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New Perspectives on Damages for Breach of Duty to Defend

November 1, 1996

When dealing with insurance bad faith, few areas are more confusing than the scope of damages for various kinds of insurer conduct. This is particularly true with respect to damages for breach of the duty to defend. Most carriers have a knee-jerk approach to the defense obligation, believing that the insured declines a defense at its peril, and if the insurer guesses wrong, it is virtually automatically liable for all contract and tort bad faith damages, including attorney's fees, emotional distress, the underlying verdict (even if in excess of policy limits), economic injury, and even punitive damages. This is not a sophisticated approach, and the case law has developed important distinctions in cases where the insurer has turned down the defense. Note the following scenarios:

The insurer declines to defend the case which it should be defending, but in fact there is no coverage for the ultimate verdict. Is the insurer liable for the verdict, for emotional distress damages of the insured and for other consequential damages as well? Since there is in fact no coverage, is the insurer's liability limited to the attorney's fees incurred by the insured to defend itself in the underlying action? Can there be degrees of "culpability" on the part of an insurer which declines a defense, subjecting an insurer who willfully fails to investigate to a higher measure of damages than the damages imposed upon an insurer which has a "reasonable" (although wrong) basis for its declination of a defense?

Is the rule of "no coverage/no bad faith" universally applied? Can an insurer be held liable for bad faith for failing to defend only, subjecting the insurer to damages not only for attorney's fees but for emotional distress, economic loss, and possibly punitive damages?

The insurer sues its own insured in declaratory relief. Under what circumstances can the insured who wins a declaratory relief action collect attorney's fees from the insurer?

What about the entire issue of attorney's fees in bad faith cases -- when are they recoverable by a victorious insured, if at all.

Are the courts still drawing distinctions between breach of contract damages and tort damages in insurance bad faith cases?

This paper will examine these intriguing questions from the standpoint of the view taken by various jurisdictions. California has developed the most comprehensive case law on damages for an insurer's breach of the duty to defend. Therefore, this paper will utilize the legal framework developed in California for illustrative purposes. Case law from other jurisdictions will then be introduced into the California framework to see how courts across the country deal with these issues. Hopefully this analysis will lend some clarity to what has long been a confusing area.


THE CALIFORNIA FRAMEWORK2

FACTOR ONE: REASONABLENESS STANDARD

In California, once it is determined that there has been a breach of the duty to defend, the first factor to consider is whether the insurer's refusal to defend was reasonable. A reasonable, though erroneous, refusal to defend can lead only to breach of contract damages. Even though an insurer may be wrong in denying coverage, if the insurer has acted reasonably and with proper cause, the insurer can only be liable for breach of contract damages. (Opsal v. USAA (1991) 2 Cal.App.4th 1197, 1205.)

Accordingly, an unreasonable refusal to defend results in bad faith liability. Where the insurer fails to deal fairly and in good faith with its insured, without proper cause, such conduct may give rise to bad faith liability. (California Shoppers, Inc. v. Royal (1985) 175 Cal.App.3d 1, 54.)

California has developed criteria for determining whether the refusal to defend was reasonable or unreasonable. Reasonableness is established if there exists under California law a genuine issue as to the insurer's liability. (Safeco v. Guyton (9th Cir. 1982) 692 F.2d 551,557.) A mere failure to defend does not demonstrate an unreasonable refusal to defend. (California Shoppers, Inc. v. Royal, supra, at 15.) Bad faith requires more than mistaken judgment. (Opsal v. USAA, supra, at 1205.) If there is no coverage under the policy, an insurer's breach of its duty to defend may be deemed reasonable. (Horsemen's Benevolent & Protective Ass'n v. Insurance Co. of North America (1990) 222 Cal.App.3d 816, 822.)

In order to establish bad faith liability, the failure to defend must have been under circumstances or for reasons which the law defines as tortious. (California Shoppers, Inc. v. Royal, supra, at 15.) However, if an insurer's breach of the duty to defend is coupled with a rejection of a reasonable settlement offer within the policy limits, bad faith liability is presumed. (Consolidated American Ins. v. Mike Soper Marine, (9th Cir. 1991) 951 F.2d 186, 190; State Farm v. Allstate (1970) 9 Cal.App.3d 508, 528.)

