with its insureds and the foreseeable damage to the insured’s peace of mind, not the existence of coverage in the contract in a particular claim.(22) The court disagreed, holding the tort recognized by Kentucky was a bad faith action for non-payment of the insured’s claim, not the more expansive cause of action urged by the plaintiff.
The plaintiff invited the court’s attention to the work of legal commentators and urged the court to expand the tort to address the behavior of the insurer rather than the terms of the contract. The court’s response was blunt:
While the court finds this an intriguing academic issue and argument, it cannot base a finding of law on such an amorphous and indeterminate legal conclusion supported by mere inferences the author deducts from a 1973 California case. [The plaintiff] asks the court to take a gargantuan leap to find as a matter of law that coverage under the policy is unnecessary to maintain this bad faith claim for mishandling. While this theory may become the law in the future, it is not grounded in current law and the court, accordingly, cannot justify its adoption.
Some courts, originally enamored with the availability of tort remedies for contractual breaches, now seem uncomfortable with the potential impact of those claims. Nonetheless, some have seemed reluctant to openly restrict them to the insurance context. A case in point is the decision of the Montana Supreme Court in Story v. City of Bozeman.(23) In Story, the court reversed bad faith damages in a construction dispute between the City of Bozeman and a contractor. In doing so it narrowed the scope of the common law tort of bad faith. The court held that “[t]he tort can be pursued in a contractual setting only where ‘special circumstances’ exist between the parties and the matter is not otherwise controlled by specific statutory provisions.”(24) A review of the special circumstances set out by the court makes it clear that they will arise infrequently, if at all, outside an insurance context.(25)
There are states that have rejected the establishment of a tort of bad faith in the first-party insurance context. The decision of the Maryland Supreme Court in Johnson v. Federal Kemper Insurance Co., 536 A.2d 1211 (Md. 1988), is a good example of the reasoning used in those cases.
While acknowledging the acceptance of the cause of action in third party insurance disputes, the court noted that [the first-party insurance claim] “presents an entirely different situation. The insured retains all rights to control any litigation necessary to enforce the claim. Because it involves a claim by the insured against the insurer, rather than a claim by a third party against both the insurer and insured, there is no conflict of interest situation requiring the law to impose any fiduciary duties on the insurer. Instead, the situation is a traditional dispute between the parties to a contract.”
The plaintiff in Johnson also argued that the legislature had signaled its recognition of an independent cause of action for bad faith when it passed a statute regulating unfair claims practices.(26) The court found the existence of the statute ran directly counter to plaintiff’s argument. Instead of providing for a separate cause of action, the statute reflected the decision of the state to address abuses within the insurance industry for the public good rather than by rewarding or providing additional compensation to individual plaintiffs.(27) Taken together, the court held, the traditional contract action addresses the expectations of the plaintiff and the fines and other penalties assessed by the state address the public interest in modifying future insurer behavior. As a consequence, the court declined to recognize a specific tort action against an insurer for bad faith failure to pay an insurance claim.
1. Strict Liability
As feared by Justice Roth in his dissent in Gruenberg,(28) there have been those who have argued for strict liability for insurance companies. Thus, the insurer who does not immediately pay every claim on the precise terms requested by the insured would act at its peril with respect to exposure to tort liability. Courts have overwhelmingly rejected this standard, but, as if to justify the fears of Justice Roth, not every one has done so.(29) The West Virginia Supreme Court held that, where an insured “substantially prevails” in a suit against its own insurer for payment of a property damage claim, the insured is entitled to “attorney’s fees, consequential damages and other net economic losses caused by the delay in settlement, as well as damages for aggravation and inconvenience.”(30) Thus, at least in one jurisdiction, it may be enough for the insurance company to be wrong.
