Conditioning Release of Bad Faith Claims Upon Payment of an Underlying Claim - Not a Good Idea.

Written by AMLO.

The Advocate by M. Austin Mehr  Jan/Feb 2003  Vol. 30, No. 1

The client arrives in your office needing assistance in pursuing a typical insurance claim. Perhaps it is an injury claim, or perhaps it is a property damage claim. In either case, a tort feasor caused damage to your client, and you proceed to successfully negotiate a settlement with the third party's insurance carrier, Tag Along Insurance Company of America.

The settlement check arrives in your office with a standard preprinted release. You scan it quickly as you prepare the settlement documents and have your secretary write the escrow account deposit slips and checks. But something in the release catches your eye and strikes you as being wrong: not only will your client be releasing all claims against the tortfeasor, he also will be releasing all claims against the third-party insurance carrier.

Out of an abundance of caution, you call your law school insurance professor (who told all of her students to call if they had any questions). You pose the question: Why does your client need to release the insurance company? She tells you that, in Kentucky, there is no direct action that your client could file against a third-party insurance carrier, as carriers are merely required to indemnify the liability of the tortfeasor. However, she reminds you that your client may have a potential cause of action against the third-party carrier for insurance bad faith. You then remember that Kentucky—like a number of other jurisdictions—has recognized the availability of a third-party bad faith lawsuit by a claimant against a tortfeasor's liability insurance company for violations of the Unfair Claims Settlement Practices Act ("UCSPA"). 1

With this information in hand, you are now in a quandary. If your client releases a cause of action that he never asserted, and for which he received no compensation, you could be facing a potential legal malpractice suit. Accordingly, you correctly conclude that you must inform him of this potential cause of action and get his consent before releasing it. But then another thought occurs—why should you release the insurance company in the first place? Your client has asserted no claim for USCPA violations in this case. The bargain that you made was only for the tortfeasor's liability.

You discuss the matter with the insurance adjuster, and he tells you that, in his twenty years as an adjuster, no one has ever disputed releasing the insurance company. The insurance company always gets released and it is always a condition of the settlement. You are told that if you want the money, you have to release the insurance company "otherwise there is no deal".

What has happened here and what does it mean? For starters, by insisting on its release and conditioning settlement on that release ”even when no claims have been made against it ”the insurance company has arguably committed an act of bad faith, both towards its insured and towards the third-party claimant. Although there is a dearth of case law on this particular issue, there are cases from other jurisdictions that support this position.

For example, in Isaac v. State Farm Mut. Auto. Ins. Co. , 2 a first-party bad faith case, the South Dakota Supreme Court was faced with a situation where the insurance company conditioned its offer of $100,000 upon the plaintiff's release of her bad faith claim. In addressing the issue of punitive damages, the court remarked:

There is evidence supporting the trial court's position that State Farm acted in reckless disregard of the rights of Isaac. Included in the actions taken by State Farm evidencing this reckless disregard is the fact that when State Farm did offer their policy limits of $100,000, the offer was conditioned on a release by Isaac of any bad faith claim that she may have with respect to State Farm's handling of the claim. Clear and convincing evidence existed to form a reasonable basis to present the issue of punitive damages to the jury. 3

The South Dakota Supreme Court reaffirmed this position in Harter v. Plains Ins. Co., Inc. , 4 and the Eighth Circuit Court of Appeals recognized and followed both decisions in Athey v. Farmers Ins. Exchange . 5

In a more recent case, National Insurance Association v. Sockwell , 6 the Supreme Court of Alabama was faced with a similar scenario. In addressing the appropriateness of a $600,000 punitive damage award, the court—citing the trial court's post-trial order—particularly noted the insurance carrier's efforts to obtain a "2-for-1" release from its insured:

Perhaps the most reprehensible conduct was committed by the defendant's claims supervisor, Kathy West, who [was the defendant's representative] at trial. West testified that upon receipt of this lawsuit in March 1999, she reviewed the claim file prepared by Patrice Hawthorne and immediately concluded that the claim had been improperly denied, and should have been paid. Nevertheless, testimony from the attorneys who were handling Sockwell's claim at that time indicated West made an offer of $41,000, and expressly conditioned payment of Sockwell's underinsured motorist claim upon her release and dismissal of the bad faith claim. Such a conditioned offer, when West knew the claim was due to be paid, is evidence of another, separate act of bad faith. 7

Based, in large part, on this evidence, the court affirmed the punitive damage award.

