Insurance bad faith
Insurance bad faith is a tort unique to the law of the United States that an insurance company commits by violating the "implied covenant of good faith and fair dealing" which automatically exists by operation of law in every insurance contract. If an insurance company violates the implied covenant, the insured person may sue the company on a tort claim in addition to a standard breach of contract claim. The contract-tort distinction is significant because as a matter of public policy, punitive or exemplary damages are unavailable for contract claims, but are available for tort claims. In addition, consequential damages for breach of contract are traditionally subject to certain constraints not applicable to compensatory damages in tort actions. The result is that a plaintiff in an insurance bad faith case may be able to recover an amount larger than the original face value of the policy, if the insurance company's conduct was particularly egregious.
Historical background
Most laws regulating the insurance industry in the United States are state-specific. In 1869, the Supreme Court of the United States held, in Paul v. Virginia, that the United States Congress did not have the authority to regulate insurance under its power to regulate commerce.In the 1930s and 1940s, a number of U.S. Supreme Court decisions broadened the interpretation of the Commerce Clause in various ways, which led the U.S. Supreme Court to hold that federal jurisdiction over interstate commerce did extend to insurance in United States v. South-Eastern Underwriters Ass'n. In March 1945, the United States Congress expressly reaffirmed its support for state-based insurance regulation by passing the McCarran–Ferguson Act which held that no law that Congress passed should be construed to invalidate, impair or supersede any law enacted by a state regarding insurance. As a result, nearly all regulation of insurance continues to take place at the state level.
Such regulation generally comes in two forms. First, each state has an "insurance code" or some similarly named statute which attempts to provide comprehensive regulation of the insurance industry and of insurance policies, a specialized type of contract. State insurance codes generally mandate specific procedural requirements for starting, financing, operating, and winding down insurance companies, and often require insurers to be overcapitalized to ensure that they have enough funds to pay claims if the state is hit by multiple natural and man-made disasters at the same time. There is usually a department of insurance or division of insurance responsible for implementing the state insurance code and enforcing its provisions in administrative proceedings against insurers.
Second, judicial interpretation of insurance contracts in disputes between policyholders and insurers takes place in the context of the aforementioned insurance-specific statutes as well as general contract law; the latter still exists only in the form of judge-made case law in most states. A few states like California and Georgia have gone farther and attempted to codify all of their contract law into statutory law.
Early insurance contracts were considered to be contracts like any other, but first English, and then American, courts recognized that insurers occupy a special role in society by virtue of their express or implied promise of peace of mind, as well as the severe vulnerability of insureds at the time they actually make claims. The key point of divergence between the United States and England on this issue is that unlike American courts, English courts have consistently refused to go further and broadly extend the duty of utmost good faith from the pre-contract period into the post-contract period.
In turn, the development of the modern American cause of action for insurance bad faith can be traced to a landmark decision of the Supreme Court of California in 1958: Comunale v. Traders & General Ins. Co. ''Comunale was in the context of third-party liability insurance, but California later expanded the same rule in 1973 to first-party fire insurance in another landmark decision, Gruenberg v. Aetna Ins. Co.
During the 1970s, insurers argued that these early cases should be read as holding that it was bad faith to deny a claim only when the insurer already knew that it had no reasonable basis for denying the claim. In other words, they contended that intentional mistreatment of an insured should be actionable in bad faith, but not claims handling which at most was grossly negligent. In 1979, California's highest court refuted that argument and further expanded the scope of the tort by holding that inadequate investigation'' of a claim was actionable in tort as a breach of the implied covenant of good faith and fair dealing.
Other state courts began to follow California's lead and held that a tort claim exists for policyholders that can establish bad faith on the part of insurance carriers. By 2012, at least 46 states had recognized third-party bad faith as an independent tort, and at least 31 states had recognized first-party bad faith as an independent tort. A few states like New Jersey and Pennsylvania declined to allow tort claims for first-party insurance bad faith and instead allowed policyholders to recover broader damages for breach of contract against first-party insurers, including punitive damages.
Bad faith defined
An insurance company has many duties to its policyholders. The kinds of applicable duties vary depending upon whether the claim is considered to be "first party" or "third party." Bad faith can occur in either situation—by improperly refusing to defend a lawsuit or by improperly refusing to pay a judgment or settlement of a covered lawsuit.Bad faith is a fluid concept and is defined primarily by court decisions in case law. Examples of bad faith include undue delay in handling claims, inadequate investigation, refusal to defend a lawsuit, threats against an insured, refusing to make a reasonable settlement offer, failing to inform the insured of a settlement offer, or adopting an unreasonable interpretation of the insurance policy. A majority of states require intentional wrongdoing by the insurer. A minority of states allow negligence to serve as a predicate for bad faith liability.
First party
A common first party context is when an insurance company writes insurance on property that becomes damaged, such as a house or an automobile. In that case, the company is required to investigate the damage, determine whether the damage is covered, and pay the proper value for the damaged property. Bad faith in first party contexts often involves the insurance carrier's improper investigation and valuation of the damaged property. Bad faith can also arise in the context of first party coverage for personal injury such as health or life insurance, but those cases tend to be rare. Most of them are preempted by ERISA.Third party
Third party situations break down into at least two distinct duties, both of which must be fulfilled in good faith. First, the insurance carrier usually has a duty to defend a claim even if some or most of the lawsuit is not covered by the insurance policy. Unless the policy is expressly structured so that defense costs "eat away" at the policy limits, the default rule is that the insurer must cover all defense costs regardless of the actual limit of coverage. In one of the most famous decisions of his career, Justice Stanley Mosk wrote:Texas follow an "eight-corners rule" under which the duty to defend is strictly governed by the "eight corners" of two documents: the complaint against the insured and the insurance policy. In many other states, including California and New York, the duty to defend is ascertained by also looking to all facts known to the insurer from any source; if those facts when read together with the complaint show that at least one claim is potentially covered, the duty to defend is thereby triggered and the insurer must undertake the defense of its insured. This powerful bias in favor of finding coverage is one of the major innovations of U.S. law. Other common law jurisdictions outside of the U.S. continue to construe coverage much more narrowly.
Next, the insurer has a duty of indemnification, which is the duty to pay a judgment entered against the policyholder, up to the limit of coverage. However, unlike the duty to defend, the duty to indemnify exists only to the extent that the final judgment is for a covered act or omission, since by that point, there should be a clear factual record from trial or summary judgment in the plaintiff's favor revealing what portions of the plaintiff's claims are actually covered by the policy. Therefore, most insurance companies exercise a great deal of control over litigation.
In some jurisdictions, like California, third party coverage also contains a third duty, the duty to settle a reasonably clear claim against the policyholder within policy limits, in order to avoid the risk that the policyholder may be hit with a judgment in excess of the value of the policy. If the insurer breaches in bad faith its duties to defend, indemnify, and settle, it may be liable for the entire amount of any judgment obtained by a plaintiff against the policyholder, even if that amount is in excess of policy limits. This was the actual holding of the landmark Comunale case.