2. The Reasonable Basis – What Would The Reasonable Insurer Do?
The majority view on the standard of culpability is the view espoused by the Wisconsin Supreme Court in Anderson v. Continental Insurance Co.(31) After announcing that a cause of action in tort would exist for a bad faith refusal to honor a claim, the Anderson court set forth the following description of the tort, encompassing a subjective component:
To show a claim for bad faith, a plaintiff must show the absence of a reasonable basis for denying benefits of the policy and the defendant’s knowledge or reckless disregard of the lack of a reasonable basis for denying the claim. It is apparent, then, that the tort of bad faith is an intentional one. . . .
The tort of bad faith can be alleged only if the facts pleaded would, on the basis of an objective standard, show the absence of a reasonable basis for denying the claim, i.e., would a reasonable insurer under the circumstances have denied or delayed payment of the claim under the facts and circumstances.(32)
Although questions of reasonableness generally must be resolved at trial, the court noted that, on the right facts, they could be an appropriate subject for summary judgment proceedings. Under the test espoused by the Anderson court, if an insurer can show that, even when the facts are viewed in a light most favorable to the plaintiff, a reasonable jury could only conclude that the challenged conduct was reasonable, then summary judgment in accordance with that conclusion can be entered for the insurer.(33) Otherwise, the issue of reasonableness is one for the jury.
3. The Reasonable Basis – No Arguable Reason To Deny
Opposite from the strict liability standard adopted by the West Virginia Court is the “reasonable basis” standard espoused by the Alabama Supreme Court in National Insurance Association v. Sockwell.(34) Though close in terminology to the test used by the Wisconsin Supreme Court in Anderson,(35) the burden of proof has been tipped decidedly in the favor of pre-trial resolution. As the Sockwell court explained, to prevail in a bad faith suit, the plaintiff must prove:
- an insurance contract between the parties and a breach thereof by the defendant;
- an intentional refusal to pay the insured’s claim;
- the absence of any reasonably legitimate or arguable reason for that refusal (the absence of a debatable reason);
- the insurer’s actual knowledge of the absence of any legitimate or arguable reason;
- if intentional failure to determine the existence of a lawful basis is relied upon, the plaintiff must prove the insurer’s intentional failure to determine whether there is a legitimate or arguable reason to refuse to pay the claim.
The standards, like the standards adopted by the Wisconsin Supreme Court,(36) are meant to ensure that bad faith is not used simply to punish bad judgment or negligence. However, that is where the standards diverge. Here the standard requires a dishonest purpose and requires a breach of known duty, (i.e., good faith and fair dealing,) through some actual motive of self-interest or ill will. The requirement that the insurer have “actual knowledge” ensures that the finding of bad faith is based upon the insurer’s conscious wrongdoing. In other words, when a claim is “fairly debatable,” the insurer is entitled to debate it, whether the debate concerns a matter of fact or law, without fear that it will subject itself to a finding of bad faith. If there is a lawful basis for denial, the insurer cannot be held liable in an action based upon the tort of bad faith as a matter of law.
If the plaintiff wants to proceed on a theory of intentional failure to determine a lawful basis for denial, he or she must prove that the insurer “intentionally failed to determine whether or not there was any lawful basis for refusal.” The relevant inquiry is whether the claim was properly investigated and whether the results of the investigation were subjected to an objective evaluation and review. When there is a reckless indifference to the facts or to the proof submitted by the insured, actual knowledge or a reckless disregard of the lack of a legitimate or reasonable basis for refusal may be inferred and imputed to the insurance company by the court or the jury.
