Bad Faith in Liability Insurance - New Appleman on Insurance Law Library Edition, Chapter 23

Bad Faith in Liability Insurance - New Appleman on Insurance Law Library Edition, Chapter 23

Chapter 23 begins by recounting the origins of a liability insurer's duty to protect its insured from exposure to a judgment in excess of limits by settling within limits.  The fact that the insurer's duty to indemnify extends only to a limited amount creates a well-known conflict of interest when there is a significant prospect of a judgment exceeding the limit.  The insurer seemingly has little to gain by paying the full policy limit to settle: the only savings would be the cost of trying the case and a trial might produce a defense verdict, or at least one lower than the policy limit.  But refusal to settle involves gambling with the insured's exposure to excess liability, a fact once used to pressure insureds to contribute to within-limits settlements.  At first, the courts placed no limits on an insurer's discretionary decision not to settle, but they came to hold insurers responsible for considering the insured's interests as well as their own, and most eventually have come to impose tort liability for failure to do so.

Section 23.02 examines the duty to settle in detail.  Section 23.02[1] examines the conflict of interest created by combining the policy limit with insurer control of settlement.  In theory, one could eliminate this conflict by holding the insurer responsible only for settling the within-limits portion of the liability and leaving the insured to settle any excess exposure.  However, the insurer is better able to evaluate claims and the insured has purchased that expertise; the insurer is also better able to bear the risk and could improperly exploit the risk aversion of most insureds. Therefore, courts have held that insurers must fully utilize the policy limits to effect appropriate settlements of the entire liability.

Section 23.02[2] examines the various standards applied to determine when an insurer has breached the duty to settle.  At one extreme, some jurisdictions require some level of subjective culpability by the insurer.  At the other extreme, Rhode Island imposes strict liability (and West Virginia imposes nearly strict liability) for any refusal to settle within limits that results in an excess judgment.  Most jurisdictions require either equal consideration of the insured's interests or exercise of due care to prevent excess judgments. These standards have generally coalesced into a requirement that the insurer make settlement decisions as if it alone would be liable for the entire judgment.  This "disregard the limits" standard is well-supported by the policies underlying the duty to settle.  Older cases that find no liability for failure to settle when the insurer had a fair prospect of successful defense, regardless of the magnitude of any potential loss, are probably superseded by more modern standards. The section closes by considering the impact on the insurer's settlement obligation when a putative joint tortfeasor may share any liability the insured may have for the claims asserted.  If possible, the insured must be protected not only against liability to the plaintiff, but also against claims for indemnity or contribution by any joint tortfeasor.  But the insurer must be cautious about limiting its own offers based on an assumption of joint liability that may not be borne out in a verdict.

Section 23.02[3] analyzes the insurer's obligation to investigate.  An insurer must exercise its rights of control over settlement honestly and intelligently, and to intelligently exercise them, it must investigate the facts and the probable extent of liability.  Failure to investigate is not itself a basis for liability, but the insurer will be charged with the knowledge that an investigation would have revealed.  Inadequate investigation may also result in impairment of the defense, leading to liability for any damages resulting from that impairment.  In jurisdictions requiring subjective culpability, deficient investigation may be evidence of indifference to the insured's interests.

Section 23.02[4] examines an insurer's duty to keep its insured informed in a timely manner of developments regarding possible settlement.  Doing this enables the insured to provide any relevant information the insured may possess, to argue for a larger offer by the insurer, grant or withhold consent to settlement if the policy provides the insured with that right, and to offer any contribution to settlement that the insured might wish to make.  An insured can excuse any duty to inform by expressing indifference to any excess exposure.  Failure to inform, standing alone, will not support liability unless that failure caused harm to the insured, such as loss of a settlement that could have been made with a contribution that the insured was willing and able to make.

Section 23.02[5] examines types of evidence that may show breach of duty.  Many older cases list factors to consider in determining bad faith and these are still relevant under more refined modern standards.  The once common, but now rare, demand that an insured contribute to a within-limits settlement is an example.  This creates a need for delicacy by insurers, who are now obliged to inform an insured of the possibility of contributing to a settlement (see Section 23.02[4]) but must not demand such a contribution, except with respect to deductibles, noncovered exposures.  Of greater current relevance are such things as insurer efforts to "save something off the policy limits" by underestimating the exposure, rejecting its own representatives' advice, or failure to reevaluate in light of new evidence.  Particularly dangerous for the insurer is rejection of a within-limits offer after a verdict in excess of limits.  There is authority that the amount of the verdict can be evidence of the value of the claim at the time of settlement negotiations, but the better reasoned authority is to the contrary: in particular, a verdict for the plaintiff says nothing about whether there was previously a significant possibility of a defense verdict.