By way of illustration, the California Shoppers court considered the reasonableness of an insurer's refusal to defend based on a mistake as to the identity of the insured. In this case, the insurer harbored a mistaken belief that a non-party to an action was seeking coverage under its policy on behalf of a named defendant. The insurer had issued policies to both the named defendant and the non-party. However, because the non-party had no exposure to liability since it was not a party to the action, the insurer refused to defend. In reality, it was the named defendant, who had tendered defense on its own policy. The court found that although the failure to defend an insured who is not a party to a lawsuit is a proper basis for declining coverage, the insurer had a duty to make further inquiry regarding the identity of the party tendering coverage. There existed no evidence that the insurer had made a conscious decision to repudiate its duty to defend the proper party. Based on the evidence, the court held that the insurer had constructive notice of the identity of the insured, and therefore had breached its duty to defend. However, the mistake was not in bad faith. (California Shoppers, Inc. v. Royal, supra, at 37-38.)


FACTOR TWO: BREACH OF CONTRACT DAMAGES

The insurer's duty to defend is a contractual undertaking defined by the policy. When the duty to defend an insured exists, the failure of an insurer to accept tender of the defense constitutes a breach of the insurance contract. When such breach is determined to be reasonable, the insured is limited to breach of contract damages. The second factor considers the scope of breach of contract damages.

In California, the scope of damages is dependent upon whether coverage is found under the policy. Having found the insurer in breach of its duty to defend, the burden is on the insurer to prove that no coverage exists under the policy or that the damages can properly be apportioned between covered and uncovered claims.

In dicta, a California court considered apportionment of damages upon the wrongful refusal of an insurer to defend an action against its insured. The court reasoned that any precise allocation would be extremely difficult, but if feasible, it would be the insurer's burden to present undeniable evidence of the allocability of specific expenses. "[T]he insurer having breached its contract to defend should be charged with a heavy burden of proof of even partial freedom of liability for harm to the insured which ostensibly flowed from the breach." (Hogan v. Midland (1970) 3 Cal.3d 553, 564.)

If an insurer can prove that no coverage exists under the policy, its liability for breach of the duty to defend is limited to attorneys fees (plus interest) and consequential damages. Recognizing that attorneys fees and costs are proper items of damage for breach of the duty to defend, such damage is also measured by the consequences proximately caused by the breach. (State Farm v. Allstate (1970) 9 Cal.App.3d 508, 527-8.)

In this area of damage determination, California case law has evolved by limiting the scope of available consequential damages for breach of contract. In 1948, the Supreme Court in Chelini v. Nieri ((1948) 32 Cal.2d 480, 484), determined that "[w]henever the terms of a contract relate to matters which concern directly the comfort, happiness, or personal welfare of one of the parties...he may recover damages for physical suffering...caused by its breach." Ten years later, the Supreme Court stated, "Where there is no opportunity to compromise the claim and the only wrongful act of the insurer is the refusal to defend, the liability of the insurer is ordinarily limited to the amount of the policy plus attorneys' fees and costs." (Comunale v. Traders & General Ins. Co., (1958) 50 Cal.2d 654, 659.) Furthermore, in the recently decided case of Amato v. Mercury Casualty ((1993) 18 Cal.App.4th 1784, 1794), the court after specifically finding no coverage under the policy held that "the proper measure of damages is that amount which will compensate the insured for the harm or loss caused by the breach of the duty to defend, i.e., the cost incurred in defense of the underlying suit."

The scope of consequential damages does not include economic losses since the insurer generally has no way of knowing what financial obligations or resources will be available to the insured when a claim arises and thus, the damages are not sufficiently foreseeable. (California Shoppers, Inc.v. Royal Globe (1985) 175 Al.App.3d 1, 58.) Moreover, the legal fees expended to enforce the insurance contract against the insurer are not recoverable unless the specific insurance policy provides for fees. (CCP §1021) The California Supreme Court has found that in the absence of a contract or statutory provision, an insured has no basis for recovering attorneys fees from an insurer. (O'Morrow v. Borad (1946) 27 Cal.2d 794, 800.)

