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. 13, #24, p. 25 (April 18, 2000). © Copyright Butler 2000.
In the trial of a bad faith case, plaintiff often tries to put into evidence the reserves the insurance company set for the claim. This article contends that evidence ought not be admissible. It will outline three reasons why not.
The term reserves
has a special meaning in the law of insurance. While its scope varies. . . it means a sum of money, variously computed or estimated, which, with accretions from interest, is set aside – reserved – as a fund with which to mature or liquidate. . . future unaccrued and contingent claims, and claims accrued but contingent and indefinite as to amount or time of payment.
Maryland Casualty Co. v. U.S., 251 U.S. 342, 350 (1920). In other words reserves are an allocation of dollars, on the books of an insurance company, to pay policy obligations. In the case of liability and property insurance, they might properly be termed loss reserves.
Insurance is one of the more heavily regulated fields of commerce. Historically, the States have done the bulk of it and many States require insurance companies to set aside reserves as a condition of licensure. For example:
No insurer shall be authorized to transact insurance in this state which does not maintain reserves as required by part I of chapter 625 applicable to the kind or kinds of insurance transacted by such insurer. . .
Section 624.404(1) Florida Statutes (1999). Some States require that companies calculate reserves in a particular way. See, e.g., Cal. Ins. Code Section 923.5 (1999). Some require reserves to include claim costs as well as indemnity dollars. See, e.g., N.Y. Ins. Law Section 1303 (1999).
Reserving is important for at least two reasons. One reason is it guards against the possibility a company will go broke and leave existing claims unpaid. Another reason is it makes the books of an insurance company more accurately show its financial condition. This is because money that likely will be paid out in the future cannot be carried as an asset.
In any determination of the financial condition of an insurer, liabilities to be charged against its assets shall include:
(1) The amount, estimated consistent with the provisions of this code, necessary to pay all of its unpaid losses and claims incurred on or prior to the date of the statement, whether reported or unreported, together with the adjustment or settlement thereof.
Section 625.041, Florida Statutes.
In any event, the practice of reserving is imbedded in the business of insurance. In bad faith litigation, the discovery and admissibility of the amount of loss reserves often is contested hotly. This is because plaintiffs can make hay with them in several ways.
Consider a first party case involving property loss. Imagine plaintiff contends the insurance company refused payment in reliance on a bogus coverage defense. If the reserves in that claim were high at or near policy limits – plaintiff will say to the jury: “See! The company knew it would have to pay it all in the end.” If the reserves in that claim were low, plaintiff will say: “Aha! The insurance company gave short shrift to my obviously valid claim just to make it’s books look better. More evidence of bad faith!”
Consider a third party case involving an excess judgment. Imagine plaintiff contends the insurance company should have settled within policy limits. If the reserves in that claim were high, plaintiff will say to the jury: “See! The company knew the injury was grievous but lowballed their offers anyway.” If the reserves in that claim were low, plaintiff will say: “Aha! The insurance company never took this matter seriously, and that’s how they got me into this mess.”
Commentators, courts and defense attorneys typically make three arguments against the admissibility at trial of loss reserves. Two are based on the rules of evidence. The other is based on public policy. In order of increasing persuasiveness, they are:
As this writer’s evidence professor observed with great force one cannot decide relevancy until one answers the question: “What are you trying to prove?” For example, if the matter to be proved is that an insurance company had notice of a claim, the fact that the company set reserves, in some amount, is both relevant and probative. See, e.g., Samson v. Transamerica Ins. Co., 636 P.2d 32 (Cal. 1981). Arguably, however, loss reserves are not relevant in a bad faith case.
To understand why loss reserves are not relevant in a bad faith case requires consideration of how reserves fit into the handling of the claim. Typically, reserves are set by line adjusters. Most companies train adjusters to establish a loss reserve amount immediately and to revisit the amount from time to time as he or she learns more about the claim. Thus, the loss reserve at the outset of a claim may be a guesstimate only. And, by the conclusion of a claim, the amount may have changed several times and become a very different number.
Moreover, a loss reserve may be calculated based on maximum exposure without regard to the strength of coverage or other defenses. Or it may be an average of actual payments made in the past on similar claims. It may or may not include claim costs, attorney fees and the like. It may or may not be adjusted for inflation over the expected time until payout. In other words, a loss reserve is a mutable thing. It may depend in part on the regulatory requirements of the particular state.
