1

The Intersection of Insurance Bad Faith Litigation and State Insurance Regulation:

A Reconsideration

Michael E. DeBow *

American insurance companies are extensively regulated by the governments of every

state in which they do business. The stated justification of the state regulation of insurance is

consumer protection. Consumers of insurance are seen as the victims of various market failures

(especially regarding the information available to them) as well as inequalities of bargaining

power, and the state government comes to their rescue in the form of a regulatory agency usually

referred to as the “insurance department.”

And yet, most states‟ courts have also announced that some version of an implied right to

“good faith and fair dealing” exists in every insurance contract. This judicially-created form of

consumer protection was first proclaimed in California in 1957, but spread quickly throughout

the country. It was initially limited to plaintiff claims that the defendant insurer had refused “in

bad faith” to settle a case for an amount within policy limits. However, inventive lawyers

sought, successfully, to expand the scope of the insured‟s right to good faith. The doctrine grew,

becoming more unpredictable in the process. Along the way, the doctrine produced some

notoriously generous plaintiffs‟ recoveries, and has garnered strong criticism.

This paper analyzes the doctrine of good faith and fair dealing in terms of the protection

it affords consumers in the insurance market, and concludes that the doctrine is almost certainly

more costly than beneficial to consumers and should, therefore, be abolished. This conclusion is

defended on empirical grounds, as well as on the grounds of both hypothetical bargain and

institutional competence analysis.

Sunsetting the common law doctrine of good faith and fair dealing with regard to

insurance contracts could be accomplished legislatively or judicially at the state level.

Unfortunately, the tide (if there is one) seems to be running the other way. There is currently an

active effort to persuade state legislatures to make insurance bad faith lawsuits easier to bring.

Maryland and Washington passed such legislation in 2007; Colorado and Minnesota followed

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suit in 2008.1 Bad faith bills were introduced in the legislatures of at least fourteen states and the

District of Columbia in 2009.2 The analysis presented here provides support for those arguing

against legislation that would expand the exposure of the insurance industry to “bad faith”

liability.

On a related point, if state legislatures are willing seriously to consider such legislation,

that fact would provide another reason to look favorably upon the various proposals to overhaul

the current system of state insurance regulation – such as moving to federal chartering or to a

“single-license” system modeled on American corporation law.3 Criticism of the current system

has intensified in recent years, and the insurance industry is increasingly inclined to support

major reform.4 Insurance regulation was included in the Congressional debate over the Dodd-

Frank Act this year, and the Act does expand the federal government‟s role in the industry.

However, the Act leaves the consumer protection mission with the states for now.5 In the event

Congress returns to the subject of insurance regulation in the foreseeable future, it should

expressly pre-empt the state common law doctrine of good faith and fair dealing with regard to

insurance contracts.

I. State insurance regulation

The legal framework for insurance regulation is currently dictated by the terms of the

federal McCarran-Ferguson Act of 1945, which declares that “the continued regulation and

taxation by the several States of the business of insurance is in the public interest,” and provides

that “[t]he business of insurance, and every person engaged therein, shall be subject to the laws

of the several States which relate to the regulation or taxation of such business,” subject to any

expressly preemptive acts of Congress.6 Accordingly, insurance regulation occurs almost

exclusively at the state level. Insurance companies are required to submit to state regulatory

oversight in every jurisdiction in which they are licensed to operate.7 The insurance

1 Schwartz &Appel (2009a), 1480 & n.11 .

2 Id., 1481 & n.12.

3 Harrington (2006), Grace (2009); Grace & Scott (2009); Detlefsen (2009); Butler & Ribstein (2008 and 2008-09).

4 Klein (2009), 33-34; Tuckey (2010) (noting support for greater federal pre-emption than included in the Dodd-

Frank Act on the part of the American Insurance Association and the American Council of Life Insurers). 5 Webel (2010).

6 15 U.S.C. §§ 1011, 1012.

7 National Association of Insurance Commissioners (no date).

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departments‟ four major areas of regulatory responsibility include 1) licensing, 2) insurer

solvency, 3) rate and form regulation, and 4) market conduct.8

The centerpiece of the states‟ regulation of market conduct is the Uniform Trade

Practices Act (“Model Act”) initially promulgated by the National Association of Insurance

Commissioners (“NAIC”) in 1947. Every state has adopted some form of the Model Act.

