Like individuals, companies purchase insurance to protect themselves against a host of risks that accompany being in business — damage to their own property or liabilities they incur from third parties. There is, however, another way of looking at what a policyholder purchases with its premium dollars. First and most obviously, the policyholder purchases financial protection to cover the variety of losses it may experience. This may generically be called "indemnity" protection. Examples of such coverage include the cost to repair a burnt building, lost profits when a factory is put out of production by a natural disaster, and damages when one of the company's trucks seriously injures a pedestrian. When most people think of insurance, it is "indemnity" coverage that they have in mind.
A second kind of insurance coverage is what may be called "litigation coverage." Provided under so-called "duty-to-defend" provisions of liability policies, this coverage pays for litigation brought against the policyholder. This duty arises not only if the claim against the policyholder is meritorious — where the insurance company's duty to indemnify may be triggered — but, ordinarily, even if the litigation is frivolous or groundless. "Litigation protection" provides insurance not only for a policyholder's wrongdoing, but for the risks arising from a legal regime that permits the bringing of frivolous and groundless lawsuits.
There is also a third promise that insurance companies make — or are deemed by courts to have made — in their policies. This is not a promise of coverage per se, but is known as the implied covenant of good faith and fair dealing. Simply put, an insurance company must perform its obligations under its policy in good faith, which is perhaps most clearly defined as not in bad faith. If the insurance company fails to do so, it may be required to pay actual and punitive damages, above and beyond its obligations to afford the coverage it promised in its policy to provide. Such "bad faith" damages are frequently known as "extra-contractual damages."
The courts say that the covenant of good faith and fair dealing is implied in every contract. While universally applicable, however, the condition has special importance where insurance is concerned. This is because of the peculiar nature of the insurance relationship. In most commercial contracts, both parties have obligations that must be performed relatively contemporaneously. The seller of goods, for example, must provide what the buyer wants, and the buyer must pay promptly. Insurance is different. The "buyer" — the policyholder — is obligated to perform its part of the contract up-front, by paying the premium right away. At that juncture, the insurance company has no obligation to do anything. Indeed, because the insurance company's contractual obligation is contingent, it may never have the obligation to render any performance. If a loss occurs, under the explicit terms of its policy, the insurance company can simply say, "You think you have a valid claim. Fine. Sue us." The implied duty of good faith and fair dealing is the one legal requirement that tempers this conduct. This implied covenant, thus, prevents an insurance company, as a contingent obligor, from using its economic power to force a low-ball settlement.
Insofar as indemnity coverage is concerned, one way to understand the different facets of the insurance company's duty of good faith and fair dealing is the distinction drawn by one federal district court between "substantive" and "procedural" bad faith. See International Surplus Lines Ins. Co. v. Univ. of Wyoming, 850 F. Supp. 1509 (D. Wyo. 1994), aff'd, 52 F.3d 901 (10th Cir. 1995). Not only do insurance companies have duties substantively to pay the indemnity dollars they have contracted to pay for covered losses, but they have the independent procedural duty to investigate policyholder claims promptly, efficiently, and open-mindedly even if they ultimately have valid reasons not to afford coverage.
When an insurance company denies coverage, its denial may fit into any of three categories. First, the denial may be justified by the policy's terms. Second, there are circumstances where there is a genuine good faith dispute between the policyholder and the insurance company about whether a claim is covered. In such a case, the policyholder and the insurance company may take their coverage dispute to court to obtain an authoritative decision. Where the policyholder prevails on such "close-call" coverage questions, the insurance company's denial may not be deemed bad faith. Analytically, such denials are simply breaches of contract, not "wrongs" in the sense that a tort is a "wrong." It is important to note, however, that in those jurisdictions that take seriously the ancient rule of Hadley v. Baxendale, (1854) 9 Exch. 341, which allows recovery for foreseeable damages, the policyholder may recover its attorneys' fees incurred to overturn the denial without any showing of bad faith. See, e.g., New Jersey Guaranty Assn. v. Cani, 242 N.J. Super. 164, 576 A.2d 300 (1990); Bankers & Shippers Ins. Co. of New York v. Electro Enterprise Inc., 287 Md. 641, 415 A.2d 278 (1980).
In some instances, however, denials of coverage do amount to wrongs, and not simply to "legitimate" disputes about policy provisions. The language courts use to articulate the level of egregiousness necessary to constitute bad faith varies between jurisdictions. For example, Pennsylvania courts point out that "mere negligence or bad judgment is not enough," and that bad faith requires a "frivolous or unfounded refusal" to cover a claim. American Franklin Life Ins. Co. v. Galati, 776 F. Supp. 1054, 1064 (E.D. Pa. 1991). Some courts seem to require "malicious" or "outrageous" conduct. Wilson v. Colonial Penn Life Ins. Co., 454 F. Supp. 1208, 1212-13 (D. Minn. 1978). Others have rejected the "extraordinary showing of disingenuous or dishonest failure to carry out a contract" standard, and have adopted instead a requirement that the policyholder establish that the insurance company acted in "gross disregard" of the policyholder's interests. Pavia v. State Farm Mut. Auto. Ins. Co., 626 N.E. 2d 24, 27 (N.Y. Ct. App. 1993).
