Focusing on insurance bad faith.

In the 1950s, Americans put their trust in God, the president, and their insurance companies. But it gradually became apparent that insurance companies were sometimes more interested in protecting their pocketbooks than their insureds.

The first area of disillusionment came in the context of liability policies. If an insurance company would not properly defend its insured or would not settle a liability action within the policy limits, there was little or no risk for the insurer. Since only breach of contract damages were available, the worst that could happen was that the insurer would have to pay the policy limits later rather than sooner.

The California courts were the first to recognize the dangers this posed to insureds. If a judgment covered by the liability policy were entered against the insured, the insurer could escape with paying only its policy limits. However, an unreasonable refusal to settle a case within the limits before trial could put the insured at risk of a judgment far in excess of the policy's liability limits -- a judgment that could devastate a family.

Tort liability for insurance bad faith evolved slowly, but once that ball started rolling, it rolled fast. In 1973, the California Supreme Court issued its first landmark case, Gruenberg v. Aetna Insurance Co., unequivocally extending tort liability for bad faith to first-party cases.(1) After that came Egan v. Mutual of Omaha Insurance Co.(2)

Both cases were at the crest of the wave of bad faith law that spread across the country, and both have been cited hundreds of times in other states and territories. As recently as last June, the Hawaii Supreme Court adopted the Gruenberg/Egan standard and noted, at footnote 10, that most jurisdictions now recognize some form of common law bad faith.(3)

In the 1970s and 1980s, many insurers suffered large judgments, including significant punitive damages awards, because of their blatant mishandling of claims. If the companies had claims manuals, they were fodder for the bad faith mill because they often instructed adjusters to follow procedures that were a best unreasonable and at worst outright malicious.(4)

Similarly, claim files in the "old days" were a gold mine of bad faith evidence. Until bad faith law took a foothold and punitive damages awards became more frequent, "smoking guns" abounded because adjusters were used to documenting the claim file with a "that'll show 'em how tough I can be" mentality to gain points with claims supervisors.

Those days, however, are pretty much gone. Most insurers are far more cautious about what goes into claims manuals and claims files.

Given the more protective posture of insurers, litigating a bad faith case requires a more creative approach than in the past. Attorneys must use consumer remedy statutes, formulate discovery addressed to the more technologically advanced work environment, and reach past the insurance company itself into the corporate structure surrounding it to get information to prove these cases.

`Institutional, Bad Faith

Often, examining the facts of one insured's case or one claim file may demonstrate negligence and may be sufficient to establish bad faith. Even when there is enough evidence to prove bad faith, the resulting economic damage or emotional distress, when it occurs in the context of a single case, may not be enough to warrant fifing suit or may not seem sufficiently outrageous to support punitive damages liability.

Many times, however, taking a step back from the individual claim will reveal an "institutional" type of bad faith. Here, the insurer implements broad policy decisions that have a significant and adverse impact on its insureds' rights overall, but that may affect an individual insured in a far less significant way.

One example is a medical insurer that reduces an insured's claim payments by a few dollars on the grounds that the medical charges are in excess of the "usual, reasonable, and customary" charges made by similar providers in the same geographic area. The patient usually does not have the sophistication to know, or the wherewithal to check, whether that is true. If the patient refuses to pay the difference, the medical provider is likely to write it off.

No one is seriously hurt. But over the course of millions of medical claims a year, the insurer significantly boosts its bottom line.

Insurers have even developed a technique to forestall bad faith allegations in the first instance. Cases now surfacing in California are being filed by insurers, under declaratory relief actions, before a claim is even denied. Some disability insurance companies, wanting to terminate their insureds' disability payments on less than legitimate grounds, first make the payments under a reservation of rights, then file a declaratory relief action. If a bad faith cross-complaint is filed, the insurer contends that because there can be no bad faith without an unreasonable withholding or denial of policy benefits, and because all the monthly payments have actually been made, there is no actionable bad faith.

On its face, it appears that the insured is caught between a rock and a hard place. Without a denial of benefits, there's no bad faith. Without bad faith, there's no way to recover the costs of litigating the declaratory relief action.