Therefore, in general, California holds that attorneys fees incurred by the insured in its action to obtain benefits under its insurance policy are not recoverable under a breach of contract theory. Fees expended to win policy benefits are deemed to be a part of the damages proximately resulting from the tort of bad faith. (California Shoppers v. Royal, supra, at 41.) As will be discussed in the next section, when bad faith exists the insured can recover legal fees incurred to prove coverage, but no legal fees are allowed to prove bad faith. (Brandt v. Superior Court (1985) 37 Cal.3d 813, 817.)

If an insurer, after having been found in breach of its duty to defend, cannot sustain its burden of proof on the coverage question, coverage is deemed to exist under the policy. Therefore, in addition to attorneys fees and consequential damages, an insurer is liable for the judgment rendered against its insured up to its policy limits. In California, an insurer is not liable for the amount of judgment exceeding the policy limit where its only wrong is breach of the duty to defend. (State Farm v. Allstate, supra, at 528.)

However, this same Court of Appeal having found coverage under the policy determined that an award for pain and distress was proper under a breach of contract theory. (State Farm v. Allstate, supra, at 527.) Generally damages for emotional distress are not recoverable for breach of contract and a subsequent appellate court reasoned that such damages are not deemed "reasonably contemplated" by the parties when the insurance contract is executed. (Sawyer v. Bank of America (1978) 83 Cal.App.3d 135, 139.)


FACTOR THREE: BAD FAITH DAMAGES

Bad faith liability is based on the insurer's breach of the implied covenant of good faith and fair dealing. Although bad faith claims may sound in tort, the cause of action is rooted in contract law. (Brown v. Guarantee Ins. Co. (1957) 166 Cal.App.2d 679, 681-682.) The covenant of good faith and fair dealing is implied in every contract and obligates each party to refrain from doing "anything which will injure the right of the other to receive the benefits of the agreement." (Comunale v. Traders & General Ins. Co., supra, at 658.) By unreasonably refusing to defend an insured, the insurer has acted in bad faith and is subject to extracontractual liability. The third factor considers the scope of bad faith liability.

Because bad faith claims sound in tort, the measure of damages permitted is more expansive allowing for recovery based on proximate cause. These extracontractual damages are over and above whatever is payable under the contract. Thus, in addition to the cost of defense and indemnity under the policy, bad faith damages include all damages proximately resulting from the insurer's conduct. In California, these damages include attorneys fees to enforce liability against the insurer, emotional distress, financial losses, as well as the entire amount of the insured's liability regardless of the policy limits.

If an insurer's refusal to defend is in bad faith, "the insured is entitled to make a reasonable settlement of the claim in good faith and may then maintain an action against the insurer to recover the amount of the settlement." (Isaacson v. California Ins. Guaranty Ass'n (1988) 44 Cal.3d 775,791.) However, whether the insured's liability is determined through settlement or judgment in a court of law, the question remains whether the injured party's claim is covered. Although the insurer cannot relitigate the merits of the third party claim absent a showing of fraud or collusion between the insured and the injured party, the coverage question remains at issue. (Clemmer v. Hartford (1978) 22 Cal.3d 865,884.) The fact that the insurer refused to defend the original action is no bar to its raising coverage defenses in the later bad faith action. (Ceresino v. Fire Ins. Exchange (1989) 215 Cal.App.3d 814.)

In California, the law has come full-circle and if the insurer can prove that its policy precludes coverage for the claim, then the insurer has negated any presumption of bad faith liability. A bad faith claim against an insurer cannot be maintained unless policy benefits are due. Absent coverage under the policy, the auxiliary implied covenant has nothing upon which to act as a supplement, and should not be endowed with an existence independent of its contractual underpinnings. (McMillin Scripps v. Royal (1993) 19 Cal.App.4th 12, 19.) Even if there was evidence the claim was improperly handled there could be no cause of action for bad faith since the insurer correctly denied the claim. (Bodkin v. State Farm (1989) 217 Cal.App.3d 210, 218.) Where coverage does not exist courts have uniformly rejected the insured's claims of bad faith. (Allstate v. Salahutdin (N.D.Cal. 1992) 815 F.Supp. 1309, 1313.)

