Requirement of Good Faith and Fair Dealing Imposed in Insurance Policies

Summary: Good faith and fair dealing form the basis for any contract of insurance. These requirements can leave insurers exposed to extra-contractual damages, including damages for pain and suffering, loss of use, emotional distress, and punitive damages, for its breach.

The tort of bad faith requires proof of the intentional failure by an insurer to perform the promises made by a policy of insurance in good faith and the failure to deal fairly and in good faith in its interactions with the insured. Generally, an insurer may be found to be acting in bad faith when it refuses to pay a claim and it can be proven that it (1) had no reasonable basis for refusing to pay, (2) had actual knowledge that there was no basis for its refusal to pay, or (3) intentionally failed to determine whether it had a reasonable basis for so refusing.

This area of insurance law has been developed by case law and statutory and regulatory action in almost all jurisdictions. Additionally, many states have recognized a common law tort action (the tort of bad faith in insurance transactions) for the violation of the duty of good faith and fair dealing. Cases establishing a tort of bad faith arose from claims where the insurer failed to handle property insurance claims in good faith, failed to reasonably settle liability claims within policy limits, an failed to tender a defense under the duty to defend.

This article examines the background and development of the tort of bad faith and examples of cases arising under the common and statutory law of various jurisdictions. It illustrates what actions by an insurer constitute examples of good faith and bad faith in insurance transactions.

Topics covered
Bad faith defined
The development of bad faith
Evolution of the concept
One state's evolution in bad faith law
The property cases—”reasonable basis'
Further refining bad faith
Bad faith in third-party situations
Reverse bad faith

Bad Faith Defined

All contracts have an implied covenant (or contractual promise) of good faith and fair dealing. All parties to contracts agree that they will do nothing to injure the right of other parties to receive the “fruits of the contract.” Before a court created the tort of bad faith, damages for the breach of this requirement of good faith and fair dealing were only contractual in nature; that is, the only damages provided for by the contract are available for its breach. The law will not, in most situations, broaden the damages available for breach of contract beyond those contemplated by the parties.

Unlike all other contracts, the promises made by an insurer when it issues a policy of insurance imposes a more stringent requirement that the insurer deal in good faith and fair dealing. Because the courts found contract damages to be inadequate they created a tort that allowed the insured who was dealt with in bad faith by an insurer, to recover tort damages in addition to the contract damages called for by the policy and the law. This more stringent requirement arises out of the importance of insurance to society (the public policy interest), and the general insurance concept of “contracts of adhesion” where the bargaining power of the parties is substantially disparate.

In a typical breach of contract claim, consequential and punitive damages are rarely, if ever, available to the aggrieved party. However, in a dispute on an insurance contract, these types of damages are available to parties who can prove that the insurance company in some way acted in bad faith in dealing with an insurance claim.

The violation of the duty of good faith and fair dealing is acting “in bad faith.” Bad faith, as a term of art in the legal community generally implies or involves “actual or constructive fraud, or a design to mislead or deceive another, or a neglect or refusal to fulfill some duty or some contractual obligation, not prompted by an honest mistake as to one's rights or duties, but by some interested or sinister motive. The term bad faith is not simply bad judgment or negligence, but rather it implies the conscious doing of a wrong because of dishonest purpose or moral obliquity; it is different from the negative idea of negligence in that it contemplates a state of mind affirmatively operating with furtive design or ill will.” (Black's Law Dictionary, 5th ed.) Insurance case law has softened the “ill will” or “conscious doing of wrong” into areas of more passive action, as is developed further in this article.

Courts have defined bad faith in differing language, often with synonymous meanings: “Bad faith is the intentional failure by an insurer to perform the duty of good faith and fair dealing implied at law” (Koch v. State Farm Fire & Casualty Co., 565 So. 2d 226 (Ala. 1990); and “An insurer's denial of coverage, without reasonable justification, constitutes bad faith (Whistman v. West Am, 686 P.2d 1086 (Wis. 1984).

The Development of Bad Faith

The tort of bad faith, when applied to the breach of a duty of good faith, is a fairly recent tort (second half of the 20th century). As seen later in this article, extra-contractual damages have been available to aggrieved insureds since the 1940s in the area of holding insurers responsible for excess judgments over policy limits in cases that the insurer refused to settle. In other words, the insurer could have reasonably settled within limits, but decided, at the insured's expense, to try their luck at trial. The development of bad faith principles in the handling of first-party claims and the awarding of punitive damages are of more recent origin, having developed in most jurisdictions during the 1980s.

The first state to hold that there is an independent tort action for the bad faith handling of claims in a first party context (i.e., for wrongful denial of a property claim), was California. In Gruenberg v. Aetna Ins. Co., 510 P.2d 1032 (1973), the insured owner of a cocktail lounge became involved in an argument with a firefighter at the scene of a fire at the insured's premises. He was arrested and subsequently charged with arson and defrauding an insurer.

Thereafter, the insurance company demanded in writing that the insured submit to sworn examination, a material condition precedent in the policy. The insured's lawyer informed the insurer that no statements would be forthcoming until the resolution of the arson charge. The insurer refused to delay the sworn examination and denied the loss for failure to comply with policy conditions since the Fifth Amendment to the U.S. Constitution applies only to governmental action, not the fulfillment of a contract requirement. The court dismissed the charges against the insured for lack of probable cause, and the insured informed the insurer that he would now comply with the examination request. The company reaffirmed the denial of coverage based on the insured's failure to appear.

