Where We’re Going To End Up – The Insurance Bad Faith “Easy Case”

Attorneys and other insurance experts need to know the twists, turns and exceptions to what I’m about to say. Insurance Bad Faith covers many more things than just the easy case, but the best place to start is the straight, middle of the road, fat pitch over the plate:

If an insurance company knows or ought to know that it should pay under a given policy and refuses to do so, that company has violated the Insurance Bad Faith Law and should be forced to pay the customer’s attorney fees, along with extra interest and maybe even punitive damages.

This isn’t true for defendants in other types of litigation, but insurance companies are a special case for the reasons we are going to discuss.

One of the best insurance defense lawyers I know uses this catchphrase to describe that core when he teaches CLE (Continuing Legal Education) courses on the topic:

Insurance Bad Faith happens at the ‘Scr#w You Moment,’ when the company ought to know better but says “Scr#w you, we’re not paying anyway.”

That is the core and wheelhouse of what the law was intended to address. But there is an angle in here that matters too. The duty to act in good faith doesn’t end when the company denies the claim. It continues all the way through trial, and in my long experience the vast majority of bad faith occurs when a company made a semi-reasonable decision at the start and then refuses to reconsider when things become clearer.

For example:

You own a building that suffers serious water damage during an enormous storm. Your insurance company refuses to pay on the grounds that the water was part of an overall flood on your street, which is excluded. And sure enough, the newspaper reports list your address as one of the flood victims, your front lawn was actually underwater, and your basement did get wet. So on its face the company seems to have a point.

But then you hire a lawyer who starts to organize your argument in a clearer way. Turns out, you aren’t worried about what happened in the basement. That was peanuts. The real problems came from water that entered through your roof. Storm damage is not excluded, and thus you should be covered – at the very least for the amounts that don’t involve your basement, and possibly for those as well depending on what turns up when we look a little deeper…

And by the way, had this been a business location with business interruption insurance? That could have added up very quickly indeed if the insurance company doesn’t pay what it knows is due.

Should the company have noticed something like that right away? Absolutely! The law says that adjustors are supposed to look for ways to find coverage, not excuses to avoid it. Does the mistake itself amount to bad faith? Maaaaaybe… In court it will come down to whether the judge concludes it was an “oops” or a “scr#w you moment.” But here’s the point: everything changes when the facts and the nature of the claim clear up. When that happens, the company must pay your claim even though it initially denied you. “We made this decision already,” may seem a natural response, but it is not, not, NOT a defense! The company’s refusal to look at the case with fresh eyes every time creates bad faith even if none had existed before (and so does offering you a “compromise” settlement, btw). The trick is to pin the company down so it can’t claim later that it misunderstood, and also to amend your additional Complaint by adding the new fact/theory of law.

More on that later. Before we go on, we need to step back in order to understand why the Insurance Bad Faith law is so unusual, and why it had to be created in the first place.

Start With The Background – The “American Rule” And The “Bad Old Days”

Here’s a basic rule that first year law students spend about a week chewing over in excruciating and brain-busting detail.

X and Y have a contract. X promises to perform a task, and Y promises to pay $1,000,000 once the task is done. That is a contract.

X does the job, but Y refuses to pay. X can sue Y for breach of contract. Under the “American Rule” – our version of the common law going back to the beginning of the Republic – X can sue to recover the promised $1,000,000, but essentially nothing more. X cannot recover the $400,000 attorney fee; X cannot recover for the time he spends on the suit (even if he is a lawyer suing on his own); X cannot recover for the suffering he goes through as part of the suit; X cannot recover punitive damages; X cannot recover for the $40,000 he had to pay out of pocket for deposition transcripts, travel expenses, expert witness fees; etc.

The bottom line is that X got cheated, and under the American Rule X is going to walk away from the courthouse with barely half of what he should have been paid in the first place, and a lot of added emotional trauma.