Therefore, the only way in which an insurer under California law can be liable for an excess of policy limits settlement or judgment is if the insurer's refusal to defend was in bad faith and coverage exists under the policy. In addition, damage to business or credit is a recoverable economic loss available to an insured who was refused a defense in bad faith. (Tan Jay Int'l, Ltd. v. Canadian Indemnity (1988) 198 Cal.App.3d 695, 704.)

The attorneys fees incurred by the insured in its bad faith suit against the insurer may also be recoverable as an economic loss proximately caused by the insurer's tortious conduct. Fees reasonably incurred by the insured to compel payment of benefits due under an insurance policy are recoverable as an element of compensatory damages in a bad faith action against the insurer. (Brandt v. Superior Court (1985) 37 Cal.3d 813, 817.) However, this amount does not include any fees expended on obtaining amount in excess of the policy such as emotional distress and economic damages. (Brandt v. Superior Court supra, at 817-819.)
Moreover, it is the claimant's duty to segregate such fees so as to prove up damages. (Slottow v American Cas. Co. (1993) 1 Fed.3d 912, 919.)

Emotional distress damages resulting from the denial of coverage and refusal to defend may also be recovered. The assurance of coverage is one of the "benefits of the agreement," therefore emotional distress damages proximately resulting from the bad faith denial of such benefit is recoverable. (Jarchow v. Transamerica Title (1975) 48 Cal.App.3d 917, 948-949.)


FACTOR FOUR: PUNITIVE DAMAGES

Where it is proven with clear and convincing evidence that an insurer is guilty of oppression, fraud or malice, the claimant may recover damages for the sake of example and by way of punishment. (Civ.Code §3294(a).)

Punitive damages are not available in California for breach of the insurance contract, no matter how willful. (Tibbs v. Great American Ins. Co. (9th Cir. 1985) 755 F.2d 1370, 1375.) Rather, the breach must have been tortious; the insurer must be found to have violated the implied covenant of good faith and fair dealing before punitive damages can be awarded. In addition, there must exist clear and convincing evidence that the insurer acted with oppression, fraud or malice. (Civ.Code §3294(a); Silberg v California Life (1974) 11 Cal.3d 452, 462-63.) Therefore, an insurer is at risk for punitive damages only if its refusal to defend is determined to be in bad faith.

In California, if the refusal to defend is found to have been in "conscious disregard" for the insured's rights, punitive damages may be imposed. (Tibbs v. Great American Ins. Co., supra, at 1375.) Punitive damages are recoverable where the insurer "act[ed] with the intent to vex, injure, or annoy." (Neal v. Farmers (1978) 21 Cal.3d 910, 922.) Recently, in Stewart v. Truck ((1993) 17 Cal.App.4th 468), the California Court of Appeal found that evidence that an insurer violated its duty of good faith and fair dealing does not thereby establish that it acted with the requisite malice to justify an award of punitive damages and therefore, the trial court's original nonsuit ruling was upheld. The court found that claimant had not presented evidence that the insurer intended to cause injury in that specific case, or that the insurer's acts constituted despicable conduct carried out in conscious disregard of the claimant's rights.

Tibbs v. Great American ((1985) 755 F.2d 1370) is the one California decision affirming a bad faith punitive judgment based solely on a refusal to defend. After receiving a defense verdict, insured's employee filed suit against its liability insurer, Great American, for bad faith. The employee had appeared in propria persona during the trial because Great American had refused to defend him in a personal injury action. (Tibbs v. Great American, supra, at 1373.)

The court found that Great American's chief in-house counsel believed that the employee was probably entitled to a defense yet conducted little or no investigation into Great American's duty to defend. The court found in particular that the chief counsel had not compared the employee's claim with the insurance company policy or had even inspected the policy itself. The court determined that the employee was covered by the Great American policy. (Tibbs v. Great American, supra, at 1375.)