However, there are significant variations from state to state, particularly in terms of who may

bring an action and what remedies are available under the Act.9 Nonetheless, the substantive

core of the Act in most states is modeled on section 5 of the Federal Trade Commission Act. For

example, the Illinois statute states that “No person shall engage in this State in any trade practice

which is defined in this Article as, or determined pursuant to this Article to be an unfair method

of competition or an unfair or deceptive act or practice in the business of insurance.”10

The 1947 version of the Model Act was apparently an attempt by the NAIC “to develop a

uniform legislative response after the McCarran-Ferguson Act,”11

and was directed primarily at

marketing practices used by insurers.12

The issue of unfair claims practices, which played a

pivotal role in the creation of the duty of good faith, was not addressed until the 1972 iteration of

the Model Act.13

The 1972 provisions, known as the Uniform Claims Settlement Practices Act

(“UCSPA”), may have been motivated by a desire by state insurance commissioners to counter

four bills then pending in Congress to give the FTC enforcement powers against insurance

companies.14

In addition, the NAIC apparently wished to provide for “violations to be dealt with

through the imposition of administrative remedies rather than judicial penalties in civil

litigation.”15

The UCSPA has been adopted by a majority of states, subject to significant

8 Thomas (2010), §8.02[2][a].

9 Id., § 13.04[2] & n.54 (collecting statutes).

10 215 ILCS 5/423(1). For a discussion of the history of California’s adoption of the Model Act in 1959, see Karlin v.

Zalta, 201 Cal. Rptr. 379, 389-90 (explaining California’s statute as proscribing “the unfair and anticompetitive trade practices enumerated therein, and . . . authoriz[ing] a private suit to impose civil liability for damages for a violation of its provisions.”). 11

Thomas (2010), § 13.04[2]. 12

Schwartz & Appel (2009), 1487 & n.48. 13

Id. 14

Ashley (1984), § 9:02. 15

Lynch & Bandle (2008), part 5.

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variations across the enacting states.16

One study shows that, as of 2008, only nine states

recognized a private right of action under the UCSPA while 32 states had decided against it.17

Clearly, state insurance departments consider their regulation of insurance company

behavior to be a critical component of their mission. According to the NAIC, the insurance

departments receive over 200,000 consumer complaints annually.18

Given the insurance

departments‟ extensive involvement in overseeing insurers‟ behavior, wouldn‟t a parallel

common law private right of action against alleged insurer bad faith be redundant at best?

Of course, the fact that the states attempt to regulate insurer behavior, and the fact that

they field thousands of consumer complaints annually, do not indicate that the states are doing a

competent job in this area. A recurring criticism of the insurance departments is that they are

chronically underfunded and understaffed, and are simply overwhelmed by the magnitude of

their task. Additionally, the agencies are often said to have been captured by, or at least

sympathetic to, the industry they oversee.19

To the extent that this description fits reality, at this

point we should not rule out the possibility that a common law adjunct to the regulatory efforts

of the state agencies would be beneficial to consumers.

II. The duty of good faith and fair dealing: creation

Most observers agree that the judicial creation of a duty on the part of insurance

companies to show “good faith and fair dealing” to their insureds began in earnest in the

California courts.20

The first landmark decision was Brown v. Guarantee Insurance Co., decided

by the California Court of Appeal in 1957.21

The insured had purchased a $5,000 automobile

policy from the insurer. An accident occurred, and the injured party sued the insured for $15,000

in damages. The plaintiff offered to settle the case for $5,000, but the insurer refused the

settlement offer. The insurer‟s reasons seem clear enough. If the matter proceeded to trial, the

insurer could do no worse than the settlement offer (that is, it would never owe the plaintiff more

16

For an attempt at a summary of these variations, see Lynch & Bandle (2008). 17

Id. 18

Tennyson (2010), 14. Also according to the NAIC, “*d+uring 2000, state insurance departments handled 4.5 million consumer inquiries and complaints.” National Association of Insurance Commissioners (no date). 19

For a summary of the classic criticisms of the state insurance departments, see Abraham (1986), 38-41. 20

The following discussion of California cases draws heavily on Jerry & Richmond (2007), 179-80. 21

Brown v. Guarantee Insurance Co., 319 P.2d 69 (Cal. Ct. App. 1957).

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the $5,000 limit on the policy) and might do better than that (if the plaintiff received anything

less than $5,000 at trial). Obviously, the insurer‟s decision exposed the insured to all the

downside risk of going to trial (that is, the risk that a trial would result in a verdict larger than

$5,000 – with the overage paid entirely by the insured).