So, Mr./Ms. One-L: Let me pose a hypothetical. Assume that you are Y, and – lucky you! – you happen to be someone (say an insurance company) who is flush with both lots of money and an army of lawyers you pay at a discounted, bulk-rate level of fees. Why not deny every single claim under every single policy regardless of what happened? Simply tell your customer this:

“Dear Mr. X: If you sue me, the most you can get is around 55% of what I owe you. Save yourself some money and settle for 60% now. All you have to do is sign this Waiver agreeing that we had a good faith dispute and agree this is a fair compromise.”

You’d hesitate for fear of earning a bad reputation with consumers? Seriously? You’re an insurance company! How much worse can your reputation get? Besides, which would cost you more – paying 100% on your claims, or paying 60% and devoting part of your savings to bolster your already-enormous advertising budget?

In fact, let’s get the number crunchers involved. Shareholder savings (and executive bonuses) are awfully important things, after all! 60% only made sense because it guaranteed that the policyholder wouldn’t “lose” by agreeing to your deal. But couldn’t you bully most claimants down to 50%? Pain, suffering, and risks are worth something too…

“In fact,” say the number crunchers, “our research shows that reasonably aggressive Account Settlement Executives can normally settle for an average of 38.6% of the amount that would have been owed under the contract’s actual terms. Our stockholders have the right to demand the maximum possible profits, so we recommend…”

Exaggeration aside, this basic pattern – offer a fraction of what was owed instead of following the contract – became a designated game plan for wide swaths of the insurance industry.

Welcome to the Bad Old Days. The worst part was this: they had to! Executives with too many scruples to go along fell by the wayside. The result was unavoidable, dictated by the logic of the American Rule, and only getting worse.

If the American Rule Is So Bad, Why Not Follow the English Rule?

The “English Rule” requires the loser in a lawsuit to pay the winner’s attorney fees and other expenses. I.e., it says that our hypothetical would end with X walking away with his full $1,000,000. So why don’t we do it that way if it seems so much fairer?

The flip side to the English Rule is that X would have to pay Y’s expenses and attorney’s fees if he loses at trial. Consider what that means. Your house burned halfway down in a fire and the insurance company is cheating you by offering $60,000 instead of the $100,000 it will take to make you whole. But if you sue for the full amount and somehow manage to lose, you will face bankruptcy and ruin because you’d have to pay for the company’s attorney too! And public shame, of course, because they can and will put your face on a billboard as an example to other policyholders that might dare to think it’s an equal playing field.

Yes, you are 100% sure that you’re in the right. And yes, everyone you meet agrees with you. But the simple fact is that no case is 100% ironclad. There’s always a 10% or 20% chance that something will go kerplooey. Are you willing to take that risk? $60 K would make the house livable even if it wouldn’t put it back the way it was…

In practical terms, the English Rule bars the courthouse door to any plaintiff who isn’t (a) wealthy beforehand, or (b) willing to run a 20% risk of destroying his life forever. This unfairness holds true in the other direction too. Wealthy people can afford to sue whenever they want on any trumped up claim, and force poorer people to settle for an extravagant amount because they can’t afford to pay the rich man’s attorney’s fee.

The English try to solve this with government programs to help court losers survive the process, but they are only partly effective (try to figure out how you would design the system and you’ll see why) and Americans don’t tend to like “government programs” in any event. And that is why our founders and our current politicians continue with things as they’ve always been: it’s an American choice that equal access to justice is worth more to society than full and complete justice for people who were wronged.

Frustrated? I hope so! First-year law students get so furious about this kind of unfairness that professors typically set aside a week of class time to let them vent. And, of course, to drill the point home: No legal system can get it all “right,” so every answer is going to be “wrong” in one way or another. All you can do is pick your poison, and find small-scale answers when you see a particular pattern of abuse.

Which gets us back to the Bad Old Days, and the way an entire industry was using this hole to systematically cheat any policyholder who couldn’t afford to take the risk of suing.

The Creation of Insurance Bad Faith Law

The solution was obvious. Insurance companies that played the Bad Old Game needed to be shot down and punished by forcing them to (a) make their policyholders whole, and (b) pay an extra price on top for trying to cheat. But how to get there?