The insured brought an action, stating that as a result of the outrageous conduct and bad faith of the insurer, he suffered economic damage, emotional distress, loss of earnings, and other damages. He sought compensatory and punitive damages. The trial court sustained a demurrer to the complaint finding that even if everything in the complaint was true, the insured, Gruenberg, had not timely submitted to an examination under oath (EUO) and Gruenberg appealed.

The California Supreme Court, in a case of first impression, found that the insured had stated a cause of action. The Supreme Court held that Aetna's refusal (without proper cause) gave rise to a tort cause of action for breach of an implied covenant of good faith and fair dealing because it would not have been prejudiced by a delay in the taking of an EUO. Since the decision in Gruenberg, insurers automatically delay the taking of an EUO until criminal charges are no longer pending and the insured no longer faces a possibility of incriminating himself.

Although the facts differ, and various spins have been put on the area of bad faith, the basic fact pattern supports litigation for the tort of bad faith. If the insurer treats the insured unfairly or requires Draconian compliance with policy conditions, a claim for the tort of bad faith can be supported.

Another significant case in the history of bad faith is Anderson v. Continental, 271 N.W.2d 368 (Wis.1978) in which the insured came home to discover the walls, drapes, carpeting, furniture, and clothing covered in oil and smoke residue from a fire or explosion in the furnace. The dispute centered on only around $4,600 in costs incurred by the insured for additional cleaning needed after the insurer's contracted cleaners finished the job. The plaintiff's complaint stemmed from Continental's repeated refusal to accept a proof of loss and refusal to negotiate the amount due to the insured.

While the Wisconsin court followed California in recognizing tort causes of action for bad faith to first party-cases, the court did not find, as did the California court in Gruenberg. Anderson, like Gruenberg, stated that the plaintiff could not establish a bad faith tort until the insured showed the absence of a reasonable basis for the denial of benefits and that the defendant knew of or had reckless disregard for the lack of a reasonable basis for denial. Andersen agreed that bad faith must be proved to be an intentional act.

Evolution of the Concept

Generally, the evolution of the doctrine in various jurisdictions is a three-step process, as follows:

1.  A finding that the duty to act in good faith and deal fairly with an insured is breached. If the duty is breached, the law recognizes extra-contractual damages. Such extra-contractual damages include the following:

a. any amounts the insured must pay in excess of policy limits when the insurer refuses to settle within the limits of liability

b. emotional distress, trouble and inconvenience, medical expenses, and the like

b. attorney's fees

c. other consequential damages

2. Policyholders have a tort action for bad faith dealing on the part of insurance companies that involves malice or fraud.

3. Extra-contractual damages, up to and including punitive awards in some jurisdictions, are available for actions not amounting to fraud or malice by the insurer (i.e., when an insurer knows that it does not have a reasonable basis to deny a claim but denies it anyway).

Note from the previous paragraph that originally, an element of fraud or malice was required in order to invoke the tort action, and fraud or malice was certainly required in order to recover punitive damages. However, current reasoning does not require a finding of out-and-out fraud or malice. The insurance company can be liable for punitive damages where the insurer violates the good faith requirement. Such violations do not reach the level of intentional wrongful conduct or fraud and may include things such as refusal to pay or defend or adequately investigate a claim.

An insurance company is held to a duty to act in good faith to protect the interests of its insured. Inherent in a policy of insurance is the insurer's obligation to act in good faith regarding settlement of a claim. A claim for bad-faith failure to settle is a tort action based on the insurer's failure to protect the interests of its insured. See [Advantage Bldgs. & Exteriors, Inc. v. Mid–Continent Cas. Co., No. WD76880, 2014 WL 4290814 (Mo. App. W.D., Sept. 2, 2014)].

It is important to note here, however, that some jurisdictions have not recognized the tort of bad faith in insurance dealings; the chart outlines how states handle bad faith concerning first-party cases.

One State's Evolution in Bad Faith Law

These cases from Ohio illustrate the evolution of the bad faith doctrine in that state. Ohio is not unique in its development of the bad faith insurance law area.

In 1949, the Ohio Supreme Court in Hart v. Republic Mut. Ins. Co., 87 N.E.2d 347 (Ohio 1949) recognized that an insurer may be liable in tort “for the excess of the judgment over the policy limit where the insurer is guilty of fraud or bad faith.” In this case, the court analogized bad faith to fraud and recognized a bad faith cause of action for a failure to reasonably settle in a third-party liability situation.

Thirteen years later, in Slater v. Motorists Mut. Ins. Co., 187 N.E.2d 45 (1962), the court overturned a lower court's ruling that the insurance company had acted in bad faith in another failure to settle case. The court took the opportunity to visit the findings of other jurisdictions and further defined “bad faith.” Among the court's holdings were the following:

1. Bad faith is an indefinite term with no constricted meaning.

2. Bad faith is not merely bad judgment or negligence.

3. Bad faith suggests a dishonest purpose and implies a conscious wrongdoing.

4. Bad faith involves breach of a known duty through some motive of interest or ill will.

5. Bad faith is in the nature of fraud.

6. Bad faith is an intentional tort of an active and affirmative nature.

7. Bad faith involves actual intent to mislead or deceive.

8. There is no bad faith absent the equivalent of actual or constructive fraud.

In 1983, about the same time as other jurisdictions were recognizing an independent tort of bad faith, the Ohio Supreme Court extended a bad faith cause of action in a first-party case for wrongful acts in handling a property claim. In Hoskins v. Aetna Life Ins. Co., 452 N.E.2d 1315 (Ohio 1983), the court explained that the burden of proof in a bad faith case is on the insured. More importantly, the court recognized that there are different levels of wrongdoing in bad faith cases. Bad faith might be evidenced by negligent handling of a claim, prompting extra-contractual damages (excess over limits liability, consequential damages, etc.); however, punitive damages arise only out of active wrongdoing.

