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The reason for this article, and its predecessor, is to remind those who understand insurance and the law of insurance, that insurance is a contract where one agrees to indemnify another against certain specified risks of loss that are contingent or unknown at the time the contract is made. Since “indemnity” puts one back in the position that existed before the loss, insurance should never pay more and neither party to the contract of insurance should profit from breach of the contract.

When US law was first organized based on English Common law if a contract was breached the only contract damages could be recovered by the aggrieved party. Tort damages were limited to tortious conduct — negligence or intentional torts like battery, assault, or trespass. The two categories of damages were mutually exclusive.

In a typical contract, one party has a duty to perform (construct a building, deliver goods, convey real estate, pay indemnity) and the other party has a duty to pay money. Breach by the performer may take the form of nonperformance, defective performance, or delay in performance. The primary purpose of damages for breach of a contract is to protect the promisee’s expectation interest in the promisor’s performance. Damages should put the plaintiff in as good a position as if the defendant had fully performed as required by the contract.

The “Law” can be defined as the understanding that actions of people — and especially of government or the courts — always have effects that are unanticipated or unintended. Insurance is controlled by the courts, through appellate decisions and by governmental agencies through statute and regulation. Compliance with the appellate decisions, statutes and regulations – different in the various states – is exceedingly difficult and expensive.

Neither the courts nor the governmental agencies seem to be aware that in a modern, capitalistic society, insurance is a necessity. No person would take the risk of starting a business, buying a home or driving a car without insurance. The risk of losing everything would be too great. By using insurance to spread the risk among all the costs of taking the risk to start a business, buy a home or drive a car becomes possible.

Insurance has existed since a group of Sumerian farmers, more than five thousand years ago, scratched an agreement on a clay tablet that if one of their number lost his crop to storms the others would pay part of their earnings to the one damaged. Over the eons insurance has become more sophisticated but makes essentially the same deal as did the ancient Sumerian farmers.

An insurer, whether an individual or a corporate entity, takes contributions (premiums) from many and holds the money to pay those few who lose their property from some calamity, like fire. The agreement, a written contract to pay indemnity to another in case a certain problem, calamity or damage occurs by accident, is called insurance.

Insurance contracts can be simple or exceedingly complex, depending upon the risks taken by the insurer. Regardless, insurance is only a contract whose terms are agreed to by the parties to the contract. Over the last few centuries almost every word and phrase used in insurance contracts have been interpreted and applied by one court or another. Ambiguity in contract language became certain. However, the average person saw the insurance contract as incomprehensible and impossible to understand.

Ostensibly to protect the public insurance regulators decided to require that insurers write their policies in “easy to read” language. Because they were required to do so by law insurers changed the words in their contracts into language that people with a Fourth Grade education could understand. Precise language interpreted by hundreds of years of court decisions were disposed of and replaced with imprecise, easy to read language.

The law of unintended consequences arose and took over. Instead of protecting the consumer the imprecise language mandated in an attempt to force insurers to deal “fairly” with their insureds, resulted in thousands of lawsuits that sought to impose penalties on insurers for attempting to enforce what were claimed to be ambiguous “easy to read” language. The multiple lawsuits cost insurers and their insureds millions (if not billions) of dollars to get court opinions that interpret the language and reword their “easy to read” policies to comply with the court decisions. For more than thirty years the unintended consequence of a law designed to avoid litigation has done exactly the opposite. Not only were most contracts made uncertain by use of imprecise language insurers were punished with tort and punitive damages for refusing to pay claims they thought were not covered.

A tort is a civil wrong from which one person can receive damages from another for multiple injuries. The tort was called the “Tort of Bad Faith” and was created because an insurer failed to treat an insured fairly and the court felt that traditional contract damages were insufficient to properly compensate the insured whose claim was denied. The court allowed the insured to receive, in addition to the contract damages that the insured was entitled to receive under the common law applied for the years before Comunale was decided, damages for emotional distress and punitive damages to punish the insurer for what the court concluded was its wrongful acts.

After the creation of the tort of bad faith, if an insurer and insured disagreed on the application of the policy to the factual situation, damages were no longer limited to contract damages as in other commercial relationships. If the court found that the insurer was wrong it could be required to pay the contract amount AND damages for emotional distress, pain, suffering, punishment damages, attorney’s fees and any other damages the insured and the court could conceive. It was hoped that the tort of bad faith would have a salutary effect on the insurance industry and force insurers to treat their insureds fairly.

However, when claims for $40.00 wrongfully denied resulted in $5 million verdicts, “fairness” found a new definition. Juries, unaware of the reason for and operation of insurance decided that insurers that did not pay claims were evil. Juries, with vigor, punished insurers severely even when the insurer’s conduct was correct and proper under the terms of its contract. The massive judgments were publicized and many insurers decided fighting insureds in court was too risky and expensive. If an insured sued for bad faith, regardless of how correct was the position of the insurer on the contract, the insurer would pay to settle.

