Study Shows Unintended Consequence of 1st-Party Bad Faith Liabiity

Bad faith remedies designed to protect insurance consumers from unfair claim settlement practices can potentially harm consumers, warns a new report published by the National Association of Mutual Insurance Companies (NAMIC).

The report, “First-Party Insurance Bad Faith Liability: Law, Theory, and Economic Consequences,” co-authored by Dr. Sharon Tennyson of Cornell University and Dr. William Warfel of Indiana State University, shows that bad faith liability laws designed to deter insurers from engaging in unfair claim handling practices often have the effect of increasing claim costs and, ultimately, increasing premiums for consumers.

The report traces the evolution of first-party insurance bad faith law and discusses various approaches that have been taken by courts and state legislatures. It identifies a number of potential adverse effects of excessive or uncertain first-party bad faith liability claims on insurance markets and analyzes insurance claims data to investigate the empirical importance of these effects. The analysis suggests that allowing tort liability for insurance bad faith results in reduced insurer incentives to challenge disputable claims and, hence, in higher claim costs.

The authors conclude that certain features of legislation recently enacted in several states, most notably, Washington;”will create incentive distortions that may lead to greater uncertainty and higher costs for insurers, higher levels of insurance fraud, and correspondingly higher insurance premiums for consumers.”

“The report clearly demonstrates that a combination of lax standards for proving bad faith and excessive damage awards are likely to produce negative consequences for insurers and policyholders,” said Robert Detlefsen, NAMIC’s vice president, public policy.

The report’s conclusions are based on a multi-state empirical analysis of uninsured motorist auto insurance claims data. That analysis indicates that claim payments are significantly higher in states that allow tort actions for insurer bad faith in claims settlements, Detlefsen explained.

“This report should serve as a warning to state lawmakers considering expansions of first-party bad faith remedies,” Detlefsen said. “Damage amounts that are too high and evidentiary standards that are too lax may encourage policyholders to file illegitimate claims and may discourage insurers from questioning claims that may be potentially illegitimate, leading to undetected fraudulent claims and higher claims costs, which leads inevitably to higher premiums.”

Source: NAMIC