Insurance bad faith
Insurance bad faith is a legal term of art unique to the law of the United States (but with parallels elsewhere, particularly Canada) that describes a tort claim that an insured person may have against an insurance company for its bad acts. Under the law of most jurisdictions in the United States, insurance companies owe a duty of good faith and fair dealing to the persons they insure. This duty is often referred to as the "implied covenant of good faith and fair dealing" which automatically exists by operation of law in every insurance contract. If an insurance company violates that covenant, the insured person (or "policyholder") may sue the company on a tort claim in addition to a standard breach of contract claim. The contract-tort distinction is significant because as a matter of public policy, punitive or exemplary damages are unavailable for contract claims, but are available for tort claims. The result is that a plaintiff in an insurance bad faith case may be able to recover an amount larger than the original face value of the policy, if the insurance company's conduct was particularly egregious.
Historical background 
Most laws regulating the insurance industry in the U.S. are state-specific. In 1869, the Supreme Court of the United States held, in Paul v. Virginia (1869), that United States Congress did not have the authority to regulate insurance under its power to regulate commerce.
In the 1930s and 1940s, a number of U.S. Supreme Court decisions broadened the interpretation of the Commerce Clause in various ways, so that federal jurisdiction over interstate commerce could be seen as extending to insurance. In March 1945, the United States Congress expressly reaffirmed its support for state-based insurance regulation by passing the McCarran-Ferguson Act (found at 15 U.S.C. §§ 1011-15) which held that no law that Congress passed should be construed to invalidate, impair or supersede any law enacted by a State regarding insurance. As a result, nearly all regulation of insurance continues to take place at the state level.
Such regulation generally comes in two forms. First, each state has an "Insurance Code" or some similarly named statute which attempts to provide comprehensive regulation of the insurance industry and of insurance policies, a specialized type of contract. State insurance codes generally mandate specific procedural requirements for starting, financing, operating, and winding down insurance companies, and often require insurers to be overcapitalized (relative to other companies in the larger financial services sector) to ensure that they have enough funds to pay claims if the state is hit by multiple natural and man-made disasters at the same time. There is usually a Department of Insurance or Division of Insurance responsible for implementing the state insurance code and enforcing its provisions in administrative proceedings against insurers.
Second, judicial interpretation of insurance contracts in disputes between policyholders and insurers takes place in the context of the aforementioned insurance-specific statutes as well as general contract law; the latter still exists only in the form of judge-made case law in most states. A few states like California and Georgia have gone farther and attempted to codify all of their contract law (not just insurance law) into statutory law.
Early insurance contracts were considered to be contracts like any other, but first English (see uberrima fides) and then American courts recognized that insurers occupy a special role in society by virtue of their express or implied promise of peace of mind, as well as the severe vulnerability of insureds at the time they actually make claims (usually after a terrible loss or disaster).
In turn, the development of the modern cause of action for insurance bad faith can be traced to a landmark decision of the Supreme Court of California: Comunale v. Traders & General Ins. Co., 50 Cal. 2d 654, 328 P.2d 198, 68 A.L.R.2d 883 (1958). Comunale was in the context of third-party liability insurance, but California later expanded the same rule to first-party fire insurance in Gruenberg v. Aetna Ins. Co., 9 Cal. 3d 566, 108 Cal. Rptr. 480, 510 P.2d 1032 (1973). Other state courts began to follow California's lead and held that a tort claim exists for policyholders that can establish bad faith on the part of insurance carriers. According to Stephen S. Ashley's treatise, Bad Faith Actions: Liability and Damages, 2nd ed. (Eagan, MN: Thomson West, 1997), §§ 2.08 and 2.15, courts in nearly thirty states recognized the claim by the late 1990s. In nineteen states, state legislatures became involved and passed legislation that specifically authorized bad faith claims against insurers.
