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There is a dirty little secret that unsuspecting policyholders don't realize. Because most states insulate insurance companies for bad faith liability in excess of policy limits except for egregious misconduct, insurance companies have no incentive to resolve claims promptly or fairly. Accordingly, insurance companies feel free to lowball their policyholders and drag out claims negotiations until the policyholder, especially individuals and small businesses, give up an settle, often for far less than they are entitled to.

There are ways to prevent this. Policyholders should know that, even without a bad faith claim, they have leverage to get the insurance company to behave properly--full damages for breach of contract that can exceed the limits of the policy.

This double whammy is enough to force many companies into bankruptcy. Even if not "killed," a company in this situation will typically have to forgo opportunities and lose profits as a result of the insurance company's breach. In any coverage action that follows, the insurance company will claim that, whatever the consequences of its breach, its liability is capped by its policy limits.

Thus, insurance companies have a perverse incentive to deny claims. Even if coverage is clearly owed, an insurance company can expect to extract significant concessions if it denies coverage to a policyholder suffering in the wake of a catastrophe. In the best case for the insurance company, the policyholder may simply walk away, either because it does not understand its insurance policy or because it does not have the resources to mount a fight. Even if the policyholder does fight back, it likely will settle for less than what it is entitled to, given litigation costs and risks, never mind the need to get back to focus on its business. Even if the policyholder wins, in most cases, it can expect only to recover what it originally was owed. The threat of extra-contractual recovery for the insurance company's "bad faith" is often of little use both because bad faith awards of damages are not permitted in many states and because, when they are permitted, they are difficult and expensive to win.

Policyholders in such position need to explore the full parameters of contract damages.

First, under black letter law, like any other party who suffers harm from a breach of contract, policyholders are entitled to recover all their damages as a consequence of breach of an insurance policy under Hadley v. Baxendale (1854). This venerable English decision held the damages recoverable for breach of contract are those that arise naturally from the breach, or those that were in the contemplation of the parties at the time the contract was made. Such "consequential damages" can include lost profits or damages for the loss of the business as a going concern, all without regard to insurance policy limits.

Hadley has been accepted and applied by U.S. courts in insurance coverage actions. In Royal College Shop, Inc. v. Northern Insurance Co. (10th Cir. 1990), a fire insurance company breached its insurance policy by failing to pay fire damages to a shoe store, resulting in its permanent closure. In the policyholder's insurance coverage action, the jury awarded both the losses explicitly covered by the policy plus "$175,000 in consequential damages for loss of the business as a going concern."

On appeal, the Tenth Circuit agreed that consequential damages were recoverable in insurance coverage disputes "because consequential damages have traditionally been allowed in breach of contract actions." Next, the court found that a policyholder may recover consequential damages if it demonstrates either that, one, they "may fairly be considered as arising, in the usual course of things, from the breach itself," or, two, that they "may reasonably be assumed to have been within the contemplation of both parties as the probable result of the breach."

As recently as 2008, New York's highest court backed the right of policyholders to consequential damages in Bi-Economy Market, Inc. v. Harleysville Insurance Co.

Second, and more generally, contract damages include all damages suffered as a result of the insurance companies' breach. In Acquista v. New York Life Insurance Co. (N.Y. App. Div. 2001), another New York appellate ruling, the policyholder, a doctor suffering from a blood disorder, sought to recover under several disability insurance policies. His claims were denied. He sued seeking extracontractual damages from the insurance company, on the basis that the company undertook a conscious campaign calculated to avoid payment of his legitimate claims, by, for instance, repeatedly requesting the same information and shifting the file from one claim handler to another.

The court first noted that a policyholder cannot be made completely whole if the remedy for an insurance company's breach of its policy is restricted to policy limits. Accordingly, the court affirmed the principle that the policyholder can recover all of the damages it suffers from an insurance company's breach of contract.

The court, even as it rejected a bad faith tort claim, underscored the need for additional damages in order to level the playing field between policyholders and insurers.

"The problem of dilatory tactics by insurance companies seeking to delay and avoid payment of proper claims has apparently been widespread enough to prompt most states to respond with some sort of remedy for aggrieved policyholders," the judges wrote.

In other words, putting the threat of full contract damages, including forseeable consequential damages, on the bargaining table is an often-overlooked way for policyholders to ensure they get the full benefits of the insurance coverage they purchased.

DOUGLAS CAMERON is a partner and practice group leader of the firmwide Insurance Recovery Group at Reed Smith.

August 16, 2011

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