Section 23.02[6] examines prerequisites to the existence of a duty to settle.  To begin with, there is no duty to settle unless there is a genuine risk of judgment in excess of policy limits. The insurer is entitled to gamble if only its own money is at stake.  Generally, there is no need for the insured to request settlement, although a few states require such a request.  The insured has contracted for the benefit of the insurer's expertise in handling claims, and the insurer has a clear right to settle if it deems that appropriate, with no obligation even to consult the insured, if it deems that appropriate.  While a few jurisdictions hold that there can be no breach of the duty to settle where the insurer was not defending, the better reasoned and more numerous cases are to the contrary.  Payment of an excess judgment by the insured is not a prerequisite for a bad faith claim, because the judgment itself is considered damaging (except, perhaps where the insured is bankrupt or an insolvent artificial entity).

As explained in Section 23.02[6][c], the duty to settle applies only to covered claims: the duty to defend includes negotiating for settlement of all claims, but payment is a function of the duty to indemnify.  There is a split of authority whether an insurer's duty to settle is affected by reasonable but mistaken doubts about coverage. If there is coverage and if a settlement was otherwise reasonable, the majority rule holds that,a failure to settle is a breach of contract regardless of any reasonable coverage doubts the insurer may have had.  The minority rule holds that, because an insurer usually has little prospect of recovering a payment for what may turn out to be a noncovered settlement, a reasonable coverage question excuses the duty to settle.  If one looked at this primarily as an issue between insurers and insureds, the majority rule would have much to be said for it.  But if one looks at what rule creates the proper incentives for the plaintiff (indirectly protecting the insured in the process), the minority rule appears superior.

Section 23.02[6][d] notes the obvious point that there can be no breach of the duty to settle if there was no opportunity to settle and the related rule that breach of the duty to defend, standing alone, ordinarily does not expose the insurer to liability beyond policy limits.  There is a division of authority on whether an insurer must initiate settlement negotiations or need only respond to demands from the plaintiff.  Courts taking the former position reason that the insurer should treat the claim as if it alone would be liable and, therefore, should initiate settlement negotiations whenever it would have done so were there no policy limit.  The contrary rule creates better incentives for plaintiffs, who might otherwise simply maneuver to induce an arguable breach by the insurer to open up the policy limits, without ever intending to accept a policy-limits offer.  To prevent such maneuvering, any demand should be required to be definite and unambiguous.

Regardless of whether the insurer is required to initiate negotiations, any demand by the plaintiff will not be a basis for liability unless it creates a real settlement opportunity.  In particular, any demand must be open for a reasonable time to permit the insurer to evaluate it with the benefit of adequate information to do so.  In making and responding to settlement demands, insureds and insurers must take proper account of liens and subrogation interests, lest the rights of the lienholder or subrogor leave the insured subject to continuing liability if the demand is accepted.  The insurer has no obligation to pay amounts in excess of policy limits unless mishandling the claim has created such an obligation.  But an insurer may create exposure if it refuses to disclose what the policy limit is and the plaintiff would have made a reasonable demand for that limit had it been disclosed.

Section 23.02[8] deals with bad faith set-ups, where the plaintiff (usually through counsel) seeks to utilize the law of bad faith to open up the policy limit to allow recovery of a claim much larger than the limit.  Typical tools in such set-ups include time-limit demands, with short deadlines for insurer action, coupled with threats that there will be no future settlement opportunities, made at a time when the insurer lacks some information necessary to evaluate the claim, and ambiguity regarding potential coverage.  The traditional response has been to evaluate the reasonableness of the insurer's response in light of any problematic features of the plaintiff's conduct.  The duty to settle runs to the insured, and even unreasonable conduct by the plaintiff does not obviate that duty.  Yet, if the plaintiff denies the insurer necessary information or sufficient time to evaluate and respond to a demand, there may be no liability.  But whether that is so often presents a jury question.  A newer approach looks to whether the claimant's conduct, rather than the insurer's obstinacy or ineptitude, was the proximate cause of the failure to settle.  The latter question would more often be one for the court.

