If you’re a coverage geek, or just someone who enjoys a good academic brawl, you already know that the ALI’s draft Restatement of the Law of Liability Insurance has come under fire from insurance industry lawyers who see many of the proposed rules as stating what the reporters believe the law ought to be, rather than a distillation of the common law into a set of rules that accurately states what the law is. Policyholder lawyers have fired back, reminding their brothers and sisters at the insurance bar that a restatement is not limited simply to identifying the majority rule, but also considers many other factors: “the nature of the majority rule,” what specific rule will best fit with the other rules, trends in the law, and the “relative desirability” of competing rules.
This academic brouhaha is an important backdrop to understanding (1) how and why the Restatement defines “bad faith”; (2) why a finding of bad faith is no longer required to impose severe penalties on an insurer who breaches its duty to make reasonable settlement decisions under Section 27; and (3) how the Restatement reporters were persuaded to revise Section 19 (Consequences of Breach of Duty to Defend) so that a finding of bad faith will be required before an insurer can be stripped of its coverage defenses.
Bad Faith under the Restatement
Under the Restatement, what determines whether an insurer has acted in bad faith or just made a knuckle-head mistake? Section 49 sets out a two-part test: “objective” and “subjective.” An insurer is liable for bad faith when (1) it fails to perform under its policy without a reasonable basis for its conduct and (2) does so with knowledge of its obligation to perform or in reckless disregard of whether it has an obligation to perform. The Restatement calls such conduct “true bad faith.” For an insurer to be liable for true bad faith, the Restatement makes clear that both parts of the two-part test must be satisfied: no reasonable basis and knowledge or reckless disregard. This definition fits the law of most jurisdictions when it comes to insurers who are liable for first-party bad faith, i.e., when insurers wrongfully deny coverage for loss suffered by their own insureds (e.g., property damage or uninsured motorist (UM)/underinsured motorist (UIM) benefits). But this is not always the case when it comes to third-party bad faith, i.e., where the insured is looking for his insurer to cover a claim against him for damages he caused to others. For example, most jurisdictions do not require a showing of subjective knowledge or reckless disregard to find an insurer liable for bad faith when it fails to settle a claim brought against its insured when liability is reasonably clear and the damages are within policy limits. In most jurisdictions, only the objective prong of the two-prong test must be met: Did the insurer lack a reasonable basis for refusing to settle? More often than not, insurers who are found liable for “bad faith failure to settle” are required to pay the full amount of any judgment, covenant judgment, or settlement, regardless of policy limits.
Rule 27: Damages for Failure to Make Reasonable Settlement Decisions
Consistent with this common law, Rule 27 does not require a finding of bad faith. Rather it applies a “commercial reasonableness” standard to determine whether an insurer will be liable for breach of its duty and obliged to pay the entire amount of the excess judgment. That is, an insurer will be liable if a judge or jury finds that its refusal to settle would not have been made by a reasonable insurer that bore “the sole financial responsibility for the full amount of the potential judgment.” The Restatement expressly does not use the term “bad faith” because: (a) it doesn’t fit with the definition of “true bad faith”; (b) the Restatement wants courts to be able to use “bad faith” and its two-prong test for insurers whose conduct goes beyond “unreasonableness”; and (c) it wants “to create an incentive for insurers to take into account the risk to insureds and excess carriers” from an excess verdict, without slapping the label of “bad faith” on the conduct of insurers who make a mistake. It also doesn’t use the term “bad faith” because (as set forth in the comments to §24) it wants to reduce “the likelihood that an inexperienced lawyer or judge will mistakenly conclude that the same legal standard applied in both categories.” Consequently, under Rule 27, an insurer who breaches its duty is “subject to liability for any foreseeable harm caused by the breach,” including the full amount of the damages assessed against the insured, regardless of the policy limits. No finding of bad faith is required.