In a 1988 case, Staff Builders, Inc. v. Armstrong, 525 N.E.2d 783 (Ohio 1988), Ohio shifted from defining “bad faith” as analogous to fraud and adopted a “reasonable justification” test. Bad faith became “refusal to pay the claim where such refusal is not founded on circumstances that furnish reasonable justification therefore.” In contrast, punitive damages were available only where there is actual malice, fraud, or insult on the part of the insurer. This further delineates the distinction between conduct found to be in bad faith and conduct found to warrant punitive damages. This “reasonable justification,” or as it is referred to in many cases, the “reasonable basis” test is apparently the standard for most jurisdictions in assessing bad faith liability.

In 1992, the Ohio Supreme Court further defined “bad faith” in a fashion consistent with the development of this area of law in other jurisdictions. In Motorists Mutual Ins. Co. v. Said, 590 N.E.2d 1228 (Ohio 1992), the court ruled that an insurer's failure to act in good faith can take one of two forms: (1) a failure to perform where it is known that there is no lawful basis for the failure and (2) a failure to determine whether there is a lawful basis for refusing to perform.

Zoppo v. Homestead Ins. Co. 71 Ohio St.3d 552, 644 N.E.2d 397 (Ohio 1994) revisited the Said and Slater decisions. Both decisions contained an element of intent in the action of bad faith, and the court overruled both with the opinion that intent is not part of the reasonable justification standard. By expressly overruling Said and Slater, the court felt it was correcting previous mistakes and reinstating the reasonable justification standard.

In Helfrich v. Allstate Ins. Co., No. 12AP-559, 2013 WL 5450931(Ohio App. Dist.10 Sept. 30, 2013) the court found damages are unavailable in an action brought pursuant to the vexatious litigator statute. To the extent that the appellant argued that the damages requirement in the policy were satisfied by the attorney fees leveled against him for frivolous conduct, the court of appeals in Siemientkowski v. State Auto. Mut. Ins. Co., No. 87299, 2006 WL 2299358 (Ohio App. 8th Dist. Aug. 10, 2006) held that the award of costs and attorney fees imposed against insureds for frivolous conduct in a prior litigation did not constitute an injury covered by the insured's homeowner's insurance policy.

Ohio recognizes, however, that the mere fact that a claim is denied does not always support a claim of bad faith. In Bob Schmitt Homes, Inc. v. Cincinnati Ins. Co., No. 75263, 2000 WL 218379 (Ohio App. 8th Dist. Cuyahoga (Feb. 24, 2000), the court found that the plaintiff could not make a bad faith claim when the plaintiff failed to satisfy its burden of showing that it is entitled to coverage. Likewise, in Sanders v. Nationwide Mut. Ins. Co. No. 99954, 2014 WL 2565770 (Ohio App. 8 Dist. June 5, 2014), since the initial factual prerequisite to the plaintiff's bad faith claim was lacking, summary judgment in favor of Nationwide was appropriate.

The law of many states followed much the same route to the tort of bad faith in insurance dealings as did Ohio. Bad faith evolved from actual malice only to bad faith as failure to perform where there is a known duty to perform. This evolution opens insurance companies to bad faith legal challenges for a variety of actions falling short of malice or fraud. The failure to handle claims adequately might well be acting in bad faith. This failure on the insurer's part might thus expose the insurer to extra-contractual claims. Going one step further, malice, intent, or wrongful purpose in the settlement of claims might well leave the insurer open to bad faith damages and punitive damages.

The Property Cases —”Reasonable Basis”

In the first-party claim area, the laws of almost all jurisdictions recognize that an insurer can violate its duty of good faith and fair dealing by failing to pay a claim promptly when liability becomes reasonably clear. This recognition has come either through common law, developed case law, or statutory or regulatory enactment.

In greatly uniform language, courts have held that the cause of action against the insurer arises “where there is no reasonable basis for a denial of a claim or when the insurer fails to determine or delays in a determination of whether there is any reasonable basis for a denial of the claim…In order to sustain a claim for breach of good faith, the insured must establish (1) the absence of a reasonable basis for denying or delaying payment of the claim, and (2) that the insurer knew, or should have known, that there existed no reasonable basis for denying or delaying payment of the claim.” (from Dixon v. State Farm Fire and Cas. Co., 799 F.Supp. 691 (S.D. Tex. 1992).

The legal basis is easily and simply stated; however, there is a great deal of litigation in this area, suggesting that the standards are not as easily recognized or practiced. The facts and outcomes of various cases provide some examples.

Following is one common fact pattern that has been litigated in several jurisdictions. An insured's building burns and the insured brings claim for loss. Upon investigating, the insurer suspects arson by the insured. Subsequently, the insured is charged by the authorities with arson. During the pending of the criminal action against the insured, the insurer denies or delays paying the claim. At either trial or pretrial hearing, the charges against the insured are dismissed or the insured is acquitted. Thereafter, the insured brings suit to recover on the insurance policy and includes a claim against the insurer for bad faith handling of the claim.

Under the same set of facts, cases have opposing outcomes, generally due to the variance in the manner in which the insurer handled the claim and investigation.

In Dixon, the court found for the insurer on the bad faith claim, while, of course, allowing recovery of policy proceeds. The court held that the insurer had demonstrated a reasonable basis for denying the claim, stating, “State Farm demonstrated that it relied on the following to determine that there was a reasonable basis for denying the insurance claim: recorded statements of plaintiff and admissions made in a subsequent interview, laboratory findings demonstrating the existence of flammable liquids, a fire scene examination concluded that the fire was the result of an incendiary act with the burn pattern denoting deliberateness, and a committee report establishing motive and opportunity.”

