Any thorough liability coverage analysis should include an answer to the question of whether the insurance carrier could possibly be held liable for damages in excess of the policy limit if a court later determines that a coverage denial was incorrect.
Surprisingly, New York law on this important topic remains unsettled.
Prior to the Court of Appeals’ decision in Bi-Economy Market v. Harleysville Insurance of N.Y., 10 N.Y.3d 187 (2008), New York appellate courts had determined that New York state law did not recognize a separate cause of action for a “bad faith” coverage denial, because such a claim is redundant to a claim for breach of contract. See, Zawahir v. Berkshire Life Ins., 22 A.D.3d 841 (2d Dept. 2005); Royal Indemnity v. Salomon Smith Barney, 308 A.D.2d 349 (1st Dept. 2003).
However, in Bi-Economy, the Court of Appeals held that in a breach of contract action against an insurance carrier for an alleged wrongful denial of coverage, consequential damages in excess of the policy limit may be recovered where (1) consequential damages were reasonably contemplated by the parties, and (2) the denial of coverage by the insurance carrier represented a breach of the covenant of good faith and fair dealing, i.e., bad faith.
While it can be argued that the Court of Appeals’ holding in Bi-Economy was intended to be limited to first party coverage, trial courts have recently held that Bi-Economy’s formula for the availability of consequential damages in excess of the policy limit is equally applicable to claims against insurance companies for wrongful denials of liability coverage. See, Axis Reinsurance Refco Related Ins. Litig., No. 07-CV-07924, 2010 U.S. Dist. LEXIS 33377, at *5-7 (S.D.N.Y. March 7, 2010)1; Schlather, Stumbar, Parks & Salk v. OneBeacon Ins., 2011 U.S. Dist. LEXIS 147931 (N.D.N.Y. Dec. 22, 2011).
Assuming that consequential damages in excess of the policy limit are now recoverable for a wrongful denial of liability coverage under Bi-Economy, uncertainty as to the proof required for such an award remains. Ultimately, New York appellate courts will need to clarify the proof required for such an award, and the manner in which such damages will be measured.
New York Bad Faith Law
New York law concerning insurance company liability for bad faith has developed largely in the context of cases in which the defense of the insured has been undertaken by the insurance company and an alleged failure to settle the case within the policy limit has occurred, resulting in a judgment in excess of the policy limit. Pavia v. State Farm Mut. Auto. Ins., 82 N.Y.2d 445 (1993). In Pavia, the Court of Appeals reasoned that the foundation of the bad faith doctrine “is the fact that insurers typically exercise complete control over the settlement and defense of claims against their insureds, and thus under established agency principles may fairly be required to act in the insureds’ best interests.” Id. at 452-453.
However, the court recognized that there is an “understandable reluctance to expose insurance carriers to liability far beyond the bargained-for policy limits for conduct amounting to a mere mistake in judgment.” Id. The Court of Appeals held in Pavia that a claim for bad faith cannot be sustained based upon conduct amounting to ordinary negligence. Id.
In order to establish a prima facie case of bad faith, a plaintiff must prove that the insurer’s conduct constituted a “gross disregard” of the insured’s interests—”that is, a deliberate or reckless failure to place on equal footing the interests of its insured with its own interests when considering a settlement offer.” Id.
Pavia also re-established that in order to prevail in a bad faith failure to settle case, the plaintiff must prove that there was an “actual opportunity to settle the claim” by the insurance carrier, at a time when all serious doubts about the insured’s liability were removed. Id.
Where the plaintiff in a bad faith failure to settle case can meet the difficult burden of proof established in Pavia, the damages recoverable are generally “the amount for which the insured becomes charged in excess of his policy coverage.” Soto v. State Farm Ins., 83 N.Y.2d 718, 723 (1994).
In the coverage denial scenario, the carrier has not assumed control of the insured’s defense, and the insurance coverage conflict between the insurance carrier and the insured can be characterized as a contract dispute regarding the intended scope of coverage under the policy.
Against this backdrop, it is not surprising that New York appellate courts have held that New York law does not recognize a separate cause of action for bad faith based on an insurance carrier’s allegedly wrongful denial of coverage under an insurance policy. Zawahir, supra; Royal Indemnity, supra. In Royal Indemnity, the Appellate Division, First Department, held that “allegations that an insurer had no good faith basis for denying coverage are redundant to a cause of action for breach of contract based on the denial of coverage, and do not give rise to an independent tort cause of action, regardless of the insertion of tort language into the pleading.” See also, Zawahir, supra; New York Univ. v. Cont’l Ins., 87 N.Y.2d 308, 315-316 (1995).
