An insurance company has many duties to its policyholders. The kinds of applicable duties vary depending upon whether the claim is considered to be "first party" or "third party." A common first party context is when an insurance company writes insurance on property that becomes damaged, such as a house or an automobile. In that case, the company is required to investigate the damage, determine whether the damage is covered, and pay the proper value for the damaged property.Bad faith in first-party contexts often involves the insurance carrier's improper investigation and valuation of the damaged property (or its refusal to even acknowledge the claim at all). Bad faith can also arise in the context of first-party coverage for personal injury such as health insurance or life insurance, but those cases tend to be rare.
Third party situations (essentially, liability insurance) break down into at least two distinct duties, both of which must be fulfilled in good faith. First, the insurance carrier usually has a duty to defend a claim (or lawsuit) even if some or most of the lawsuit is not covered by the insurance policy. Unless the policy is expressly structured so that defense costs "eat away" at the policy limits (a so-called "burning limits" policy), the default rule is that the insurer must cover all defense costs regardless of the actual limit of coverage. In one of the most famous decisions of his career (involving Jerry Buss's bad faith lawsuit against Transamerica), Justice Stanley Mosk wrote: "[W]e can, and do, justify the insurer's duty to defend the entire 'mixed' action prophylactically, as an obligation imposed by law in support of the policy. To defend meaningfully, the insurer must defend immediately. To defend immediately, it must defend entirely. It cannot parse the claims, dividing those that are at least potentially covered from those that are not."This strong bias in favor of coverage is one of the major innovations of U.S. law; other common law jurisdictions outside of the U.S. continue to construe coverage much more narrowly.
Second, the insurer has a duty of indemnification, which is the duty to pay a judgment against the policyholder, up to the limit of coverage, but only if the judgment is for a covered act or omission. As a result, most insurance companies exercise a great deal of control over litigation.
Bad faith can occur in either situation—by improperly refusing to defend a lawsuit or by improperly refusing to pay a judgment or settlement of a covered lawsuit.
In California, third-party coverage also contains a third duty, the duty to settle a reasonably clear claim against the policyholder within policy limits, in order to avoid the risk that the policyholder may be hit with a judgment in excess of the value of the policy (which a plaintiff might then attempt to satisfy by writ of execution on the policyholder's assets). If the insurer breaches in bad faith its duties to defend, indemnify, and settle, it may be liable for the entire amount of any judgment obtained by a plaintiff against the policyholder, even if that amount is in excess of policy limits. This was the holding of the landmark Comunale case.
Bad faith is a fluid concept and is defined primarily by court decisions in case law. Examples of bad faith include an undue delay in handling claims, inadequate investigation, refusal to defend a lawsuit, threats against an insured, refusing to make a reasonable settlement offer, or making unreasonable interpretations of an insurance policy.
In some cases, punitive damages are warranted against insurance companies as a mechanism to prevent future behavior.
In California, the plaintiff in a bad faith action may be able to recover some of its attorneys' fees separately and in addition to the judgment for damages against a defendant insurer, but only up to the extent that those fees were incurred in recovering tort damages (for breach of the implied covenant) as opposed to contractual damages (for breach of the terms of the insurance policy). The allocation of attorneys' fees between those two categories is usually a question of fact (meaning it usually goes to the jury).
Sometimes, an insurance company will cancel (rescind) your insurance policy retroactively after you file a legitimate claim. This practice is known as insurance rescission. In California, post claims underwriting (investigating an insured's application after a claim is filed) is illegal. Unfortunately for policyholders, many large insurers still illegally rescind insurance policies. When they do, this is also an act of insurance bad faith for which the insured is entitled to damages.
In some U.S. states, bad faith is even more complicated because, under certain circumstances, a liability insurer may ultimately find itself in a trial where it is being sued directly by the plaintiff who originally sued its insured. This is allowed through two situations: assignment or direct action.
The first situation is where an insured abandoned in bad faith by its liability insurer makes a special settlement agreement with the plaintiff. Sometimes this occurs after trial, where the insured has attempted to defend himself or herself by paying for a lawyer out of pocket, but went to verdict and lost (the actual situation in the landmark Comunale case); other times it occurs before trial and the parties agree to put on an uncontested show trial that results in a final verdict and judgment against the insured. Either way, the plaintiff agrees to not actually execute on the final judgment against the insured in exchange for an assignment of the assignable components of the insured's causes of action against its insurer.
The second situation is where the plaintiff does not need to obtain a judgment first but instead proceeds directly against the insured's insurer under a state statute authorizing such a "direct action." These statutes have been upheld as constitutional by the U.S. Supreme Court.
Bad faith lawsuits may result in large awards of punitive damages. A famous example is State Farm Mutual Auto. Ins. Co. v. Campbell, in which the U.S. Supreme Court overturned a jury verdict of $145 million in punitive damages against State Farm Insurance. Bad faith cases may also be slow, at least in the third party context, because they are necessarily dependent upon the outcome of any underlying litigation. For example, the 2003 Campbell decision involved State Farm's handling of litigation resulting from a fatal car accident in 1981, 22 years earlier.
In many situations, you must obtain a verdict in excess of the at-fault party's policy limits and then proceed against the insurance company for their failure to reasonably settle the claim when they had the chance within limits.