While these cases all specifically involve traditional first-party bad faith situations, their reasoning holds up when applied to other bad faith scenarios under Kentucky law. For example, by conditioning settlement of a claim against its insured upon release of any claims against it, an insurance company could find itself in breach of the implied covenant to exercise good faith in protecting its insured from an excess judgment, as set forth in Grundy v. Manchester Ins. and Indem. Co. (Grundy I). 8In essence, the company would be gambling with the policyholder's money by demanding a release that—more likely than not—the insured has no idea is being sought. This emphasis on self-interest—at the possible risk of exposing the insured to an excess verdict—creates an inherent conflict of interest that should be disclosed to a policyholder, and it exposes the company to a potential common law bad faith suit where none had existed before.

Furthermore, conditioning settlement upon insurer release ”particularly where no bad faith case has been asserted previously” almost certainly constitutes a violation of the UCSPA, opening the insurer up to a potential bad faith suit by the third-party claimant. Most notably, such action would appear to violate KRS 304.12-230(6), which states that an insurer has committed an unfair claims settlement practice by “[n]ot attempting in good faith to effectuate prompt, fair and equitable settlements of claims in which liability has become reasonably clear.” Using settlement of an underlying claim as leverage to dispose of an actual or potential bad faith claim could not be a clearer example of this type of inappropriate behavior.

As a practical matter, an insurance company has no right to condition settlement upon release of a bad faith claim because this issue undoubtedly did not come up during settlement negotiations. Why should it? Settlement of a liability insurance tort case involves a claimant reaching a resolution with a tortfeasor who happens to be a beneficiary of an insurance contract with an insurance carrier. The focus on any settlement discussions would necessarily be on the underlying merits of the tort claim, with the insurer only aiding in its policyholder's defense and indemnifying him for any damages. The insurer's own conduct in handling the claim is a matter that is distinct and separate from whether its policyholder is tortiously at fault for the incident in question. Accordingly, considerations about the insurance company's behavior and any liability for that behavior should never enter into that company's mindset when it comes to settling or evaluating an underlying claim. Why, then, should an insurance carrier be allowed to obtain a release of bad faith claims whenever it settles a liability claim on behalf of its insured when it wasn't bargained for and rightfully wasn't an issue in the first place?

In most cases, this stance is more of a matter of principle than anything else. Unlike the hypothetical that begin this article, rarely, if ever, will an insurance adjuster pull a settlement offer off of the table once you explain to her why you don't release third-party insurers. However, consistently and firmly refusing to release third-party insurers in these cases fulfills a broader purpose by reinforcing their duty to act promptly and in good faith. If every claimant could be leveraged, via settlement, into releasing the third-party insurance company, there never would be any third-party bad faith causes of action brought against insurance companies, no matter how egregious their conduct. This would render the legal duty of good faith as to third-party carriers virtually meaningless. However, refusing to release bad faith claims encourages good faith behavior throughout the entire claims process ”up to and including settlement".

  1. State Farm v. Reeder , Ky., 763 S.W.2d 116 (1988).
  2. Isaac v. State Farm Mut. Auto. Ins. Co. , 522 N.W.2d 752 (S.D. 1994).
  3. Id. at 61.
  4. Harter v. Plains Ins. Co., Inc. , 579 N.W.2d 625, 634 (S.D. 1998).
  5. Athey v. Farmers Ins. Exchange , 234 F.3d 357, 362 (8 th Cir. 2000).
  6. National Insurance Association v. Sockwell , No. 1001627, 2002 WL 399041 (Ala. Mar. 15, 2002).
  7. Id. at *24.
  8. Grundy v. Manchester Ins. and Indem. Co. , Ky., 425 S.W.2d 735 (1968).