During the trial, the insurance company made settlement offers of $3,000, $3,500, and

$4,000 – all of which were rejected by the plaintiff. The trial court returned a verdict in favor of

the plaintiff for $15,000; the insured was liable for the $10,000 amount above his insurance

policy‟s coverage. Afterwards, the insured sued his insurer and argued that by undertaking the

defense of the suit the insurer owed a “good faith” duty to the insured to take his interests into

account in weighing the settlement offer. The trial court dismissed plaintiff‟s case, but the

intermediate appellate court reversed, reasoning that “the law imposes a duty upon the insurer

when it undertakes to defend an action against the insured and enters negotiations for

settlement.”22

The court opined that the relationship between insurer and insured “closely

approximates that of principal and agent or beneficiary and trustee.” The appeals court remanded

the case to the trial court, with directions to allow plaintiff leave to file an amended complaint

asserting breach of good faith.

A year later the California Supreme Court put its stamp of approval on the cause of action

in Comunale v. Traders & General Insurance Co., explaining that the insurer‟s implied duty of

good faith is just one instance of the covenant that exists “in every contract that neither party will

do anything which will injure the right of the other to receive the benefits of the agreement.” In

the insurance context, the duty requires that “[t]he 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.”23

As to remedy, the court noted with approval

earlier decisions that held bad faith insurers that assumed the defense of the underlying action

liable for “the entire amount of a judgment against the insured, including any portion in excess of

the policy limits.”24

Furthermore,

An insurer who denies coverage does so at its own risk, and, although its position may

22

Id. at 74. 23

Comunale v. Traders & Gen. Ins. Co., 328 P.2d 198, 201 (Cal. 1958). 24

Id. at 201.

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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.25

Up to this point, the California courts treated the cause of action for bad faith as sounding in both

contract and tort, and had discussed only contract-type measures of damages.

This changed nine years later, with the California Supreme Court announcement in Crisci

v. Security Insurance Co.,26

that tort damages would be available in bad faith cases. This was

another failure to settle case, with the twist that plaintiff claimed insurer‟s refusal caused her

“mental distress.” The trial court awarded her $25,000 on the mental distress claim, and the

supreme court affirmed. Although the court agreed that the cause of action for insurance bad

faith sounds in both contract and tort, its decision nonetheless “firmly establish[ed] the

availability of tort-based remedies for breach of the duty to settle.”27

Crisci thus opened the door

to awards of punitive damages in bad faith cases.

Together, Brown, Comunale, and Crisci set out the basic framework for California law

regarding the doctrine of good faith and fair dealing with respect to insurance policies covering

liabilities to third parties – often referred to as good faith “in third-party insurance.” In 1973, the

California Supreme Court extended an insurer‟s duty of good faith to controversies involving

first-party insurance (such as automobile, fire, health and homeowners insurance contracts) in its

decision in Gruenberg v. Aetna Insurance Co.28

The case stemmed from the refusal by three

insurance companies to pay claims under fire insurance policies they issued. The insured

alleged, in part, that the insurers had maliciously sought to have him investigated by the police

on suspicion of arson in order to put him in a position where he would have to refuse to appear

for an examination under oath by the companies, thus voiding his coverage. The decision

25

Id. at 202. 26

Crisci v. Security Ins. Co., 426 P.2d 173 (Cal. 1967). 27

Jerry & Richmond (2007), 180. For a spirited defense of Crisci, see Thomas (2002). 28

510 P.2d 1032 (Cal. 1973).

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explains the insurer‟s duty in the first-party context as follows: When an insurance company, in

the course of “discharging its contractual responsibilities” “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, such conduct may give rise to a cause of action in tort for breach of an implied

covenant of good faith and fair dealing.”29

One final California innovation should be mentioned, even though it does not involve the

duty of good faith per se. In its 1979 decision Royal Globe Insurance Co. v. Superior Court,30

the California Supreme Court interpreted the state‟s version of the Model Act in a case brought

by a claimant against one of the insurer‟s customers. The court decided that under the Act an

insurer may, under some circumstances, owe a good faith duty to settle to the third party. Royal

Globe attracted “virtually no following outside California”31

and eventually provided a bridge

too far, even for California. It was overruled by the post-Rose Bird Supreme Court in 1988.32

Royal Globe is mentioned here for two reasons. First, it represents what seems to be the

inevitable end of the road that the California courts embarked upon in 1957. Second, empirical

research into the effects of the Royal Globe decision raises serious questions about the

competence of the courts to regulate consumer protection in the insurance industry. A RAND

Corporation study showed that Royal Globe “triggered sharp increases in both the average bodily

compensation payment [by 25%] and the relative frequency of bodily injury claims in California

relative to the other tort states.” The California court‟s decision to reverse Royal Globe

“dramatically reversed these trends.”33

This evidence is open to conflicting interpretations:

[H]igher claim payments or claim filing rates should not be construed negatively

if, in the absence of bad faith liability, a tendency exists for insurers to underpay

or to wrongfully deny claims. . . . However, if higher payments or claim filings are

occurring because insurers are less inclined to investigate potential fraud (that is,

unwarranted amounts are paid in order to avoid potential bad faith liability),

29

Id. at 1037. 30

Royal Globe Ins. Co. v. Superior Ct., 592 P.2d 329 (Cal. 1979). 31

Jerry & Richmond (2007), 143 & n.310 (noting West Virginia and Kentucky as two states that have partially followed Royal Globe). 32

Moradi-Shalal v. Fireman’s Fund Ins. Cos., 758 P.2d 58 (Cal. 1988) (en banc). 33

Hawken, Carroll & Abrahamse (2007), ___.

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this phenomenon should be a source of concern for policymakers.34

Regardless of which effect predominated in this instance, the increased costs of operation that

insurers faced under Royal Globe were passed along to their customers in the form of higher

premiums. The net effect on the consumer might thus have been negative, even if some

improvement in insurance company performance had been forthcoming.

III. The duty of good faith and fair dealing: proliferation

California‟s invention of bad faith insurance litigation proved very popular. By 1994, 43

states had recognized a tort cause of action for third-party bad faith.35

By 2009, 27 states had

adopted a tort cause of action for first-party bad faith, while another nine recognized only a

contract-based cause of action in such cases.36

In addition to its geographic spread, the law of good faith grew in terms of its doctrinal

scope. It often proved a simple matter for a plaintiff suing an insurance company for breach of

contract to add a bad faith count to his complaint, and the attraction of tort damages proved

irresistible. Bad-faith-refusal-to settle begat allegations of bad-faith-refusal-to-defend, bad-faith-

refusal-to-pay-a-covered-claim and bad-faith-litigation-tactics, to name just three. Bad faith

claims became “a major source of tort litigation”37

and “one of the most familiar types of

punitive damages claims known to our case law.”38

Framing the test for liability for bad faith has proven very difficult. It was agreed that

something beyond simple breach of contract was necessary, but states arrived at somewhat

varied answers to this question. The early California decisions, hardly models of clarity, were

read as creating a “negligence” standard. Most states chose to place a heavier burden on

plaintiffs than California had. The result, according to one treatise, is that “Although judicial

formulations of what constitutes bad faith vary widely, the weight of authority favors what is

commonly called the „fairly debatable‟ standard.”39

This standard, also known as the

34

Tennyson & Warfel (2009), 240. 35

Richmond (1994), 80 n.33. 36

Tennyson & Warfel (2009), 242. 37

Schwartz & Appel (2009), 1478. 38

Hartford Underwriters Ins. Co. v. Williams, 936 So.2d 888, 895 (Miss. 2006). 39

Jerry & Richmond (2007), 186. For a very different view of the variation among states, see Mauldin (2008), 166 n.84 (“The laws on bad faith are so inconsistent as to “border on schizophrenia in the standards to which insurers

9

“reasonable basis” test, is traceable to a 1978 decision of the Wisconsin Supreme Court which

required plaintiffs to show “an absence of a reasonable basis for denial of policy benefits and the

knowledge or reckless disregard of a reasonable basis for a denial.”40

The Wisconsin court

admitted that failure to require a showing of intentional or willful conduct on the part of the

company would put insureds in a position to “scar[e] insurers into paying questionable claims

because of the threat of a bad faith suit.”41

As noted in the above description of the RAND study

of Royal Globe‟s effects, it is precisely the effect on insurers that is troubling about the

expansion of bad faith liability. To the extent that the law gives insurers an incentive to pay bad

claims, the cost of that change in insurer behavior will flow through (primarily) to the insurance

companies‟ customers in the form of higher premiums.

The difficulties inherent in framing a legal test for bad faith are exacerbated by the fact

that the question whether bad faith exists in any particular case will be decided by the jury, as a

question of fact. The jury‟s critical role, combined with the vagueness of the legal test (as in

“fairly debatable” or “reasonable basis”), has resulted in a system which makes it difficult to

predict trial outcomes. Juries seem to have some considerable discretion in these cases, and

given the volume of this litigation can be seen using it in what were probably unpredictable

ways.