Section 23.02[9] addresses the problems presented when there are multiple claimants or insureds and inadequate limits to cover all claims.  When there are multiple claimants and inadequate limits, payment to one claimant may reduce the funds available to pay others.  The cases are essentially unanimous in holding that an insurer owes no duty to claimants to refrain from depleting the policy limits by disproportionate settlements with other claimants.  Most courts hold that an insurer has wide discretion to make reasonable settlements with some claimants, even if that depletes the limits available for other claims.  But some courts hold that the insurance fund should be used to compromise as much of the insured's potential liability as possible.  At least for an impecunious insured, that rule is usually unsound, as the insured will normally file for bankruptcy if left with any substantial personal exposure.  Unless the claim is nondischargeable (e.g., for drunken driving), bankruptcy will eliminate a large excess judgment as easily as a small one.  The insurer should be allowed to hold out for a global settlement that will fully protect the insured.  (Insureds with substantial assets should be involved in settlement strategy.)  Interpleader can be a tool in multiple claimant cases, but is not a complete solution, because it does not prevent continued pursuit of the insured.

Multiple insured cases present problems when the plaintiff demands policy limits to settle with one insured (typically the one with the fewest assets), while insisting on continued pursuit of the other insureds (who may then need to defend themselves, as well as paying for any settlement or judgment for the remaining liability).  A few courts have held that settling for less than all insureds improperly prefers those benefiting from the settlements (or at least permits the reasonableness of the preference to be examined).  But the majority of courts disagree, reasoning that the remaining defendants would get credit for the amount paid in settlement.  At least as long as liability is joint, rather than several, an insured with assets available to respond to an excess judgment should expect to contribute to any settlement where the estimated verdict value of the claim exceeds the policy limit.  So, the majority rule is the better rule.

Section 23.02[10] considers the duties of co-insurers of the same liability (where neither is secondary or excess to the other).  In event of dispute as to respective obligations, coinsurers should fund advantageous settlements, subject to reallocation in later litigation.  If the insurers disagree whether a proposed settlement is advantageous, their rights should depend on the law governing an insured's rights in a similar situation.  (Some states allow an insured who wishes to accept an allegedly excessive demand to do so and sue the insurer for reimbursement, while others hold that an insurer has a right to insist on trying the case, subject to possible liability if an excess judgment results.)

Section 23.03 addresses the relevance of the insured's conduct to the duty to settle.  While a fair number of cases state that the insured's fault is a factor in determining whether a failure to settle was a breach of duty, that appears to be so only if that fault contributes to a failure to settle, such as by providing misinformation that made defense prospects appear brighter than they actually were.  But an insured's request that the insurer not settle may preclude liability, if the insured were fully advised of the risks of trying the case.

Section 23.04 discusses an insurer's right, explicit in most policies, to settle whenever it deems expedient.  Unless the settlement may create obligations for the insured for a deductible or retrospective premium, this right is virtually absolute.  However, the insurer ordinarily may not, without the insured's consent, sacrifice an insured's affirmative claims or commit the insured's assets to settlement. The reserved right to settle must be exercised with the insurer's own funds.  The rules applicable to fixed-cost policies are modified for loss-sensitive policies, with deductibles or retrospective premiums payable by the insured.  If policy language gives the insurer settlement authority, the insured's consent still is not required.  But, the insured may be able to contest the propriety of the payment as a breach of the insurer's duty of good faith.  Courts apply a variety of standards and burdens of proof to such challenges.

Section 23.05 examines the basis and implications of the rule that an insurer usually has no duty to a third-party claimant to settle the claim against the insured.  The duty to settle is an aspect of the duty of good faith and fair dealing, which arises from the insurer's contractual relationship with the insured.  A third party claiming against the insured has no such relationship, and so the insurer owes it no special duty.  The third party is an adversary of both insurer and insured and they may treat it as an adversary.  The insurer's duty is to protect the insured by seeking to defeat or minimize the claim.  Even where insurance is mandatory, avoiding inflation of insurance rates requires subjecting third-party claims to adversarial testing.  To be sure, regulatory statutes in many states require insurers to attempt to settle claims where liability has become reasonably clear.  But only a few states permit private actions based on such requirements.  Because the insurer typically owes the claimant no duty, claimants suing insurers for failure to settle ordinarily must rely on assignment of claims by the insureds.  Similarly, as Section 23.06 explains, an insurer has no duty (except in Montana) to make advance payments to a claimant before final resolution of the claim against its insured.

