Matching Bad Faith Doctrine and Damages

Courts are charged under the common law with deciding new cases based on established legal principles and precedent. The system allows for growth and change as new circumstances require, but failure to follow the purpose and logic of precedent risks irrational outcomes and unjust results. These risks are apparent in recent efforts to apply a “future benefits” rule in cases alleging bad faith by commercial insurers.

Doctrinal Origins of Insurer Bad Faith

Since the middle of the last century, the common law of contracts generally accepts that the contracting parties have a duty of “good faith” to each other. See Steven J. Burton & Eric G. Andersen, Contractual Good Faith: Formation, Performance, Breach, Enforcement 2, 391-92 (1995). In the development and application of this doctrine to insurance contracts, there has been an “important departure” from “the mainstream approach.” See Id. at 392, 398-400. See also Michael Sean Quinn, Insurer Bad Faith & Insurance Expertise, 22 Ins. L. Reporter 80 (2000).

The key difference is that a number of jurisdictions have created a remedy for contractual bad faith that sounds in tort, rather than contract. See Nelson v. State Farm Mut. Auto. Ins. Co., 988 F. Supp. 527, 533-34 (E.D. Pa. 1997) (gathering cases); Burton & Andersen, supra, at 392. In a purely contract-based bad faith case, the damages would be measured by the expectation of the parties, usually meaning a potential recovery of cancellation and compensatory damages. Burton & Andersen, supra, at 252. And in many insurance cases alleging bad faith, the insured seeks extra-contractual damages sounding in tort. Id. at 396. The result in many jurisdictions is a hybrid of contract and tort ' “contort” ' a development that risks blurring and confusing the lines between contract and tort principles. See generally, Grant Gilmore, The Death of Contract (1974).

Damages Based on Future Benefits

Some commercial insureds seek to press this duality by arguing that damages for their bad faith claims should be based on an accelerated lump sum payment of policy limits. To support this future-benefits argument, those insureds cite a subset of disability insurance decisions allowing damages not only for the present breach of the insurance contract, but also for future claims for the insurance limits. For instance, in DeChant v. Monarch Life Ins. Co., 554 N.W.2d 225 (Wisc. Ct. App. 1996), a state appellate court affirmed a trial court decision that the plaintiff's insurer had, in bad faith, declared that the plaintiff was only “residually disabled” for purposes of a disability insurance contract and, accordingly, reduced the plaintiff's benefits. See Id. at 227. The appellate court agreed that the trial court could deem these acts a repudiation of the insurance contract and award the insured a lump sum equal to the present value of the future benefits the plaintiff would be entitled to under the policy if he continued to be totally disabled. See Id. at 228.

Insurer repudiation of the contract is an essential element of a future-benefits claim. In New York Life Ins. v. Viglas, 267 U.S. 672 (1936), the U.S. Supreme Court ruled against such a claim because the record did not show that the insurer had taken an unreasonable position or repudiated the disability contract at issue. More recently, federal courts of appeal have recognized that a future-benefits remedy might be considered in appropriate circumstances. See Royal Maccabees Life ins. Co. v. Choren, 393 F.3d 1175, 1183 (10th Cir. 2005) (trial court has discretion to consider remedy); Greenberg v. Paul Revere Life Ins. Co., 91 Fed. Appx. 539, 541-42 (9th Cir. 2004) (Arizona law likely would allow remedy in disability case and affirming award).

Need for Consistency in Future-Benefits Cases

The Supreme Court in Viglas correctly considered the future-benefits remedy as an option that could be considered in disability insurance cases based on the legal standards for breach of contract, applying a classic contract analysis. See Viglas, 267 U.S. at 676. In contrast, later decisions cite Viglas but focus their discussions on tort law. See Choren, 393 F.3d at 1184-85; Egan v. Mutual of Omaha Ins. Co., 620 P.2d 809, 824 n.7 (Cal. 1979). The approach taken in these cases is consistent with tort law or the rationales advanced for allowing tort remedies in bad faith insurance cases.