The insurer's deviation from the standards of the industry played a part in arriving at a judgment for the insured on his bad faith claim with similar facts in Brewer v. American and Foreign Ins. Co., 837 P.2d 236 (Colo. 1992). The insurer made the argument that there can be no bad faith claim if there is “any colorable evidence supporting the denial of an insurance claim.” The court disagreed, holding that although the insured's case could not, as a matter of law, be decided by directed verdict on the underlying arson claim (i.e., there were issues that required the verdict of the jury regarding the arson and the insured could not move for a summary or directed verdict), the bad faith issue could still be decided in favor of the insured.

The difference between Dixon and Brewer is the claims handling and investigation by the insurer. The court said, “Here, evidence indicates that acceptable investigative procedure such as determination of the chronology of the fire, its origin, its cause, whether burn patterns were present, and if burn patterns were found, an interpretation of the patterns by an experienced arson investigator, were not followed by the insurance company.”

The court further stated the following:

Additional testimony supported the conclusion that it was not customary in the insurance industry to rely exclusively on an inexperienced insurance adjuster/fire investigator to determine and interpret burn patterns. Nor was it customary in the industry for an insurance company's representatives to advise potential witnesses that the insured had committed arson and that it was conducting an arson investigation during the initiation of an interview. Because there was evidence that all or some of the industry standards were deviated from, there exists ample support in the record for the jury's conclusion that the insurance company acted unreasonably and had no reasonable basis for denying the insured's claim.

Further Refining Bad Faith

Having dealt with the matter of what constitutes bad faith and its attendant principles, litigators and courts have turned to further refining the issues that might be raised in a bad faith claim.

Good faith error. The Vermont Supreme Court allowed a first-party bad faith action against an insurer in part because no alternative independent remedy was available in Bushey v. Allstate Ins. Co., 670 A.2d 807 (Vt. 1995). The Bushey case extended the tort of bad faith cause of action to first-party claims by insureds. Vermont noted that the bad faith remedy would generally be superfluous if mere negligence in handling a claim would be sufficient for liability.

An insurance company can make a good faith erroneous decision, or at least a decision that is later disagreed with by a fact finder, without subjecting itself to bad faith liability. An example of this line of cases is State Farm Lloyds, Inc. v. Polasek, 847 S.W.2d 279 (Tex. 1992). The insured's video rental business burned. The insurer denied coverage on the grounds that the fire was caused by arson and that the insureds had made material misrepresentations. The insureds were not charged with arson by the authorities.

The insureds filed suit and a jury found that the insureds had not caused the burning of their premises. The jury further found that the insurer had acted in bad faith because it did not have a reasonable basis for denying the claim. The jury awarded the insureds $40,000 for the property loss, $200,000 for mental anguish, and $500,000 in punitive damages. In overturning the mental anguish and punitive damages awards, the court held that “an arguable basis” existed to deny the claim, thus defeating a bad faith claim. In other jurisdictions, “arguable basis” is synonymous with reasonable basis.

The court stated that the insureds had argued that they had nothing to do with the fire and that the jury believed them. Absent appeal, that decided the issue of coverage and the insurer was required to pay the claim. But the insureds did not demonstrate bad faith on the part of the insurer simply by proving that they did not commit arson. The court said, “It is not satisfied by proof that [the insurer] should have paid their claim, or that [the insurer] acted unreasonably in denying their claim.” Instead, the insured must prove that no reasonable basis existed for denying or delaying payment of the claim or that the insurer failed to determine whether there was any reasonable basis for so denying or delaying.

It is important to note that, in effect, the court held the following in bad faith cases: the issue is not whether the fact finder (court or jury) believes the evidence used by the insurer to deny a claim, but whether such evidence existed, so as to give the insurer a reasonable basis.

In Polasek, the court found that the following facts gave the insurance company its reasonable basis for denying the claim:

1.     The store was marginally profitable, at best.

2.     The insureds had a note for $6,500 due five days after the fire.

3.     The insureds had only $365 in the company bank accounts.

4.     The insureds had borrowed money and paid operating accounts from personal funds and not cash flow.

5.     Rent payments had been late.

6.     An uninsured air compressor was removed by the insured on the day of the fire.

In favor of their bad faith claim, the insureds argued that the insurer had failed to adequately investigate. For example, the insurer had not talked to persons who had been willing to loan the insureds money. The court specifically rejected the notion that the insurer must “leave no stone unturned” in its investigation before denying or delaying payment of a claim. The court said, “We have not upheld bad faith cases for failure to investigate when the insurer simply failed to pursue every lead.”

The court took the opportunity to address the issue of bad faith in its decision, stating, “Bad faith counts are now routinely pleaded in suits on insurance contracts. [Our] Supreme Court did not intend [this] result; it did not intend to convert first-party cases into tort cases. It simply gave a tort remedy for the exceptional case in which the insurer denies or delays payment even though no reasonable basis for that decision exists. Courts should be careful to ensure that the bad faith action is reserved for cases of flagrant denial or delay of payment where no reasonable basis existed, and not for mere unreasonable denial or delay.”

In White v. Western Title Ins., 710 P.2d 309 (Cal. 1985), California Supreme Court Justice Kaus said: “The problem is not so much the theory of the bad faith cases, as its application. It seems to me that attorneys who handle policy claims against insurance companies are no longer interested in collecting on those claims, but spend their wits and energies trying to maneuver the insurers into committing acts which the insureds can later trot out as evidence of bad faith.” It is important, therefore, for the court to be certain that there are sufficient facts to establish bad faith conduct and not just indications of bad faith conduct.