Most of the massive verdicts were reversed or reduced on appeal. The bad actors raised their premium and lost little business. Other insurers, faced with the massive verdicts allowed fear to control reason, and paid claims that were improper or fraudulent. The extra cost was passed on to all insurance consumers, not to the insurers who acted improperly. The bad actors, in fact, profited. They continued their wrongful acts and paid the few insureds that sued.

The law of unintended consequences struck. The tort of bad faith, designed to help the innocent, resulted in punishing the honest and professional insurers, honoring the insurers who acted in bad faith with profit. Also, because of the fear of punishment with bad faith suits, insurers allowed many frauds to succeed rather than face potential tort damages. Insurers whose contract terms and conditions were clear and unambiguous were ignored to avoid litigation.

In construction contracts, for example, damages for defective or incomplete construction generally are measured by the cost of repair or the cost of completion. In contracts for the sale of goods, on the other hand, damages for nonconformity with the contract generally are measured by the diminution in value of the defective goods. The purpose of both measures is to place the plaintiff in as good a position as if the defendant had performed the contract according to its specifications.

Although a wrongful refusal to settle has generally been treated as a tort (see Keeton, Liability Insurance and Responsibility for Settlement, 67 Harv. L. Rev. 1136, 1138; Anno., 131 A.L.R. 1499, 1500), it is the rule that where a case sounds both in contract and tort the plaintiff will ordinarily have freedom of election between an action of tort and one of contract. (Eads v. Marks, 39 Cal. 2d 807, 811 [249 P.2d 257]. ) An exception to this rule is made in suits for personal injury caused by negligence, where the tort character of the action is considered to prevail (Huysman v. Kirsch, 6 Cal. 2d 302, 306 [57 P.2d 908]; Krebenios v. Lindauer, 175 Cal. 431 [166 P. 17] ), but no such exception is applied in cases, like the present one, which relate to financial damage (cf. County of Santa Clara v. Hayes Co.,43 Cal. 2d 615, 619 [275 P.2d 456]; Jones v. Kelly, 208 Cal. 251, 255 [280 P. 942]).

In California the Comunale decision established that breach of an implied covenant, that is, breach of contract, as the theoretical basis of the claim allowed the plaintiff to recover contract and tort damages. This was a major change in jurisprudence and because a few people were harmed by bad actors in the insurance industry created an evil system that allows a few to grow rich from insurance claims while those who invest in insurance or who seek only the indemnity promised by the insurance policy, are subject to the law of unintended consequences.

In more than 60 years of application across the U.S. the tort of bad faith has not, in my opinion, had a salutary effect on the insurance business or the people and businesses who are insured. Insurance costs more than is reasonable or necessary so that sufficient funds exist to pay claims and tort damages from those insureds who believed they were done wrong.

Suits relating to claims presented for the 1994 Northridge earthquake in California are still pending seeking tort and punitive damages for failure to pay what the insureds’ believed they were owed. In Louisiana and Mississippi multiple millions were paid to settle claims that flood damage was covered as a result of hurricane Katrina although the policies excluded flood and the plaintiff insureds failed to buy flood insurance.

Abuse of insurers is so rampant and so successful that lawyers argue of multimillion dollar fees and have even attempted to (or successfully) bribed judges to increase their recovery. The tort of bad faith is like the mythical Vampire: It hides in the dark. The truth about the tort of bad faith will die only if it is put into the light of day. It does not solve the problem anticipated. Rather it makes a few lawyers very rich, a few insureds receive indemnity for which they did not bargain and makes the cost of insurance to those who wish only to receive the benefits of the contract prohibitive.

In New York, for example, the courts were unwilling to adopt the widely-accepted tort cause of action for “bad faith” in the context of a first-party claim, because they recognized that to do so would constitute an extreme change in the law of the state. New York accepted the more conservative approach adopted by the minority of jurisdictions that the duties and obligations of the parties [to an insurance policy] “are contractual rather than fiduciary” [Beck v Farmers Ins. Exch., 701 P2d 795, 798-799 [Utah 1985]].

Nothing inherent in the contract law approach mandates this narrow definition of recoverable damages. Although the policy limits define the amount for which the insurer may be held responsible in performing the contract, they do not define the amount for which it may be liable upon a breach. [Acquista v. New York Life Insurance Company, 285 AD2d 73 [1st Dept 2001]

The Court in Acquista, supra. looked at damages broadly but was still unwilling to adopt the widely-accepted tort cause of action for “bad faith” in the context of a first-party claim, because it recognized that to do so would constitute an extreme change in the law of New York. It allowed the insured to recover foreseeable damages, beyond the limits of its policy, for breach of a duty to investigate, bargain for and settle claims in good faith. Essentially, the court accepted the more conservative approach adopted by the minority of jurisdictions that the duties and obligations of the parties to an insurance policy are contractual rather than fiduciary.

