The Law of Unintended Consequences and Insurance Bad Faith

The Tort of Bad Faith was Created with Good Intentions Only to Obtain Opposite Results

This article was adapted from my book “The Law of Unintended Consequences and the Tort of Bad Faith” available at https://zalma.com/blog/insurance-claims-library/ and as a Available as a paperback  or Available as a Kindle book.

THE TORT OF BAD FAITH MAKES NO SENSE

The law of unintended consequences is not statutory. No state or federal government has enacted it into law. No executive has signed the law. It is, rather, an example of what happens when people interact with each other. Human nature, the normal actions of human beings, when they try to do something that the believe is fair and reasonable, often results in consequences not intended by – or even considered – by the actions of normal human beings. It is an adage or idiomatic warning that an intervention in a complex system always creates unanticipated and often undesirable outcomes.

Science and general observation allow the statement that actions of people, especially of governments, will always have effects that are unanticipated or unintended.

Economists and other social scientists have heeded its power for centuries. Regardless, for just as long, politicians, insurers and popular opinion have largely ignored it to their detriment.

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PHILOSOPHERS, ECONOMISTS AND POLITICIANS

The concept of unintended consequences is one of the building blocks of economics. Adam Smith’s “invisible hand,” the most famous metaphor in social science, is an example of a positive unintended consequence.

Smith maintained that each individual, seeking only his own gain, “is led by an invisible hand to promote an end which was no part of his intention,” that end being the public interest. “It is not from the benevolence of the butcher, or the baker, that we expect our dinner,” Smith wrote, “but from regard to their own self-interest.”

Most often, however, the law of unintended consequences illuminates the perverse unanticipated effects of legislation and regulation. In 1692 the English philosopher John Locke, a forerunner of modern economists, urged the defeat of a parliamentary bill designed to cut the maximum permissible rate of interest from 6 percent to 4 percent.

In the first half of the nineteenth century, the famous French economic journalist Frédéric Bastiat often distinguished in his writing between the “seen” and the “unseen.” The seen were the obvious visible consequences of an action or policy. The unseen were the less obvious, and often unintended, consequences. In his famous essay “What Is Seen and What Is Not Seen,” Bastiat wrote: “There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.”

Bastiat applied his analysis to a wide range of issues, including trade barriers, taxes, and government spending.

A policy that protects one industry from foreign competition makes it harder for another industry to compete with foreign competition.

Similarly, Social Security has helped alleviate poverty among senior citizens and the disabled. Many economists argue, however, that it has carried a cost that goes beyond the payroll taxes levied on workers and employers. Martin Feldstein, and others, maintain that today’s workers save less for their old age because they know they will receive Social Security checks when they retire. If Feldstein and the others are correct, it means that less savings are available, less investment takes place, and the economy and wages grow more slowly than they would without Social Security. The fact that people live longer – due to advances in medical science – Social Security is not funded sufficiently for the longer life span and people who rely on Social Security find it is insufficient to support them after retirement.

The law of unintended consequences is at work always and everywhere. People outraged about high prices of plywood in areas devastated by hurricanes, for example, may advocate price controls to keep the prices closer to usual levels. An unintended consequence of such efforts is that suppliers of plywood from outside the region, who would have been willing to supply plywood quickly at the higher market price, are less willing to do so at the government-controlled price. Thus, the good intentions of the government-controlled price resulted in a shortage of a good that was badly needed.

Government licensing of electricians, to take another example, keeps the supply of electricians below what it would otherwise be, and thus keeps the price of electricians’ services higher than otherwise. One unintended consequence is that people sometimes do their own electrical work, and, occasionally, one of these amateurs is electrocuted or causes a fire that burns down the house.

Licensing of some trades and professions to protect the public has the opposite effect by reducing the available hair dressers, podiatrists, physicians, lawyers, plumbers, and carpenters. When each state has a different licensing law it makes it almost impossible for a licensed person to move to another state without obtaining a new license. Some national firms find their employees must be licensed in all 50 states.

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.

In the United States alone, people pay insurers more than $1.2 trillion in premiums, and insurers pay out in claims and expenses as much or more than they take in. Profit margins are small because competition is fierce, and a year’s profits can be lost to a single firestorm, hurricane, or flood.