Not surprisingly, the award of punitive damages has been one of the most controversial

aspects of bad faith litigation. Consider this snapshot of the role of punitive damages, from a

2003 article that argues that bad faith litigation is “a dramatic threat to insurers.”42

In April 2003, for example, an Arizona jury awarded $84.5 million, including $79

are held in their claims-administration responsibilities.’” (quoting Jonathan M. Kuller, Towards a Common (Sense) Definition of an Insurance Company's Claims-Handling Standard of Care, 13 Coverage (ABA Section of Litig.) 29 (2003).) 40

Anderson v. Continental Ins. Co., 271 N.W.2d 368 (Wis. 1978). For a discussion of Anderson’s impact, see Schwartz & Appel (2009), 1485. 41

271 N.W.2d at 377. Accord, Hudson Universal, Ltd. v. Aetna Ins. Co., 987 F.Supp. 337, 341-42 (D.N.J. 1997) (“The ‘fairly debatable’ standard is premised on the idea that when an insurer denies coverage with a reasonable basis to believe that no coverage exists, it is not guilty of bad faith even if the insurer is later held to have been wrong. ‘The rationale for this legal principle is based upon the potential in terrorem effect of bad faith litigation upon the insurer. *citation omitted+ ‘An insurer should have the right to litigate a claim when it feels there is a question of law or fact which needs to be decided before it in good faith is required to pay the claimant.’ *citation omitted+ In order to impose ‘bad faith’ liability, the insured must demonstrate that no debatable reasons existed for denial of the benefits available under the policy.”) 42

Richmond (2003), 1.

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million in punitive damages, to a doctor whose disability insurer strung her along for

years before denying her claim. Earlier in 2003, a California jury returned a $31.7

million verdict, including $30 million in punitive damages, against a disability

insurer for allegedly halting payments to a disabled doctor so that it could meet its

quarterly profit goals. In May 2002, an Oregon jury returned a verdict that included

punitive damages of $20 million against an insurer that allegedly delayed in settling a

wrongful death claim. In April 2002, an Iowa jury returned a $20 million verdict

against an insurer that allegedly acted in bad faith in handling a workers'

compensation claim. In Illinois, an insurer that denied its insured's $9,500 claim for

the theft of his car was hit for $35,000 in compensatory damages and $3 million in

punitive damages. Similar cases abound. Although it is true that significant bad

faith verdicts often do not survive appeal and huge punitive damage awards are

especially susceptible to reversal or reduction, many sizable bad faith awards are

affirmed, and still more bad faith cases that are at best dubious are settled while on

appeal for generous amounts because insurers cannot chance an unfavorable appellate

outcome.43

All these examples are drawn from a twelve-month period, thus highlighting the risks faced by

insurers from punitive damage awards in bad faith litigation.

In fact, a Utah bad-faith-failure-to-settle case provided the vehicle for one of the U.S.

Supreme Court‟s recent decisions involving punitive damages. In State Farm v. Campbell, the

plaintiff won a jury verdict of $2.6 million in compensatory and $145 million in punitive

damages against the insurer.44

The trial judge reduced the compensatory award to $1 million and

the punitive award to $25 million. The Utah Supreme Court reinstated the jury‟s punitives

award, on the theory that State Farm had behaved reprehensibly in trying to reduce payouts on its

policies, that the company had pursued this strategy nationwide, and that it deserved to be

punished in the context of this single Utah lawsuit for its national misbehavior. The U.S.

Supreme Court disagreed, holding that the 145-to-1 ratio of punitive to compensatory damages

violated due process. The court was very critical of the fact that “[t]his case . . . was used as a

43

Id., 1-2 (footnotes omitted). See also Richmond (1994), 75 (“In 1993 . . . California juries returned $425,600,000 and $89,320,000 verdicts against insurers in bad faith cases. In another 1993 case, a Texas jury assessed compensatory damages of $2,170,000 and punitive damages of $100,000,000 against an insurer that denied a $20,000 underinsured motorist claim.”) (footnotes omitted). 44

State Farm Mut. Auto. Ins. Co. v. Campbell, 538 U.S. 408 (2003).

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platform to expose, and punish, the perceived deficiencies of State Farm's operations throughout

the country. The Utah Supreme Court's opinion makes explicit that State Farm was being

condemned for its nationwide policies rather than for the conduct directed toward the

Campbells.”45

On remand, the Utah Supreme Court held that punitive damages of just over $9

million were warranted.46

Of course, the threat of punitive damage is magnified in class actions against insurers –

which appear to be numerous. A database assembled by Helland and Klick contains

information on 748 class actions filed against 130 insurance companies “that were open at least

one point during the period of 1992 to 2002.”47

A seven-page appendix lists the allegations

made in these class action suits, arranged by line of insurance.48

Although the authors do not

address bad faith claims separately, it seems a reasonable surmise that many, if not most, of these

suits included claims for bad faith.