Later, in Bi-Economy Market, Inc. v. Harleysville Insurance Company of New York, No. 14 (N.Y. 02/19/2008) in light of the nature and purpose of the insurance contract at issue, as well as Bi-Economy’s allegations that Harleysville breached its duty to act in good faith, the appellate court held that Bi-Economy’s claim for consequential damages including the demise of its business, were reasonably foreseeable and contemplated by the parties, and thus cannot be dismissed on summary judgment. New York, still has problem with the tort.

Since there is no separate tort for bad faith refusal to comply with an insurance contract, this claim should have been dismissed (see New York Univ. v Continental Ins. Co., 87 NY2d 308, 318-320; Johnson v Allstate Ins. Co., 33 AD3d 665; Zawahir v Berkshire Life Ins. Co., 22 AD3d 841, 842). Contrary to the plaintiffs’ contentions, they do not have a claim for consequential damages beyond the limits of the policy for the claimed breach of contract (cf. Acquista v New York Life Ins. Co., 285 AD2d 73, 82). [Paterra v. Nationwide Mutual Fire Insurance Co., 2007 NY Slip Op 01847, No. 2006-04562 (N.Y.App.Div. 03/06/2007)]

In California, and most states that allow a breach of an insurance contract to support a tort cause of action, only allow it to go in one direction. Insurance litigants are not equal. An insured can obtain tort damages for bad faith breach of the insurance contract but an insurer may not receive tort damages for bad faith breach of an insurance contract.

The inequality of treatment of insurers and insureds resulted in a distinction between tort and contract liabilities that convinced one state supreme court to reject comparative bad faith as a defense in a bad faith action against an insurer because “the [insurer's] tort cannot be offset comparatively by the [insureds’] contract breach.” It characterized the differing legal concepts as “apples and oranges.” [Stephens v. Safeco Ins. Co. of America (Mont. 1993) 852 P.2d 565, 568-569]. In addition a different court rejected a comparative bad faith defense for an insured’s misperformance of its contractual duties in a bad faith action against the insurer for refusal to defend. [First Bank v. Fidelity and Deposit Ins. (Okla. 1996) 928 P.2d 298, 306-309]

In California, the decision in Agricultural Ins. Co. v. Superior Court (1999) 70 Cal.App.4th 385 agreed. Agricultural involved a bad faith action arising out of an insurance claim for earthquake damage. After the insurer paid the claim in part controversies arose, ultimately leading to the insured’s suit for breach of contract and bad faith. The trial court stayed the action to allow the insurer to complete its investigation. The insurer did, and then cross-complained, contending that the insured’s claim was in significant part falsified. Making a false claim is a ground usually sufficient to allow the insurer to declare the policy void and deny all payments.

The insurer pleaded various contract theories, and also the tort theories of fraud and what was called “reverse bad faith,” i.e., tortious breach of the covenant of good faith and fair dealing by the insured. The insured demurred to the tort theories, and the trial court sustained the demurrers without leave to amend. The decision made the following amazing conclusion:

Although there is an implied covenant of good faith and fair dealing in every contract, although each party is bound by it, and although this principle applies to insurance contracts (see, e.g., Liberty Mut. Ins. Co. v. Altfillisch Constr. Co. (1977) 70 Cal.App.3d 789, 797), the potential liability for breach is different for insurers and insureds. In summary, an insured may be held liable in contract for breaching the covenant, but cannot be held liable in tort. (Emphasis added)

No State shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States; nor shall any State deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdiction the equal protection of the laws. (Emphasis added)

If the law allows an insured to sue for tort damages as a result of a breach of the covenant of good faith and fair dealing equal protection should allow an insurer to sue the insured for tort damages as a result of the breach of the same covenant. Our system of constitutional law does not allow one litigant to be more equal than others. Insurers are clearly not as equal as their insureds with regard to the tort of bad faith. Even when there is clear evidence that the insured breached the covenant of good faith and fair dealing the insurer is only entitled to contract damages while the insured, whose insurer acted in breach of the covenant can be awarded tort and punitive damages.

Although the courts may not think so, the insured’s breach of the covenant of good faith and fair dealing should also be separately actionable as a contract claim. Some forms of misconduct by an insured will void coverage under the insurance policy. (Imperial Cas. & Indem. Co. v. Sogomonian (1988) 198 Cal.App.3d 169, 182). However, the court in Agricultural believed that contract remedies “adequately serve to protect an insurer from the insured’s misconduct without creating the logical inconsistencies and troublesome complexities of a defense of comparative bad faith.”