A subsequent case, State Farm Fire & Cas. Co. v. Simmons, 857 S. W. 2d 126 (Tex. App.-Beaumont, 1993) disagreed with Polasek. This case involved a homeowners fire claim that the carrier denied based on suspicions that the insured was responsible for the fire. The claim was made that the insurer did not make a thorough investigation of the claim. This court disagreed with Polasek in that the insured must prove that the carrier denied or delayed payment due to no reasonable basis in fact for such action. Simmons believed that this makes it possible for the carrier to pursue only one line of investigation and not look at all evidence in a case, which deteriorates the degree of care required of an insurer towards its insured. Simmons believed a better rule for dealing with bad faith is asking if the insurer fulfilled its duty by performing a thorough, systematic, objective, fair, and honest investigation of the claim.

Prolonged investigation without cause. The court held that an insurer might open itself to bad faith damages for prolonging an investigation beyond reasonable limits in Livingston v. Auto Owners Ins. Co., 582 So.2d 1038 (Ala. 1991). In this case, the court characterized the insurer's behavior in investigation of a fire loss as “a last ditch effort to find some evidence to support its suspicions that the [insureds] started the fire.”

The residence in this case had burned on May 14, 1988. The insurer suspected the insured of arson. Auto Owners hired an independent fire investigator and adjuster, whose reports were done by July 15. The state fire marshal's report was also complete on July 15. The experts listed the cause of fire as incendiary, but reported no suspicions of involvement of the insureds. On August 16, the insured sued for coverage, including claims for bad faith. The insurer moved for summary judgment on the bad faith issue, but lost. In its denial, citing an earlier case, the court held that “where evidence of arson by the insured was slight, mere suspicion and speculation that new evidence will present itself at some future date is not reasonable grounds upon which to deny a claim.” The court remanded the case for trial.

In Livingstone the insurer's four-month delay in paying the claim—coupled with the fact that the insurer's actions appeared to the court to be foot-dragging—was held to be unreasonable. In a similar case, a five-month delay in which an interim advance was made by the insurer was held not to be in bad faith in Neal v. State Farm Fire and Cas. Co., 908 F.2d 923 (11th Cir. 1990). The court held the following in denying the insured's claim of bad faith by State Farm:

1. The insurer had a reasonable suspicion of insured-arson.

2. Even with this suspicion, the insurer had made a $2,500 advance of policy proceeds, under a reservation of rights as to coverage.

3. The insurer proceeded in a timely fashion in completing its own investigation prior to confirming coverage.

Placing Extra-contractual limitations on coverage. A Tennessee court of appeals held that placing a limitation on coverage that is not contained in the policy gives rise to bad faith damages under the state's “refusal to pay in good faith insurance statute.” In Minton v. Tenn. Farmers Mut. Ins. Co., 832 S.W.2d 35 (Tenn. App. 1992), the insured lost a stone from an insured ring worth more than $6,000. After the insurer's adjuster confirmed coverage, the insured proposed to send the ring, certified mail, out of town to the original jeweler for repair. The adjuster then informed the insured that the policy would not cover the ring should it be lost in the mail. The adjuster cited the policy provision that eliminates coverage for “neglect of the insured to use all reasonable means to protect covered property at and after the time of the loss.” The ring was lost in the mail and the insured sued for coverage, invoking the state's “refusal to pay insurance claims in good faith” statute. The statute allowed damages of 25 percent additional above the amount of the loss for breach of the duty of good faith.

The court held that the insured's mailing of the ring was not prohibited nor excluded by the policy. Additionally, when the adjuster told the insured not to mail the ring, the court held that he was then adding an extra-contractual limitation on coverage after a loss. This action, thus, triggered the statutory bad-faith damage award.

Nonrenewal or policy termination. The Alabama Supreme Court held that the tort of bad faith does not apply to the insurer's alleged bad faith non-renewal of a policy in Alfa Mutual Ins. Co. v. Northington, 604 So.2d 758 (Ala. 1992). In this case, the insurance company did not renew a policy of insurance because the insured and the insurance agent had become involved in an argument over the extent of coverage that had been represented. A company representative testified that the policy was not renewed, at least in part, due to the atmosphere of distrust that had arisen between the company and the insured.

The issue, as seen by the court, was whether an insured can sue for the tort of bad faith for a wrongful, bad faith cancellation, nonrenewal, termination, or other repudiation of an insurance policy. In answering no, the court stated that the law in the majority of jurisdictions is that the sole remedy for cancellation or nonrenewal of an insurance policy is under a contract action, and not in tort. Therefore, punitive damages would not be available in such situations.

Bad Faith in Third-Party Situations

Several issues arise that involve bad faith in the third-party liability area. In every contract, there exists an implied covenant of good faith and fair dealing. Under this covenant, neither party shall do anything that will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract. In addition, where a contract grants a party discretion, the party must exercise that discretion reasonably.

Some actions that establish third-party bad faith include the following:

1. Failure by the insurer to reasonably settle within policy limits

2. The insurer's wrongful denial of a defense

3. The assignment, by the insurer, of an insured's bad faith claim to a third party

4. The effect of an insured's “judgment-proof” status on an award of excess amounts in a failure to settle situation

A liability insurer's duty to settle a third-party claim is not precipitated solely by the likelihood of an excess judgment against the insured. In the absence of a settlement demand or any other manifestation the injured party is interested in settlement, when the insurer has done nothing to foreclose the possibility of settlement, the California Court of Appeal was asked to determine if there is liability for bad faith failure to settle. In Reid v. Mercury Ins. Co., 220 Cal.App.4th 262 (2013), the court found that the tort of bad faith was created to deter an insurer from acting against the interest of its insured. It was not designed to make plaintiffs who inadequately insured themselves wealthy. The plaintiff's counsel attempted to set up Mercury for a bad faith lawsuit without making a demand for the limits but failed.