The common law of torts requires that any future damages a court might award must be shown to be reasonably certain to occur and subject to fair quantification at the time of decision. See, e.g., Simpson v. American Fam. Ins. Co., 603 N.W.2d 860, 863-64 (Minn. Ct. App. 2000). The denial of a claim in bad faith does not satisfy either of these requirements. First, the denial of a claim in the present does not logically lead to reasonable likelihood of denial of an insured's claim in the future. To the contrary, if the court rules that the position an insurer has taken is not in good faith and creates liability, the insurer would be unlikely to take that position again and risk greater sanctions. Second, when quantifying future damages at the time of judgment, one cannot know what future claims will be made, if any, and it would be arbitrary to award the policy limit accelerated to present value. This is especially so with third-party insurance where the future exposure depends on claims by third parties that have not yet been made or, if asserted, have not been reduced to judgment.

Nor does an award of future benefits advance the policies often invoked as justification for treating insurer bad faith as a tort. The rationale most commonly advanced by those making such claims is the need to impose a deterrent and punishment that extracts more from the insurer than just the cost of making good its breach of contract. See Burton & Andersen, supra at 399. Yet, that effect is just as clearly achieved ' and more sensibly imposed where required ' by the court's award of extra-contractual damages. The addition of future damages cannot do more to deter future conduct or punish the insured than a court order finding bad faith and awarding appropriate extra-contractual damages. At the same time, by accelerating the payments of limits not yet due, the future-benefits remedy creates a potential windfall for the claimant should future events not support payment at that level, an outcome contrary to basic principles of tort law. See, e.g., Acuar v. Letourneau, 531 S.E.2d 316, 323 (Va. 2000).

Judicial equities call both for doctrinal consistency and a matching of the remedy to the harm requiring redress. A future-benefits remedy that accelerates policy payments is clearly linked to the contract and should be decided, as the Viglas court showed, under a contract analysis. That approach would help assure that the remedy is not wrongly extended beyond the disability context in which it has been recognized while allowing remedies such as extra-contractual damages to serve the distinct tort purposes for which they were developed. Cleaner analytic lines and reasoning will help to develop more coherent and better-reasoned case law.

Kenneth W. Erickson is a partner and Bryan R. Diederich is an associate at Ropes & Gray LLP in Boston. The views expressed in this article are those of the authors and not necessarily those of their law firm or the firm's clients.

Courts are charged under the common law with deciding new cases based on established legal principles and precedent. The system allows for growth and change as new circumstances require, but failure to follow the purpose and logic of precedent risks irrational outcomes and unjust results. These risks are apparent in recent efforts to apply a “future benefits” rule in cases alleging bad faith by commercial insurers.

Doctrinal Origins of Insurer Bad Faith

Since the middle of the last century, the common law of contracts generally accepts that the contracting parties have a duty of “good faith” to each other. See Steven J. Burton & Eric G. Andersen, Contractual Good Faith: Formation, Performance, Breach, Enforcement 2, 391-92 (1995). In the development and application of this doctrine to insurance contracts, there has been an “important departure” from “the mainstream approach.” See Id. at 392, 398-400. See also Michael Sean Quinn, Insurer Bad Faith & Insurance Expertise, 22 Ins. L. Reporter 80 (2000).

The key difference is that a number of jurisdictions have created a remedy for contractual bad faith that sounds in tort, rather than contract. See Nelson v. State Farm Mut. Auto. Ins. Co., 988 F. Supp. 527, 533-34 (E.D. Pa. 1997) (gathering cases); Burton & Andersen, supra, at 392. In a purely contract-based bad faith case, the damages would be measured by the expectation of the parties, usually meaning a potential recovery of cancellation and compensatory damages. Burton & Andersen, supra, at 252. And in many insurance cases alleging bad faith, the insured seeks extra-contractual damages sounding in tort. Id. at 396. The result in many jurisdictions is a hybrid of contract and tort ' “contort” ' a development that risks blurring and confusing the lines between contract and tort principles. See generally, Grant Gilmore, The Death of Contract (1974).

