5.1.1 Covenant of Good Faith and Fair Dealing

• Jurisdiction: Arizona

Insurance policies are unique contracts that are purchased for protection against calamity, not commercial advantage. When a covered loss occurs, the insured expects to have the protection she purchased. However, when such casualty loss occurs, the insured may be put in a vulnerable economic position if the insurance company refuses or fails to pay a valid claim without sufficient justification. In this situation, contract damages may fail to provide adequate compensation for the breach of security purchased through the insurance contract. Moreover, limiting the insured only to contract damages may create an incentive for insurance companies to deny claims before an adequate evaluation of the claim has been performed. Deterring this type of conduct was discussed by the court in Rawlings v. Apodaca.^[1] According to the Apodaca court, contract damages:

". . . offer no motivation whatsoever for the insurer not to breach. If the only damages an insurer will have to pay upon a judgment of breach are amounts that it would have owed under the policy plus interest, it has every interest in retaining the money, earning the higher rates of interest on the outside market, and hoping eventually to force the insured into a settlement for less than the policy amount."^[2]

It was against this backdrop that the court, in Noble v. National American Life Insurance Co.,^[3] created tort liability for an insurance company's unreasonable denial of coverage.^[4] Under the standard adopted by the Noble court, "[t]he tort of bad faith arises when the insurance company intentionally denies, fails to process or pay a claim without a reasonable basis for such action."^[5] Insurance companies are permitted, however, to challenge claims that are "fairly debatable."^[6]

The question of "fair debatability" for a particular claim submission turns on whether the claim was properly investigated and whether the results of the investigation were reasonably reviewed and evaluated.^[7] This is an objective standard. An insurance company's subjective belief and assertion that the claim is fairly debatable is not dispositive.^[8]

Although an incomplete pre-denial investigation of an insured's claim can expose the insurance company to liability for bad faith, it, too, is not dispositive. "An insurance company's failure to adequately investigate only becomes material when a further investigation would have disclosed relevant facts."^[9] In order to prevail on a claim for bad faith arising from an inadequate investigation, the insured must present some evidence that additional pertinent facts would have been disclosed or determined by further investigation. The information submitted to the insurance company by the insured may be sufficient, in itself, to form the basis upon which the insurance company denies the claim without further independent investigation on the part of the insurance company.

The tort of bad faith "arises when the insurer's conduct is 'conscientiously unreasonable'-i.e., when the insurer knows it is acting improperly or when its improper actions permit such knowledge to be imputed to it."^[10] If the insurance company intends its actions or omissions, and lacks a "founded belief" that such conduct is permitted by the policy, it will be liable for tort damages even though it did not intend harm to its insured.^[11] This "founded belief is absent when the insurer either knows that its position is groundless or when it fails to undertake an investigation adequate to determine whether its position is tenable."^[12]

The tort of bad faith has been described as being a hybrid cause of action, sharing elements of both a negligence action and an intentional tort.^[13] The tort is comprised of two essential elements. The first element-whether the insurance company acted unreasonably toward its insured-is based upon a simple, objective, negligent standard. The second element-whether the insurance company acted knowingly, unreasonably, or with such reckless disregard that such knowledge may be imputed to it-is a subjective determination. It is the introduction of this second element of knowledge that elevates the cause of action to a quasi-intentional tort.^[14]

The negligence element of the tort acts as a threshold test for all bad faith actions.^[15] "Where the insurer acts reasonably, there can be no bad faith."^[16] The court in Trus Joist Corp. v. Safeco Insurance Co. of America,^[17] gives an excellent exposition of this concept:

[D]id the insurance company act in a manner consistent with the way a reasonable insurer would be expected to act under the circumstances. This is the threshold test for all bad faith actions, whether first or third-party. Where an insurer acts reasonably, there can be no bad faith. However, the converse of this proposition is not necessarily true: merely because an insurer acts unreasonably does not mean that it is guilty of bad faith. Negligent conduct which results solely from honest mistake, oversight or carelessness does not necessarily create bad faith liability even though it may be objectively unreasonable [citation omitted]. Some form of consciously unreasonable conduct is required.^[18]