Perhaps the most high-profile insurance class action in the recent past was brought in

Illinois against State Farm Insurance. The plaintiffs‟ complained of the use of replacement parts

in covered repairs that were not manufacturer by the original equipment manufacturers

(“OEMs”). The plaintiffs‟ case was not grounded in the common law duty of good faith, but

rather in the Illinois consumer protection act – the terms of which track the FTC Act and the

Model Act. Therefore, since similar claims might have been raised under at least some states‟

common law duty, a discussion of Avery v. State Farm seems warranted.49 The trial court in

rural southern Illinois certified a national class, and awarded a total of $1,186,180,000 to the

class – including $600 million in punitive damages. The Illinois Supreme Court overturned this

result on a number of grounds, but declined to address the relationship between the Illinois

consumer protection act and the Model Act. Avery was widely discussed, and still stands as a

vivid example of the threat posed to insurance companies by class action lawsuits seeking

punitive damages for breaches of insurance contracts.50

45

Id. at 420. 46

Campbell v. State Farm Mut. Auto. Ins. Co., 98 P.3d 409 (Utah), cert. denied, 543 U.S. 874 (2004). 47

Helland & Klick (2007), 5. 48

Id. at 6-23. 49 Avery v. State Farm Mut. Auto. Ins. Co., 835 N.E.2d 801 (Ill. 2005), cert. denied, 547 U.S. 1003 (2006). 50

See Schwartz, Silverman & Appel (2007), 112-13; Schwartz & Lorber (2001).

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IV. Reconsidering insurance bad faith as a matter of legal doctrine

As we have seen, the breakthrough California decisions were justified on two grounds.

The first was the idea of a “special relationship” between insurer and insured, derived from the

(alleged) differences in information and bargaining power between the two. The second

justification was the idea that the judges were simply applying a comprehensible duty of good

faith, which exists in all contracts, to insurance contracts. The first justification is discussed in

the next section. The second justification is based on a badly flawed understanding of the

concept of good faith in contract law, broadly considered.

In spite of frequent assertions to the contrary, the idea of a clear, legally enforceable duty

of good faith is a relatively recent development in American contract law. As one article

explains the point, with reference to contract law generally:

Despite its widespread recognition, the implied covenant of good faith and

fair dealing is shrouded in mystery. Efforts to devise workable standards or

relevant criteria for determining when the covenant has been violated have been

unavailing. The result is a doctrine whose application has been ad hoc, yielding

inconsistent results and depriving parties of the ability to predict what conduct

will violate the covenant.51

Although these authors do not address insurance bad faith litigation, this passage actually

describes it quite well.52

The idea that the California courts had anything like a well-defined set of rules grounded

in a duty of good faith that they could apply to insurance cases is simply anachronistic.

Although the Uniform Commercial Code by the 1950s provided for a general obligation of good

faith in the performance or enforcement of contracts in §1-102(3), “good faith” is narrowly

51

Diamond & Foss (1996), 585-86. A comparative perspective on the “mystery” of the duty of good faith is provided by Woloniecki (2010), 63 (“The duty of good faith in insurance law, first enunciated by Lord Mansfield in 1766 in Carter v. Boehm, predates the coming into existence of the United States. Yet, more than 200 years of English legal history have not solved all the problems that arise from the lack of good faith of insureds and sometimes of insurers and the ingenuity of their legal advisers. As recently as 1996, the House of Lords were split 3-2 over fundamental questions on the duty of disclosure.” It is interesting to note, as Woloniecki does, that “there is no basis under English law for awarding damages against an insurer or reinsurer for ‘bad faith’ in relation to the handling of claims.” Id. at 70) 52

Diamond & Foss (1996), 601, specifically exempts insurance law from the reforms proposed.

13

defined in §1-201(19) as “honesty in fact in the conduct or transaction concerned.” Professor

Robert Summers, the leading academic commentator on good faith during the early years of

insurance bad faith litigation, concluded that “neither standards nor criteria can be devised for

resolving when conduct violates the covenant of good faith.”53

The subsequent announcement of

a duty of good faith in §205 of the Restatement (Second) of Contracts has not done much to help

settle the meaning of the term. One commentator sums up the current state of the debate as

follows:

Although its existence in the U.S. is no longer questioned, U.S. courts and

scholars have mixed, and often strong, opinions about the doctrine. As an

initial matter, U.S,. courts and scholars cannot agree on a precise definition

of “good faith.” Some have lamented the difficulty of identifying the precise

parameters of the doctrine. Other U.S. scholars have attributed definitional

difficulties to the doctrine‟s context-dependent nature.54

The duty of good faith has penetrated insurance law more deeply than any other field of

law and yet remains so vague and unpredictable as applied to insurance that it serves as a

warning to those who wish other areas of contract law would treat the concept more seriously.