The failure to reasonably settle within policy limits represents an area where it is long established that an insurer may be guilty of bad faith. In fact, these were the first situations where bad faith principles were recognized by the courts.

An interesting development in this area is that there may be no duty to settle a case where the insurance company has competently assessed the potential of excess-over-limit damages as unlikely. Such was the result of Stevenson v. State Farm Fire and Cas. Co., 628 N.E.2d 810 (Ill. 1993). In this case, an insured was sued for negligently wounding another person in a shooting incident. The insurance company had a reasonable basis to believe that the policy might not provide coverage due to the intentional acts exclusion. Recognizing its duty to defend in questionable cases and its conflict in so providing a defense where the policy may not provide coverage, the insurer provided independent counsel for the insured. However, when faced with a settlement demand of $87,000, the company offered only $3,000. The policy had a liability limit of $100,000.

The insured then, on the advice of its independent counsel, settled with the injured party for the amount of $87,000. The insured then assigned his rights under the party to the claimant. In exchange the insured received a pledge from the injured party that he would not proceed personally against the insured. The injured party then sued the insurer and included a claim for bad faith in failing to reasonably settle.

The court held that the insurer had competently assessed the claim and determined that there was little possibility of a verdict or judgment in excess of the policy limits, if indeed the claim was covered. Inasmuch as the insurance company had tendered an independent defense to the insured, because the claim was “fairly debatable” as to coverage, and because of the reasonable decision to try the case rather than settle (and the fact that any likely verdict would be in an amount under policy limits), the plaintiff's bad faith claim failed.

In another unreasonable failure to settle suit, it was held that there was no bad faith where the insurer settled a claim within policy limits without exposing the insured to above-the-limits liability but where the insured claimed additional damages arising out of the settlement. In Shuster v. South Broward Hospital District Physicians' Professional Liability Ins. Trust, 570 So.2d 1362 (Fla. 1990), the insured was a doctor who claimed the insurer acted in bad faith in settling a malpractice claim within the policy limits because the settlement damaged his reputation and ability to generate income. The insurance policy specifically gave the insurer the right to investigate and settle claims.

The court concluded that “where an insurance policy gives the insurer the right to make such settlement of a claim as it deems expedient and the insurer settles the claim within the policy limits of insurance so that the insured is not exposed to liability, there is no cause of action for bad faith in effecting the settlement. The insurer obligates itself to indemnify the insured for liability on claims, not damage to the insured's reputation as a result of the claim. It is the insurer's funds which are to be used for that purpose. Thus, its insistence on having the broad discretionary right to settle as it deems expedient is not only understandable, but indeed is probably good business. An insurance company may not want to defend an insured's action based upon “principle,” for instance, if it can use fewer dollars by settling. Furthermore, it is the public policy of this state to encourage settlement of litigation.”

Lawyers with a weak case can get creative when attempting to obtain coverage for an insured whose claim was denied. In Lewis Holding Co. Inc. v. Forsberg Engerman Co., 318 P.3d 822 (Wyo. 2014) the Supreme Court of Wyoming was called upon to resolve an insurance coverage dispute where the insured claimed payment of a previous claim estopped the insurer from denying a subsequent claim. The trial court granted summary judgment in favor of defendants Lexington Insurance Company, NTA, Inc., and Forsberg Engerman Company, and against plaintiff Lewis Holding Company, Inc. Wyoming requires that to prove a claim for bad faith, a plaintiff must demonstrate 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. Since the Supreme Court concluded there was no liability that alone was sufficient to establish that these parties had reasonable bases for denying Lewis Holding's claim and did not breach the covenant of good faith and fair dealing.

Section 627.4147(1) of Florida statutes was enacted after the Shuster decision (eff.10/1/03) and requires malpractice insurance policies to grant the insurer the sole authority to settle a claim where settlement is within policy limits. The statute also sets a standard for the insurer's exercise of its authority and requires that such a settlement be made in the best interests of the insured. This requires a larger duty on the insurer as Shuster permitted the insurer to settle a claim within the policy limits in its own self-interest, and did not require the insurer to consider the interests of the insured. Amerisure Mut. Ins. Co. v. Summit Contractors, Inc., No. 8:11-CV-77-T-17TGW, (M.D. Fla. Mar. 20, 2013) discusses this further.

While on the subject of duty to settle, some specific advice from Wierck v. Grinnell Mut. Reinsurance Co.,  456 N.W.2d 191 (Ia. 1990) is appropriate: 

Authorities establish the following principles. We begin with the simple assumption that an insured buys an agreed amount of liability protection for a set premium. The insured, in the first instance, is at risk for the amounts in excess of the protection which has been purchased. The policy limits, however, set a boundary which the insurer cannot misuse to the detriment of the insured. It is bad faith for an insurance company to act irresponsibly in settlement negotiations with respect to the insured's risk in that part of the claim in excess of coverage. It is bad faith for the company to factor in its consideration of settlement offers the limited amount between an offer and the policy limit. The best standard for good faith in a specific negotiation is to ignore the policy limits. If, but for the policy limits, the insurer would settle for an offered amount, it is obliged to do so (and pay toward settlement up to the policy limits). But the insurer is free to reject the offer if it would have rejected the same offer under policy limits covering the whole claim.

