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You are an insurance claims representative attending a pre-trial settlement conference in a medical malpractice lawsuit. The plaintiff’s attorney makes a demand that is within policy limits, but you consider it unreasonable and not consistent with the nature of the injury claimed. You make an offer that is more consistent with your assessment of the value of the case. After much discussion with the judge, negotiations break down, and the plaintiff’s attorney storms out. His last comment to you is: “you better be ready to defend a bad faith action.”

What does this mean? Could there really be a bad faith action? “Bad faith” is a term that is sometimes used loosely. However, this cause of action involves more than just the failure to settle a case prior to trial. It must be shown, through an analysis of several factors, that the insurance carrier acted in bad faith by failing to settle the claim, placing its own interests above those of its insured.

I. The Duty of Good Faith

Illinois law sets forth that an insurer has a duty of good faith and fair dealing to an insured in a case in which recovery may exceed insurance policy limits. Cernocky v. Indemnity Insurance Company of North American, 69 Ill. App. 2d 196, 216 N.E.2d 198 (1966). This duty arises in the context of an insurance policy in which the insurer reserves the right to settle claims made under the policy and to conduct settlement negotiations. Id. Once there is a demand to settle a case within policy limits, an insurer must give the interests of the insured at least equal consideration with its own interests. A failure to do so would be bad faith.  See Adduci v. Vigilant Insurance Company, 98 Ill. App. 3d 472, 424 N.E.2d 645, 648 (1st Dist. 1981). An insurer need not submit to demands for the policy limits simply because there is a risk of an excess verdict. An insurer need not make settlement proposals when it reasonably believes it has a good defense to the claim. Haas v. Mid American Fire & Marine Ins. Co., 35 Ill.App.3d 993, 343 N.E.2d 36 (3rd Dist. 1976). “An insurer is only required to settle within the policy limits if that is the honest and prudent course of action.” LaRotunda v. Royal Globe Ins. Co., 87 Ill.App.3d 446, 454; 408 N.E.2d 928 (1st Dist. 1980).

The duty of an insurance carrier to settle typically arises when a third party makes a claim against the insured and there is (1) a reasonable probability of recovery in excess of policy limits; and (2) a reasonable probability that the court will find the insured liable for the claim.  Haddick v. Valor Insurance, 198 Ill. 2d 409, 417, 763 N.E.2d 299, 304 (2001).  Insurance carriers are generally not required to initiate settlement negotiations under Illinois law.  Id.  Thus, as a matter of law, an insurer is generally not liable on claims of bad faith where the plaintiff’s basis for the claim is that the insurance carrier did not initiate settlement negotiations.  Adduci, 98 Ill. App. 3d 472, 424 N.E.2d 645. The duty to settle typically does not arise until a third party claimant demands a settlement within the policy limits. Id.see also Kavanaugh v. Interstate Fire & Casualty Co., 35 Ill. App. 3d 350, 342 N.E.2d 116 (5th Dist. 1975) (refusing to hold that the law imposes a duty on an insurance company to initiate negotiations to settle); Oda v. Highway Ins. Co., 44 Ill. App. 2d 235, 253, 194 N.E.2d 489, 499 (1963) (imposing a duty on a carrier to initiate settlement negotiations puts the carrier at a negotiating disadvantage not imposed on any other litigant). Illinois law does not require that the insured party demand settlement by its insurer.  Rather, courts only require that some third party make a demand to settle a claim.  It does appear, however, that courts give weight to the fact that the insured had made a demand to settle the claim where the insured alleges bad faith against the insurer.  See, e.g., Cernocky v. Indemnity Ins. Co. North American, 69 Ill. App. 2d 196, 216 N.E.2d 198 (2d Dist. 1966). (Multiple requests by the insured’s personal attorney to settle the case were ignored by the insurer).

Some exceptions exist to the general principle that there must be a demand to settle within policy limits before the good faith duty by the carrier is triggered. When the probability of an adverse finding on liability is great, and the amount of probable damages would greatly exceed the policy limits, an insurer is obligated to initiate settlement negotiations.  See Adduci, 98 Ill. App. 3d at 478.  This is an exception, which courts have sought to apply sparingly and only in “the most glaring cases of an insured’s liability [.]”  Id. More recently, the appellate court in Central Illinois Public  Service Co. v. Agricultural Ins. Co., 378 Ill. App. 3d 728, 880 N.E.2d 1172 (5th Dist. 2008), held that an underlying insurer has a duty to participate in settlement negotiations in good faith regardless of whether it is capable of settling a matter within the policy limits.  Id. at 737.  The court held that instead of the duty arising only when a third party demands that the claim be settled within policy limits, the duty is “tied to the possibility of a finding of liability against the insured.”  Id.  Thus, the duty of an insurer arises where there exists a reasonable probability that the insured will be exposed to a recovery in excess of the policy limits.  Id.