The negligible doctrinal clarification gained from a half-century of bad faith insurance litigation

strongly suggests that this experiment in law reform was ill-advised.

V. Evidence that the duty of good faith and fair dealing fails the cost-benefit text

There are four reasons for skepticism about the net effect of the duty of good faith on

consumer welfare in the insurance market. Taken together, they constitute a strong case for

rejecting the common law doctrine and leaving consumer protection to the administrative

ministrations of state insurance departments – or their successor agency at the federal level.

A. Competition in the insurance market

53

Id. at 600 (citing Robert S. Summers, “Good Faith” in General Contract Law and the Sales Provisions of the Uniform Commercial Code, 54 Va. L. Rev. 195 (1968)). 54

Leonhard (2010), 312 (citations omitted). See also Dobbins (2005), 229-30 (arguing that the implied duty of good faith as applied in contract law (broadly defined) is “not capable or worthy of being saved from the chaos that currently surrounds it. The inability to define good faith leaves contracting parties with no clear understanding of their obligations.”).

14

The duty of good faith in insurance is defended in part by reference to the supposed

disadvantages suffered by consumers – especially their lack of bargaining power and lack of

access to and ability to process useful information about the insurance market. Both of these

disadvantages are also invoked to justify the regulation of the industry, of course. To the extent

that consumers are not as helpless as the standard account assumes that they are, the argument

for the duty of good faith (and for regulation) is undermined.

The standard account overlooks the fact that the insurance market is a national market

composed of many sellers.55

In such a competitive setting, insurance companies who mistreat

customers will lose business. Insurance contracts may be offered on a take-it-or-leave-it basis,

but it is a mistake to view them as evil “adhesion contracts.” As Judge Posner explains:

The sinister explanation for the form [adhesion] contract is that the seller

refuses to dicker with each purchaser because the buyer has no choice but to

accept the seller‟s terms. But if one seller offers unattractive terms, won‟t a

competing selle, wanting sales for himself, offer more attractive terms, the

process continuing until the terms are optimal? All the firms in the industry

may find it economical to use standard contracts and refuse to negotiate

with purchasers. But what is important is not whether there is haggling in

every transaction ut whether competition forces sellers to incorporate in

their standard contracts terms that protect the purchasers.56

Thus, competition among insurance companies for customers puts pressure on the

companies to treat customers fairly, to offer them a competitive product at a competitive price.

Each company‟s concern for maintaining a good reputation will lead it to treat customers fairly.

In short, competition greatly reduces the need for paternalistic government intervention.57

Another implication of competition in the insurance market is that there is no free lunch

available for insureds through court-imposed standards of company behavior. The costs incurred

by the companies to comply with the duty of good faith – including the cost of paying

55

The industry’s structure and history are sketched in Klein (2009). 56

Posner (2007), 116. 57

On “self-enforcing” contracts generally, see Telser (1980); Klein & Leffler (1981).

15

questionable claims rather than risk being sued for breach of good faith – will be passed through

to customers in the form of higher premiums.

B. Empirical evidence on first-party insurance.

Two recent economic studies support the conclusion that implying a duty of good faith in

first-party insurance is a bad deal for insureds. A 2004 article studied claims settlements made

under auto policies written by 60 companies in 38 states. The authors “exploit[ed] differences in

state laws that govern insurer bad faith to examine empirically whether bad-faith remedies affect

the size of settlement payments and the allocation of settlement payments between economic and

noneconomic damages.” They found “a positive correlation between the existence of a bad-faith

remedy and higher settlement payments.”58

As noted in the earlier discussion of the empirical

evidence on the effects of the Royal Globe decision, an increase in settlement payments should

result in an increase in premiums. On the other hand, the net effect on insureds is ambiguous,

since the more generous payments may reflect (in whole or in part) the insurers‟ decision to

cease their earlier bad faith tactics.