The failure to determine whether there is a duty to provide defense may also be considered bad faith. In Bracciale v. Nationwide Mutual Fire Ins. Co., No. CIV.A. 92-7190, 1993 WL 323594 (E.D. Penn. Aug. 20, 1993) the complaint against the insured alleged negligence on the part of the insured; however, the insurance company read the complaint as consisting in actuality of a suit for damages due to (the excluded) intentional acts of the insured.

In this case, a police officer who stopped a driver was injured by the passenger in the car during the arrest. The police officer sued the passenger for wanton acts but also pleaded negligence on the part of the person. The insurance company tendered no defense. After a judgment for more than $400,000 in favor of the officer (based, in part, upon the ground of negligent acts), the insured settled for the assignment of the insured's policy rights. The officer then brought suit against the insurer, including a claim for bad faith.

The court ruled, “An insurer who refuses to defend a claim potentially within the scope of the policy does so at its own peril. If an insurer has refused to provide a defense at trial, it may not later protest that it was deprived of an opportunity to litigate and establish that the underlying claims fell outside its policy coverage. Those insurers who did not contribute a defense are also precluded from arguing that the underlying claims fell outside their policies since they had the opportunity and declined to litigate the claims to conclusion.“

The emphasized portion of the previous paragraph is of extreme importance to insurers. The correct course of action in a disputed coverage case where a claim for defense is tendered is to provide a defense under a reservation of rights and bring a declaratory judgment action on the coverage issue. It was specifically held in Zurich Ins. Co. v. Killer Music Inc., 998 F.2d 674 (9th Cir. 1993) that bringing such a declaratory action to determine coverage is not impermissible delay on the part of an insurer and does not, of itself, give the insured cause for a bad faith claim.

In two cases it has been held that the inability of the insured to pay an excess judgment over the policy limit has no effect on the insurer's obligation for this amount in a bad faith claim. In Camp v. St. Paul Fire and Marine Ins. Co., 616 So.2d 12 (Fla. 1993), although the insured declared bankruptcy prior to a final judgment in a case against him, and therefore could not be personally liable for a judgment against him, the insurance company was still held liable for the excess amount of the judgment over policy limits. The same result occurred in Frankenmuth Mut. Ins Co. v. Keeley, 461 N.W.2d 666 (Mich. 1990).

Reverse Bad Faith

The tort of bad faith was created as a one-way street. Courts concluded that insureds needed protection against insurers who did not keep their promises but that insurers did not need protection against insureds who did not keep their promises.

Although the covenant of good faith and fair dealing devolves equally upon the insured and the insurer, the tort of bad faith, in its application, is only available to the insured in an action against the insurer. Some insurers have sought to establish a tort of reverse bad faith, or the tortious breach of the covenant of good faith and fair dealing by the insured. Mostly their efforts have failed.

Although the Oklahoma Supreme Court in First Bank of Turley v. Fidelity and Deposit Ins. Co. of Maryland, 928 P.2d 298 (Okla. 1996) refused to recognize a tort of reverse bad faith, it described the doctrine as an “independent tort allowing insurers to seek affirmative relief for an insured's breach of the duty of good faith and fair dealing. The approach draws from the principle that an insurer should not be subjected to bad-faith liability if the insured (a) procured the policy through fraud, (b) breached contractual obligations, or (c) engaged in other misconduct.” In 3 Law and Prac. of Ins. Coverage Litig. §28:38, the authors list courts that have considered and rejected claims of reverse bad faith, including: Johnson v. Farm Bureau Mut. Ins. Co., 533 N.W.2d 203 (Iowa 1995); First Bank of Turley v. Fidelity and Deposit Ins. Co. of Maryland, supra.; Parker v. D'Avolio, 664 N.E.2d 858 (Mass. App. 1996); In re Tutu Water Wells Contamination Litigation, 78 F. Supp. 2d 436 (D.V.I. 1999); and Snap-on Tools Corp. v. First State Ins. Co., 502 N.W.2d 282 (Wis. Ct. App. 1993).

In addition, courts have specifically declined to recognize the tort of reverse bad faith. See Tokles & Sons, Inc. v. Midwestern Indem. Co., 605 N.E.2d 936 (Ohio 1992); Wailua Associates v. Aetna Cas. and Sur. Co., 183 F.R.D. 550 (D. Hawaii, 1998); and Lewis v. Aetna Ins. Co., 78 F. Supp.2d 1202 (N.D. Okla. 1999).

There is some authority that insurers may recover against insureds under the terms of a penalty statute for the lesser of the amount of the insurer's actual loss or the statute's stated penalty. In Adams v. Tennessee Farmers Mut. Ins. Co., 898 S.W.2d 216 (Tenn. Ct. App. 1994), the court determined that a policyholder who filed a complaint against his insurer alleging bad faith in rejecting his claim for a loss in connection with a house fire would be subjected to a statutory penalty for not bringing the lawsuit in good faith and would not be permitted to avoid a penalty on the basis that the policy was void ab initio due to material misrepresentations in policy application. According to the court, such an argument would render the statute, which provided a penalty of up to 25 percent of amount of the loss claimed, a nullity.

However, the court held that the statute provided the amount awarded to be measured by additional expense, loss, or injury inflicted on the defendant by reason of suit, and, accordingly, the insurer's recovery would be limited to the amount that represented a 25 percent statutory ceiling and had been awarded by the trial court.

Of course it is unfair that an insurer can be held liable for the tort of bad faith but cannot be the victim of the same tort. All litigants are supposed to be equal in the courts of the United States, but in this situation, the insured is more equal than the insurer.

