REPORTS AND ARTICLES

Bad Faith and Excess Liability -- 
Insurer Conduct on Trial

By Robert J. Prahl, CPCU
Director of Education
American Association of Insurance Services (AAIS), Wheaton, IL 

Bad faith claims continue to be of serious concern to insurers, and cannot only adversely affect their loss ratios, but their reputations as well. The following article provides an explanation of bad faith and examines insurer conduct that can lead to bad faith claims. It also identifies steps that insurers can take to avoid or minimize the chances that its conduct will result in such claims.

What is Bad Faith? 
It is a general rule that every contract implies the exercise of good faith and fair dealing between the parties to the contract -- that neither party will do anything that impairs the right of the other to receive the benefits of the agreement. Good faith simply means that each party places its faith and trust in the other to fulfill the terms of the contract. The failure of either party to fulfill its obligation is referred to as bad faith. Since an insurance policy is a contract, the same general rule applies to insurance policies. The implied covenant of good faith does not arise out of the policy itself, but is a legally recognized principle apart from the policy. 

Bad faith claims can result from an attempt by an insurer to avoid paying a justified claim. They involve an insurance company and its insured and arise out of the handling of the claim. Bad faith can arise from the handling of a first-party claim or a third-party claim. In a first party property claim, it might involve deliberate concealment on the part of the insurer of a coverage that might be available to the insured, or the wrongful denial of coverage. In a third party liability claim, it may involve an insurer's failure to protect the insured by not settling a lawsuit within the liability limits, resulting in a trial verdict for the plaintiff in excess of those limits. The insured would ordinarily be personally responsible for the amount of the verdict or award in excess of the policy limits. 

In a bad faith case, the company's conduct is really on trial, more so than its actual decision or the particular coverage question that might have led to the bad faith claim. Thus, the insurer's claim handling, not the policy itself, is the basis for the claim or suit. In a bad faith claim, the insurer is faced with liability beyond that represented by the policy limits, and because of this, bad faith claims are said to be claims involving extra-contractual liability. 

It can be said that bad faith is to insurance companies what products liability is to manufacturers and malpractice is to professionals. 

The subject of bad faith got the attention of the industry rather dramatically not too long ago with the case of Ballard v. Farmers Insurance Company ¹ , in which a Texas court awarded the plaintiff $32 million in a suit involving mold damage. The lion's share of the award was not for mold damage, but rather for bad faith, despite what contrary impressions the media may have conveyed. The concept of bad faith is particularly attractive to plaintiff's attorneys, because recoveries against insurers usually result in awards in excess of policy limits, as was the situation in the Ballard case. Ordinarily, there must be a showing of malice, fraud, or oppression on the insurer's part before punitive damages² will be awarded. 

A good rule of thumb for insurers to keep in mind in order to avoid claims of bad faith is that when handling a claim, an insurer must place its insured's interest on at least an equal footing with its own. If the insurer fails to do this, a bad faith claim, including an award for punitive damages, could result.

Since an award for bad faith can substantially exceed the policy limits and include punitive damages, plaintiff attorneys often add a count or claim for bad faith in lawsuits involving coverage disputes. The real money in these suits is in extra-contractual damages.

Broad Interest in the Subject

In order to demonstrate the widespread interest in this topic, a search of one Web site, keying in "Bad faith in insurance," produced well over 149,000 hits. As might be expected, many of the hits linked to plaintiff's law firms. 

One hit accessed a site titled "Fight Bad-faith Insurance Companies" (FBIC), which while unmistakably critical from an industry perspective, nevertheless, demonstrates what the industry is up against. It contains a ranking of insurance companies by non-payment vs. payment of claims. The former group represents what FBIC refers to as the bad faith insurers while the latter represents companies exhibiting good faith claim handling. The rankings are based on State Department of Insurance complaint ratios, state and federal court records, FBIC "Bad Faith Survey" of consumer complaints, and other consumer complaint and research information. FBIC acknowledges that the rankings are subject to change from year to year.


As of January 2003, the top five rankings for the best insurers, according to FBIC, are:

Good Faith Insurers

1. Amica Mutual
2. Chubb Companies
3. Allianz
4. W. R. Berkley
5. State Auto

Visitors to this site may also view the rankings of more than 100 insurers with notes and details. (www.badfaithinsurance.org)

Sources of Bad Faith 

An insurer can commit bad faith in several ways. They might include: failing to promptly and thoroughly investigate a claim; denying claims or coverage without justifiable reasons; unreasonably delaying payment; unreasonably interpreting a coverage provision; or refusing to settle a claim. Taking a proactive approach to claim handling by conducting the fundamental steps of investigation, evaluation, and disposition of the claim in a thorough and timely manner can help avoid problems. 

Specifically, the following areas of claim handling are potential sources of bad faith:

Investigation -- The investigation of a claim (both first and third party claims) must be complete and thorough concerning both the liability question and the damages aspect. Since the claim file itself is ordinarily discoverable (which means the plaintiff attorney can get access to it in litigation), the file should be as complete as reasonably possible. This doesn't mean that every file requires an intensive, elaborate investigation, but it does mean that sufficient information must be obtained to allow the claim person to make an intelligent decision based on the facts.

