THE DEVELOPMENT by American courts of a cause of action for breach of the implied covenant of good faith and fair dealing has created a number of concerns for insurance carriers and their counsel, particularly in relation to liability for damages in excess of stated limits specified in the insurance contract. Multimillion dollar bad faith awards against both domestic and foreign insurers are becoming commonplace. In 1993, a Los Angeles Superior Court jury awarded $386.4 million in punitive damages against underwriters at Lloyd's and 40 companies. And this after the jury earlier had awarded $34.2 million in compensatory damages, $1.5 million in attorney's fees and approximately $3.4 million in pre-judgment interest after finding the insurers had breached contracts and committed acts of bad faith, fraud, oppression or malice for refusing to pay several product liability claims.(1)
This article focuses on the issues counsel for an excess carrier must consider when presented with the excess third-party liability case. After a brief summary of the evolution of the bad faith cause of action in both the first- and third-party context, it
* sets forth the various standards adopted by American jurisdictions for imposition of bad faith liability and damages on insurers,
* focuses on the issues counsel must consider before the excess liability trial in order to shield the excess carrier from potential bad faith exposure should the underlying case result in a verdict in excess of policy limits, and
* addresses the issues counsel must consider once the post-trial excess liability verdict has been returned and the possible bad faith actions that may be maintained by the excess carrier.
American courts did not take notice of the unequal bargaining power between insurance companies and their policyholders before the 20th century.(2) Contract law served as the exclusive theory on which policyholders could recover from an insurers for the bad faith handling of claims.(3) Although a policyholder may have successfully proved that an insurer wrongfully denied benefits, damages were limited to the amount due under the policy, plus interest.(4) The policyholder was prevented from recovering damages for emotional distress or economic loss caused by the deprivation of policy benefits. Punitive damages also were unavailable to deter insurers from wrongfully or even fraudulently denying claims.(5) Therefore, insurers had nothing to lose by wrongfully denying claims or coercing unfair settlements.
The vulnerability of policyholders dissipated as a result of the American courts' recognition of an implied covenant of good faith and fair dealing. In 1931, the Wisconsin Supreme Court in Hilker v. Western Automobile Insurance Co. observed:
[W]here an injury occurs for which a recovery may be had in a sum exceeding the amount of the insurance, the interest of the insured becomes one of concern to him. At this point a duty on the part of the insurer to the insured arises. It arises because the insured has bartered to the insurance company all of the rights possessed by him to enable him to discover the extent of the injury and to protect himself as best he can from the consequences of the injury.(6)
The Hilker court concluded that insurers could be liable for actual damages caused by their failure to consider the interests of their policyholders when evaluating settlement offers from third parties.
This decision has been cited by courts and commentators as the doctrinal source for the development of the third-party bad faith tort action, and today nearly every state recognizes a tort cause of action against insurers whose improper settlement conduct in the third-party setting causes the policyholder to suffer out-of-pocket liability.(7)
It was not until 1970, however, 40 years after Hilker, that the implied covenant of good faith and fair dealing was deemed to apply in the first-party context, such as life, health, disability and property insurance. …