CHAPTER 6 DUTIES OF THE INSURED AND THE INSURER

• Jurisdiction: United States

A. Good Faith

1. The Implied Covenant of Good Faith and Fair Dealing

Insurance is considered a business of the utmost good faith. The principle of utmost good faith, as first stated in the British House of Lords by Lord Mansfield in 1766, is that the duty of good faith rests upon both the insured and the insurer (see Carter v. Boehm in Chapter 1.) It is still the law followed in England, and has been adopted by California and other states that recognize the covenant of good faith. Imposing a duty upon parties to deal with each other in good faith in all insurance transactions requires that the duty exists during the negotiation for the contract and throughout the term of the contract. The breach of the implied covenant of good faith originally resulted in the imposition of contract damages, not tort damages.

The courts of many states have created a tort called "bad faith conduct of insurance contract requirements" (the "tort of bad faith"). The duty imposed by the contract is defined as follows:

In every insurance contract, there is an implied covenant of good faith and fair dealing that neither party will do anything which will injure the right of the other to receive the benefits of the agreement.¹

Many states have accepted a form of the tort of bad faith, including Noble v. National American Life Ins. Co. 624 P.2d 866 (Ariz. 1981); Escambia Treating Co. v. Aetna Cas. & Sur. Co. 421 F. Supp. 1367 (N.D. Fla. 1976) (applying Florida law); Grand Sheet Metal Products Co. v. Protection Mut. Ins. Co., 375 A.2d 428 (Conn. Super. 1977); Ledingham v. Blue Cross Plan for Hospital Care of Hospital Service Corp., 330 N.E.2d 540 (Ill. 1976) (reversed on other grounds) 356 N.E.2d 7 (Ill. 1976); Vernon Fire & Cas. Ins. Co. v. Sharp, 349 N.E.2d 173 (Ind. 1976); Amsden v. Grinnell Mut. Reinsurance Co., 203 N.W.2d 252 (Iowa 1972); Robertsen v. State Farm Mut. Auto Ins. Co., 464 F. Supp. 876 (D.S.C. 1979) (applying South Carolina law); Farmers Ins. Exchange v. Schropp, 567 P.2d 1359 (Kan. 1977); Phillips v. Aetna Life Ins. Co., 473 F. Supp. 984 (D. Vt. 1979) (applying Vermont law); Arnold v. National County Mut. Fire Ins. Co., 725 S.W.2d 165 (Tex. 1987), and others in Kansas, Mississippi, Montana, Nevada, New Mexico, North Dakota, Ohio, Oklahoma, Wisconsin, and Connecticut.

In California, the courts began the transformation of the breach of the doctrine of good faith and fair dealing from a contract to a tort remedy, primarily through six cases spanning a 21-year period.

B. Tort of Bad Faith

In Comunale v. Traders & General Ins. Co., 50 Cal. 2d 654, 328 P.2d 198 (1958), the California Supreme Court of California was faced with a request to allow tort damages to people hurt by their insurer. The court wrote:

Mr. and Mrs. Comunale were struck in a marked pedestrian crosswalk by a truck driven by Percy Sloan. Mr. Comunale was seriously injured, and his wife suffered minor injuries. Sloan was insured by defendant Traders and General Insurance Company under a policy that contained limits of liability in the sum of $10,000 for each person injured and $20,000 for each accident. He notified Traders of the accident and was told that the policy did not provide coverage because he was driving a truck that did not belong to him. When the Comunales filed suit against Sloan, Traders refused to defend the action, and Sloan employed competent counsel to represent him. On the second day of the trial Sloan informed Traders that the Comunales would compromise the case for $4,000, that he did not have enough money to effect the settlement, and that it was highly probable the jury would return a verdict in excess of the policy limits.

Traders was obligated to defend any personal injury suit covered by the policy, but it was given the right to make such settlement as it might deem expedient. Sloan demanded that Traders assume the defense and settlement of the case. Traders refused, and the trial proceeded to judgment in favor of Mr. Comunale for $25,000 and Mrs. Comunale for $1,250.

Comunale obtained an assignment of all of Sloan's rights against Traders and then commenced the present action to recover from Traders the portion of his judgment against Sloan which was in excess of the policy limits. The jury returned a verdict in Comunale's favor, but the trial court entered a judgment for Traders notwithstanding the verdict.