Outside of a few weird exceptions, insurance policies are governed by state law. California began the reform process with a court case in 1958 and over the course of the next 10-20 years was followed by virtually every other state in the union. Pennsylvania was one of the very last to go along. Our Insurance Bad Faith Law didn’t get enacted until 1990, when the Supreme Court forced the legislature to act by refusing to do so on its own.

The logic of the early judge-made law ran something like this:

  1. Every contract includes an implied promise that each side will act in the spirit of good faith and fair dealing. That’s so central that it can’t ever be written out of the deal.
  2. Insurance companies have an even higher duty of good faith than most parties. There are lots of reasons for this, ranging from the sales pitch they give to the public (inevitably some variation on, “We’ll look after you as if you were one of our own”) to the special knowledge it takes to understand a policy and the fact that customers have no opportunity to negotiate specific terms.
  3. When an insurance company denies coverage that it knows it should pay, that violates the duty of good faith in the most basic possible way.
  4. In fact, it’s more like punching someone in the nose or committing a fraud than merely breaching a contract. And punitive damages are available for punches in the nose…

Right about now your head has begun to swim. Punitive damages are available for “torts” like assault & battery or fraud, but not for breach of contract? Why is that? And why isn’t every breach of contract a kind of fraud if you think about it right? And why…?

I SURRENDER!! You are 100% right. Those distinctions are very technical, and they only exist because the common law developed piece by piece over time. The best reason for keeping them is the fact that they’ve been around and almost-working for a thousand years. That doesn’t mean they’re “right.” Nor does it mean they’re “wrong” – see above. It’s simply an example of why the courts are lousy places to make new public policy.

But the process had to go on because the problem had to be solved! The abuses were so big and so profound that even the industry insiders were beginning to blush and gag at the outrages their industry was committing and the course they were collectively on. And so it came to pass that thousands of brilliant, highly trained men and women focused their immense creativity and decades of experience on ways to pound square legal pegs into round legal holes, with a lot of chiseling (pun fully intended) on the corners that got in the way.

After a while, though, the clunky, court-built changes began to work. If you lived in California (or a state where the courts followed suit) the insurance company treated you a whole lot better than if you lived in a state like Pennsylvania. That, combined with the insurance industry’s worries about judges with too much independence, built up the sort of pressure that forces state legislators into action. And thus you got statutes like the 1990 one in Pennsylvania:[1]

42 Pa. C.S.A. § 8371. Actions on insurance policies.

In an action arising under an insurance policy, if the court finds that the insurer has acted in bad faith toward the insured, the court may take all of the following actions:

(1) Award interest on the amount of the claim from the date the claim was made by the insured in an amount equal to the prime rate of interest plus 3%.

(2) Award punitive damages against the insurer.

(3) Assess court costs and attorney fees against the insurer.

What The Insurance Bad Faith Law Means In Practice

First and foremost, the new statute outlawed the “Bad Old Game”. If an insurance company knows or ought to know that it has to pay your claim, and forces you to hire a lawyer to collect, then the insurance company has to pay for your lawyer and may have to pay punitive damages on top.

Sort of.

First, you’ll notice that the statute says a court “may” choose to enforce the statute. That leaves a certain amount of discretion even if bad faith has been found. Boiling things down, the appellate courts have basically said that the trial courts ‘should’ award costs and attorney’s fees, and ‘all but must’ award the enhanced interest, but can withhold punitive damages unless the bad faith was really outrageous.

Next, your contract with the lawyer probably specifies a set contingency fee. In Pittsburgh that’s usually 40%. But the courts only award attorney fees based on hourly rates, which means your lawyer has to keep track of every second like he was working for a big firm and then justify it to the court. If the court’s award is less than the 40%, you end up paying the difference. On the other hand, the hourly rate often yields an amount far higher than the 40% contingency, in which case the insurance company has to pay the full hourly amount. I have known lawyers to take outrageous bad faith cases where the insured had a relatively small amount at stake simply because they were confident that the insurance company would end up paying for their time. (This is called the “private attorney general” effect.)