Section 23.07 examines the settlement duties and rights of excess insurers.  If a primary insurer breaches its duty to settle, requiring an excess insurer to pay liability that should have been avoided by that settlement, the law generally recognizes that the excess carrier is equitably subrogated to the rights of the insured regarding the excess judgment.  A few states recognize a direct duty to settle running from the primary insurer to the excess insurer, protecting the latter from defenses based on the insured's conduct (see Section 23.03).  While an excess insurer may owe its insured a duty to settle, most jurisdictions hold (consistent with industry practice) that the excess insurer has no duty to defend or settle until the primary coverage has been exhausted or tendered for settlement.  If a primary insurer is insolvent or wrongfully refuses to defend, an excess insurer may be obliged to "drop down" and provide a defense or indemnity, depending on policy language and local law; but most excess insurers now have language that avoids any such obligation.

Section 23.08 discusses issues presented by the need to post an appeal bond after an excess judgment has been rendered.  Under usual policy language, the insurer has the obligation to pay the premium for the bond, but not to furnish it.  If the insurer bonded the excess judgment, it would have to pay that judgment whether or not the judgment had been caused by any error or omission by the insurer, and few insureds would be able to reimburse a payment that the insurer had not been legally obligated to pay.  So, insurers resist bonding excess judgments if they contend they are not responsible for the excess.  Some jurisdictions permit the insurer to post a partial bond, in the amount of the policy limit, leaving any excess unbonded.  If the insured has assets subject to execution, that may require the insured to file for bankruptcy to protect such assets during the pendency of the appeal.

Section 23.09 examines the compensatory damages recoverable for breach of the duty to settle.  Of course, the primary item of damage is the amount of any excess judgment (possibly a consent judgment, if there was a permissible settlement by the insured).  That is recoverable whether breach of the duty to settle is regarded as a tort or as a breach of an implied contractual term.  Liability for prejudgment interest varies with local law; postjudgment interest is likely to be recoverable as a matter of course.  And even under the restrictive contract rules for recovery of consequential damages, some of the consequences of a breach of the duty to settle might be regarded as within the contemplation of the parties at the time of contracting.

If the breach is regarded as a tort, other damages suffered by the insured will be recoverable.  The insurer cannot avoid liability by eventually paying the excess judgment if damages apart from the judgment have been proximately caused by that judgment.  Most obviously, the insured can recover economic damages, and tort liability extends to recovery for such things as emotional distress and, possibly, loss of consortium.

Section 23.10 considers availability for punitive damages for breach of the duty to settle.  As in any other type of case, punitive damages are recoverable only where the defendant's conduct is accompanied by circumstances of aggravation or outrage, such as spite or malice, or a fraudulent or evil motive on the part of the defendant, or such a conscious and deliberate disregard of the interests of others that the defendant's conduct may be called willful or wanton.  They usually are recoverable only if breach of the duty to settle is regarded as tort.  But at least some courts may be willing to allow recovery even if breach is regarded as merely contractual.  The primary goals of punitive damages are to punish and deter; they serve as a reward to plaintiff for bringing a wrongdoer to justice rather than as compensation for loss.  In some states, the plaintiff must prove the requisite culpability (which typically goes beyond that required for compensatory recovery) by clear and convincing evidence.  Many states have a common law requirement that punitive damages bear a reasonable relation to the harm, though this requirement is much criticized and usually is not strictly enforced.

Punitive damages are also subject to constitutional restrictions, especially where (as in most bad faith cases) the harm is purely economic, rather than physical.  The permissible level of damages depends on the reprehensibility of the defendant's conduct, the harm to the plaintiff caused or threatened by that conduct, and any applicable statutory penalties for similar conduct.  Except in cases of minimal harm or extreme reprehensibility, punitive damages with more than a single digit ratio to the harm caused or threatened are unlikely to be constitutional.  Where the harm is substantial, a one-to-one ratio may be the constitutional limit.

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