The business of insurance is, like everything else subject to the law of unintended consequences. Unfortunately for insurers and the insurance buying public, the law of unintended consequences effects insurance as if it were on steroids.

INSURANCE AS A NECESSITY

Neither the courts nor the governmental agencies seem to be aware that in a modern, capitalistic society, insurance is a necessity. No prudent 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, 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 5,000 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 the deal is essentially the same. 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.

In a modern industrial society, almost everyone is involved in or with the business of insurance. They insure against the risk of becoming ill, losing a car in an accident, losing business due to fire, becoming disabled, losing their life, losing a home due to flood or earthquake, or being sued for accidentally causing injury to another. They are insurers, insureds, or people dependent on one another. Insurance allows an individual to transfer the risks of loss normal to modern life to an insurer.

THE TORT OF BAD FAITH

In 1958 the California Supreme Court, with the best of intentions, changed centuries of contract law in a case called Comunale v. Traders & General Insurance Company, 50 Cal. 2d 654, 328 P.2d 198 (Cal. 07/22/1958). By changing the law using judicial fiat, the California Supreme Court made an insurer’s breach of contract, under particular egregious circumstances, a tort. By doing so the Supreme Court allowed an insured to recover from an insurer damages more than those allowed under the contract of insurance as required by the common law.

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 considered appropriate. 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 insignificant claims deemed 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 and punished them, often feeling sorry for the insureds.

This happened 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.

The logarithmic growth of insurance fraud in the state of California, and other states that have allowed tort damages for bad faith breach of insurance contracts, may be directly traced, in part, to the judicial creation of the tort of bad faith. Before the tort of bad faith, insurers with a reasonable belief that an insured was presenting a fraudulent claim would refuse to pay it. Persons perpetrating the fraud did, in most cases, accept the refusal as a cost of doing business and went on to the next fraudulent claim. After the recognition of the tort of bad faith, those who perpetrated fraudulent insurance claims that were denied went to lawyers instead. Suits for bad faith popped up like wild flowers in the desert after a rainstorm.

Juries, angered by insurers accusing their insureds of fraud, punished the insurers with multi-million dollar judgments. After each judgment, hundreds of cases settled (even though no monies were owed) for fear of being victims of the same out of control juries. Fraud units that had been instituted in the 70’s were disbanded in the late 80’s because of fear of punitive damage judgments and only reinstated after states passed statutes requiring insurers to maintain insurance fraud investigation units.

Insurers now have professional claims departments. Insureds are almost universally treated with courtesy and respect. More than 90% of all claims are resolved without litigation or argument. Legitimate claims are paid with alacrity. It seems clear to me that the tort of bad faith has served its purpose. It should be killed. The courts of the United States should return to the common law of contracts where the insured is provided the benefits of the contract of insurance promised by the policy. I am, however, a practical person and understand that the possibility of a state legislature, a court, the federal government or the U.S. Supreme Court, will find the tort of bad faith to be improper and a violation of the common law or the U.S. Constitution, is miniscule.


© 2019 – Barry Zalma

This article, and all of the blog posts on this site, digest and summarize cases published by courts of the various states and the United States.  The court decisions have been modified from the actual language of the court decisions, were condensed for ease of reading, and convey the opinions of the author regarding each case.

Barry Zalma, Esq., CFE, now limits his practice to service as an insurance consultant  specializing in insurance coverage, insurance claims handling, insurance bad faith and insurance fraud almost equally for insurers and policyholders. He also serves as an arbitrator or mediator for insurance related disputes. He practiced law in California for more than 44 years as an insurance coverage and claims handling lawyer and more than 50 years in the insurance business. He is available at http://www.zalma.com and zalma@zalma.com.

Mr. Zalma is the first recipient of the first annual Claims Magazine/ACE Legend Award.

Over the last 51 years Barry Zalma has dedicated his life to insurance, insurance claims and the need to defeat insurance fraud. He has created the following library of books and other materials to make it possible for insurers and their claims staff to become insurance claims professionals.

 

About Barry Zalma

An insurance coverage and claims handling author, consultant and expert witness with more than 48 years of practical and court room experience.
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