In so doing the California court ignores the logical inconsistencies and troublesome complexities of the tort of bad faith when it finds an insurer breached the covenant. What is tortious conduct by an insurer should be tortious conduct by an insured. Damages available to the insured should be available to the insurer.

In Kransco v. American Empire Surplus Lines Insurance Company, 23 Cal.4th 390, 2 P.3d 1, 23 Cal.4th 951, 97 Cal.Rptr.2d 151 (Cal. 06/22/2000) the California Supreme Court agreed with Agricultural and held that “[A]n insured does not bear a risk of affirmative tort liability for failing to perform the panoply of indefinite but fiduciary-like obligations contained within the concept of ‘insurance bad faith.’” Since Kransco the courts support the inequity by claiming that there is a fundamental disparity between the insured who performs its basic duty of paying the policy premium and the insurer, which, depending on a number of factors, may or may not have to perform its basic duties of defense and indemnification under the policy. An insured is believed to not be on equal footing with its insurer. Because the court believes that the relationship between insured and insurer is inherently unequal, the inequality rests on contractual asymmetry. An insurer’s tort liability for breach of the covenant is believed to be predicated upon special policy factors inapplicable to the insured. But that is so with regard to all contracts where a manufacturer’s breach of a contract is inherently unequal to the breach of the purchaser of its product, but they are treated equally.

An insurer can commit the tort and is obliged to pay tort and punitive damages. An insured, who is totally evil, whose only interest in the insurance agreement is to defraud the insurer, who refuses to cooperate with the insurers investigation, who does everything possible to harm the insurer, cannot commit the tort.

This decision is as logical as stating that only black men can commit a battery while black women, white or Asian men and women cannot commit the tort of battery regardless of how hard the victim is battered. It is a statement that equal protection applies to all citizens of the U.S. except insurers since only they can only be the tortfeasor but can never the victim.

In Wade v. Emcasco Insurance Co., 483 F.3d 657 (10th Cir. 04/10/2007) the Tenth Circuit recognized that the undisputed evidence in the record showed that Plaintiff’s counsel’s sole reason for rejecting the insurer’s offer of settlement made after the running of an arbitrary deadline was his hope to pursue a bad faith claim against the insurer. As a result it refused to allow the plaintiff to pursue the bad faith case. The Tenth Circuit also noted that although the impetus for insurance bad faith claims derives from the idea that the insured must be treated fairly and his legitimate interests protected. It is designed as a shield for insureds – not as a sword for claimants. “Courts should not permit bad faith in the insurance milieu to become a game of cat-and-mouse between claimants and insurer, letting claimants induce damages that they then seek to recover, while relegating the insured to the sidelines as if only a mildly curious spectator.”

It seems to me that attorneys who handle policy claims against insurance companies are no longer interested in collecting on those claims, but spend their wits and energies trying to maneuver the insurers into committing acts which the insureds can later trot out as evidence of bad faith. [White v. Western Title Insurance Co., 40 Cal. 3d 870, 710 P.2d 309, 221 Cal. Rptr. 509 (Cal. 12/31/1985)]

It is time to put a stake in the heart of the tort of bad faith. Insureds who are wronged by their insurer should limit their recovery to contract damages. They should be compelled to waive the tort and sue in assumsit. If the tort of bad faith must exist it must be applied equally. The abuse of the tort of bad faith has become so extreme that the tort must be eliminated or otherwise made fair.

If there is a tort of bad faith – as the courts seem to believe – the Fourteenth Amendment to the U.S. Constitution requires equal protection. An insurer who is wronged by its insured should have the same right to tort damages and punitive damages for breach of the covenant as can the insured. Americans do not live on George Orwell’s “Animal Farm”. No litigant is more equal than another.

In the alternative, if there must be a tort of bad faith, then it should be applied equally. There should be no call for comparative bad faith but only that any party to a contract of insurance treated in bad faith by the other should be entitled to recover the same damages, both contract and tort damages.

Mr. Zalma can also be seen on World Risk and Insurance News’ web based television program “Who Got Caught” with copies available at his website at http://www.zalma.com.

He founded Zalma Insurance Consultants in 2001 and serves as its senior consultant. He recently published the e-books, “Zalma on Diminution in Value Damages – 2012,”“Zalma on Insurance,” “Heads I Win, Tails You Lose — 2011,” “Zalma on Rescission in California,” “Arson for Profit,” “Insurance Fraud,” and others that are available at www.zalma.com/zalmabooks.htm.