The applicable standard for testing the tort of bad faith claim under this test is a directed verdict on the contract claim. As the Alabama Supreme Court noted:
This ‘directed verdict on the contract claim’ test is not to be read as requiring, in every case and under all circumstances, that the tort claim be barred unless the trial court has literally granted plaintiff’s motion for a directed verdict on the contract. . . Rather, this test is intended as an objective standard by which to measure plaintiff’s compliance with his burden of proving that defendant’s denial of payment was without any reasonable basis either in fact or law; i.e., that defendant’s defense to the contract claim is devoid of any triable issue of fact or reasonably arguable question of law.(37)
When the courts refused to recognize the new tort of bad faith, the state legislatures in a number of states passed statutes providing traditional tort remedies for bad faith in the insurance context. In D’Ambrosio v. Pennsylvania Nat. Mut. Cas. Ins. Co.,(38) the Pennsylvania court declined to provide a common law action for bad faith and, in response, the Pennsylvania legislature created a statutory remedy in 42 Pa. C.S.A. § 8371. It provides:
§ 8371. Actions on insurance policies
In an action arising under an insurance policy, if the court finds that the insurer has acted in bad faith toward the insured, the court may take all of the following actions:
- Award interest on the amount of the claim from the date the claim was made by the insured in an amount equal to the prime rate of interest plus 3%.
- Award punitive damages against the insurer.
- Assess court costs and attorney fees against the insurer.(39)
Interpreting the Pennsylvania bad-faith statute, the courts have found that “bad faith” is any frivolous or unfounded refusal to pay proceeds of policy.(40) Except in extreme cases, this is a question for the jury.
Some state statutes, while providing for a cause of action for bad faith, have provided some procedural hurdles before the cause of action may be filed. These statutes appear to have the laudatory purpose of promoting communication between the insured and the insurer and thus settlement of insurance disputes. Florida’s statute is an excellent example of such a provision.(41) The Florida statute provides:
§ 624.155. Civil remedy
(1) Any person may bring a civil action against an insurer when such person is damaged:
(a) By a violation of any of the following provisions by the insurer. . .
In general terms, the various provisions prohibit behavior such as not attempting in good faith to settle claims, not advising the insured the coverage under which payments are being made, failing to promptly settle claims under one portion of the insurance policy coverage in order to influence settlements under other portions of the insurance policy coverage and various unfair trade practices.(42)
What makes the Florida statute interesting are the subsections that prohibit suit until the insurer is given notice and an opportunity to respond. Sections of the statute also prohibit suit if the insurer pays the damages claimed or when the circumstances giving rise to the violation are corrected within the notice period.(43) The Florida courts have further interpreted the statute as prohibiting a suit for bad faith until after the suit for liability on the insurance policy has been resolved in the insured’s favor.(44)
Regrettably, anecdotal evidence indicates that the notice requirement of the statute is largely ignored. Plaintiffs’ attorneys have little incentive to provide information that might permit an insurer to discern the facts underlying the plaintiff’s claims and respond within the notice period. Inquiries concerning notice forms filed under the statute either go unanswered or are met with assertions that the insured’s letters concerning the notice are additional evidence of the insurer’s bad faith harassment of the insured.
As noted in the above, the creation of a tort of bad faith in the first-party insurance context has had a profound impact on the insurance industry and the parties to disputes over insurance contracts. While the courts have told us there is a duty of good faith and fair dealing, it has been less clear precisely what the duty is or who is bound by it.(45) After three decades, this legal and claims uncertainty continues.
The nature of the relationship between the insurer and the insured is somewhat uncertain.(46) It has been argued by some that the insurer is a fiduciary with respect to the insured’s interests and there is some support for that contention in the third-party context.(47) However, the idea that the insurer, embroiled in a dispute with its insured over the nature or extent of coverage in the first-party context, must act as a fiduciary is completely inconsistent with the concept of the fiduciary relationship and the realities of the marketplace. One group of commentators outlined the problem with the concept of assigning fiduciary duties to parties in an ordinary commercial setting in this way:(48)
The broad imposition of fiduciary duties would be enormously disruptive of ordinary transactions. A fiduciary’s power to transact business with his beneficiary is severely limited; he must use utmost good faith and, if he profits from the transaction, the law presumes the agreement was entered into by the beneficiary without sufficient consideration and under undue influence. Most transactions, whether or not they involve insurance, are entered into with the expectation of profit. Thus, a presumption that profits would be illicit and must be disgorged to the other party would bring most business to a halt by destroying any incentive to undertake the risks and expense of the transaction. Moreover, most parties would be extremely reluctant to enter into relationships where they are forbidden to even consider, much less protect, their own interests.