A 2009 article sought to answer the critical question “whether tort liability for insurer bad

faith deters insurers from appropriately challenging potentially fraudulent or otherwise invalid

claims, leading to greater amounts of fraud and to unwarranted costs and higher insurance

premiums.”59

The article presents “evidence that tort liability for first-party bad faith may

reduce insurers‟ incentives to monitor for claim fraud, leading to less intensive use of

investigative techniques and to more paid claims that contain characteristics often associated

with fraud. Although constructing a baseline comparison for determining the appropriateness of

claim investigations is difficult, these findings are consistent with the predictions of theory when

bad faith liability is uncertain and/or excessive.”60

These two studies cast a dark shadow on the application of a duty of good faith to first-

party insurance. As a consumer protection device, this doctrine seems to have a fatal flaw. It

would be a boon to consumers if state legislators take note of these two empirical studies. As

noted at the beginning of this article, four states have recently made bad faith cases easier to

58

Browne, Pryor & Puelz (2004), 355. 59

Tennyson & Warfel (2009), 240. 60

Id.

16

bring – and numerous other states are considering similar legislation. The new statutes and the

proposed legislation are directed at first-party insurance bad faith, and would make filing such a

suit easier by enacting California‟s “negligence” standard for bad faith.61

A reading of the two

articles summarized here supports the view that this legislation will prove a net harm to

consumers.

C. Hypothetical bargain analysis

A fruitful way to think about the duty of good faith is to ask what would happen if

insurers and insureds negotiated about it. Would insurers and insureds tend to agree to include

the duty as an express term of the insurance contract, or not? If so, on what terms would they

most likely agree? Perhaps most importantly, what price would the insurer ask to include such a

term?

Make no mistake: insurance premiums currently include a payment to cover the firms‟

cost of compliance with the duty of good faith. If insureds could be given a choice between the

status quo and a cheaper policy that includes a waiver of the right to sue for bad faith,62

what

would most people choose?

An opinion poll recently conducted on behalf of the insurance industry may shed some

light on this question. It found 57% of respondents

not in favor of allowing first-party bad-faith lawsuits against their insurers while

34% of respondents are in favor of allowing them, findings that are similar to

those from an IRC poll on the subject conducted in 2000. When asked what

might be the possible effects of allowing such suits, 25 percent cited “higher

insurance costs,” 14 percent “more frivolous lawsuits” and 7 percent making

“insurance companies more accountable,” but 71 percent said that they were

largely unwilling to pay the increased costs. Of those who were willing to pay

more, 59 percent were willing to pay only up to $49 more.63

61

For more on the four statutes, see id. at 215-17. 62

For more on contractual solutions to liability issues, see Rubin (1993). 63

Insurance Information Institute (2010).

17

Opinion survey data suffers from obvious weaknesses, but these results provide yet another

argument against those who call for loosening the standards for first-party bad faith cases.

What would a hypothetical bargain over a duty of good faith with respect to third-party

insurance most likely produce? Consider bad-faith-failure-to-settle. On the one hand, the

insured might well be surprised by his insurer‟s rejection of a settlement offer within policy

limits. On the other, the doctrine has the effect of eroding policy limits, and allowing an insured

to externalize the costs of her decision to underinsure to the insurer and, ultimately, to all

insureds. The answer to this question would ultimately depend on the cost of including the term

in the contract.

D. Institutional competence analysis

If you view the issue of good faith in terms of optimal contract design, but decide that

you do not want the parties to have the ability to bargain over this particular term, then the

question becomes whether it is better to resolve this question once-for-all in a regulatory agency

setting (the state department of insurance) or case-by-case in litigation (before state courts). The

question is one of institutional competence, as has been discussed by at least two contributors to

this debate.64

My own assessment of this is that, if we are determined to have some governmentally-

mandated form of good faith in third-party insurance, the design work would be better done by

the departments of insurance than by the courts. At least one other commentator, after reviewing

the doctrinal chaos of insurance bad faith litigation, also opted for an “administrative

enforcement system” over than litigation.65

However, both he and I admit that pursuit of this

alternative would require an increase in state department of insurance budgets and manpower in

order to better handle consumer complaints. As compared with the costs of bad faith litigation,

the regulatory alternative would seem to offer the prospect of lower administrative costs.

VI. Conclusion

64

Bisbecos (2002); Bisbecos & Schwartz (2003). 65

Rice (1992), 376-82.

18

Scholars have taken note of the functioning of the bar as an “interest group” in the

development of tort law.66

The reader is entitled to suspect that the development of insurance

bad faith litigation had at least as much to do with the benefits it conferred on the bar as the

benefits that flowed to consumers – particularly with regard to first-party insurance. If more

states adopt statutes that make first-party bad faith cases easier to bring, cynicism about good

faith will be even easier to embrace.

* Michael E. DeBow, Professor of Law, Cumberland School of Law, Samford University. B.A.

1976, M.A. 1978, University of Alabama; J.D., 1980, Yale University. Professor DeBow

wishes to thank Edward Rowe, of the Cumberland class of 2012, who provided vital research

assistance on this project.

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