What Is Insurance Bad Faith?

Insurance bad faith occurs when an insurance company unreasonably denies, delays, or underpays a valid claim, or otherwise fails to fulfill its obligations to its policyholder. Every insurance contract carries with it an implied covenant of good faith and fair dealing, which requires the insurer to act honestly, fairly, and promptly when handling claims. When an insurer violates this duty, the policyholder may have a cause of action for bad faith, which can result in damages far exceeding the original policy limits.

Bad faith litigation is a growing area of practice, and paralegals who understand the principles, procedures, and evidence involved in these cases are highly valuable to litigation teams. This topic also connects to tort law and contract law concepts tested on the NALA Certified Paralegal exam.

The Insurer's Duties

What Duties Does an Insurance Company Owe Its Policyholders?

Insurance companies owe their policyholders several fundamental duties:

Duty to investigate: The insurer must conduct a thorough, fair, and timely investigation of every claim. This includes gathering relevant evidence, interviewing witnesses, and considering all available information before making a coverage determination
Duty to defend: In liability insurance, the insurer has a duty to defend the policyholder against covered claims. This duty is typically broader than the duty to indemnify and is triggered by the allegations in the complaint, not by the actual facts
Duty to indemnify: The insurer must pay covered claims up to the policy limits
Duty to settle: When a reasonable settlement opportunity exists within policy limits, many jurisdictions require the insurer to accept it, particularly when the policyholder faces exposure beyond policy limits
Duty of good faith and fair dealing: The overarching obligation to treat the policyholder honestly and fairly in all dealings

Types of Bad Faith

First-Party Bad Faith

First-party bad faith occurs when an insurer acts in bad faith toward its own policyholder regarding a first-party claim (a claim the policyholder makes under their own policy). Common examples include unreasonably denying a homeowner's insurance claim after a fire, delaying payment on a disability insurance claim without justification, offering an unreasonably low settlement on an auto damage claim, and failing to properly investigate a health insurance claim before denying it.

Third-Party Bad Faith

Third-party bad faith occurs in the liability insurance context, where the insurer fails to properly handle a claim made by a third party against the policyholder. The most common form is the insurer's failure to accept a reasonable settlement within policy limits, exposing the policyholder to a judgment exceeding those limits. Other examples include failing to defend the policyholder when a duty to defend exists, conducting the defense in a way that prioritizes the insurer's interests over the policyholder's, and failing to inform the policyholder of settlement opportunities.

Common Bad Faith Practices

What Actions Constitute Bad Faith by an Insurer?

Courts and regulators have identified numerous practices that may constitute bad faith:

Denying a claim without conducting a reasonable investigation
Failing to affirm or deny coverage within a reasonable time after receiving proof of loss
Unreasonably interpreting policy language to avoid coverage
Requiring excessive or unnecessary documentation before processing a claim
Lowballing settlement offers to force the policyholder to accept less than the claim is worth
Using delay tactics to pressure policyholders into settling for less
Misrepresenting policy provisions to policyholders
Failing to provide a reasonable explanation for denying a claim
Retaliating against policyholders who file claims by canceling their policies
Ignoring or not following the insurer's own claims handling guidelines

Damages in Bad Faith Cases

What Damages Are Available in Bad Faith Litigation?

Bad faith claims can result in several categories of damages:

Contract damages: The amount of the original claim that should have been paid, plus interest from the date the claim should have been paid.

Consequential damages: Additional losses the policyholder suffered as a result of the bad faith conduct, such as the cost of alternative housing when a homeowner's claim is wrongfully denied, lost income or business losses caused by the delay, and emotional distress damages in some jurisdictions.

Punitive damages: In cases involving particularly egregious conduct, courts may award punitive damages to punish the insurer and deter similar behavior. These damages can be substantial, sometimes exceeding the original claim amount many times over. The availability and caps on punitive damages vary significantly by jurisdiction.

Attorney fees: Many states allow the recovery of attorney fees in bad faith actions, either by statute or as an element of damages.

Proving Bad Faith

What Evidence Is Needed to Prove Bad Faith?

Proving bad faith typically requires demonstrating that the insurer's conduct was unreasonable under the circumstances. Key evidence includes:

The claim file: The insurer's internal claim file is the most important evidence in a bad faith case. It reveals the insurer's investigation, decision-making process, and communications
Claims handling guidelines: The insurer's own internal guidelines and procedures, which may show that the adjuster deviated from established protocols
Expert testimony: Insurance industry experts can testify about the standard of care for claims handling and whether the insurer's conduct fell below that standard
Communications: Letters, emails, and recorded calls between the insurer and the policyholder showing delays, misrepresentations, or unreasonable demands
Statistical evidence: Patterns of claim denials or underpayments that may suggest systemic bad faith practices

The Paralegal's Role in Bad Faith Litigation

Paralegals are essential to bad faith litigation teams, handling tasks such as:

Organizing and indexing the insurer's claim file, which can contain thousands of pages
Creating timelines of the claims handling process to identify delays and procedural failures
Reviewing insurance policy language to identify coverage issues
Drafting discovery requests targeted at obtaining the insurer's internal guidelines, training materials, and communications
Coordinating with expert witnesses on claims handling standards
Calculating damages, including consequential losses and interest
Researching applicable bad faith statutes and case law in the relevant jurisdiction

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Regulatory Framework

In addition to common law bad faith claims, many states have enacted unfair claims settlement practices acts that define specific prohibited conduct by insurers. These statutes often create additional remedies for policyholders and may allow claims to be brought through the state insurance commissioner. The National Association of Insurance Commissioners (NAIC) has developed a model act that many states have adopted in some form.

CP Exam Preparation

Insurance bad faith intersects with both tort law and contract law on the CP exam. Understanding the duties insurers owe, the types of bad faith, and the damages available will help you answer questions about insurance litigation and the implied covenant of good faith. Create your free account to practice with tort law and contract law questions. Explore our pricing options for full access to all study materials.

Key Takeaways

Every insurance contract includes an implied covenant of good faith and fair dealing
First-party bad faith involves claims between the insurer and its own policyholder; third-party bad faith involves liability claims
Damages can include contract damages, consequential damages, punitive damages, and attorney fees
The insurer's claim file is the most critical evidence in a bad faith case
Many states have unfair claims settlement practices acts that create additional remedies

Insurance Bad Faith Litigation: What Paralegals Need to Know