Summer, 1999

CLAIM LAW UPDATE

FIRST PARTY INSURANCE:
BAD FAITH

[Ref: Avoiding Bad Faith, Paras. 5.11 & 5.12; Liability Insurance Principles,
Paras. 128 & 129; and Loss Adjustment and Subrogation, Para. 326.]

First party insurance reimburses the insured for bodily injury or damage to insured property covered by the insurance policy. First party bad faith claims are brought by insureds when they feel the insurer has unfairly denied or delayed payment. Historically,since the insurance policy is a contract, theinsured’sremedy against the insurer was limited to breach of contract and traditional principles of contract law limited the damages recoverable to the amount the insured should have recovered under the policy. In many instances, the insured was denied recovery of any consequential (or “extra-contractual”) damages such as emotional distress or attorney’s fees resulting from the insurer’s failure or delay in making payment under the insurance policy.

This limit on recovery of consequential damages for breach of contract has given way to other theories of liability against the insurer. Plaintiffs have argued, and many courts have held, that the insurance policy is a unique contract requiring a unique remedy for its breach. And so, the tort of first party bad faith was created. This article will present an overview of first party bad faith and how it differs in application from the original contract remedy. It will also review statutes that have been enacted in some states to specifically control the bad faith cause of action.

A REMEDY BASED IN CONTRACT

A minority of jurisdictions, following the common law approach, regard bad faith strictly as a breach of contract. The difference between the historical contract remedy and the modern contract remedy is in the damages recoverable. Of the jurisdictions that recognize first party bad faith solely as a breach of contract, few of them limit recovery to policy amounts. Rather, under this modern approach, damages are broadly determined by what was reasonably foreseeable to the parties at the time of contracting. For example, in Billings v. Union Bankers Insurance Company, 918 P2d 461 (1996), the Supreme Court of Utah quoted from one of its previous holdings:

This court observed that although it had rejected the tort approach, the measure of damages that the law makes available for breach of the implied covenant should not ignore the principal reason for other courts’ adoption of the tort approach, i.e., to remove any incentive for insurers to breach the duty of good faith by expanding their exposure to damages caused by such a breach beyond the predictable fixed dollar amount of coverage provided by the policy. In furtherance of this purpose, we departed from the restrictive traditional contract damages approach and followed a course more closely aligned with a tort damages approach. This court concluded that a first party insurer who breaches the implied covenant by unreasonably denying the insured the benefits bargained for may be held liable for broad consequential damages foreseeably caused by the breach, damages which might include those for mental anguish and which would be closely analogous to those available in states taking a tort approach.

Maine too allows expanded contract damages to the insured in the event an insurer breaches its contractual duty to act in good faith. This would include full general and consequential damages, but the Supreme Judicial Court of Maine specifically precluded recovery of damages for emotional distress and punitive damages. In Marquis v. Farm Family Mutual Insurance Co., 628 A2d 644 (1993) the court said:

As a general rule, in order to recover for emotional distress suffered as a result of a breach of contract, the plaintiff must suffer some accompanying physical injury, or the contract must be such that a breach of it will result in a serious emotional disturbance, such as contracts for the carriage or proper disposition of dead bodies, and contracts for the delivery of messages concerning death. Since the plaintiffs did not suffer any physical injury, and since an insurance contract is not one of those special types of contracts warranting damages for emotional distress, we conclude that the lower court correctly dismissed the plaintiff’s request for such damages in this contract action.

With respect to punitive damages the Marquis court said:

In view of the broad range of compensatory damages available in a contract action and in view of the statutorily provided remedies of interest on the judgment and attorney fees, we believe sufficient motivation exists to stifle an insurer’s bad faith tendencies without the further imposition of the specter of punitive damages under an independent tort cause of action.

In both tort and contract actions, liability beyond the policy limit can result from unreasonable delay or denial if the basis for the delay or denial wasn’t, at least, fairly debatable. But, the distinction between the traditional remedies for breach of contract and the independent tort action for first party bad faith still remains significant because in many states breach of contract will still not give rise to either emotional distress or punitive damages.

WHAT IS THE TORT OF BAD FAITH?

The starting point for first party bad faith is the landmark decision of the Supreme Court of California in Gruenberg v. Aetna Insurance Co., 510 P2d 1032 (1973). In deciding whether benefits were owed under a fire insurance policy, the court cited the principle that there is an implied covenant of good faith and fair dealing in all contracts of insurance. Explaining its willingness to recognize a bad faith tort cause of action in the first-party context, the court stated:

The insurer has an obligation imposed by law to act fairly and in good faith in discharging its contractual responsibilities. Where the insurer 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 the implied covenant of good faith and fair dealing.

The court noted that the insured had alleged damages for mental distress in addition to substantial damages for loss of property. The court held that a tort measure of damages should apply and that consequential damages for mental distress, as well as economic loss (in excess of the policy limit), would be available.

