A Defining Moment

Should applicants for an insurance policy or those who file a claim for policy benefits be required to tell the truth? Should insurance companies be required to honestly and fairly investigate applicants and claimants? The answer to both questions should be equally, “yes.”

For insurance to work well, applicants, insurers, insureds, and claimants must act in good faith. Consumers rely upon an insurer to act in good faith and to keep its promises when an insured event occurs. The reverse also is true. In order to underwrite the risk, set a premium, create the policy, and pay valid claims, insurers must be able to rely upon the consumer to act in good faith.

For noninsurance contracts, the legal duty to act in good faith generally means little more than honesty, in fact. For insurance contracts, the law has imposed a higher good faith standard. 

The duty of utmost good faith, previously known by its Latin name, uberrimae fidei, originated in marine insurance three centuries ago as a duty imposed upon insurance applicants, but it has since evolved so that this duty is now generally imposed only upon the insurer. This article will advance the position that it is in the best interests of both consumers and insurers that the obligation in the law to act in good faith be equally applicable to both insurers and insureds.

In the 17th century, if an English importer wanted to insure a shipment of goods coming to London from Italy, he would go to the Lloyd’s Coffee House in London and ask who would be willing to insure the shipment against loss at sea. The perils could be pirates, storms, faulty seamanship by the captain, shipwreck, or mutiny by the crew. The London underwriters had no ability to independently confirm the insurance applicant’s description of the risk: i.e., the ship’s condition, the nature and condition of the cargo, or the skill of the captain and crew. They had to rely on the statements of the applicant. Thus, the duty arose that the applicant for insurance must act in utmost good faith because the insurers were relying on a full and honest representation of the facts when they accepted the risk. 

In marine insurance today, it remains the duty of an applicant to truthfully answer all questions posed by the insurer plus reveal all facts material to the risk. That duty to affirmatively disclose all material facts known to the applicant is not generally recognized in other forms of insurance. Though insurers today have a greater ability to check the honesty of the applicant’s responses, the applicant for insurance of all types should still be bound by the duty to tell the full and complete truth about any information material to the risk when inducing the insurer to accept a risk. 

It is in the interests of both insurers and insureds that the same duty apply to those claiming benefits under an insurance policy. The Coalition Against Insurance Fraud estimates that there is $80 billion in fraudulent claims in the U.S. each year across all lines of insurance. This cost, plus the millions of dollars spent by insurers to investigate and detect insurance fraud, increases the cost of insurance for everyone.

The strength of a country’s insurance industry has a close relationship to the strength of its economy. If an equal application to both insurer and insured of the duty to act in good faith will strengthen the insurance industry and the economies in which they operate, then the law ought to reflect that.

The insurance principle states that insurance is a risk transfer mechanism under which the policy owner exchanges a small certain loss (the premium) for a large uncertain loss (the event insured against, e.g., death, illness, fire, accident, etc.). Unlike tangible products, such as hammers, cars, and clothes sold by manufacturers, an insurance company sells an intangible promise to pay benefits to or on behalf of its policyholders in the event of a covered loss.

Insurance exists to transfer risk. Risk is formally defined as uncertainty about outcomes, which can be positive or negative. Risk can be separated into business risk and hazard risk. Business risk (aka speculative risk) is that which is inherent in the operation of a business and presents the possibility of loss, no loss, or gain. It is generally not insurable because insurance is intended only to indemnify actual losses and not the failure to achieve a hoped-for gain. Hazard risk (aka pure risk) is that which results from exposure to accidental loss from such events as fire, wind, or illness. Hazard risk presents only the possibility of loss or no loss; there is no opportunity for gain. This risk is generally insurable. 

Fundamentally, insurance is the combining of resources by the members of a pool. Each insured, as a member of the pool, has an equal interest that all applicants tell the truth when applying for insurance and when seeking benefits. An insurer can be envisioned as a money bucket that holds and prudently invests policy owner premiums in order to have sufficient cash to pay claims as they arise. If the insurer has a large number of insureds paying a proper premium, the more likely it is that the invested premiums and the investment returns will be adequate to pay all valid claims. But, if premiums are too low because applicants have made misrepresentations as to the nature of the risk they present to the pool or if the money in the pool is consumed by the payment of invalid or exaggerated claims, then all of the honest members of the pool will suffer.

When risks are properly disclosed and insurance is properly priced, then, based upon the law of large numbers and the insurance principle, insurance creates a near approximation of certainty for the pool of insureds and shifts the risk of loss from the few to the many. Bad faith actions by applicants, insureds, and claimants destroy this balance and threaten the ability of the pool to pay valid claims.