If liability for bad faith were limited to wrongful denials of coverage, insurance companies would have a simple way of avoiding bad faith liability — never deny coverage. Were that the case, insurance companies could engage in all measure of delay in investigating losses and issuing coverage opinions, relying on the safe harbor of never having issued a denial. Obviously, the law does not permit that result. The International Surplus Lines court called this "procedural bad faith," because, although the insurance company never committed the substantive breach of its contract by denying coverage for a loss that should have been covered, it violated the implied covenant of good faith and fair dealing by not adopting fair and reasonable procedures for the handling of the claim. Courts have recognized that, because insurance companies receive premiums in exchange for contingent promises, they must investigate whether those contingencies have happened in a fair, reasonable, and prompt manner. See, e.g., Rawlings v. Apodoca, 151 Ariz. 149, 726 P.2d 565 (1986).
Insofar as "litigation insurance" is concerned, the insurer also has duties not just substantively to undertake the duties it has promised to undertake, but also procedurally to perform in such a way that the policyholder gets the real benefit of its bargain. Clearly, if an insurance company wrongfully fails to perform its duty to defend, that failure can give rise to bad faith liability. See Kelmo Enterprises, Inc. v. Commercial Union Ins. Co. 285 Pa. Super.13, 426 A.2d 680 (1981). Likewise, if the insurer assumes that duty, it must conduct that defense so as to place the policyholder's interests at least on an equal footing with its own. Comunale v. Traders & Gen. Ins. Co., 328 P.2d 198 (Cal. 1958). Thus, wrongful refusal of the insurer to settle within policy limits can constitute bad faith, Opel v. Empire Mut. Ins. Co., 517 F. Supp. 1305, 1306 (S.D.N.Y. 1981), and an insurer that wrongfully refuses to settle within policy limits may be liable for the entire amount of a subsequent, adverse judgment. AFIA v. Continental Ins. Co., 527 N.Y.S.2d 420, 422 (1st Dept. 1988); Green v. J. C. Penny Auto Ins. Co., 806 F.2d 759, 763-64 (7th Cir. 1986).
Where a policyholder suffers consequential damages arising out of bad faith, those damages may be recovered. In jurisdictions where a successful coverage action, by itself, is not sufficient to entitle a policyholder to an award of attorneys' fees, a bad faith judgment may be sufficient for such an award. See, e.g., Brandt v. Superior Ct., 37 Cal. 3d 813 (1985). Other consequential damages include the time value of money caused by the insurance company's delay in resolving a claim, the policyholder's costs of investigating where the insurer wrongfully breaches its duty to investigate, and lost profits damages where an insurance company's delay does not allow damaged business premises time to resume operations.
Punitive damages are also frequently available in bad faith cases. The states are divided on whether allegations of bad faith are regarded as contract actions, or actions sounding in tort. Traditionally, punitive damages lie in actions sounding in tort, and not for breach of contract. The bad faith area has witnessed some erosion of the traditional rule, allowing punitive damages for "bad faith" breach of contract. See, e.g., Rocanova v. Equitable Life Assurance Society of the United States, 83 N.Y.2d 603, 634 N.E.2d 940, 612 N.Y.S.2d 339 (1994).
Punitive damages remain a viable remedy in bad faith cases. In BMW of North America, Inc. v. Gore, 517 U.S.559, the U.S. Supreme Court made it clear that, in extreme cases, there are constitutional limits on the amount of punitive damages that can be awarded. From the standpoint of opponents of punitive damages, BMW presented tailor-made facts: a well-to-do physician, whose loss was a $4,000 diminution of value in his luxury automobile, received an award of $4 million punitive damages. Contrary to the prophecies of some in the insurance industry, however, BMW did not put an end to punitive damages as long known to the common law. An analysis done in the first year after BMW showed that, on applications for certiorari, the Supreme Court did not disturb verdicts where the ratio of punitive awards to actual damages was 20 to 1 or less, regardless of the reprehensibility of the defendant's conduct. When the ratio exceeded 110:1, the Court remanded, except where the defendant's conduct was particularly egregious. See Mealey's Litigation Reports: Insurance, March 11, 1997.
This is encouraging news for policyholders whose insurance companies have treated them inconsistently with their duties of good faith and fair dealing. Where insurance companies have wrongfully failed to afford either the indemnity or litigation coverage contained in their policies, or have simply played an endless game of delay with them in handling claims, the law provides avenues for awards of actual damages, attorneys' fees, and, on the right facts, punitive damages.
* Stephen M. Goldman is of counsel in the Washington, D.C. office of McKenna & Cuneo, L.L.P. His practice focuses on insurance recovery for policyholders under both first-party and third-party policies. Mr. Goldman can be reached at 202-496-7837.
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