II. Factors Considered in a Determination of Bad Faith

Courts in Illinois have developed seven factors by which to evaluate whether an insurer committed bad faith by failing to settle a claim. These factors have been set forth as follows:

  1. The advice of the insurance company’s own adjusters;
  2. A refusal to negotiate on the part of the carrier;
  3. The advice of defense counsel;
  4. Communication with the insured of the claimant’s willingness to settle for the amount of coverage;
  5. Adequacy of the investigation and defense;
  6. A substantial prospect of an adverse verdict; and
  7. The potential for damages to exceed the policy limits.

Phelan v. State Farm Mutual Insurance Company, 114 Ill.App.3d 96, 448 N.E.2d 579 (1st Dist. 1983). An insurer’s mere refusal to settle within the policy limits does not render it liable per se to its insured. Kavanaugh v. Interstate Fire & Casualty Company, 35 Ill. App. 3d 350, 342 N.E.2d 116 (1st Dist. 1976). This is only one factor that will be considered. The courts do not require that all seven factors be satisfied in order to determine if the insurer acted in bad faith. The court will consider these factors, however, in making this determination. Overall, the courts will ask, did the insurer put its own interests above those of its insured? Conversely, did the insurer give the interests of its insured at least as much consideration as it did its own interests? If the evidence shows that the insurer did give the insured’s interests as much consideration as its own, it is less likely that the insurer will be found liable for bad faith.

III. Damages

The facts in a bad faith action typically include a demand to settle within the policy limits and a refusal or failure by the insurer to do so. The case goes to trial, and a judgment is entered against the insured in excess of the policy limits. The insured then has a cause of action against the insurer for bad faith, but the insured typically assigns this cause of action to the plaintiff who obtained the judgment. The plaintiff in the underling case then pursues the action against the insurer. With respect to compensatory damages, if a plaintiff prevails in showing bad faith on the part of the insurer, the insurer will typically be held responsible for the entirety of an excess verdict suffered by the insured, regardless of the limits of insurance. See e.g. National Union Fire Insurance Company of Pittsburgh v. Continental Illinois Corporation, 673 F. Supp. 267 (N.D. Ill. 1987). Thus, an insurer could be held liable for the entire judgment entered against the insured.

Punitive damages have been found to be available in Illinois in actions for bad faith. The only reported case in Illinois involving the imposition of punitives is the case of O’Neill v. Gallant Ins. Co., 329 Ill.App.3d 1166, 769 N.E.2d 100 (5th Dist. 2002). In O’Neill, Marguerite O’Neill was seriously injured due to Gallant’s insured’s negligence. Her attorney sent a letter to Gallant demanding the policy limits of $20,000. Gallant made no response, even though the Gallant claims adjuster who reviewed the file recommended, before the demand was even made, that policy limits be paid on the claim. The claims manager concurred in that recommendation. The executive vice president of Gallant essentially ignoredthe recommendations of his adjusters and also disregarded the advice of the lawyers hired by Gallant to represent the insured. Counsel had urged the VP to tender policy limits in response to the demand and predicted that a jury verdict for Mrs. O’Neill was likely to be 15 to 30 times the amount of coverage. A jury in fact awarded $731,063 in damages to Mrs. O’Neill in her trial against Gallant’s insured.

The insured then assigned her bad faith claim against Gallant to Mrs. O’Neill. The bad faith case went to trial, and the jury awarded over $3 million to O’Neill, which represented not only the judgment against the insured in the underlying case but punitive damages. Gallant appealed. The punitive damage award was upheld on appeal. The appellate court held that where an insurer’s conduct amounts to an “utter indifference and reckless disregard of its policy-holder’s financial welfare”, punitive damages could be awarded. In this case, Gallant’s complete control over the claim and defense of the underlying case created a fiduciary duty on its part.

In assessing the availability of punitive damages, the court in O’Neill looked at the nature of the insurer’s conduct and concluded that its failure to settle was reckless and showed an indifference to the policyholder’s interest. 329 Ill. App. 3d at 1180.  The court found that there was a fiduciary relationship between these parties.  The court pointed out that the insured was in a position of vulnerability in this relationship.  By virtue of the insurer’s bad faith failure to act in compliance with this relationship, the court held it necessary to allow an award of punitive damages in order to provide “some degree of deterrent against unscrupulous insurers who would otherwise take advantage of customers and abuse their fiduciary relationship in order to promote their own economic self interest.”  Id. 1178.  The court also found that Gallant had a pattern of bad faith based on evidence adduced at trial that Gallant had exposed policyholders to more than $10 million in excess judgments.  Id. at 1179.  Thus, awarding punitive damages served to punish the insurer and inform it that: “it had to stop its common practice of ignoring policy-limit demands in serious cases where liability was clear-cut.”  Id.  Based on the evidence in the record, the court held that the jury was entitled to believe that the insurer acted with utter indifference and reckless disregard for the insured’s financial welfare.  Id. at 1180.

IV. Conclusion

You were not able to settle your case in the pre-trial conference; that doesn’t necessarily mean that the carrier is at risk for a bad faith action. As set forth above, several factors in each case would need to be evaluated in order to determine if bad faith exists. Consideration of these factors can help determine whether an insurer may be at risk for a bad faith action.