Yet, it is inherently unfair to permit an insurer to reserve its rights to recoup benefits paid under a reservation of rights and at the same time not be exposed to the risk of bad faith liability if the grounds for the reservation of rights or for seeking declaratory relief are, in fact, unreasonable. In California, at least, a recent case provides the insured a toehold for scaling that cliff.

In Dalrymple v. USAA, the court discussed whether the insurer could be liable for bad faith where it provided benefits (a defense in a liability action), but did so only conditionally and under a reservation of rights while pursuing a declaratory relief action to determine coverage.(5) The insurer argued that the payment of defense costs (even though under a reservation of rights) precluded any allegation of bad faith since no benefits were "withheld."

In response, the insured argued that her contractual right was to fill, prompt, and unconditional payment of benefits. The court held that a bad faith cause of action could properly be stated in that context if the insurer did not have a good faith basis for the coverage dispute.(6)

This example teaches that a case that demonstrates some bad faith but that may not otherwise be worthwhile litigating in other contexts should be looked at one more time from the "big picture" perspective.

The Attack

If there is institutional bad faith, how can the attorney attack it? The obvious solution is a class action because many people arc damaged a little bit by the same wrongful conduct. But there are a number of ways to address these issues without the complication of a class action. How? By using appropriate statutes.

One type of statute to consider is an unfair competition or antitrust statute. These are typically assumed to be a means by which one business or industry can stop competitors from undercutting profits. But look again.

Although antitrust and unfair competition statutes are most often directly employed by one business against another, or by a government authority against a business, the reason for their existence is to ensure a competitive economy. The rationale for that, in turn, is to ensure that consumers can get the best products at the best prices. Thus, where the statutory scheme provides a basis for standing, an insurance consumer may properly litigate the action.

In California, the Unfair Competition Act, embodied in Business & Professions Code [subsections] 17200-17209, is one such statute.(7) Section 17200 defines unfair competition as "any unlawful, unfair or fraudulent business act or practice." Those terms are given broad construction by the courts to maximize the protections intended by the statute.

The "prosecutors" authorized to bring an action are primarily government enforcers: the attorney general, a district attorney, county counsel, or city attorney. However, a critical catchall at the end of [sections] 17204 gives every person in the state standing to sue because an action may be brought "by any person acting for the interests of... the general public."

The remedies available may, at first blush, appear to be less than scintillating since, under California law, an individual may not seek to recover personal damages under the statutory scheme.(8) That just means it is time to think creatively, again. The statute does permit the court to make such orders or judgments [including injunctions] ... as may be necessary to restore to any person in interest any money or property, real or personal, which may have been acquired by means of such unfair competition."

Thus, not only can the court issue an injunction to prohibit the same wrongful conduct in the future, it can order restitution to all victims of the insurer's business practice. The court can order the insurer to identify all insureds affected by the practice and to notify them they may be entitled to relief As discussed in more detail below, this type of approach also opens the discovery doors much wider than in the usual bad faith case.

In California, insurers have been fighting long and hard in order to avoid being subject to statutory liability under $17200. Companies argue that after the state supreme court's decision in Moradi-Shalal v. Fireman's Fund Insurance Cos.(9) eliminating any private right of action under California's Insurance Code sections specifying unfair trade practices in insurance, the general unfair trade practices provisions of [sections] 17200 do not apply to insurers.

Although some courts bought into that argument,(10) the tide is turning. In Manufacturer's Life Insurance Co. V. Superior Court,(11) the California Supreme Court rejected that argument in a case asserting that the insurer engaged in antitrust activities under the state's antitrust statute.

The court held that although the violation of any part of Insurance Code [subsections] 790-790.10 could not by itself provide a basis for a cause of action, where that same conduct also violated some other statutory mandate, the action was maintainable.

Insurers have now turned to arguing that Manufacturers Life stands solely for the proposition that an insurer is subject to regulation under [sections] 17200 only if the conduct violates another statute and that violation of common law rights does not support a [sections] 17200 cause of action. One of California's intermediate appellate courts disagrees.