Rule 19: Consequences of Breach of Duty to Defend
The final draft of Rule 19 that was presented to the ALI’s membership for approval in May 2017 came under withering fire. As it was then drafted, there were two consequences or penalties, set out in two paragraphs, that resulted from an insurer who breached its duty to defend. First, an insurer that breached its duty “lost the right to assert any control over the defense or settlement of the action.” Second, an insurer who breached its duty “without a reasonable basis” automatically forfeited all its coverage defenses to the action brought against the insured. This meant that not only was the insurer liable for all the insured’s defense costs, it also was required to indemnify the insured for any damages awarded up to the policy limits, regardless of any coverage defenses it could have asserted. The first consequence was expected, because it is a common penalty in most jurisdictions. The second consequence drew outrage and protest from a number of insurance company coverage counsel, academics, and at least one judge who pointed out that (1) the proposed rule was not the majority rule in the United States (indeed, 28 states require a finding of bad faith before the penalty can be applied); (2) the reporters didn’t cite to any “trends” that would support the adoption of the rule; and (3) there was no “social science evidence” that would support the claim that adopting the rule would incentivize insurers to “to fulfill their duty to defend.” As a result, the critics warned, the Restatement, and the ALI itself, risked losing the legitimacy and high regard for its pronouncements that come with a reputation for exacting and neutral scholarship.
Considering these protests, the ALI postponed the vote on approving the Restatement until its annual meeting in May 2018, and the reporters went to work answering the criticisms of Rule 19 and several other rules. The next iteration of Rule 19, released in August 2017 as part of “Preliminary Draft No. 4,” did nothing to assuage the criticism because the language of Rule 19 remained the same. The only difference was in the “Comment” section to the rule, where the reporters agreed that “the majority rule is that insurers that breach the duty to defend are generally permitted to contest coverage, subject to the risk of facing additional consequences for a bad faith breach.” While admitting that the proposed rule did not represent the current majority rule, the reporters argued that the change was warranted and necessary. First, the reporters pointed out that coverage for defense attorneys’ fees and costs was critical to policy holders. Insurance defense coverage provides “the access to civil justice for defendants that corresponds to the access to civil justice that contingent-fee arrangements provide for plaintiffs.” Without it, most individual consumers and small businesses “would be deprived of an adequate defense.”
Second, like Rule 27, the proposed Rule 19 aligns the insurer’s interests with those of the insured. If an insurer knows that it will forfeit its coverage defenses if it wrongfully denies a defense, it will be forced to make its decision by considering “full liability for the action,” not only the defense costs it will have to pay, but the full amount of any judgment (or settlement) up to its policy limits. Because the insured’s need for defense coverage, like the insured’s need for the insurer to make reasonable settlement decisions, are both recurring and critical, the reporters declined to require a two-part finding of bad faith. Instead, the reporters adopted half of the two-part bad faith standard, “reasonableness,” while imposing a penalty so severe that most jurisdictions currently require a finding of bad faith. Critics of the Restatement’s Rule 19 remained outraged.
Rule 19 Revised
The debate over Rule 19 and other sections of the Restatement continued through the fall of 2017 with the reporters continuing to meet with judges and receiving comments and suggestions from other members of the ALI as well as from other advisory bodies. In December 2017, the reporters submitted “Council Draft No. 4” that was approved by the ALI’s Council in January 2018. In that draft, the offending paragraph 2 of Rule 19 was deleted in its entirety. Rule 19 now reads:
§19. Consequences of Breach of the Duty to Defend.
An insurer that breaches the duty to defend a legal action loses the right to assert any control over the defense or settlement of the action.
The reason for the change was a newly acquired consensus by the reporters and their advisors that there was insufficient authority to support stripping an insurer of its coverage defenses for breach of its duty to defend without a finding of bad faith. Notwithstanding this retreat to the majority rule, the Comment to §50, Remedies for Liability for Bad Faith, makes clear that insurers risk forfeiting their coverage defenses if they are found to have acted in bad faith. But that “bad faith” must be determined by the two-prong test: a finding of no reasonable basis; and knowledge or reckless disregard that there was no reasonable basis.
At the ALI’s annual meeting in May 2018, Council Draft No. 4 was approved in its entirety by the ALI’s membership. It is now the ALI’s official Restatement of the Law of Liability Insurance. Time will tell whether the Restatement is accepted as articulating a broad consensus of what the law is, or whether it is viewed as advocating what the law should be. Either way, it undoubtedly will be a factor in how lawyers argue coverage cases and how courts decide them.