The Court of Appeals blocked another potential avenue to extra-contractual damages when it held that punitive damages are not available for breach of an insurance contract unless the plaintiff shows both “egregious tortious conduct” directed at the insured claimant and a “pattern of similar conduct directed at the public generally.” Rocanova v. Equitable Life Assur. Soc’y, 83 N.Y.2d 603, 613 (1994); New York University, supra.
Any comfort that insurance carriers enjoyed based on the notion that damages in excess of the policy limit could not be awarded in disputes concerning denials of coverage was eliminated by the Court of Appeals’ decisions in Bi-Economy and Panasia Estates v. Hudson Ins., 10 N.Y.3d 200 (2008). In Bi-Economy, the insured alleged that it was forced out of business when its insurance carrier failed to satisfy its claim for business interruption insurance following a fire that resulted in a complete loss of inventory and heavy structural damage to its building.
The insured commenced an action against its insurance carrier, asserting causes of action for bad faith claims handling, tortious interference with business relations and breach of contract. The insured sought consequential damages in excess of the policy limit, for the complete demise of its business operation. It was alleged that the insurance carrier improperly delayed payment for the building and contents claim, and failed to timely pay the full amount of lost business income sustained.
The Court of Appeals held in Bi-Economy that the insured had a viable claim against the insurance carrier in excess of the policy limit for consequential damages arising from the alleged breach of contractual obligations by the insurance carrier.
The Court of Appeals held in Bi-Economy that in order for a policyholder to recover consequential damages against an insurance carrier on a breach of contract claim, it must prove that (1) consequential damages were “reasonably foreseeable and contemplated by the parties” at the time of contracting, and (2) the breach of contract represented a breach of the covenant of good faith and fair dealing. As support for its allowance of consequential damages, the majority cited the purpose of business interruption insurance, which is to “indemnify the insured against losses arising from inability to continue normal business operation and functions due to the damage sustained as a result of the hazard insured against.” Bi-Economy, supra at 194. The court reasoned that to limit an insured’s damages to the amount of the policy would not place the insured in the position it would have been in had the contract been properly performed.
In a scathing dissent, Judge Robert Smith warned that the majority in Bi-Economy had abandoned the holdings of Rocanova and NYU in which it had been established that punitive damages are generally not available for breach of an insurance contract. The majority achieved this result, according to Smith, simply by changing labels: “Punitive damages are now called ‘consequential’ damages, and a bad faith failure to pay a claim is called a ‘breach of the covenant of good faith and fair dealing.’” Bi-Economy, supra at 196. Smith ridiculed the notion that an insurance carrier would have ever intended to be potentially liable for damages in excess of the stated policy limit, and warned that the majority’s attempt to punish unscrupulous insurers would “undoubtedly lead to the punishment of many honest ones.” Bi-Economy, supra at 199.
In Panasia, the Court of Appeals held that the formula for consequential damages for a denial of coverage applied to a case involving a denial of commercial property coverage. Panasia, supra at 203.
Because Bi-Economy and Panasia both involved claims for first party coverage, a strong argument can be made that the holdings of Bi-Economy and Panasia do not apply to denials of liability insurance. New York law treats liability coverage and first party coverage differently and each is subject to different statutory schemes. Moreover, in Pavia, the Court of Appeals held that the underpinning for claims of bad faith against a liability insurance carrier is the control exercised by the insurance carrier over the defense and settlement of claims. When an insurance carrier denies liability coverage, it typically exercises no control over the defense or settlement of the claims against the insured.
However, trial courts that have addressed this issue in the wake of Bi-Economy have ruled that consequential damages in excess of the policy limit are available in claims by policyholders against liability insurance carriers for allegedly wrongful denials of coverage. See, Schlather, supra; In re Axis Reinsurance Refco Related Insurance Litigation, supra.
Axis Reinsurance involved a dispute between a policyholder and its Directors & Officers insurance carrier with regard to indemnity for the settlement of claims against the policyholder asserted in a securities class action lawsuit. The D&O carrier denied coverage based on the “prior knowledge” exclusion in the policy. The facts were unique in that following the coverage denial, the D&O carrier was ordered to pay its full policy limit to the policyholder for defense costs while the coverage issues were being litigated. Nonetheless, when the disputed settlement had been tendered to the carrier, its policy limit had not been exhausted and it declined to fund the settlement based in part on its determination of no coverage.
