An Overview of Third Party Bad Faith: Failure to Accept Reasonable Settlements

By:  Guy O. Kornblum1

Personal Insurance Claims Lawyer

Implicit in every insurance contract is a covenant of good faith and fair dealing. This covenant of good faith serves as the foundation for the expansion of the insurers’ legal responsibility into the realm of tort liability stemming from its “bad faith” conduct2. If the insurer breaches the covenant of good faith and fair dealing by wrongfully handling an insurance claim under the applicable standard, a tort is committed3 and tort damages can be recovered. Thus, in addition to contract damages, the insured may recover compensatory damages for emotional distress, economic losses, and attorneys’ fees4. In addition, punitive damages may be recovered5.  

Insurance bad faith cases primarily fall into two categories: first-party and third-party cases. First-party cases evolve from instances in which the insurance company is obligated to indemnify or reimburse its insured directly or to defend an insured against lawsuits brought by third parties6. Third-party cases involve claims by parties who are strangers to the insurance relationship and in which “the right to coverage…draws on traditional tort concepts of fault, proximate cause and duty… In liability insurance, by insuring personal liability, and agreeing to cover the insured for his or her own negligence, the insurer agrees to cover the insured for a broader spectrum of risks.”7

In the “excess cases,” in which the insurer has unreasonably refused to settle a third-party claim within the policy limits, the insured may assign his or her rights to the excess judgment8, and the third-party claimant may file suit for the amount of excess. However, the insured cannot assign the personal claims to emotional distress damages or punitive damages9. Also, a third-party claimant’s actions based on traditional tort theories of fraud or intentional infliction of emotional distress may result in an extra-contractual award10.

The focus of a third-party case is on the failure to settle a case in which a judgment is entered in excess of the liability protection11. This can occur when an insurer defends a case under a reservation of rights, fails to defend at all, or simply defends in each case; the carrier refuses to settle within the policy limits12.

“Failure to settle” lawsuits may be brought directly by the insured or by a third-party claimant through an assignment from the insured13. The covenant of good faith and fair dealing that is implied in every insurance contract obligates the insurer to avoid conduct that would deprive the insured of the contract’s protection for which he or she has bargained14. Thus, where there is a substantial likelihood of recovery in excess of the policy limits, the insurer owes a duty to the insured to settle within those limits15. To do otherwise would expose the insured to a risk of excess, i.e., personal liability and thereby deprive the insured of the bargained-for protection16.

As noted, the insurer’s failure to settle within policy limits under these circumstances subjects the insurer to liability for all damages proximately resulting from its refusal to settle, regardless of whether the damages were anticipated17. As a result, the insurer may be liable to the insured for the entire judgment plus other compensatory damages resulting from the wrongful conduct18. This includes damages for emotional distress and possibly punitive damages, as long as there is an additional showing of the proscribed conduct19. If the cause of action is assigned to a third-party claimant, then only the amount of the excess judgment can be recovered by the third party as assignee20. The insured party’s claim to compensatory damages for emotional distress and punitive damages is not assignable21. They can only be pursued by the insured, who can join with the third party to bring the bad faith claim22. The insured and third party claimant cannot sue separately since that would split the single cause of action, which originally resided in the insured23.

To recover on a theory of breach of the implied covenant of good faith and fair dealing by failure to settle, the insured (or the third-party claimant by assignment) must plead and prove that a) the insurer received timely notice of the insured’s claim; b) it had an opportunity to settle within the policy limits, c) it unreasonably rejected that settlement demand, d) there was a final judgment in excess of the policy limits, e) and, if the third party is a plaintiff, that the claim to the excess was assigned to that third party24.

If the refusal was based on a coverage dispute, and the insurer is later determined to be wrong, the insurer acts at its own risk; its good faith belief regarding non-coverage is no defense to a bad faith action by the insured25. In contrast, where the insurer’s refusal to settle was based on its evaluation of the demand – that is, if the insurer took the position that it could obtain a defense verdict or that the plaintiff’s verdict would be lower than the demand – the insurer is judged by the “prudent insurer standard.”26 This test determines whether a prudent insurer would have accepted the settlement offer if it alone were liable for the entire judgment. However, the excess judgment itself may be sufficient evidence of the case’s value27.