Bad faith defined 
An insurance company has many duties to its policyholders. The kinds of applicable duties vary depending upon whether the claim is considered to be "first party" or "third party." A common first party context is when an insurance company writes insurance on property that becomes damaged, such as a house or an automobile. In that case, the company is required to investigate the damage, determine whether the damage is covered, and pay the proper value for the damaged property. Bad faith in first party contexts often involves the insurance carrier's improper investigation and valuation of the damaged property (or its refusal to even acknowledge the claim at all). Bad faith can also arise in the context of first party coverage for personal injury such as health insurance or life insurance, but those cases tend to be rare. Most of them are preempted by ERISA.
Third party situations (essentially, liability insurance) break down into at least two distinct duties, both of which must be fulfilled in good faith. First, the insurance carrier usually has a duty to defend a claim (or lawsuit) even if some or most of the lawsuit is not covered by the insurance policy. Unless the policy is expressly structured so that defense costs "eat away" at the policy limits (a so-called "burning limits" policy), the default rule is that the insurer must cover all defense costs regardless of the actual limit of coverage. In one of the most famous decisions of his career (involving Jerry Buss's bad faith lawsuit against Transamerica), Justice Stanley Mosk wrote: "[W]e can, and do, justify the insurer's duty to defend the entire 'mixed' action prophylactically, as an obligation imposed by law in support of the policy. To defend meaningfully, the insurer must defend immediately. [Citation.] To defend immediately, it must defend entirely. It cannot parse the claims, dividing those that are at least potentially covered from those that are not." This strong bias in favor of coverage is one of the major innovations of U.S. law; other common law jurisdictions outside of the U.S. continue to construe coverage much more narrowly.
Second, the insurer has a duty of indemnification, which is the duty to pay a judgment against the policyholder, up to the limit of coverage, but only if the judgment is for a covered act or omission. As a result, most insurance companies exercise a great deal of control over litigation.
Bad faith can occur in either situation—by improperly refusing to defend a lawsuit or by improperly refusing to pay a judgment or settlement of a covered lawsuit.
In some jurisdictions, like California, third party coverage also contains a third duty, the duty to settle a reasonably clear claim against the policyholder within policy limits, in order to avoid the risk that the policyholder may be hit with a judgment in excess of the value of the policy (which a plaintiff might then attempt to satisfy by writ of execution on the policyholder's assets). If the insurer breaches in bad faith its duties to defend, indemnify, and settle, it may be liable for the entire amount of any judgment obtained by a plaintiff against the policyholder, even if that amount is in excess of policy limits. This was the holding of the landmark Comunale case.
Bad faith is a fluid concept and is defined primarily by court decisions in case law. Examples of bad faith include undue delay in handling claims, inadequate investigation, refusal to defend a lawsuit, threats against an insured, refusing to make a reasonable settlement offer, or making unreasonable interpretations of an insurance policy.
In some cases, the tort or the governing state statute allows punitive damages against insurance companies as a mechanism to prevent future behavior.
In California, the plaintiff in a bad faith action may be able to recover some of its attorneys' fees separately and in addition to the judgment for damages against a defendant insurer, but only up to the extent that those fees were incurred in recovering tort damages (for breach of the implied covenant) as opposed to contractual damages (for breach of the terms of the insurance policy). The allocation of attorneys' fees between those two categories is usually a question of fact (meaning it usually goes to the jury).
Assignment or direct action 
In some U.S. states, bad faith is even more complicated because under certain circumstances, a liability insurer may ultimately find itself in a trial where it is being sued directly by the plaintiff who originally sued its insured. This is allowed through two situations: assignment or direct action.
The first situation is where an insured abandoned in bad faith by its liability insurer makes a special settlement agreement with the plaintiff. Sometimes this occurs after trial, where the insured has attempted to defend himself or herself by paying for a lawyer out of pocket, but went to verdict and lost (the actual situation in the landmark Comunale case); other times it occurs before trial and the parties agree to put on an uncontested show trial that results in a final verdict and judgment against the insured. Either way, the plaintiff agrees to not actually execute on the final judgment against the insured in exchange for an assignment of the assignable components of the insured's causes of action against its insurer.
