AAIS COVERAGE PERSPECTIVE
By Robert J. Prahl, CPCU
Insurance company conduct on trial!
Bad faith claims continue to be of serious concern to insurers and can
adversely affect not only their loss ratios, but their reputations as well.
The subject of bad faith got the industry's attention not too long ago with the case of Ballard v. Farmers Insurance Company, in which a Texas court awarded the plaintiff $32 million in a suit involving a claim for mold damage. The lion's share of the award was not for mold damage but rather for bad faith, despite 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 damages will be awarded.
This 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 their 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 may be considered bad faith. Because 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 insurer's handling of the claim. Bad faith can be alleged in the handling of a first-party claim or a third-party claim. In a first-party property claim, bad faith might involve an insurer's deliberate concealment of a coverage that might be available to the insured, or the wrongful denial of coverage. In a third-party liability claim, bad faith 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.
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, so 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.
To avoid allegations of bad faith in the handling of 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.
Because an award for bad faith can substantially exceed the policy limits and include punitive damages, plaintiff's 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
As evidence of the widespread interest in this topic, a search of the Web, 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 insurance industry perspective, nevertheless demonstrates what the industry is up against. The site contains a ranking of insurance companies by nonpayment 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, an 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 allegations
An insurer can commit bad faith in several ways, including: failing to promptly and thoroughly investigate a claim; denying a claim or coverage without justifiable reasons; unreasonably delaying payment; unreasonably interpreting or failing to advise of a specific coverage provision that may be available; or making an unreasonable settlement offer intended to "lowball" or underpay a claim.
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 the company has established. 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 the like. 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, the company may have unintentionally created standards that are difficult for most adjusters to attain. In such a case, it may be fairly 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, insurers should exercise care and discretion in creating their claim and training manuals.
With that in mind, one insurer maintains a fairly comprehensive claim manual but includes the following introductory paragraph:
This manual should be used as a general guide in your claim handling. We acknowledge the reality that the manual may not be followed, either entirely or partially, in every situation. At times, it will be necessary for you to use your judgment and common sense as your primary guide or as a complement to the guidelines set forth in this manual. In all cases, your own judgment, experience, and common sense are guides that you should utilize in handling the many types of claims that may arise.
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 failed to fulfill the duty of good faith and fair dealing. This approach may be used when, for example, 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 used involves 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 performs 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 the doctrine of comparative bad faith appears to be gaining 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.
Avoiding the danger
Bad faith claims are a real danger to insurers. Although 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 can protect itself, however, by practicing 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 achieving 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.
Update on Ballard
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 the hope 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 (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.
Punitive damages or exemplary (to make an example of) damages are intended to punish a wrongdoer and to provide an incentive not to engage in similar behavior or conduct in the future. Liability policies generally 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 do so defeats their purpose of punishing the wrongdoer by allowing the wrongdoer to transfer responsibility to an insurer. In many states, however, such damages are insurable.
State-by-state positions on the insurability of punitive damages are available in various insurance publications and on the Internet. *
The author
Robert J. Prahl, CPCU, is director of education for the American Association of Insurance Services.