If you believe that third-party bad faith is applicable only in a handful of jurisdictions, you are sadly mistaken. Although only a few jurisdictions have case law or statutes that officially allow the recovery of damages for bad faith involving third parties in a direct action, most states still have some route for a third party to recover for the actions of the insurance company resolving their claim.
Direct action states are few and far between. In Kentucky, two statutes and the defining case of State Farm v. Reeder allow a direct action against an insurance carrier at any time for a violation of the Unfair Claims Settlement Practices Act. The extracontractual claims can be included in the initial lawsuit, added by amendment later, or filed separately even after the case has been resolved by settlement or verdict.
However, other direct-action states like Massachusetts require that, before filing a third-party bad faith claim, a claimant must serve a demand letter 30 days before filing suit, reasonably describing the unfair or deceptive act and the actual injuries suffered in sufficient detail in order to permit the carrier to determine its potential exposure. Others, like Montana, require a claim to be settled or a judgment entered in favor of a claimant in an underlying claim before a direct action can be instituted by a third party to assert third-party extracontractual damages.
The most common ways, however, that you will see a third-party bad faith case is not a direct action against the insurance carrier by a third-party plaintiff, but rather in a judgment creditor or a third-party beneficiary action or when the jurisdiction allows an assignment of bad faith claims by the insured to the claimant. As a judgment creditor, the insurance carrier usually has a limited amount of days (30 or 60) to pay the judgment against its insured. If it does not, then the plaintiff can act as a judgment creditor and sue the insurance company for the judgment amount directly.
In Alabama, for instance, the recovery against an insurer is limited to the amount of coverage of the policy only—not any excess amounts or punitive damages. Other states, such as Iowa, give the third party the same rights that an insured would have against the insurer after a verdict is rendered.
Assignments might be the most common way that you will see third-party bad faith, and those can be both pre-suit and post-suit depending on the state. Many states require an excess verdict before there can be an assignment of the extracontractual claim. In some cases, there can even be an assignment to the claimant if the insurer defended the action or there was no excess verdict.
So what do you do to make sure that extracontractual damages are not asserted or recovered against your company? The simplest answer—and the one that almost everyone will echo—is to treat every claimant the same and thoroughly investigate and evaluate the claim that has been presented. Everyone knows that mantra and can repeat it without hesitation, yet still there are first- and third-party bad faith cases filed every day, usually asserting that there was a delay in paying a valid claim in a timely manner or a failure to defend an insured. That means somewhere there is a disconnect. Yes, actual bad faith requires some element of intent or recklessness, but juries do not always care about that requirement. What they care about is that the insured paid the premium for coverage that was then denied them, or that someone was legitimately hurt and the insurance company is not paying them. A thorough investigation is only the beginning.
Another tried-and-true method that many insurers rely on is the declaratory judgment action to determine whether coverage exists. But have you ever filed a declaratory judgment action to determine if there is viable coverage and provided a defense during that time in the underlying case and still were hit with bad faith damages? It can happen when you lose your declaratory judgment coverage case. A declaratory judgment case does not insulate the insurance carrier in most states from bad faith allegations. In fact, it can be evidence that the insurance carrier—despite knowledge that the language in the policy is either ambiguous and should be interpreted in favor of the insured or they have lost on that issue before in another court at another time—committed bad faith by delaying settlement in the underlying case or caused inconvenience and aggravation to the insured by delaying payment to the third-party plaintiff in the underlying suit where fault is reasonably clear.
What an insurer must do to protect itself from extracontractual damages, especially in assignment states, is to keep the insured informed. If there is a possibility of an excess verdict, then there likely is a standard letter that goes to the insured for the carrier when it is suspected. Sometimes it is based on the vague prayer for relief; other times from the demands transmitted by the claimant or her counsel. What many insurers do not do—or do not do well—is to keep the insured fully apprised during the entirety of the claim of settlement demands and offers. If there is a mediation, involve the insured. Bring them to the mediation to witness the position of the third party as well as provide information that you might not know because the question was not asked of the insured. Communication with the insured will help avoid extracontractual damages, and they won’t feel left in the dark.
The importance of communication isn’t just related to negotiations. It also involves the communication about the investigation. In one recent case, there were two insurance policies that applied to the insured from one company, XYZ Insurance, one of which was an excess policy, as well as one that applied as excess, by its terms, issued by my client that was being challenged in a declaratory judgment action. The insured’s extracontractual inconvenience and aggravation damages were based on the fact that the insured thought he would lose his business if there was no coverage beyond the one five-figure policy of the other carrier, resulting in both emotional and physical health issues being claimed. No one checked the language of that carrier’s excess policy. Had they done so, they could have communicated that the excess policy of the XYZ company would apply if the excess policy did not, and that there would be multiple millions of coverage. There would not have been any extracontractual claim had there been communication throughout the claim as well as a thorough investigation into the excess policy of the XYZ company.
An insurance carrier also can try to effectuate either covenants not to execute or stipulated judgments where there is a possibility of an excess verdict but there also are issues of fact that make the excess verdict uncertain or even a high/low stipulation. In one case that involved a minor and the viewing of pornography with my client’s 16-year-old son at home, we stipulated to a high/low of $20,000/$100,000. After the minor could not identify the film that he watched, the case was settled for the low number. Had we tried the case, the plaintiff could have recovered no more than $100,000. By entering into these types of agreements, you can limit the exposure to a known number that can be reserved properly and will not affect the insured financially. If the plan is communicated to the insured and the limitation of exposure explained, then an uncertain case can be tried without significant repercussions, which could include punitive and extracontractual damages.
One final suggestion is not to wait until a demand is made by the claimant to make an offer, regardless of whether the case is in litigation or at the claim stage. Many carriers still believe that there can be no bad faith if there is no demand. That is true in many states, but the law can change quickly. How many times has your Supreme Court changed a law that had been in effect for years? In fact, in 2015, Louisiana ruled that insurers must make a reasonable effort to settle claims even without a demand. This could be a trend and not a minority position over the next few years.
If you have enough information upon which to make a reasonable offer, do it and explain how you arrived at that offer. Showing a detailed basis for your thought process in arriving at the offer will be the best evidence that you were neither reckless in handling the claim nor intentionally trying to lowball the claimant. And keeping the insured apprised of the same facts will ease his fears on the fact of the claim against him.