The insurer is obligated to consider the interests of the insured as well as its own interests when evaluating a settlement offer. Whether the insurer acted reasonably is determined in part by certain criteria; including, the strength of the insured claimant’s case and whether the insurer properly investigated the circumstances relating to liability and the damages, along with other factors28 which point to the unreasonableness of the insurer’s decision29.

If the demand is reasonable and the insurer does not accept the offer within the time limits stated (if those time limits are reasonable), a breach of the implied covenant of good faith has occurred, and the injured party is relieved of any further duty to continue negotiations30.  

True/False Questions

  1. Implicit in every insurance contract is a covenant of good faith and fair dealing which serves as the foundation for the expansion of insurers’ potential for liability to its insured if a claim is wrongfully handled.  (True)
  2. If the insurer breaches the covenant of good faith by wrongfully handling an insurance claim tort damages can be recovered by the insured.  (True)
  3. In such case the insured may recover compensatory damages for emotional distress, economic losses, and even attorneys’ fees.  (True)
  4. The insured cannot recover punitive damages even if the insurer commits a tort and meets the requirement for recovery of punitive damages.  (False)
  5. Third party “bad faith” cases involve claims by those injured by an insured’s conduct where there has been an assignment of the insured’s rights for breach of the covenant of good faith and fair dealing.  (True)
  6. In cases in which an insurer has unreasonably refused to settle a third-party claim within the policy limits, the insured may assign his or her rights to the excess judgment. (True)
  7. When an insured assigns the type of claim mentioned in 6, the third party can recover all the damages that the insured can recover for “bad faith”.  (False)
  8. The focus of a third-party case is on the failure to settle a case in which a judgment is entered in excess of the liability protection.  (True)
  9. Failure to settle cases can arise even if an insurer defends under a reservation of rights.  (True)
  10.   Failure to settle cases cannot arise when an insurer refuses to defend.  (False)
  11.   Failure to settle cases cannot arise if any insurer defends without reserving rights.  (False)
  12. “Failure to settle” lawsuits may be brought directly by the insured.  (True)
  13.   Such claims can also be brought by a third-party claimant through an assignment from the insured.  (True)
  14. Where there is a substantial likelihood of recovery in excess of the policy limits, the insurer owes a duty to the insured to settle within those limits.  (True)
  15. The insurer’s failure to settle within policy limits under these circumstances subjects the insurer to liability for all damages proximately resulting from its refusal to settle, regardless of whether the damages were anticipated.  (True)
  16.  If the insured assigns the cause of action to a third-party claimant, then only the amount of the excess judgment can be recovered by the third party as assignee.  (True)
  17.  The claim of the insured party to compensatory damages for emotional distress and punitive damages are not assignable. (True)
  18. The insured and third party claimant cannot sue separately since that would split the single cause of action, which originally resided in the insured.  (True)
  19.  If the refusal to settle was based on a coverage dispute, and the insurer is later determined to be wrong, the insurer acts at its own risk.  (True)
  20.  If an insurer’s refusal to settle was based on its evaluation of the demand, the test for the insurer’s liability is whether a prudent insurer would have accepted the settlement offer if it alone were liable for the entire judgment.  (True)

Footnotes

1 Mr. Kornblum has been a specialist is civil trials, arbitrations and appeals, and is a principal in his San Francisco based trial firm, Guy Kornblum & Associates.   He is certified in Civil Trial Advocacy and Civil Pretrial Practice Advocacy by the National Board of Trial Advocacy and is a member of numerous prestigious honoraries for trial lawyers.  He has been a Super Lawyer each year since 2006.  He is co-author of “Negotiating and Settling Tort Cases,” published by Thomson West and the American Association for Justice (formerly Association of Trial Lawyers of America).  His firm’s website is www.kornblumlaw.com.   Mr. Kornblum also testifies as an expert witness on issues pertaining to civil litigation and insurance claims handling, having co-authored the California Practice Guide:  Bad Faith, published by The Rutter Group, which is now merged into the 3 volume work, California Practice Guide: Insurance Litigation. He serves on the San Francisco Bar Association Mediation Panel.