The second situation is where the plaintiff does not need to obtain a judgment first, but instead proceeds directly against the insured's insurer under a state statute authorizing such a "direct action." These statutes have been upheld as constitutional by the U.S. Supreme Court.
Bad faith lawsuits may result in large awards of punitive damages. A famous example is State Farm Mutual Auto. Ins. Co. v. Campbell, in which the U.S. Supreme Court overturned a jury verdict of $145 million in punitive damages against State Farm Insurance. Bad faith cases may also be slow, at least in the third party context, because they are necessarily dependent upon the outcome of any underlying litigation. For example, the 2003 Campbell decision involved State Farm's handling of litigation resulting from a fatal car accident in 1981, 22 years earlier.
Toxic mold is a common cause of bad faith lawsuits, with about half of the 10,000 toxic mold cases in 2001 being filed against insurance companies on bad faith grounds. Before 2000 the claims were uncommon, with relatively low payouts. One notable lawsuit occurred when a Texas jury awarded $32 million (later reduced to $4 million). In 2002 a suit was settled for $7.2 million.
International comparison 
No other jurisdiction has gone as far as the United States in recognizing a separate tort based on an insurer's bad faith treatment of an insured, although Canada has come quite close. Thus, outside of the U.S. and Canada, insurers remain free to mistreat insureds during the claims handling process to an extent that Americans and Canadians find appalling.
In 2002, the Supreme Court of Canada upheld an award of punitive damages for an insurer's bad faith claims handling, but expressly refused to recognize insurance bad faith as an independent tort under Ontario law, and instead held that when extremely egregious, an insurer's breach of contract becomes an "actionable wrong" (something different than a tort) which justifies punitive damages. Since then, one Canadian appellate court, the Court of Appeal of New Brunswick, has gone farther and expressly embraced the American concept of a tort of insurance bad faith.
New Zealand's then-highest court in 1998 refused to decide the issue of whether to impose extracontractual tort liability for bad faith claims handling.
The Australian Law Reform Commission considered but declined to adopt a tort of insurance bad faith when it drafted the Insurance Contracts Act 1984. Since then, Australian courts have consistently refused to judicially impose what Parliament did not legislatively impose, of which the most recent example was when the New South Wales Court of Appeal refused to adopt insurance bad faith in 2007.
See also 
- Paul v. Virginia, 75 U.S. (8 Wall.) 168, 19 L.Ed. 357 (1869).
- Eugene R. Anderson, Jordan S. Stanzler, & Lorelie S. Masters, Insurance Coverage Litigation (New York: Aspen Publishers, 2009 supp.), § 11.04 at 11-13 to 11-16.
- Kanne v. Connecticut Gen. Life Ins. Co., 867 F.2d 489 (9th Cir. 1988).
- Buss v. Superior Court, 16 Cal. 4th 35 (1997).
- Cassim v. Allstate Ins. Co., 33 Cal. 4th 780 (2004).
- Essex Ins. Co. v. Five Star Dye House, Inc., 38 Cal. 4th 1252 (2006).
- Watson v. Employers Liability Assurance Corp., 348 U.S. 66 (1954).
- State Farm Mutual Auto. Ins. Co. v. Campbell, 538 U.S. 408 (2003).
- Hartwig RP, Wilkinson C. (2003). Mold and Insurance. Insurance Issue Series.
- Whiten v. Pilot Insurance Co., 2002 SCC 18,  1 SCR 595.
- Walsh v. Nicholls  NBJ No. 281.
- State Insurance Ltd v. Cedenco Foods Ltd (CA 216/97, 6 August 1998), p. 7.
- Banque Keyser Ullmann SA v. Skandia (UK) Insurance Co Ltd.  1 QB 665.
- Banque Financiere de la Cite SA v. Westgate Insurance Co. Ltd.  2 AC 249, 280.
- Sprung v. Royal Insurance (UK) Ltd  1 Lloyd's Rep. 111.
- CGU Workers Compensation (NSW) Limited (CAN 003 181 002) v. Garcia  NSWCA 193.