In State Farm Fire KY Casualty Co. v. Superior Court (Allegro),(12) the plaintiffs, a group of insureds whose homes were damaged by the Northridge earthquake, alleged that in the mid-1980s their insurer effectuated a fraudulent scheme to significantly reduce its potential liability in the event of a catastrophic earthquake to the detriment of its own insureds.

Petition for review has been denied on this case by the California Supreme Court, and the factual scenario is instructive about how to approach those issues.

Before the mid-1980s most insurers, including State Farm, provided earthquake coverage under their homeowner's program by adding an endorsement that designated an earthquake as a covered peril. The policy limits and benefits, such as guaranteed replacement cost, were the same for loss by earthquake as they were for a loss resulting from any other covered peril.

The Allegro complaint alleges, however, that in about 1985, State Farm began issuing "stand-alone" earthquake policies (a policy separate from the general homeowner's policy). Although there is nothing inherently wrong with that, the complaint states that in doing so, State Farm significantly reduced the coverage while at the same time failing to give its insureds adequate notice of the reduction.

For example, assume the homeowner had $100,000 coverage on the dwelling, with guaranteed replacement coverage,(13) $70,000 for contents, and an unlimited amount for additional living expenses (ALE) under the homeowner's policy. The Allegro complaint alleges that when State Farm issued the earthquake coverage as a separate policy, that policy was normally issued with a $100,000 single limit -- combining all the coverages (dwelling, contents, and ALE), with no guaranteed replacement coverage on the dwelling. Thus, the insured suddenly became grossly underinsured for loss by earthquake without, Allegro alleges, sufficient notice.

The plaintiffs alleged standard bad faith and fraud causes of action and sought relief under [sections] 17200. After State Farm's demurrer was overruled, it petitioned for a writ of mandate to the court of appeal. The court concluded that the section applied to insurers where their conduct violates common law rights despite the fact that the same conduct also violates Insurance Code [sections] 790.

One thing Allegro teaches is that not only "small" cases can benefit from a creative approach. Each of the individual insureds in Allegro was significantly damaged and could maintain an individual action for damages. But looking beyond the immediate case to the underlying institutional bad faith disclosed what is alleged to be a wide-ranging, deliberate scheme to defraud thousands of insureds.

In turn, the Supreme Court has found that kind of conduct to be a proper basis for imposing punitive damages far in excess of the typical 1 to 3 ratio of compensatory to punitive damages now being advocated by many legislators.

In TXO Production Corp. v. Alliance Resources Corp.,(14) the Court held that where the tortious, wrongful conduct constitutes a pattern and practice, even a compensatory to punitive damage ratio of 1 to 526 was proper.

In sum, we do not consider the

dramatic disparity between the actual

damages and the punitive award

controlling in a case of this character ... The

punitive damages award in this case is

certainly large, but in light of the

amount of money potentially at stake,

the bad faith of petitioner, the fact that

the scheme employed in this case was

part of a larger pattern of fraud,

trickery and deceit, and petitioner's wealth,

we are not persuaded that the award

was so "grossly excessive" as to be

beyond the power of the state to allow.(15)

Nor is the impact of that discussion in the TXO case in any way diminished by the Supreme Court's later decision in BMW v. Gore.(16) The Court was dealing with a "wrong" that was not actually a wrong in some states.(17) As such, the Court felt that it was inappropriate to punish BMW for conduct that occurred in other states where, in fact, the plaintiff had not proved that a "wrong" had been committed under the law of those states.

The implication is that had the wrongful conduct been universally condemned or had the punitive damages been calculated solely on the basis of the pattern and practice of wrongful activity in the forum state, the punitive damages award would have been constitutionally defensible. This is, of course, an important distinction to keep in mind when attacking institutional bad faith under a consumer remedy statute.

Obviously, using these statutes to attack institutional bad faith has to be financially worthwhile for the attorney. Some of the statutes provide for attorney fees. Others are silent on that issue, but the good done may fall within the "private attorney general doctrine," permitting recovery of fees based on the "common fund" generated as the result of the attorney's efforts.

