Issues for excess insurer counsel in bad faith and excess liability cases.

• Author: McGuire, James A.

THE DEVELOPMENT by American courts of a cause of action for breach of the implied covenant of good faith and fair dealing has created a number of concerns for insurance carriers and their counsel, particularly in relation to liability for damages in excess of stated limits specified in the insurance contract. Multimillion dollar bad faith awards against both domestic and foreign insurers are becoming commonplace. In 1993, a Los Angeles Superior Court jury awarded $386.4 million in punitive damages against underwriters at Lloyd's and 40 companies. And this after the jury earlier had awarded $34.2 million in compensatory damages, $1.5 million in attorney's fees and approximately $3.4 million in pre-judgment interest after finding the insurers had breached contracts and committed acts of bad faith, fraud, oppression or malice for refusing to pay several product liability claims.(1)

This article focuses on the issues counsel for an excess carrier must consider when presented with the excess third-party liability case. After a brief summary of the evolution of the bad faith cause of action in both the first- and third-party context, it

* sets forth the various standards adopted by American jurisdictions for imposition of bad faith liability and damages on insurers,

* focuses on the issues counsel must consider before the excess liability trial in order to shield the excess carrier from potential bad faith exposure should the underlying case result in a verdict in excess of policy limits, and

* addresses the issues counsel must consider once the post-trial excess liability verdict has been returned and the possible bad faith actions that may be maintained by the excess carrier.

HISTORICAL EVOLUTION

American courts did not take notice of the unequal bargaining power between insurance companies and their policyholders before the 20th century.(2) Contract law served as the exclusive theory on which policyholders could recover from an insurers for the bad faith handling of claims.(3) Although a policyholder may have successfully proved that an insurer wrongfully denied benefits, damages were limited to the amount due under the policy, plus interest.(4) The policyholder was prevented from recovering damages for emotional distress or economic loss caused by the deprivation of policy benefits. Punitive damages also were unavailable to deter insurers from wrongfully or even fraudulently denying claims.(5) Therefore, insurers had nothing to lose by wrongfully denying claims or coercing unfair settlements.

The vulnerability of policyholders dissipated as a result of the American courts' recognition of an implied covenant of good faith and fair dealing. In 1931, the Wisconsin Supreme Court in Hilker v. Western Automobile Insurance Co. observed:

[W]here an injury occurs for which a recovery may be had in a sum exceeding the amount of the insurance, the interest of the insured becomes one of concern to him. At this point a duty on the part of the insurer to the insured arises. It arises because the insured has bartered to the insurance company all of the rights possessed by him to enable him to discover the extent of the injury and to protect himself as best he can from the consequences of the injury.(6)

The Hilker court concluded that insurers could be liable for actual damages caused by their failure to consider the interests of their policyholders when evaluating settlement offers from third parties.

This decision has been cited by courts and commentators as the doctrinal source for the development of the third-party bad faith tort action, and today nearly every state recognizes a tort cause of action against insurers whose improper settlement conduct in the third-party setting causes the policyholder to suffer out-of-pocket liability.(7)

It was not until 1970, however, 40 years after Hilker, that the implied covenant of good faith and fair dealing was deemed to apply in the first-party context, such as life, health, disability and property insurance. The California Court of Appeal in Fletcher v. Western National Life Insurance Co.(8) held that the implied in law duty of good faith and fair dealing imposes on a disability insurer a duty not to threaten to withhold payments, maliciously and without probable cause, for the purpose of injuring its insured by depriving him of the benefits of the policy.

The suggestion in Fletcher was affirmed in 1973 by the California Supreme Court in what is widely acknowledged as the landmark case of first-party bad faith litigation--Gruenberg v. Aetna Insurance Co.(9) The Gruenberg court declared than an insurer's obligation to make payments due under a policy is the obligation, deemed to be imposed by law, under which the insurer must act fairly and in good faith in discharging its contractual responsibilities. Where the insurer fails to deal fairly and in good faith with its insured by refusing, without proper cause, to compensate its insured for a loss covered by the policy, the Greenberg court found such conduct may give rise to a cause of action in tort for breach of an implied covenant of good faith and fair dealing.