The Gruenberg court also held that an insurer breaches the implied covenant of good faith where its conduct in refusing to pay a valid claim is found “unreasonable.”Based on this holding, bad faith in the first party context can be established by proving that the insurer’s conduct (with respect to claim denial or payment delay) was merely negligent.

The negligence standard has also been followed in Ohio in Zoppo v. Homestead Insurance Company, 644 NE2d 397 (1994). Donald Zoppo owned Windy’s Bar Restaurant which was destroyed by an incendiary fire. At the time of the fire, Zoppo had an insurance contract with Homestead Insurance Company. Following its investigation, Homestead denied coverage to Zoppo. Homestead concluded that there was sufficient evidence that Zoppo had participated in setting the fire. Zoppo then brought suit against Homestead for breach of the insurance contract and for the tort of bad faith. The insurer argued that bad faith requires intentional conduct on the part of the insurer. The Ohio Supreme Court disagreed and held that actual intent is not an element of the tort of bad faith. The court held that an insurer is liable for bad faith when its decision is based on circumstances which do not furnish a reasonable justification for denial.

In both of these cases, the degree of wrongful conduct required to prove insurer bad faith appears to be nothing more than common law negligence. Simply stated, if a reasonable insurer would not have denied or delayed payment of the claim under the same facts as the defendant insurer did, then the defendant insurer acted in bad faith.

The negligence standard for first party bad faith actions has also been followed in:

Colorado -- Farmers Group v. Trimble, 691 P2d 1138 (1984)

North Dakota -- Seifert v. Farmers Union Mutual Ins. Co., 497 NW2d 694 (1993)

South Carolina -- Nichols v. State Farm, 306 SE2d 616 (1983)

Washington -- Safeco v. JMG Restaurants, 680 P2d 409 (1984)

Most states which have recognized a separate tort of first party bad faith require more than mere negligent conduct by the insurer. In Anderson v. Continental Insurance Company, 271 NW2d 368 (1978), the Wisconsin Supreme Court said:

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.

Despite the Anderson court’s specific reference to the tort as one which requires intentional misconduct, a fair reading of the entire case supports the proposition that recovery under the new tort would be permitted when it is shown that there was no reasonable basis for denying the claim and that at least one of two possible culpable states of mind exist. First, as in a traditional intentional tort context, if the insurer knows that there is no reasonable basis for denying the claim, the insurer is liable for intentionally violating the insured’s rights. Second, if the insurer is aware of facts that should cause it to realize that there is a very high probability that there is no reasonable basis for denying the claim, it is also liable for that conduct. To disregard such facts and their meaning would constitute the conscious indifference that forms the basis for the reckless conduct mentioned by the court. This standard requires, at a minimum, reckless conduct, which is a greater degree of fault than negligence.

The majority of jurisdictions recognizing the tort of first party bad faith adhere to the more stringent standard set forth in Anderson:

Alabama -- Coleman v. Gulf Life Ins. Co., 514 So2d 944 (1987)

Alaska -- Hillman v. Nationwide Mutual, 855 P2d 1321 (1993)

Arizona -- Lasma Corp. v. Monarch Ins. Co., 764 P2d 1118 (1987)

Arkansas -- First Marine Ins. Co. v. Booth, 876 SW2d 255 (1994)

District of Columbia -- Washington v. Group Hospitalization, 585 F. Supp. 517 (D.D.C. 1984)

Hawaii -- Best Place Inc. v. Penn America Ins. Co., 920 P2d 334 (1996)

Idaho -- White v. Unigard, 730 P2d 1014 (1986)

Indiana -- Erie Ins. Co. v. Hickman, 622 NE2d 515 (1993)

Iowa -- Kiner v. Reliance, 463 NW2d 9 (1990)

Mississippi -- Pioneer Life Ins. Co. v. Moss, 513 So2d 927 (1987)

Nebraska -- Braesch v. Union Ins. Co., 464 NW2d 769 (1991)

New Jersey -- Pickett v. Lloyd’s, 621 A2d 445 (1993)

New Mexico -- Jessen v. National Excess Ins. Co., 776 P2d 1244 (1989)

South Dakota -- Mitzel v. Employers Ins. of Wausau, 878 F2d 233 (8th Cir. 1989)

Vermont -- Bushey v. Allstate, 670 A2d 807 (1995)

Virginia -- Yow v. American Home Assurance, 606 F. Supp. 3 (E.D.Va. 1979)

Wyoming -- McCullough v. Golden Rule Ins. Co., 789 P2d 855 (1990)

Regardless of which standard applies, an insurer may deny a claim without incurring tort liability for bad faith as long as the issue of coverage is fairly debatable. Generally speaking, courts have decided that a mistake is not bad faith if it arises from a reasonable position, even though litigation may prove the insurer’s position wrong. The issue of an insurer’s bad faith should not focus on whether the underlying claim is ultimately held to be valid. Instead, the focus should be on the insurer’s conduct and the basis for its decision to deny the claim. An insurer has the right to deny claims it decides are unfounded and should not be subject to bad faith liability for an error in judgment in making that decision. When an insurer discharges its duty of ordinary care and reasonable diligence to investigate and evaluate a claim and determines that the claim is fairly debatable, that is, a question of law or fact must be decided in order to determine the claim’s validity, the insurer is entitled to debate or litigate the claim. While a jury may still find in favor of the insured in the underlying action for contract benefits, that should not automatically subject the insurer to bad faith liability as well.