In a bad faith action, the plaintiff (insured, in most cases) is claiming that the insurer committed a serious error and was neglectful or even fraudulent in the handling of the claim, which caused the insured to sustain damages. If the claim file is incomplete, it may demonstrate proof of an inadequate investigation and a failure on the insurer's part to protect properly its insured's interest. In short, the insurer's decision concerning the handling of the claim must be supported by the claim file.

Settlement Negotiations -- Another possible source of bad faith is the conduct of settlement negotiations, particularly with regard to third party liability claims. Discussions with the plaintiff's attorney must be documented in the file. The adjuster must respond promptly to all demands of plaintiff's counsel and the response should be in writing. If the attorney makes a demand and the claim file is not complete, the attorney must be advised of what information is lacking and required from him or her.

On occasion, a plaintiff's attorney will send an adjuster a demand letter and place a time limit on the demand. When this occurs, the adjuster must respond to the attorney within the time designated. This is not to say that the adjuster must make an offer if there is insufficient information in the file, but he or she must respond, if only to ask for an extension of time in order to complete the file. Ignoring such a deadline could prove damaging to the insurer.

In order to avoid bad faith, an adjuster should respond in writing to such demands. Otherwise, if the claim goes to trial and there is an excess verdict, the plaintiff's attorney can assert that the company had an opportunity to settle the claim, but ignored it and forced the matter to trial. This could constitute bad faith on the company's part for ignoring the opportunity to settle.

Inadequate Defense -- Occasionally insurers may be uncertain regarding whether coverage applies until the outcome of the trial. If an insurer simply refuses to defend a claim involving a question of coverage, it may subject itself to a bad faith claim, including an award for punitive damages. In these situations, insurers ordinarily will defend the insured under a reservation of rights or nonwaiver agreement. This approach notifies the insured that a coverage question exists and that the insurer accepts the claim, but reserves the right under the policy to deny coverage should investigation reveal that coverage does not apply. An insurer's failure to reserve its rights under these circumstances will prohibit it from denying a claim after completion of the trial when the facts reveal that no coverage actually applied.

Unfair Claim Practices Acts -- Unfair claim practices acts, in effect in virtually all states, address many aspects of claim handling, including an insurer's responsibility for prompt communications with its insureds, adequate investigation, detailed explanations of coverage denials, and so on. Generally, such laws require that insurers handle claims promptly, which means prompt investigations, evaluation and, where warranted, prompt settlement. Ordinarily, if an insurer is found to have violated a provision of an unfair claim practices law with such frequency as to indicate a general business practice, penalties can be assessed against it by the state insurance department. 
Although the provisions of such an act generally do not permit a claimant to sue an insurer for the violation of the act, some states permit a claimant to bring a separate tort action for bad faith directly against an insurer.

Claim File Reporting -- Claim adjusters can unwittingly make written or electronic remarks in a paper or electronic claim file which may come back to haunt them in the event the file is later subpoenaed in a bad faith suit. Claim people need to refrain from making derogatory, personal, or unprofessional comments in the claim file. Such comments can be damaging and costly to the company as well as personally embarrassing to the adjuster who made them.

Examples of remarks that might have appeared in a claim file and which should be avoided are:

• "I can save on the policy limits."

• "I will pay this under Medical Payments coverage and forget about the uninsured motorists claim because the medical bills will satisfy the insured."

• "Mr. Claimant, if you retain an attorney, you'll have to wait a few years for a recovery and it will cost you at least one-third of the proceeds."

Personal comments of a derogatory nature about a claimant, insured, doctor, or lawyer must be avoided. Claim people should keep in mind the thought that someday the comment put in the file may be read back while its author is on the witness stand in a bad faith trial. Common courtesy and common sense can avoid this potentially dangerous source of bad faith litigation. It is dangerous to editorialize or emotionalize; comments should be confined to the facts.

Additional sources of bad faith include: wrongful denial of coverage (or inadequate explanation of the denial); unreasonable delay in the handling of a claim regarding decisions on coverage, liability, or damages; misrepresentation of coverage (or failure to advise of a specific coverage that may be available); and unreasonable settlement offers designed to "low ball" or underpay a claim.

Discovery Process May Involve Claim Personnel

What happens when a bad faith suit is actually filed? Just what and whom is the plaintiff's attorney looking for? Soon after the complaint is filed, the attorney will begin the discovery process, usually with a request for the adjuster to answer interrogatories. The attorney will want to approach the company personnel who played any role in the handling of the claim. If the only name that surfaces is that of the adjuster, then it can be expected that the adjuster will eventually be subpoenaed, along with the claim file, and asked a number of questions. 
The questions asked of the adjuster in the interrogatories as well as in the depositions will involve not only the investigation of the claim, but also general claim procedures and the identity of other claim people (supervisors, managers, consultants, etc.,) who may have been involved with the claim.