New Discovery Approaches

As noted above, the consumer remedy, approach to institutional bad faith can open doors to discovery that would otherwise be hard to get through. Since consumer remedy statutes are often keyed to stopping a general business practice, the plaintiff has to be permitted discovery on the nature and extent of the targeted practice. Absent that, the court has no basis for deciding whether some action needs to be taken and, if so, the best means of corralling the practice. Also, where the statute provides restitutionary remedies, discovery must be permitted to identify the insureds entitled to restitution and the amount of the restitution.

Even in a "standard" bad faith case, the pattern and practice language from TXO virtually mandates that a plaintiff be permitted to discover other instances of similar wrongful conduct. Thus, a plaintiff should be entitled to discovery of claim files dealing with claims and conduct like that alleged in the complaint.

One of the insurer's primary attacks, and one of the court's primary concerns, will be the confidentiality of the other insureds in discovery of their files. The argument that they will ultimately benefit from a positive outcome will have little sway.

There are, of course, ways to meet this challenge. The most time-consuming method, but the one likely to get the most information, is a "consent" letter. in a motion to compel production of the similar claim files (and there will be a motion to compel), counsel should propose that the court order the insurer to identify the relevant files and send a letter to each of the affected insureds.

The letter should generally describe the nature of the case, the fact that the court has determined that other claim files may be relevant to determining some issues in the case, and that the insured's file is one of those possibly relevant files. The insureds are requested to permit release of their files by signing consent forms and returning them to the plaintiff's attorney. Once the consent is received, a copy is provided to the insurer, who is required to produce the file. This procedure has been adopted by California judges on a case-by-case basis.

A faster way of getting the information is to agree to accept copies of files in which an insured's identifying information (name, address, phone number) is redacted and the files identified solely, by their claim numbers. This way the confidentiality of the information is maintained while substantive information regarding the scope and extent of the challenged practice is available.

In a consumer remedy case, the court will be much more inclined to permit disclosure of the identity of individual insureds once the case is proven and the judge determines that an injunction and restitution are warranted. The substantive information from the redacted files can be used to prove the unfair practice and the need for restitution, and the court can then order the insurer to identify the affected insureds so that restitution can be given.

Another insurer objection will undoubtedly be that it would take thousands of hours to pull and inspect all the claim files to determine which are relevant. To forestall or overcome this argument, it will be necessary to depose the person or persons most knowledgeable about the insurer's computer system.

Many insurers, especially larger ones, have sophisticated computerized claim-tracking systems that can be used to locate specific types of files. The best approach is to serve the request for production of documents asking for relevant files and at the same time to set the deposition of the employee most knowledgeable about the computer systems. The notice of deposition should also include production of documents relevant to the computer issues.

A computer specialist may be helpful in outlining questions for the deposition and in developing the document request. The resulting testimony and documents will show the court that the company can efficiently locate relevant files.

A fruitful source for damning information is a company's e-mail records. The "smoking guns" that used to be found in claim files or claim manuals are now often found in these records.

Most standard document requests should ask for computer and e-mail "documents." Still, counsel will probably not get this information. Again, deposing the insurer's computer guru may be necessary to establish the existence and operation of the company's e-mail system. Then, a motion to compel may be needed to require production of the e-mail documents themselves.

In some cases, the relevant e-mails win have been "purged" from the system, inducing the insurer to believe the information is safe from discovery. However, much information in a computer system remains stored in a "ghost" form somewhere in the system and can be retrieved with specialized software. A motion to compel to permit an independent computer consultant to access the system will likely be necessary.

Once counsel has obtained several hundred f or several thousand) claim files, computer systems are the ideal way of sorting through the information that proves the pattern and practice. Several forms of litigation software can be used to extract the information. It is critical that the specialist know what information to look for and where in the claim file that information might be available. Then, the specialist can design an approach that will most efficiently derive the information from the files.