The following questions are presented on Comunale's appeal from the judgment:

1. Did Sloan have a cause of action against Traders for the amount of the judgment in excess of the policy limits?

2. Was Sloan's cause of action against Traders assignable?

3. Was the cause of action barred by the statute of limitations?

In determining whether Traders was liable for the portion of the judgment against Sloan in excess of the policy limits, the court took into consideration the fact that Traders not only wrongfully refused to defend the action against Sloan but also refused to accept an offer of settlement within the policy limits. Because of its wrongful denial of coverage, Traders failed to consider Sloan's interest in having the suit against him compromised by a settlement within the policy limits.

Applying the covenant of good faith and fair dealing the insurer, in deciding whether a claim should be compromised, must take into account the interest of the insured and give it at least as much consideration as it does to its own interest.

The decisive factor in fixing the extent of Traders' liability is not the refusal to defend; it is the refusal to accept an offer of settlement within the policy limits. Where there is no opportunity to compromise the claim and the only wrongful act of the insurer is the refusal to defend, the liability of the insurer is ordinarily limited to the amount of the policy plus attorneys' fees and costs.

An insurer who denies coverage does so at its own risk, and, although its position may not have been entirely groundless, if the denial is found to be wrongful it is liable for the full amount which will compensate the insured for all the detriment caused by the insurer's breach of the express and implied obligations of the contract.

Certainly, an insurer who not only rejected a reasonable offer of settlement but also wrongfully refused to defend should be in no better position than if it had assumed the defense and then declined to settle. The insurer should not be permitted to profit by its own wrong.

The question is what would Sloan have gained from the full performance of the policy contract with Traders? If Traders had performed its contract, it would have settled the action against Sloan, thereby protecting him from all liability. The allowance of a recovery in excess of the policy limits would not give the insured any additional advantage but merely place him in the same position as if the contract had been performed. Therefore, an insurer, who wrongfully declines to defend and who refuses to accept a reasonable settlement within the policy limits in violation of its duty to consider in good faith the interest of the insured in the settlement, is liable for the entire judgment against the insured even if it exceeds the policy limits.

The supreme court noted that an insurer who has undertaken to defend a third-party claim may be liable for a judgment in excess of the limits stated in the policy of insurance, where it has wrongfully refused to settle within those limits.

The tort of bad faith continued to develop with Critz v. Farmers Ins. Group, 230 Cal. App. 2d 788, 41 Cal. Rptr. 401 (Cal. Ct. App. 1964), when plaintiff Betty Critz, as a passenger in an automobile driven by her husband, was involved in a collision with an automobile driven by David Arnold. Arnold lost control of his vehicle while trying to negotiate a curve; his automobile crossed over to the opposite side of the road and crashed head-on into the Critz car. Mrs. Critz received numerous injuries, including the loss of sight in one eye and fractures of the neck and jaw. Arnold had liability insurance issued by defendant Farmers Insurance Group, with a coverage limit of $10,000 for injuries to one person.

Almost five months after the accident, on July 8, 1960, plaintiff offered to settle her claim against Arnold for $10,000, the policy amount. Without notifying Arnold of the offer, defendant replied with a counteroffer of $8,250.

The adjuster advised his management that it was obvious that Mrs. Critz's case had a value far in excess of their limits, and yet he suggested a settlement figure of $8,250 and advised the family that they could not expect the policy on her case.

Without regard to a policy limit on liability, an insurer may be liable for the entire amount of a judgment against its insured if it has been guilty of bad faith in refusing an offer of settlement within the policy limit. When there is great risk of a recovery beyond the policy limits so that the most reasonable manner of disposing of the claim is a settlement which can be made within those limits, a consideration in good faith of the insured's interest requires the insurer to settle the claim. Its unwarranted refusal to do so constitutes a breach of the implied covenant of good faith and fair dealing.

The assignment from Arnold to Mrs. Critz represents an unorthodox tactic which had not previously confronted the courts. Its novelty lies in its timing. In the fairly standardized situation, the policyholder assigns his damage claim to the injured person after the latter recovers a judgment exceeding the policy limit; or, being driven into bankruptcy by the personal judgment against him, is succeeded by the trustee in bankruptcy, who then files suit against the insurer or assigns the cause of action to the judgment creditor. Here, in contrast, David Arnold had not been fastened with an excess judgment, had not even been named as formal defendant in a personal injury suit, when he executed the assignment document.

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