In determining whether a claim denial is reasonable, a court must examine the information available to the insurer at the time of its denial. If a reasonable argument to support denial exists, the claim is said to be fairly debatable and thus, an insurer cannot be liable for the tort of bad faith. For example, where appellate courts in a jurisdiction have rendered conflicting opinions on a coverage issue, that issue is said to be fairly debatable. Until the supreme court of the state resolves the conflict, insurers cannot be held liable for bad faith if they rely on an appellate court opinion which supports denial of the claim.

Van Holt v. Liberty Mutual Fire Ins. Co., 163 F3rd 161 (3d Cir. 1998), involved a factual rather than a legal dispute. The insurer denied a claim on a flood insurance policy on the grounds that it was fraudulent. The insureds sued for bad faith denial of benefits. The insurer’s investigation had uncovered evidence that the insureds had overstated the claim. While the insureds denied the allegations of fraud, they did not submit any evidence to show that the insurer lacked a reasonable basis for its denial. The court held that “it was at least fairly debatable that the Van Holts intentionally misrepresented the extent of their claimed losses.” Since the issue was fairly debatable, there was no bad faith on the part of the insurer.

In Radecki v. Mutual of Omaha Insurance Company, 583 NW 2d 320 (Neb. 1998), a case involving a claim for long term disability benefits, the Supreme Court of Nebraska upheld a trial court’s application of the fairly debatable rule to bar a bad faith recovery. The Nebraska Supreme Court explained the requirements for the cause of action as follows:

In order to establish a claim for bad faith, a plaintiff must show an absence of a reasonable basis for denying the benefits of the insurance policy and the insurer’s knowledge or reckless disregard of the lack of a reasonable basis for denying the claim.

If a reasonable basis for denial actually exists, the insurer cannot be held liable in an action based on the tort of bad faith.

STATUTORY BAD FAITH

An insured may also or aternatively have a cause of action against the insurer for bad faith based on statute. The purpose of the statute must be determined, though, because some statutes do not grant the insured a private cause of action against the insurer. Rather, some statutes merely call for administrative penalties to be assessed against the insurer by the state.

Some statutes do allow an insured to bring a private cause of action against an insurer. A few of these statutes broadly prohibit bad faith conduct without specifically defining what constitutes bad faith. In this case, the state courts are left to define bad faith. Pennsylvania has enacted this type of statute (42 Pa. C.S.A. § 8371), which permits, under specified circumstances, punitive damages and attorney’s fees.

Many states have statutes which specifically define unfair claims practices, and which are referred to as “Unfair Claims Settlement Practices Acts.” When adopting such an act, a state legislature has the option of creating a private cause of action. For example, the Florida legislature enacted Fla. Stat. Section 624.155 which expressly authorizes a private civil action for damages against an insurer who commits various unfair claims settlement practices. The Florida statute provides for compensatory damages (damages proximately caused by the insurer’s bad faith), and in appropriate circumstances, punitive damages. If a statute does not expressly allow a private cause of action, a majority of states hold that such a statute does not create a private cause of action. However, a few state courts, including Texas, have implied a private cause of action.

Texas has had a rather unique combination of common law and statutory remedies. It has been said that the Texas Insurance Code and the Deceptive Trade Practices Act are “in large measure statutory fleshings- out of the already existing common law requirements,” and, according to the Texas Supreme Court in Universe Life Ins. Co. v. Giles, 950 SW2d (1997), Texas has now adopted the statutory standard for bad faith. Under the Texas standard courts will inquire if “the insurer knew or should have known that it was reasonably clear that the claim was covered.” In Robert Douglas v. State Farm Lloyds, SW2d (1999), the court held that under this standard the insurer acted in good faith because a difference of opinion among appellate courts in Texas on a homeowners policy exclusion made the issue fairly debatable and State Farm’s actions reasonable in denying coverage.

Another type of statute addressing insurer bad faith grants attorney’s fees and penalties if an insurer engages in unreasonable claims practices. These statutes usually assess a monetary penalty if the insurer acted “unreasonably” in denying a claim. For example, Illinois Rev. Stat. Ch. 73 § 767, grants the court authority to award attorneys’ fees and penalties if the insurer’s denial or delay is “vexatious and unreasonable.”

Where a statute addressing insurer bad faith exists, particular attention must be paid to the statutory criteria and the judicial interpretation of the statute.

CONCLUSION

There is no doubt that allegations of bad faith will continue to have a significant impact even though insurance professionals strive to apply sound judgment in evaluating claims. Support of denials or delays in payment based on the applicable good faith principles required in the jurisdiction, however, remains the best defense.

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