Third, I have summarized the central rule as, “bad faith exists when the insurer knows or ought to know that the claim should be paid and refuses to do so.” But that’s not the full answer, and it’s actually untrue as a technical matter. Courts typically use the words “recklessly disregarded” instead of “ought to know.” Good lawyers in this field go to extremes to pin the insurance companies down and force them to actively “disregard” the truth rather than “merely failing to notice.”

For example, one of my favorite tactics is to write an extremely long and thorough letter to the company and/or its attorney that analyzes the case and identifies the insurance company’s (potentially) valid defenses. Then I continually supplement that analysis as the case moves on, explaining when and why each defense has disappeared. The letters get rid of any argument that the company might have innocently missed the problem. Sometimes the defendant comes back with an offer to “compromise” the claim because liability has (now) been established. My reaction? Hooray! Anything other than full payment is an open-and-shut bad faith claim once liability has been established.

This article has focused on giving the general public an overview of how things work and why. Please don’t mistake this summary for a description of how things actually work. Any real case involves a lot of technicalities, and technicalities matter in a court of law.

“Bad faith” also includes a variety of related sins that go far beyond the mere refusal to pay. If you’re angry enough to be suing, there’s little doubt that the company has done a variety of things to you that were “wrong.” The question is whether those things add up enough to be “bad faith”. It’s what the courts call a balancing test. I have an in-house list of about 50 factors that various courts have cited as examples of bad faith over the years. You can find a lot in the Pennsylvania Unfair Insurance Practices Act, 40 P.S. §§ 117.1. et. seq. too. Just remember that each of those factors is evidence of bad faith, not proof. It’s the overall balance that counts, not the simple fact that the company did a few things wrong. Your lawyer should be able to explain all this if you ask, but probably won’t make the effort to explain until you ask him to spend the time.

Then there is the standard of proof for a bad faith claim (“clear and convincing evidence” rather than the normal “preponderance of the evidence”) and the fact that bad faith verdicts get issued by a judge rather than a jury (a terrible rule in my opinion but one we are stuck with until the Pennsylvania Supreme Court changes its mind). And, of course, the fun point that you can’t get attorney’s fees if you’re representing yourself (whether or not you’re a lawyer, btw). And all the vagueness that goes into anything touching on punitive damages. And a whole lot of other things.

Conclusion – Insurance Bad Faith Law Helps To Level The Field

The bottom line is that Insurance Bad Faith Law exists to fix the imbalance between relatively powerless individuals who have been cheated and relatively monstrous insurance companies that turned customer abuse into a legal art form while spending hundreds of millions of advertising dollars to convince potential jurors that the customers (and their lawyers) deserved it.

Does the legal “fix” succeed in that lofty goal? No. It’s still easier to be the defendant holding the money than the plaintiff who’s trying to get it. But the Insurance Bad Faith Law does make things way, way better than they were in the Bad Old Days if you know how to use it correctly. This is one of the reasons why it’s so important to make sure that your lawyer knows what he or she is doing.

A Final Note – This Has Been About “First Party Claims”; Third-Party Cases Are Different

This article has summarized the rules for “First Party Bad Faith”; i.e., what happens in a fight directly between the company and its customer. “Third Party Bad Faith” happens when your insurance company does a too-cheap job of defending you against a claim filed by someone else. Hmmm… An example may help:

Your house goes up in flames, starting a fire that consumes your neighbor’s house as well. She (or her insurance company) sues, claiming that you did something wrong to start the fire.

Your claim for the damage to your house would be a “First Party” case. Your right to have your insurance company defend you against the neighbor’s claim would be a “Third Party” case.

The situation comes up even more often in malpractice and automobile cases. In any event, third party bad faith claims have a somewhat different set of rules and rationales, but those are beyond the scope of this article.

[1] Which actually passed because our Supreme Court refused to follow the other states, but that’s a story for another day.