It is at the time that depositions are taken when mistakes or misjudgments that the adjuster made several years earlier may resurface. It is at this time that the adjuster may wish that he or she had taken a little more time or exercised more care in completing the investigation. The fact that the adjuster might have been extremely busy back when the claim occurred and could not give it sufficient attention will not be much of an excuse some years later when that pressure is long removed. All of these problems can be avoided, but they must be avoided from the beginning. Once the act of bad faith is committed, it is too late; it is there forever. The emphasis needs to be on doing what is proper right from the start.

In a bad faith suit, the plaintiff's attorney will delve into the inner workings of the insurance company in an effort to learn what claim handling "standards" have been established by the company. Once those standards are determined, the attorney will try to show that the adjuster breached or failed to meet them.

In an effort to determine the standards, the attorney will subpoena claim manuals, training manuals, claim bulletins, and perhaps even pertinent memos of what the company requires and expects of its claim personnel. If there is a lack of written material in claim manuals, training guides, etc., the attorney may point to the absence of such information as evidence of bad faith in itself on the company's part for not giving sufficient guidance to its claim personnel. On the other hand, if claim and training manuals contain too much detail in regard to what is required of claim personnel, the company may have unintentionally created standards which, for the most part, are difficult to attain by most adjusters. In such a case, it may be rather easy for a plaintiff's attorney to show that an adjuster failed to meet the claim handling standards established by the company. For this reason, insurance companies should exercise care and discretion in creating their claim and training manuals.

With that in mind, it is probably good advice to make claim manuals simple and clear and include language to the effect that the content and procedures outlined are to be viewed as aids and suggestions, not cast in stone rules. For example, one company maintains a fairly comprehensive claim manual, but includes the following introductory paragraph:

Comparative Bad Faith
An emerging concept is that of "comparative bad faith," in which an insurer asserts that the conduct of an insured caused or contributed to the injury or damage, and that fault should be apportioned among the parties. More and more insurers have attempted to limit damages in a bad faith action by contending that their insureds have failed to fulfill the duty of good faith and fair dealing. Examples of where this approach may be applicable might be where an insured impedes the insurer's ability to investigate a claim, commits fraud, exaggerates a first party claim, or fails to cooperate in the defense of a lawsuit. 

Another situation where a comparative bad faith defense may be imposed could involve a business firm with a self-insured retention (SIR). Such firms ordinarily maintain a risk management staff that provides loss prevention and risk management services, assists with obtaining the necessary insurance, and directly or indirectly conducts the claims handling function. If the insured firm fails to settle a claim within the retention, and a judgment is awarded in excess of the SIR, the insurer may be able to take the position that the insured acted in bad faith and should be responsible for the excess amount. 

A potential extension of the comparative bad faith defense is the concept of reverse bad faith. Reverse bad faith involves a claim or counterclaim by an insurer that seeks a recovery against the insured for breaching the duty of good faith and fair dealing.

Although it appears that the doctrine of comparative bad faith is receiving increased acceptance, the doctrine of reverse bad faith apparently is not. Typically, courts take the position that allowing a reverse bad faith action by an insurer fails to compensate an insured for its unequal bargaining power in the insurance process. 

Conclusion

Bad faith claims are a real danger to insurers. Though it is true that the doctrine of comparative bad faith may be leveling the playing field somewhat, recovery is still being made against insurance companies and individual company employees for both compensatory and punitive damages. A company, however, can protect itself by avoiding placing itself in bad faith situations. To avoid bad faith, companies must engage in careful, thorough, professional claim handling. Training, communication, and particularly continuing supervision of investigation, settlement evaluations/negotiations, and applicable law by the appropriate claim personnel are vital to this goal. The key is to recognize potential problems early, and to obtain the thinking and support of claim management so that the best possible course of action can be taken right from the start.

1. In December, 2002, the Texas Court of Appeals reduced the $32 million award in 
   the Ballard case to $4 million. The court concluded that there was no evidence of unconscionability or fraud on the part of the insurer, nor did it believe the insurer breached its duty of good faith and fair dealing toward the plaintiff.
   
   Keep in mind, however, that it is a fairly common practice in coverage litigation for plaintiff's attorneys to allege bad faith in hopes that there will be grounds for extra-contractual damages, specifically punitive damages. Although the reduced award was a good result for the insurer, the initial bad press it received when the case was first tried damaged its reputation considerably (even though it may have been temporary), to say nothing of the legal expenses it incurred to defend and appeal this case. It is clearly in the best interest of insurers (and the industry) to actively practice good faith claim handling and avoid the damage to their pocketbooks as well as their reputations that can result from a bad faith award.
   

2.  Punitive damages or exemplary (to make an example of) damages are designed 
   to punish a wrongdoer and to provide an incentive not to pursue similar behavior or conduct in the future. Generally, liability policies do not exclude claims for punitive damages, but exclusionary endorsements are available in several states. Whether punitive damages are recoverable, and whether they are insurable, depends on the particular state involved. In some states, recovery for punitive damages is allowed, but such damages are not insurable. One line of reasoning in states in which punitive damages are not insurable is that to make such damages insurable defeats their purpose of punishing the wrongdoer by allowing the wrongdoer to transfer responsibility to an insurer. However, in many states, such damages are insurable.
   
   State-by-state positions on the insurability of punitive damages are available in various insurance publications and on the Internet.