The law of large numbers states that, as the number of repetitions of an event increases, the deviation of actual experience from expected experience decreases. The smaller the deviation, the more predictable the anticipated losses. If you flip a coin 10 times, it is hard to predict how many times the coins will land on heads. If you flip the coin a million times, it is more likely that a prediction of 50 percent heads will be close to the observed amount. This law applies to tossing coins and to insuring risk. Applying this law to insuring property and lives creates predictability and permits insurability. 

Based upon underwriting, insurers select who or what will be insured and classify the selected risks so that the owner of each risk pays a premium actuarially equal to the risk presented to the pool of insureds. This can be done accurately and fairly only when applicants truthfully disclose all information they possess that is material to the risk. 

While insurers could charge all insureds the same premium, it is fair that people who present a higher risk of loss (e.g., death for a male aged 90 or fire for a straw house) pay a higher premium than those who present a lower risk of loss (e.g., death for a female aged 20 or fire for a brick house). 

Insurers set premiums by estimating the future in four categories, which are known in life and health insurance by the acronym MIX-P—which stands for the mortality (death) or morbidity (sickness), the peril insured against; the investment income anticipated to be earned on the premiums paid by policyholders over the life of the policy; the expenses anticipated to be incurred to operate the insurer; and the persistency of the policies sold. Persistency is the opposite of the lapse rate and estimates how many policies will be renewed at each succeeding renewal period. Bad faith actions by the consumer reduce the ability of insurers to predict the future in all four.

When a claim is received, the insurer attempts to determine which claims are valid. The insurer has a duty to its policyholders to pay valid claims. But the insurer has an equal duty to its policyholders to deny invalid claims. These two duties are different sides of the same coin and are equal in their importance to the ability of the insurer to fulfill the promises made to honest policy owners.

What is the difference for an insurer between acting in good faith and acting in bad faith? A review of the case law establishes that the many attempts to define when an insurer has acted in bad faith offer little consistency and that there is no universally accepted definition of the term. 

The term “bad faith” applies to something worse than simply being negligent. It is bad behavior combined with bad intent, and scholars agree that bad faith requires a showing of more than that the insurer did something wrong. An accusation that an insurer acted in bad faith requires more than a showing that the insurer didn’t act in good faith. 

A Proposal for an Objective Definition 

The law of bad faith arose as a result of bad acts by some insurers. These acts were viewed as intentionally wrong and caused courts and legislatures to create remedies for the parties injured by them. Consistent with this principle, the foundational element of a bad faith claim should be a showing of actual bad intent by the insurer. For example, the plaintiff should be required to show that the insurer acted with an intent to deny the plaintiff the benefits of the contract. 

With that definition, bad faith moves away from negligence and closer to the definition of insurance fraud. This is appropriate. Fraud is an act committed with the intent to obtain something you would not get absent the intentional misrepresentation. Acting in bad faith is an act committed with the intent to gain something to which one is not entitled.

Bad faith is not, and should not be, merely a mistake, ordinary negligence, or error. Bad faith should not be established if the record shows that the insurer, through unintentional error, didn’t properly process the claim or did a less-than-thorough investigation. The law should recognize the reality that someone can be wrong without acting in bad faith.

There ought to be a requirement for a showing of some element of intentional behavior or at least a reckless disregard for the rights of the insured. Bad faith should be established if the record shows evidence of a knowing intent to evade the requirements of the contract or to improperly process the claim or to conduct an inadequate investigation.

It is suggested that a finding of bad faith is proper if the insurer acted in a manner that was arbitrary or capricious. However, the vagueness of these terms makes it hard to know in advance what will be deemed to be arbitrary or capricious. A clearer standard might be that, in order to have a finding of bad faith, there ought to be evidence that the insurer’s subjective mental state (meaning as it is displayed by the actions of its agents and employees) was based upon an intent to do the wrong thing or upon a reckless disregard of whether the action was wrong. Satisfying this requirement should be based upon facts or a reasonable inference based upon facts; not upon mere speculation.

A finding of bad faith also could be found based upon objective unreasonableness. This might be defined as: no reasonable person having the same duties, knowledge, and experience would have committed the acts in question. That definition also can be fairly applied to a duty of an applicant or a claimant to act in good faith with respect to the insurer.

Since insurers must rely upon consumers to tell the truth in order to create a fair insurance contract and consumers must rely upon insurers to perform the duties created by the contract, the standard for bad faith should be based on intent and be equally applicable to insurers as well as to applicants for insurance and claimants for policy benefits.