Even though the tort of reverse bad faith is not recognized, when an insured acts in bad faith it is usually by misrepresenting a material fact, concealing a material fact, or doing something inimicable to the rights of the insurer. The insurer is, therefore, not without a remedy when an insured acts to deprive the insurer of the benefits of the contract of insurance.

It may, if there is evidence of misrepresentation or concealment of material fact an insurer can sue its insured for damages caused by fraud.

Insurance fraud is a tort, a civil wrong. Black's Law Dictionary, 6th Edition, defines fraud as follows:

An intentional perversion of the truth for the purpose of inducing another in reliance upon it to part with some valuable thing belonging to him or to surrender a legal right; a false representation of a matter of fact, whether by words or by conduct, by false or misleading allegations or by concealment of that which should have been disclosed, which deceives and is intended to deceive another so that he shall act upon it to his legal injury.

In simple language, fraud can be defined as a lie told for the purpose of obtaining some value from another who mistakenly believes the lie to be true.

If evidence exists to establish the elements of fraud an insurer can effectively sue the insured for damages. Those elements require that an insured

• makes a representation to the insurer that the insured knows is false;

• conceals from the insurer a fact he knows is material to the insurer;

• makes a promise he does not intend to keep; and

• makes a misrepresentation on which the insurer relies in issuing the policy, that results in the insurer incurring damage.

In Stephens v. Safeco Ins. Co., 852 P.2d 565 (Mt. 1993), both the insured and the insurer were held to have acted in bad faith in the settlement of a property claim. The jury had assessed the insured's mental distress damages under his bad faith claim as $38,000. However, the jury had allocated the insured's wrongful conduct at 53 percent and the insurer's at 47 percent. The insurer argued that the insured could recover nothing on the bad faith claim as the insured's wrongful conduct exceeded that of the insurer's.

The court disagreed, declaring, “Insurance companies have a duty to act in good faith with their insureds, and this duty exists independent of the insurance contract and independent of statute. If this duty is breached the cause of action against the insurer is in tort. However, if the situation is reversed, and the insured breaches the covenant of good faith, the result is not a tort, but a breach of contract.” The court held that the tort of bad faith serves to discourage oppression in contracts which necessarily give one party a superior position and that the action is not available to the party in the superior position. Therefore, the insurer could not use the insured's bad faith to off-set its own bad faith conduct.

In citing Stephens, the California Supreme Court in Kransco v. American Empire Surplus Lines Ins. Co., 54 Cal. App. 4th 1171 (1997) went even further to reject the idea of comparative bad faith. The court said, in part: “The doctrine of comparative bad faith is marked by inconsistencies and complexities. . .[and] is founded on the faulty premise that the obligations of insurer and insured—and thus their bad faith—are comparable. They are not.” Even though both parties may have a “reciprocal obligation of good faith and fair dealing,” the duties of the two differ because of “the differing performance due under the contract of insurance.” Because the disparity between the parties “rests on contractual asymmetry,” an insured and an insurer cannot be considered to be on “equal footing.”

In Agricultural Ins. Co. v. Superior Court, 70 Cal. App. 4th 385 (1999), the court held that the tort of reverse bad faith “finds no support in case law.” It concluded that “an insured may be held liable in contract for breaching the covenant [of good faith dealing], but cannot be held liable in tort.” In this case, the insurer contended that the insured—a health club damaged by an earthquake—had committed reverse bad faith when the club turned in questionable and possibly falsified loss notices.

In rejecting Agricultural's position, the court stated that this argument failed on two grounds. The first, said the court, was that no evidence existed to suggest that “the Legislature, in enacting [the insurance fraud statute] intended to expose all insureds to suits for 'reverse bad faith' whenever they make an insurance claim.”

Secondly, Agricultural contended that the insurance fraud statute “created a new private right of action.” The insurer said, in effect, that the concept of reverse bad faith was equivalent to that of fraud. In also rejecting this argument, the court held that “[t]he legislature did not attempt to criminalize 'bad faith' in [the insurance fraud statute] and probably could not do so constitutionally.”

The Supreme Court of Ohio also struck down an attempt to create the tort of reverse bad faith in Tokles & Son, Inc., v. Midwestern Indem. Co., 605 N.E.2d 936 (Ohio 1992). Here the court said that it had “never recognized such a tort and refuses to do so now.” The justices went on to call the insurer “the holder of the purse strings” with “certain built-in protection from such evils” (e.g., an insured's attempt to defraud it). Because an insured “often finds himself in dire financial straits after [a] loss,” he is entitled to the equal footing provided by the ability to sue an insurer for bad faith. The court concluded that “other avenues [exist] for an insurer to pursue” in the event of a fraudulent claim.

Although there is an implied covenant of good faith and fair dealing in every contract, although each party is bound by it, and although this principle applies to insurance contracts, the potential liability for breach is different for insurers and insureds. In summary, as stated in the Agricultural case, an insured may be held liable in contract for breaching the covenant but cannot be held liable in tort.

Although the courts may have ruled so, the insured's breach of the covenant of good faith and fair dealing is also separately actionable as a contract claim, and some forms of misconduct by an insured will void coverage under the insurance policy. See Imperial Cas. & Indem. Co. v. Sogomonian, 198 Cal.App.3d 169 (1988). The court in Agricultural held that contract remedies “adequately serve to protect an insurer from the insured's misconduct without creating the logical inconsistencies and troublesome complexities of a defense of comparative bad faith.” In so doing it ignores the logical inconsistencies and troublesome complexities of the tort of bad faith. What is good for the insured should be good for the insurer.