Whatever one may call the relationship, the decision of the Nevada Supreme Court in Powers v. United Services Auto. Ass’n,(49) is instructive concerning what courts might mean when it uses the term fiduciary. It quickly becomes clear that they are using the term rather more loosely, or less technically, than commentators fear. In Powers, the insured brought suit against a marine insurer after it denied his claim for the sinking of his boat and unsuccessfully sought to have him prosecuted for insurance fraud. The Nevada Supreme Court noted that “Not only was the impropriety of USAA’s denial of Powers’ claim supported by substantial evidence, the jury was shown that USAA manufactured evidence to support its denial of coverage, and then was instrumental in sending this false evidence to the FBI, which resulted in Powers being indicted and eventually acquitted at trial when the falsity of the evidence was uncovered. In all likelihood, this evidence substantially influenced the jury’s decision to award punitive damages.” The court’s observation would seem to be a model of understatement.
In upholding the multi-million dollar verdict for the insured, the Nevada Supreme Court held that the duty owed by an insurance company to an insured is fiduciary in nature and that in order to recover, the plaintiff must establish by a preponderance of the evidence that a fiduciary relationship existed between plaintiff and defendant and that defendant breached a duty to disclose known facts to plaintiff. The court held that a fiduciary relationship exists when one has the right to expect trust and confidence in the integrity and fidelity of another. Finding such a relationship in the insurance context, the court held that “This special relationship exists in part because, as insurers are well aware, consumers contract for insurance to gain protection, peace of mind and security against calamity.”
On a practical level, whatever the rhetoric, both parties to the insurance contract know the insurer is not a fiduciary in the classic or legal sense. The typical policy contains exclusions and penalties that make it abundantly clear that the insurer will not pay all requested claims. The provisions set out the steps the insurer may take to verify the loss and investigate the scope of the loss to determine whether or how much of the loss is covered. The typical policy also contains provisions that address what the insured may do if the insurer decides that some or all of the claim will not be paid. Unlike a fiduciary, an insurer engaged in determining and performing its contractual obligations may give consideration to its own interests and the interests of other insureds so long as it gives “at least as much consideration to the welfare of its insured as it gives its own interests” and refrains “from doing anything to injure the right of the insured to receive the benefits of the agreement.”(50)
While the precise edges of the envelope are unclear, it is clear that the duty of good faith and fair dealing does not end with the denial of coverage and the start of litigation. On a common sense level, if the duty is merely to refrain from acts that unfairly deprive the insured of the benefits of the contract, they should not stop once litigation begins. However, if the plaintiff’s cause of action is to be judged at the time the cause of action was filed, it is difficult to understand how evidence of post-filing conduct can be relevant. Despite criticism from commentators, the cases seem in accord in allowing plaintiffs to establish bad faith by presenting evidence of the insurer’s acts through litigation.(51)
In Norman v. American Nat. Fire Ins. Co.,(52) the trial court permitted the plaintiff to place the insurance company’s post-filing correspondence and memos into evidence on the issue of bad faith. The trial court also imposed statutory penalties of over $105,000 on the insurer, giving great weight to the delay caused by the discovery and trial tactics of the insurer. The appellate court agreed that the strategies and tactics of trial counsel are not an adequate basis for the imposition of statutory penalties unless they violate applicable rules of ethics or procedure, or constitute an attempt to obstruct or deliberately delay the judicial process. The court nevertheless upheld the entire judgment against American National.