2 The term “bad faith” is a generic reference to actions seeking recovery beyond the policy, regardless of the theory of recovery.  The term “bad faith” can also refer specifically to the theory of violation of the implied covenant of good faith and fair dealing.

3 See, e.g., Gruenberg v. Aetna Ins. Co. (1973)9 Cal.3d 566, 575; Sparks v. Republic Nat. Life Ins. Co. (1982) 132 Ariz. 529, 538.

4 Gruenberg, supra, n. 3, at 579.

5 Egan v. Mutual of Omaha Ins. Co. (1979) 24 Cal.3d 809, 823; see also, Neal v. Farmers Ins. Exchange (1978) 21 Cal.3d 910.

6 See, e.g., Garvey v. State Farm Fire & Casualty Co. (1989) 48 Cal.3d 395, 399; Bodenhamer v. Superior Court (St. Paul Fire & Marine Ins. Co.) (1987) 192 Cal.App.3d 1472, 1476.

7 Garvey, supra, n. 6, at 407.

8 See, e.g., Murphy v. Allstate Ins. Co. (1976) 17 Cal.3d 937, 942; Purcell v. Colonial Ins. Co. (1971) 20 Cal.App.3d 807, 813.

9 Purcell, supra, n. 8, at 814.

10 See, e.g., Fletcher v. Western National Life Ins. Co. (1970) 10 Cal.App.3d 376.  The third party’s direct action against a tortfeasor’s insurer (i.e., defendant in the third-party action) based on Insurance Code section 790.03(h) (see Royal Globe Ins. Co. v. Superior Court (Keoppel) (1979) 23 Cal.3d 880) was abolished by Moradi-Shalal v. Fireman’s Fund Ins. Cos. (1988) 46 Cal.3d 287.

11 See n. 8, supra.

12 For two duty to defend cases see Amato v. Mercury Cas. Ins. Co. (1997) 53 Cal.App.4th 825; DeWitt v. Monterey Ins. Co. (2012) 204 Cal.App.4th 233. 

13 See, e.g., Hamilton v. Maryland Cas. Co. (2002) 27 Cal.4th 718, 732.

14 See Comunale v. Traders & Gen. Ins. Co. (1958) 50 Cal.2d 654.

15 Id.

16 Crisci v. Security Ins. Co. of New Haven, Conn. (1967) 66 Cal.2d 425, 431.

17 See Hamilton, supra, n. 13, at 725.

18 Id.

19 See generally, Croskey et al., California Practice Guide: Insurance Litigation (The Rutter Group 2007) ¶ 13:80.

20 Murphy, supra, n. 8, at 946.  But see Baron v. Fire Ins. Exch. (2007) 154 Cal.App.4th 1184 (allowing receiver to pursue punitive claims against insurer which were within the scope of the receivership).

21 Murphy, supra, n. 8, at 942; Purcell, supra, n. 8, 9. 

22 Cain v. State Farm Mutual Automobile Ins. Co, (1975) 47 Cal.App.3d 783, 796.

23 Purcell, supra, n. 9, at 814.

24 See generally, H. Walter Croskey et al., Judicial Council of California Civil Jury Instructions, CACI No. 2334 (2007).

25 See Johansen v. California State Auto Assn. Inter-Ins. Bureau (1975) 15 Cal.3d 9, 16.

26 Crisci, supra, n. 16, at 430.

27 Johansen, supra, n. 25, at 17 (citing Crisci at 431).

28 The fact the insured is not financially solvent or has insufficient assets to pay a personal judgment does not relieve the insurer of its duty to settle in the face of an opportunity to do so or within the liability limits of coverage.  See Purdy v. Pac. Auto Ins. Co. (1984) 157 Cal.App.3d 59, 74.

29 See Croskey et al., California Practice Guide: Insurance Litigation (The Rutter Group 2007) ¶ 12:388 (citing Brown v. Guarantee Ins. Co. (1957) 155 Cal.App.2d 679, 689); Critz v. Farmers Ins. Group (1964) 230 Cal.App.2d 788, 796).

30 See, e.g., Coe v. State Farm Mut. Ins. Co. (1977) 66 Cal.App.3d 981, 994.