Does the Threat of Insurer Liability for “Bad Faith” Affect Insurance Settlements?

• Date: 01 March 2014
• Author: Sharon Tennyson,Danial P. Asmat
• Published date: 01 March 2014
• DOI: http://doi.org/10.1111/j.1539-6975.2012.01499.x

© The Journal of Risk and Insurance, 2014, Vol. 81, No. 1, 1–26

DOI: 10.1111/j.1539-6975.2012.01499.x

1

DOES THE THREAT OF INSURER LIABILITY FOR “BAD

FAITH”AFFECT INSURANCE SETTLEMENTS?

Danial P. Asmat

Sharon Tennyson

ABSTRACT

Economic reasoning predicts that policyholders in states that treatfor insurer

bad faith in settling claims as a tort should receive higher payments from

insurers because of the greater potential damages insurers face in claims

disputed in court. Wetest this hypothesis using data on automobile insurance

claims for accidents occurring during 1972–1997, exploiting differences in

states “laws and variation in timing of states” adoption of bad faith rules to

identify the effects of tort liability. We find that the presence of tort liability

for insurer bad faith increases settlement amounts and reducesthe likelihood

that a claim is underpaid.

INTRODUCTION

U.S. common law has long recognized the unequal bargaining power of insurance

companies and policyholders in the insurance relationship. The insurer not only

writes the contract terms, but settlements are negotiated at a time when the insured is

particularly vulnerable. For these reasons insurers are held to high standardsof “good

faith” in dealings with policyholders (Jerry, 1994). Nevertheless, until relatively re-

cently policyholders who were treated unfairly in claims settlement had few available

legal remedies. Legal disputes over insurance claims were settled under standards

set in 19th-century English common law,1which limited policyholders to recovering

only the amounts specified in the insurance policy even if the insurer intentionally

breached the contract.

Over the past 30 years the compensation available to policyholders in cases where

insurers violate good faith standards has increased.A majority of states now recognize

Danial P. Asmat is a Ph.D. student in the Department of Business Economics and Public

Policy at the University of Michigan. Sharon Tennyson is Associate Professor of Policy Anal-

ysis and Management at Cornell University. The authors can be contacted via e-mail: da-

nial.asmat@gmail.com and sharon.tennyson@cornell.edu, respectively. The Insurance Research

Council (IRC) provided data for the empirical analysis. Useful comments were received from

Tom Baker and from seminar participants at Cornell Law School, Georgia State University,

Florida State University, Temple University, the World Risk and Insurance Economics Con-

ference, and the ARIA session at the Allied Social Science Association meetings. The authors

remain solely responsible for the content of the work.

1See the discussion in Tennyson and Warfel (2010).

2 THE JOURNAL OF RISK AND INSURANCE

the right of policyholders to file private lawsuits against insurers alleging unfair claim

settlement practices. However, the legal philosophies under which these cases may

be brought vary across the states. Some states view an insurer’s bad faith in settling an

insurance claim as a contract breach, but other states consider insurer bad faith to be a

tort (Stempel, 2008; GenRe, Palmer,and Dodge, 2008). Under tort law an injured party

may recover for all harm or injuries sustained, including legal expenses, economic

loss, and mental distress. Punitive damages may also be awarded if the conduct giving

rise to liability was particularly egregious. Thus, tort standards greatly increase the

potential costs to an insurer for bad faith dealings in settling a claim.

The theoretical law and economics literature posits that differences in the litigation

environment will alter the bargaining game for claims settlements between insurance

companies and their policyholders.2The threat of greater expected financial penalties

in the event of a bad faith ruling by the courts increases the relative bargaining power

of policyholders and reduces the incentives of an insurer to deny, delay, or underpay

claims (Abraham, 1994; Sykes, 1996; Crocker and Tennyson, 2002). If this threat is

salient, policyholders in states that permit tort liability for insurer bad faith should

receive more favorable insurance settlements.

We test this hypothesis using a large sample of automobile insurance claims from

accidents occurring in 42 states over the period 1972–1997 when tort liability for

insurer bad faith was expanding.3The use of repeated cross-sectional data allows us

to exploit the differences in states’ dates of adoption of tort standards to identify its

effects on insurance settlement amounts. Ours is the first study of bad faith regimes

to use this approach.4This research design addresses the difficulty in identifying

the effects of laws based on cross-sectional differences across states with different

laws. It also permits examination of the long-run effects of tort liability for insurer

bad faith. We test for statistically significant effects of tort-based bad faith regimes

on settlement amounts and examine how settlement generosity evolves over time in

relation to changes in states’ bad faith regimes.

We find that tort liability for insurer bad faith is associated with higher settlement

amounts and that this increase is statistically significant even after accounting for po-

tential changes in claimed loss amounts when bad faith liability is expanded. We find

further that tort liability reduces the likelihood of claims being underpaid. Examining

changes in the impact of bad faith liability over time, we find little evidence that its

effects on settlements have diminished over time. These results provide new evidence

that tort liability for first-party-insurer bad faith has real economic consequences for

the settlement of insurance claims.

The remainder of the article is organized as follows. After providing background on

liability regimes for insurer bad faith, we discuss the predicted implications of tort

2Cooter and Rubinfeld (1989) and Spier (2007) providecomprehensive reviews of the theoretical

law and economics literature on litigation and dispute resolution.

3The first court decision that allowed the application of tort liability to first-party insurance

bad faith was decided by the California Supreme Court in 1973. Courts in 27 states followed

this precedent between 1973 and 1997.

4However, Browne and Schmit (2008) use this research design to examine litigation patterns

over time.