Damages Based on Future Benefits

Some commercial insureds seek to press this duality by arguing that damages for their bad faith claims should be based on an accelerated lump sum payment of policy limits. To support this future-benefits argument, those insureds cite a subset of disability insurance decisions allowing damages not only for the present breach of the insurance contract, but also for future claims for the insurance limits. For instance, in DeChant v. Monarch Life Ins. Co. , 554 N.W.2d 225 (Wisc. Ct. App. 1996), a state appellate court affirmed a trial court decision that the plaintiff's insurer had, in bad faith, declared that the plaintiff was only “residually disabled” for purposes of a disability insurance contract and, accordingly, reduced the plaintiff's benefits. See Id. at 227. The appellate court agreed that the trial court could deem these acts a repudiation of the insurance contract and award the insured a lump sum equal to the present value of the future benefits the plaintiff would be entitled to under the policy if he continued to be totally disabled. See Id. at 228.

Insurer repudiation of the contract is an essential element of a future-benefits claim. In New York Life Ins. v. Viglas, 267 U.S. 672 (1936), the U.S. Supreme Court ruled against such a claim because the record did not show that the insurer had taken an unreasonable position or repudiated the disability contract at issue. More recently, federal courts of appeal have recognized that a future-benefits remedy might be considered in appropriate circumstances. See Royal Maccabees Life ins. Co. v. Choren , 393 F.3d 1175, 1183 (10th Cir. 2005) (trial court has discretion to consider remedy); Greenberg v. Paul Revere Life Ins. Co. , 91 Fed. Appx. 539, 541-42 (9th Cir. 2004) (Arizona law likely would allow remedy in disability case and affirming award).

Need for Consistency in Future-Benefits Cases

The Supreme Court in Viglas correctly considered the future-benefits remedy as an option that could be considered in disability insurance cases based on the legal standards for breach of contract, applying a classic contract analysis. See Viglas, 267 U.S. at 676. In contrast, later decisions cite Viglas but focus their discussions on tort law. See Choren, 393 F.3d at 1184-85; Egan v. Mutual of Omaha Ins. Co. , 620 P.2d 809, 824 n.7 (Cal. 1979). The approach taken in these cases is consistent with tort law or the rationales advanced for allowing tort remedies in bad faith insurance cases.

The common law of torts requires that any future damages a court might award must be shown to be reasonably certain to occur and subject to fair quantification at the time of decision. See, e.g., Simpson v. American Fam. Ins. Co. , 603 N.W.2d 860, 863-64 (Minn. Ct. App. 2000). The denial of a claim in bad faith does not satisfy either of these requirements. First, the denial of a claim in the present does not logically lead to reasonable likelihood of denial of an insured's claim in the future. To the contrary, if the court rules that the position an insurer has taken is not in good faith and creates liability, the insurer would be unlikely to take that position again and risk greater sanctions. Second, when quantifying future damages at the time of judgment, one cannot know what future claims will be made, if any, and it would be arbitrary to award the policy limit accelerated to present value. This is especially so with third-party insurance where the future exposure depends on claims by third parties that have not yet been made or, if asserted, have not been reduced to judgment.

Nor does an award of future benefits advance the policies often invoked as justification for treating insurer bad faith as a tort. The rationale most commonly advanced by those making such claims is the need to impose a deterrent and punishment that extracts more from the insurer than just the cost of making good its breach of contract. See Burton & Andersen, supra at 399. Yet, that effect is just as clearly achieved ' and more sensibly imposed where required ' by the court's award of extra-contractual damages. The addition of future damages cannot do more to deter future conduct or punish the insured than a court order finding bad faith and awarding appropriate extra-contractual damages. At the same time, by accelerating the payments of limits not yet due, the future-benefits remedy creates a potential windfall for the claimant should future events not support payment at that level, an outcome contrary to basic principles of tort law. See, e.g., Acuar v. Letourneau , 531 S.E.2d 316, 323 (Va. 2000).

Judicial equities call both for doctrinal consistency and a matching of the remedy to the harm requiring redress. A future-benefits remedy that accelerates policy payments is clearly linked to the contract and should be decided, as the Viglas court showed, under a contract analysis. That approach would help assure that the remedy is not wrongly extended beyond the disability context in which it has been recognized while allowing remedies such as extra-contractual damages to serve the distinct tort purposes for which they were developed. Cleaner analytic lines and reasoning will help to develop more coherent and better-reasoned case law.

Kenneth W. Erickson is a partner and Bryan R. Diederich is an associate at Ropes & Gray LLP in Boston. The views expressed in this article are those of the authors and not necessarily those of their law firm or the firm's clients.