Use the Threat of a Bad-Faith Claim

April 13, 2006

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Selecting the types and levels of insurance is vitally important to a small business owner seeking to avoid day-to-day liability risks. So an owner should follow some general insurance guidelines if he or she wants to take full advantage of the protections purchased.

"Bad faith" is a tort cause of action that can be used against an insurance company that has denied a claim, provided inadequate representation under its duty to defend or engaged in other wrongful conduct.

Bad faith can be a serious form of leverage used against an insurance company. Many times, the mere mention of "bad faith" causes an insurance company to change its position. A successful bad-faith claim will result in the insurance company being held liable to pay the claim, along with defense costs (if there is a duty to defend clause) and, in many cases, punitive damages as well.

A common form of bad faith involves an insurance company's refusal to settle a case for the policy limits, which is based on a reasonable offer from the injured party.

Insurance companies have a financial incentive to behave in this way. For example, assume the policy limit on an automobile insurance policy is $100,000. Assume the plaintiff, who has damages that equal or exceed $100,000, offers to settle the case for the policy limit.

The worst-case scenario, for the insurance company, is paying the policy limit. Its liability, of course, cannot exceed this limit. Thus, in this situation, the insurance company may conclude that it has nothing to lose by refusing to settle these case and going to trial. If, after a trial, the judgment is $400,000, the insurance company still only pays $100,000, the policy limit.

Thus, by refusing to settle the case and going to trial, the insurance company is gambling that the jury might award less than the policy limit, thus producing savings for the insurance company. In engaging in this gambling, however, the insurance company is taking no risk at all. Instead, all the risk is on the insured. Essentially, the insurance company is gambling with the insured's money. In this case, for example, the additional $300,000 in damages would have to be paid entirely by the insured.

If it can be shown that the injured party's offer to settle the case, at the policy limit, was reasonable, but the insurance company refused the offer and went to trial, the insurance company may be held liable on a bad-faith tort claim brought by the insured. The result of a successful bad-faith claim in this case will be that the insurance company will be ordered to pay the entire judgment. In other words, the insurance company's liability will not be limited to the policy limit. In this case, continuing our example, a successful bad-faith claim would mean that the insurance company would be required to pay the entire $400,000 of damages.

Clearly, insurance companies have plenty of incentive to dispute and delay claims up to the point in engaging in bad faith.

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The insured also would be taking a risk if he actually files a bad-faith claim against his insurance company. The risk, of course, is the possibility of losing the action.

As stated above, many times the mere mention of the possibility of a bad-faith claim is sufficient to cause an insurance company to change its position. Thus, if the insured believes his insurance company is guilty of bad faith, the best strategy would be to send a carefully worded letter to the company that subtly mentions the possibility of a bad-faith claim. This letter ought to be drafted by an attorney. The insurance company will understand the implications of the letter.

The threat of a bad-faith claim also can be coupled with another effective strategy. Involving the government in a lawsuit or dispute can be very effective in inducing a favorable settlement. The government has immense resources and, in certain cases (e.g., disputes with insurance companies), the power to levy civil fines. Involving the government is the equivalent of hiring a large law firm free of cost.

Every state has an insurance department. The threat of a complaint to the insurance department can, many times, force an insurance company to act reasonably. However, as is true with any threat, if the threat does not produce results, it should be followed by the actual filing of a complaint.