The first-party bad faith tort action gained acceptance rapidly, and at least 25 states have recognized it judicially.(10)

BAD FAITH AND RECOVERABLE DAMAGES

1. Common Law

   The majority of courts recognizing a tort cause of action for bad faith in third-party cases has expressed the insurer's duty to the insured in responding to settlement offers in terms of good faith.(11)

   New York maintains one of the most stringent standards, requiring "an extraordinary showing of a disingenuous or dishonest failure to carry out a contract" before bad faith liability can be imposed on an insurer.(12) Because of this strict standard, efforts to recover extracontractual damages from insurance companies have largely failed in New York.

   The New York Court of Appeals in Pavia v. State Farm Mutual Automobile Insurance Co.(13) in 1993 revisited the standard an insured must meet in order to recover damages for an excess judgment that the insurer could have avoided by settling within its policy limits.

   The underlying case arose from an April 1985 accident in which the third-party claimant, Pavia, was injured while he was a passenger in a car driven by Rosato, a State Farm insured. The insured collided with a double-parked car, and Pavia's injuries rendered him a hemiplegic. In June of 1987, Rosato gave deposition testimony that suggested the possibility of liability defenses. Although defense counsel regarded liability as "extremely unfavorable," he recommended further inquiry into these defenses.

   At the end of June 1987, Pavia's counsel made an offer to settle the case for the policy's $100,000 limits, with the stipulation that the offer would remain open for 30 days. State Farm never responded to the offer. The investigation to corroborate Rosato's account was unsuccessful and was discontinued in November of 1987. State Farm offered the policy limit in January of 1988, but Pavia rejected it.

   At trial, the jury returned a verdict for $6.322 million, apportioning 85 percent of the fault to Rosato and 15 percent to the owner of the double-parked car. The award subsequently was reduced to $3.880 million, and Rosato assigned his bad faith claim to Pavia.

   In the subsequent bad faith case, the court instructed the jury that State Farm would be liable if its failure to settle involved a "deliberate or reckless decision to disregard the insured's interests." The jury returned a verdict for Pavia, and State Farm appealed, urging that the trial court should have instructed the jury according to the Gordon standard, allowing compensation only on "an extraordinary showing of disingenuous or dishonest failure" to carry out the insurance contract. State Farm also urged that the evidence did not support a finding of bad faith.

   The Appellate Division affirmed on both counts. While agreeing that the jury had been properly instructed, the Court of Appeals found the evidence of bad faith insufficient.

   Approving of the trial court's bad faith instruction, the court noted:

   The gross disregard standard, which was utilized by the trial court here, strikes a fair balance between two extremes by requiring more than ordinary negligence and less than a showing of dishonest motives. The former would remove the latitude that insurers must be accorded in investigating and resisting unfounded claims, while the latter would be all but impossible to satisfy and would effectively insulate insurance carriers from conduct that, while not motivated by malice, has the potential to severely prejudice the rights of its insured. The intermediate standard accomplishes the two-fold goal of protecting both the insured's and the insurer's financial interests.(14)

   Continuing, the court stated:

   that an insurer "cannot be compelled to concede liability and settle a questionable claim" simply "because an opportunity to do so is presented." Rather, the plaintiff in a bad faith action must show that "the insured lost an actual opportunity to settle the ... claim" at a time when all serious doubts about the insured's liability were removed.(15)

   With respect to State Farm's failure to respond to the plaintiff's settlement offer, the court held:

   By any view of the evidence, State Farm's failure to promptly respond to the time-restricted demand did not amount to more than ordinary negligence--an insufficient predicate for a bad faith action.(16)

   Other courts adopting the "bad faith" standard have foreseen the practical difficulties in applying a negligence standard and have considered the penalty of liability for an excess judgment as too harsh for mere negligence.(17) Yet, few courts demonstrate the remarkable reluctance of the New York Court of Appeals to impose extracontractual liability for insurer claims handling practices.

   In defining bad faith, the majority of jurisdictions require an insurer's actions to constitute more than...