Thus, mere negligence or inadvertence is insufficient to establish the cause of action.^[19] The court in Apodaca observed:

Insurance companies, like other enterprises and all human beings, are far from perfect. Papers get lost, telephone messages misplaced and claims ignored because paperwork was misfiled or improperly processed. Such isolated mischances may result in a claim being unpaid or delayed. None of these mistakes will ordinarily constitute a breach of the implied covenant of good faith and fair dealing, even though the company may render itself liable for at least nominal damages for breach of contract in failing to pay the claim.^[20]

A party claiming breach of an implied covenant of good faith and fair dealing is ordinarily limited to contract damages.^[21] However, a party may bring a tort action for breach of this implied covenant if there is a "special relationship between the parties arising from elements of public interest, adhesion, and fiduciary responsibility."^[22]

In Enyart v. Transamerica Insurance Co.,^[23] the court held that the insurance company had created a sufficient "special" relationship with an injured claimant to permit a tort action for the insurance company's breach of the implied covenant of good faith and fair dealing. This special relationship was created by entering into a settlement agreement with the claimant involving the purchase of an annuity to cover the claimant's injuries. The claimant gave releases of his legal claims in return for the promises contained within the settlement agreement, which included the insurance company's necessary participation in the annuity plan. The insurance company's participation in the annuity plan transformed the relationship between the insurance company and the injured claimant, "previously only that of potential adversaries in litigation," to one involving fiduciary obligations. When the insurance company failed to procure a backup annuity as required by the settlement agreement, the court in Enyart held that a tort claim for the insurance company's breach of the covenant of good faith and fair dealing, implied into the settlement agreement, was legally redressable in tort.

In Dodge v. Fidelity & Deposit Co. of Maryland,^[24] the court explained that "[t]he two most important factors" in determining whether a tort action for bad faith will lay "are (1) whether the plaintiff contracted for security or protection rather than for profit or commercial advantage, and (2) whether permitting tort damages will "provide a substantial deterrence against breach by the party who derives a commercial benefit from the relationship."^[25] Thus, where the insured is at risk of losing, at most, only a potential "profit or commercial advantage" in the form of a refund or of a portion of the premium paid, the court in Beaudry v. Insurance Company of the West^[26] found that such an interest was adequately protected by contract remedies such as a judgment for the amounts wrongfully withheld.

In Knoell v. Metropolitan Life Insurance Co.,^[27] the district court reviewed Arizona bad faith law. First, on the issue of "fair debatability," the court found that, if there was a question of fact as to whether the insurance company owed benefits under the policy, then the claim is fairly debatable.^[28] When a claim is fairly debatable, the insurance company will not be liable for acting in bad faith by declining to pay such claim immediately.^[29] Accordingly, when there is a question of fact as to liability on the underlying policy, then as a matter of law, the court concluded that the insurance company cannot be liable for bad faith.^[30]

The court in Knoell reviewed the threshold question of whether the insurance company had violated the first prong of the test for bad faith which objectively centers upon reasonableness. The court acknowledged that where the actions taken on the part of the insurance company are reasonable, the insurance company will not be found to have acted in bad faith.^[31] In determining whether the insurance company acted reasonably in a case premised on a failure to pay benefits, the court will consider whether the insurer's liability under the policy was "fairly debatable."^[32] Under the first prong of the test for bad faith, insurance companies can challenge claims that are fairly debatable without having acted in bad faith.^[33] If the plaintiff meets the burden of establishing the first prong of the test, then the plaintiff must also be able to show the second prong. The second prong is a subjective test.^[34] Under the second prong of the test, the plaintiff must show that the insurance company committed "consciously unreasonable conduct."^[35] "Consciously unreasonable conduct" requires that the insurance company either acted knowing it was...