The court held that Great American's refusal to defend breached the implied covenant of good faith and fair dealing. Chief counsel's failure to consider seriously the opinions of Great American's own staff and to adequately investigate supported a finding of bad faith. The court found that such evidence further supported a finding that Great American consciously disregarded the employee's rights and was therefore guilty of oppression, fraud or malice. (Tibbs v. Great American, supra, at 1375.) The compensatory award of $200,000 and punitive damage award of $600,000 was affirmed. (Tibbs v. Great American, supra, at 1376.)


JURISDICTIONAL SURVEY3

In considering the scope of damages for breach of the duty to defend, a review of case law across the nation may add further insight and refinement to the CALIFORNIA FRAMEWORK developed thus far. With regard to the issues presented in FACTOR (1), the Texas courts give deference to the insurer, while the courts in Illinois give deference to the insured . The courts in New York parallel California regarding many of the issues relating to FACTOR (2). Both Texas and Illinois fail to distinguish between "Coverage" and "No Coverage" when assessing damages relating to FACTOR (3). Finally, regarding FACTOR(4), a court in Texas recently conducted a survey on the subject of punitive damages in bad faith insurance litigation. The following is a synopsis of a jurisdictional survey on these issues. Among the states surveyed and included in the synopsis are Colorado, Illinois, Oregon, New York, Texas, Virginia and Washington.


FACTOR ONE: Texas Expansion and Illinois Retraction

In Colorado, if the insurer's alleged misconduct is in the context of a third party claim, then the standard for bad faith must be characterized by general principles of negligence. (Wheeler v. Reese (1992) 835 P.2d 572, 578.) The issue is whether a reasonable insurer under the circumstances would have denied the benefit under the given facts and circumstances. (Farmers v. Trimble (1984) 691 P.2d 1138.)

This is the general test adopted by California. (Transit Cas. Co. v. Spink Corp. (1979) 94 Cal.App.3d 124, 133.) The test of liability is whether a prudent insurer would have paid the claim. "Imprudent failure of duty is the terminology of negligence law." (Transit Cas. Co. v. Spink Corp. (1979) 94 Cal.App.3d 124, 133.) However, at least two jurisdictions have developed their own distinctive approaches to this issue.

In determining whether an insurer has a reasonable basis for its failure to defend, the courts in Texas give much deference to the insurer. In the field of insurance bad faith, the Texas courts have considered the scope of evidence needed to establish a proper basis for denying a claim. Although the cases deal more generally in the area of first party coverage, an analogy can be drawn for purposes of our risk analysis. The Texas courts have found that an insurer need not prove that its denial was objectively reasonable. Rather, it need only show that there exists some evidence to support the insurer's position which would shield the insurer from bad faith liability as a matter of law.

In National Union v. Hudson Energy Co.,((Tex.Ct.App. 1989) 780 S.W.2d 417), the Texas court held that uncertainty regarding who was actually piloting a small plane and whether the insured had the pilot qualifications which he had represented in his application provided the insurer a reasonable basis for denying the claim.

In State Farm Lloyds, Inc. v. Polasek ((Tex.Ct.App. 1992) 847 S.W.2d 279), the insureds' video rental business was destroyed by a fire. The insureds submitted a claim to their insurer who denied coverage on the basis that the insureds had committed arson. The evidence concerning arson conflicted sharply.

Supporting the insurer's defense was circumstantial evidence showing an incendiary origin, opportunity for the insureds to have started the fire, and their motive for doing so. The court held that the issue in the bad faith case is not whether the factfinder believes the evidence that the insurer believed when it denied the claim; the issue is whether such evidence existed. The court further cautioned that bad faith actions should be reserved for cases of flagrant denial or delay of payment where no reasonable basis existed, and not for mere unreasonable denial or delay. (State Farm Lloyds, Inc. v. Polasek, supra, at 286-287.)