Despite the implicit error in the Norman court’s methodology, a District Court of Appeal decision in Florida(53) relied on Norman to uphold the admission of an insurer’s pleadings as well as the insurer’s negative response to a request for admissions tendered by the plaintiff. The insurer’s answer to the original complaint asserted numerous reasons why no coverage existed, including expiration of the policy, laches, waiver and estoppel, exclusions, and lack of consideration for issuance of the coverage. Like the strategy and tactics in Norman, there was no evidence that the pleadings or the denial were improper. Rather, the court considered the propriety and reasonableness of the pleadings and the negative response to the request for admission to be questions for the jury.(54)
However ill considered, these decisions caution a sharp defensive shift in litigation behavior that clearly has nothing to do with the inherent good faith of the insurer. It would appear that lawyers would be well advised to draft pleadings, letters and memorandum so they can be understood by the typical juror rather than their putative audiences of client, court or opposing counsel. The primary question may now be how the communication will look blown up on a screen in the courtroom in front of a jury of laypersons. It remains to be seen how the potential litigants will respond to the strictures of such an environment.
Those who after Gruenberg(55) feared tort would swiftly swallow contracts, and those who advocated that position, have been, respectively, elated and disappointed. California, the state court that released the tort of bad faith, has penned it in, allowing it to forage only on the assets of insurance companies.(56)
For the “outer limits” of punitive damages perhaps we can consider the claim of the plaintiff in Ferguson v. Lieff, Cabraser, Heimann & Bernstein LLP.(57) In Ferguson, class action clients alleged their attorneys’ malpractice cost them the chance to recover punitive damages in litigation. The California court seemed bemused by the claim and held the plaintiffs could not recover the “lost” punitive damages in a suit against the attorney because making the attorney liable for punitive damages serves no societal purpose and imposes a heavy social cost. In light of the impact of Gruenberg and its progeny, such restraint and balancing should be appreciated however late and unexpected it might be.
The Gruenberg court and the courts that have followed its reasoning sought to remedy what they saw as the inherent injustice of the traditional contract remedies available to insureds. From the beginning, it has been recognized that the potential of litigation and extra-contractual remedies would have a profound impact on the claims process.(58) If unpredictable damage awards for the few are left unchecked, economic realities may mean that insurance as we have come to know it may soon be unavailable to the many. The Supreme Court’s decision in Campbell may have reduced that uncertainty but the future still remains unclear.(59) While California courts and a handful of others initially embraced a broader independent contract-tort claim for breach of the covenant of good faith,(60) most other jurisdictions steadfastly refused to create a new cause of action outside of an insurance context.(61)
As the decisions in Hawaii, Pennsylvania and Minnesota have indicated, the acceptance of tort damages as the trend in contractual disputes may be turning as the societal costs mount but it is too soon to tell.(62) What is clear is that, thirty years after its arrival, the doctrine of extra-contractual damages for bad faith in first-party insurance disputes has dramatically changed the insurance arena. What seems certain is that the laws of the marketplace will continue to assert themselves and, as in the more general tort arena, the awards to the few will ultimately be paid by the many. Insurance companies, like manufacturers and health care providers before them, will attempt to factor the less certain risks of litigation and runaway damage awards into the risks of the originally insured loss.
As in any area of human endeavor, there will always be disputes over the proper resolution of insurance contracts. The courts should remain available for those consumers who believe an insurer has made an improper decision as to the scope of coverage. However, the continued viability of insurance as a consumer product requires that the resolution of such a dispute should not be transformed into a potential windfall for the insured and his or her counsel. One solution is for more courts or legislatures to follow the example of Alabama(63) and establish clearer threshold tests for the litigation of bad faith and thus make the disputes more subject to resolution by the courts in motions for summary judgment. Until that happens, the insurance industry and consumers must hope that juries will begin to be more predictable about the acts that warrant a finding of bad faith and what awards are appropriate when it is found. The experience of the last thirty years makes that seem a slender reed on which to lean.
(1) the contract must be such that the parties are in inherently unequal bargaining positions;
(2) the motivation for entering the contract must be a non-profit motivation, i.e., to secure peace of mind, security, future protection;
(3) ordinary contract damages are not adequate because
(a) they do not require the party in the superior position to account for its actions, and
(b) they do not make the inferior party “whole;”
(4) one party is especially vulnerable because of the type of harm it may suffer and of necessity places trust in the other party to perform;
(5) the other party is aware of this vulnerability.