Citing Bi-Economy, the policyholder argued that the insurance carrier should be found liable for amounts in excess of the policy limit for the disputed settlement payment.
In a decision that was later adopted by the trial court, the special master discussed the holdings in Bi-Economy and Panasia and held that a liability insurance carrier can be found liable for consequential damages in excess of the policy limit where it has been found to have acted in bad faith. Axis Reinsurance, supra at 23. The court rejected the argument made by the insurance carrier that the holdings of Bi-Economy and Panasia only apply to claims for first party coverage and should not be applied to liability coverage. Axis Reinsurance, supra at 21-22, fn. 4. The court ruled that the question of bad faith involved triable issues of fact.
Schlather involved a denial of professional liability coverage to a law firm that had been sued for legal malpractice. The carrier asserted that there was no duty to defend or indemnify because the claim against the insured had not been made during the policy period as required by the insuring agreement, but instead had been made before the inception of the policy. Alternatively, the carrier argued that if the claim was made during the policy period, coverage was excluded under the “known claims” exclusion. The court determined that the “known claims” exclusion applied, and that no duty to indemnify the insured was owed. However, the court ruled that the carrier had still owed a duty to defend until the determination that the exclusion applied was made by the court.
Citing Bi-Economy, the trial court held that the plaintiffs were entitled to both general and consequential damages arising from the insurance carrier’s breach of its contractual duty to defend. Schlather, supra at 40. Surprisingly, there is no mention by the court of the requirement of bad faith for the imposition of consequential damages.
It remains to be seen whether New York appellate courts will rule that consequential damages in excess of the policy limit are available for a wrongful denial of liability insurance coverage. If damages beyond the policy limit are available, courts will need to clearly articulate the elements of proof required.
The Court of Appeals has repeatedly held that an insurance carrier will not be liable for bad faith in the liability insurance context for conduct amounting to ordinary negligence, and that a finding of reckless conduct is required. Pavia, supra at 452-453; Soto, supra.
Based upon the well-established “gross disregard” standard for bad faith, it should be clear that a liability insurance carrier will not be found liable for damages in excess of the policy limit for a denial of liability insurance coverage where there is at least an arguable basis for the carrier’s position. Hugo Boss Fashions v. Federal Ins., 252 F.3d 608, 625 (2d Cir. 2001). If the insurance carrier’s determination of no coverage is later found to be an error caused by mere negligence or poor judgment, an award of damages beyond the policy limit should not be sustainable. Due to a lack of case law, the notion of what might constitute evidence of a bad faith denial of liability coverage remains unclear.
Another element of proof that must be addressed is whether an award of consequential damages in excess of the policy limit can be imposed for a denial of liability coverage absent a showing that there was an actual opportunity to settle the case within the policy limit. The actual opportunity to settle requirement for a finding of bad faith in the liability insurance context has been an essential element under New York law for decades. See, United States Fidelity & Guaranty v. Copfer, 48 N.Y.2d 871 (1979). Assuming that the “actual opportunity to settle” requirement remains in place for consequential damage claims arising from liability coverage denials, the manner in which such a lost opportunity to settle would be proven is problematic. Where the insurance carrier denies coverage and does not defend the insured, a finding that the claims could have been settled within the policy limit would likely be speculative.
In Bi-Economy and Panasia, the Court of Appeals held that consequential damages in excess of the policy limit may be recovered for a wrongful denial of coverage where it is established that “consequential damages were reasonably contemplated by the parties” at the time of contracting, and that the denial of coverage represented a breach by the insurance carrier of the covenant of good faith and fair dealing. Trial courts that have examined this issue in the wake of Bi-Economy and Panasia have held that consequential damages in excess of the policy limit may be awarded against an insurance carrier in actions for wrongful denials of liability insurance coverage.
However, significant questions remain concerning the proof required for awards of consequential damages against insurance carriers in the liability coverage denial scenario. Ultimately, further clarification of the requirements for consequential damages will be required from New York state appellate courts.
Michael P. Kandler is a partner at Callan, Koster, Brady & Brennan in New York; he heads the firm’s insurance coverage and appellate practice groups.
1. Report and Recommendation Adopted by Access Reinsurance Refco Related Ins. Litigation, 2010 U.S. Dist. LEXIS 33322, 2010 WL 1374891 (S.D.N.Y. March 7, 2010).