Federal Rule of Evidence 401 defines relevant evidence as “having any tendency to make the existence of any fact that is of consequence to the determination of the action more probable or less probable than it would be without the evidence.” When the “fact of. . . consequence” is whether the insurance company intentionally raised a bogus coverage defense when it denied a claim (the argument goes) the loss reserve mutable as it is, and calculated as it may be according to requirement of law has no tendency to prove the company’s state of mind on the defense.
The argument is the same when the “fact of. . . consequence” is whether the insurance company should have settled the claim within policy limits. “[A] reserve cannot accurately or fairly be equated with an admission of liability or the value of a particular claim.” In re Couch, 80 B.R. 512, 517 (S.D. Cal. 1987), citing Union Carbide Corp. v. Travelers Indemnity Co., 61 F.R.D. 411, 413 (W.D. Pa. 1973). A loss reserve simply is not a species of thing that bears on those issues.
Even assuming loss reserves may be relevant to a “fact of. . . consequence” in a bad faith case, they still ought not be admitted. Federal Rule of Evidence 403 provides:
Although relevant, evidence may be excluded if its probative value is substantially outweighed by the danger of unfair prejudice, confusion of the issues, or misleading the jury, or by considerations of undue delay, waste of time. . . [etc.]
The reasoning outlined above, to argue that loss reserves are not relevant, is more persuasive when used to argue that they have low probative value. They are squishy estimates, often prescribed by law; and “mere guesses. . . based on conservative accounting principles. . . . [T]he probative value [of the reserve], if any, is substantially outweighed by its prejudicial aspects.” Federal Realty Investment Trust v. Pacific Ins. Co., 760 F. Supp. 533, 540 (D. Md. 1991). Yes, a reserve is a number that has to do with the claim. But it does not really prove much else.
On the other hand, admission of loss reserves can be highly prejudicial and misleading. Plaintiffs spin the significance of the amount of a loss reserve, whether it be high or low, to suit the case. And it is human nature to attach importance to a number. A number seems to be objective or precise, regardless of how it relates to the issue presented. Thus, a jury is likely to give it too much weight.
Moreover, when a court admits evidence of a loss reserve, the consequence is confusion, undue delay and waste of time. This is because the insurance company then is compelled to rebut it. Doing so entails testimony from the adjuster about how he or she calculated the number; another witness to explain what a reserve is; judicial notice of statutes and regulations; publication to the jury of those statutes and regulations, and so on. All this substantially outweighs any small probative value of the evidence.
Perhaps the most adjuring reason why loss reserves should not be admissible in a bad faith case is the one least likely to be adopted by a trial court. It is the public policy (actually the policies) that admissibility tends to undermine – the policies that favor good faith reserving of money to pay losses. As discussed above, there are at least two important functions of reserving. And there are two policies furthered thereby.
It is an important function of insurance commissioners and departments of insurance periodically to audit insurance companies. That is one way they protect the insurance buying public. Thus arises one important policy: that insurance commissioners, departments of insurance, rating agencies and the general public see accurate books of accounting. When an adjuster sets a loss reserve with an eye on how it possibly could be used against the company in some future bad faith case, there can be no doubt the reserve will be compromised. This particularly is so in a first party claim, where the incentive will be to keep a reserve low.
The other public policy is the one that favors availability of money to pay claims. Here again, if the adjuster is distracted from the true purpose in setting a loss reserve, the danger is obvious. And, in this writer’s opinion, the danger is not speculative. Large verdicts against insurance companies in bad faith cases are of great interest and concern to claims persons. No one wants to be involved in such a case. No one wants his or her employer to be subjected to such a verdict.
The law of evidence has evolved in the past to foster social policy. For example, the rule against admitting subsequent remedial measures, codified as Federal Rule of Evidence 407, rests on the policy to not discourage people from taking steps in furtherance of safety. Similarly, evidence that a party paid or offered to pay medical expenses for an injury is inadmissible to prove liability for the injury. Federal Rule of Evidence 409. The same kind of thinking is applicable to the admissibility of loss reserves.
There is no good reason to admit evidence of loss reserves in a bad faith case. The amount of a reserve is neither relevant nor probative. Plus, it injects needless time wastage into a trial. Finally, the important public policies served by candid setting of reserves are thwarted when those reserves are used as a weapon against the company.