Corporate Structure

Another way of making the most of a bad faith case, md applying the most settlement pressure, is to look beyond the company that wrote the policy. And, just like crossing the street, counsel should look both ways -- in one direction to a potential parent or other entity in a related "group" and in the other direction to the individual agent whose liability may be primary but who, as an agent of the insurer, imputes notice, knowledge, and liability to the company.

The relationship of the punitive damages award to the wealth of the defendant is one controlling factor that a jury is to consider in awarding punitive damages and that an appellate court is to consider in assessing the insurer's claim that an award is excessive.(18) If an award is too small to have any meaningful effect on the insurer's conduct, the award is insufficient. If an award will financially cripple the company, the award may be excessive. Thus, the insurer's wealth Is critical to determining an appropriate award.

The insurance "group" style of organization is not only common,(19) it is a technique used by the industry to protect profits from attack. The insurer creates parent companies, holding companies, or group affiliations and moves its money around among them so that the true "profits" are obscured.(20)

The original rationale for developing this group form of organization was to overcome state regulations prohibiting insurers from investing surplus in certain types of high-yield, but high-risk, securities.(21) By creating "upstream" companies (parents or holding companies), funds over and above the statutorily required reserves could be paid to the parent company as "dividends." The parent company could then invest the money in otherwise-prohibited securities and gain a larger return.

As one commentator noted, "There is nothing illegal in any of these activities, but, together or separately, their purpose is to remove money from insurers in order to maximize profits of a parent whose interests may be in conflict with the protection of policyholders."(22)

Arguing this analysis to the court in conjunction with a standard "alter ego" argument can establish the relevance of extensive discovery into the inner workings of the insurer and its related companies. This analysis can also permit including the parent or affiliates as defendants if the court finds that an alter ego, attorney-in-fact, or managing agent relationship exists.(23) More important, such a ruling allows including the affiliates' financial statements in the "wealth" assessment for purposes of punitive damages.

An adaptation of this analysis has been applied in Downey Savings and Loan Association v. Ohio Casualty Insurance Co. The opinion upheld a punitive damages award based on the parent holding company's wealth.(24)

In analyzing the facts, the court noted that the parent owned 100 percent of the stock of the insurer and other companies. Also, "the companies" (not just the parent and the insurer at risk) shared the same office space, used the same claims manuals, used the same claim handling procedures, employed many of the same personnel, and submitted consolidated financial statements. The court concluded that "for all intents and purposes, therefore, these companies were one and the same."(25)

Other company "groups", may also share similar overlaps, justifying the inclusion of the holding company, parent, or affiliate's financial statement in assessing punitive damages.

There are many cases in which the insureds did not have the coverage they thought they were buying and the insurer denies the claim on apparently legitimate contract grounds. Counsel should not, however, assume that the case is "merely" an agent negligence case.

For example, in Allegro, looking at only one insured's situation, it would have been easy to assume that the agent was simply negligent in failing to get equivalent limits on the earthquake coverage. But once the allegations are viewed from the big picture, it is obvious the agent was just the "straw man" the insurer used to help effectuate the plan.

Also, where an agent is the insured's primary contact, the agent often has notice of information or knowledge of circumstances that, when imputed to the insurer, can make a dramatic difference not only on the right to policy benefits but on bad faith liability as well.

Naturally, insurers argue that an agent acted for the insured, not the insurer, in procuring the coverage. That argument overlooks the "dual capacity" doctrine in which an agent is acting on behalf of both and owes a duty of care to both. Even where the insured may refer to the agent as "my agent," if there is an agency contract between the agent and the insurer, or if the insurer has filed a "notice of appointment" with the state department of insurance, notice to, or knowledge of, the agent will be imputed to the insurer.(26)

If all else fails, an agent's negligence man, even be imputed to an insurer under respondeat superior.(27) And if an agent's errors and omissions coverage is not adequate to cover the losses, the insurer is another source of funds to make a client whole.

Worse Conduct

Any argument that bad faith law is on the wane is inaccurate. The reality is that insurer conduct is worse than ever because it affects so many more insureds than one rogue adjuster could in the old days."

Exposing bad faith now requires more creativity, persistence, and proactive litigation, but the satisfaction counsel can obtain is well worth the effort. As long as insurance companies remain oriented to the bottom line,(28) bad faith law will have a role in curbing abuses and ensuring that the protective goal of insurance is achieved.

Notes

(1) 510 P.2d 1032 (Cal. 1973).

(2) 598 P.2d 452 (Cal. 1979) (the law, implies in every insurance case that there is a covenant of good faith and fair dealing and that an insurer may breach that covenant when it fails to properly investigate an insured's claim).

(3) Best Place, Inc. v. Penn Am. Ins. Co., 920 P.2d 334, 341-42 n. 10 (Haw. 1996).

(4) See, e.g., Sprague v. Equifax, Inc., 213 Cal. Rptr. 69 (Ct. App. 1985); Downey Sav. & Loan Ass'n v. Ohio Casualty Ins. Co., 234 Cal. Rptr. 835 (Ct. App.), cert. denied, 486 U.S. 1036 (1987); Neal v. Farmers Ins. Exch., 582 P.2d 980 (Cal. 1978).

(5) 46 Cal. Rptr. 2d 845, 853-54 (Ct. App. 1995).

(6) Id.

(7) See Randall Scott Hetrick, Unfair Trade Practices Acts Applied to Attorney Conduct: A National Review, 18 J. LEGAL PROF. 329 n.7 (1993), for a list of similar acts.

(8) Bank of the W. v. Superior Ct., 833 P.2d 545 (Cal. 1992).

(9) 758 P.2d 58 (Cal. 1988).

(10) See, e.g., Safeco v. Superior Ct., 265 Cal. Rptr. 585 (Ct. App. 1990); Industrial Indem. Co. v. Superior Ct., 257 Cal. 655. (Ct. App. 1989); Mahler v. Superior Ct., 270 Cal. Rptr. 222 (Ct. App. 1990).

(11) 895 P.2d 56 (Cal. 1995).

(12) 53 Cal. Rptr. 2d 229 (Ct. App. 1996).

(13) Standard replacement cost coverage provides replacement cost of the property up to the policy limits. Guaranteed replacement cost coverage provides replacement of the property irrespective of the policy limits. Thus, with guaranteed replacement cost coverage, the house will be repaired or replaced even if the cost to do so exceeds the stated limits of the policy.

(14) 113 S. Ct. 2711 (1993).

(15) Id. at 2721-23 (footnote omitted).

(16) 116 S. Ct. 1589 (1996).

(17) In Gore, the plaintiff alleged that the manufacturer, distributor, and dealer who sold him a damaged and repainted car as "new" were guilty of fraud. Under some states' laws, however, the cost to repair was within the amount allowed for purposes of a "new" car sale.

(18) See TXO, 113 S. Ct. 2711.

(19) See BEST'S KEY RATING GUIDE, PROPERTY-CASUALTY, UNITED STATES 798-818 (1996 ed.).

(20) John R. Dunne, Intercompany Transactions Within Insurance Holding Companies, 20 FORUM 445, 450-51 (1985); Emeric Fischer, Banking and Insurance -- should Ever the Twain Meet? 71 NEB. L. REV. 726, 760 (1992).

(21) Fischer, supra note 20, at 760.

(22) Dunne, supra note 20, at 448.

(23) See, e.g., Delos v. Farmers Ins. Group, 155 Cal. Rptr. 843 (Ct. App. 1979).

(24) 234 Cal. Rptr. 835.

(25) Id. at 851.

(26) See, e.g., Loehr v. Great Republic Ins. Co., 276 Cal. Rptr. 667 (Ct. App. 1990); Lippert v. Bailey, 50 Cal. Rptr. 478 (Ct. App. 1966).

(27) See, e.g., Desai v. Farmers Ins. Exch., 55 Cal. Rptr. 2d 276 (Ct. App. 1996).

(28) Don't assume that just because a company is "nonprofit" there is less chance there was bad faith conduct. Nonprofit companies often provide executives with significant financial incentives tied to overall financial or claim performance. Those executives are often the driving force behind decisions to enhance profits and cut costs. Discovery of financial incentive agreements is a must.