In the context of the duty to defend, the rationale of the Texas courts would support a finding that a failure to defend based on some evidence that no potential for coverage existed would defeat a claim for bad faith. Thus, if an insurer could point to some evidence supporting a theory tending to show that no potential for coverage could exist under the given set of facts, the insured's bad faith claim could not be sustained. A coverage opinion obtained from outside counsel would qualify as such evidence.

While courts in Texas may require as little as the existence of evidence to support a reasonable refusal to defend, and as much as flagrant denial to support an unreasonable refusal to defend, the courts in Illinois find otherwise.

In Illinois, the First Appellate District has determined that the refusal to defend is reasonable only if the insured seeks a declaratory judgment. If the insurer has not done so, it refusal to defend is unjustified. (Reis v. Aetna (1978) 387 N.E.2d 700.) This plainly objective test grants deference to the insured as it does not consider under any analysis the reasonableness of the insurer's position.

Under this approach, in reference to the CALIFORNIA FRAMEWORK, the reasonable refusal to defend standard is sub-divided into "justified" and "unjustified" sub-segments. A justified refusal to defend, where the insurer has sought declaratory relief, would subject the insurer to damages in accordance with the CALIFORNIA FRAMEWORK, while an unjustified refusal to defend would bar the insurer from disputing the question of coverage. Thus, the insurer would be liable for attorneys fees and costs as well as the amount of the judgment up to its policy limits regardless of whether coverage existed under the policy.

The Third Appellate District Court of Illinois found specifically (and contrary to California law) that an honest mistake of the insurer will not serve to justify an insurer's refusal to defend. (Sims v. Illinois Nat'l Casualty Co. (1963) 43 Ill.App.2d 184, 190.) The insurer who through an honest mistake unjustifiably refuses to defend its insured is subject to liability for defense and indemnity up to its policy limits regardless of coverage. (Sims v. Illinois Nat'l Casualty Co., supra, at 197.)

However, the Supreme Court of Illinois had found that a refusal to defend is justified if there exists a conflict of interest between the insured and the insurer. (Thornton v. Ben Paul (1979) 74 Ill.2d 132.) An insurer's right to raise policy defenses of noncoverage is preserved when an insurer's interest in a finding that would preclude coverage conflicts with the insured's interest in a finding of no liability.

In Thornton, the insurer was faced with such a conflict when its insured was sued for assault and battery. If the insurer would have assumed the defense, it would have had the right to control the defense of the case. Its interest would not necessarily lie in a finding of not guilty, but would have been just as well served by a finding that the defendant was guilty since such conduct was excluded by the policy. Here, the court found that an insurer's obligation to provide a defense is satisfied by reimbursing the insured for the costs of defense if it is later determined that the claim was one within the policy covenant to pay. (Thornton v. Ben Paul, supra, at 155.)

Finally, the First Appellate District Court of Illinois has found that if a comparison of the complaint and the policy demonstrates that there is clearly no coverage, the refusal to defend is justified. (Rotunda v. Royal Globe (1980) 87 Ill.App.3d 446, 451.) (Emphasis added.) Here the insurer would not be estopped from late alleging that the insured was not covered under the policy or that there were policy defenses. (Rotunda v. Royal Globe, supra, at 452.)


FACTOR TWO: Jurisdictional Accord and Illinois Independence

As previously discussed, the First and Third appellate districts of Illinois hold that an insurer's unjustified breach of the duty to defend subjects the insurer to liability for the amount of the judgment up to the policy limits regardless of whether coverage exists under the policy. Therefore, the scope of damages for an unjustified breach of contract is the same in Illinois whether or not the policy in fact provides coverage. Washington and New York side with California on this issue finding liability for indemnity only to the extent the policy provides coverage.

In the State of Washington, an insurer's failure to defend a claim ultimately found not to be covered by the policy does not entitle the insured to reimbursement within the policy limits. (Underwriters at LLoyds v. Denali Seafoods, Inc. (1991) 927 F.2d 459, 464.)

According to the Court of Appeals of New York, an insurer who breaches the duty to defend is only liable to the extent of coverage up to the policy limits. (Servidone Construction v. Security Ins. Co. (1985) 64 N.Y.2d 419.) The court reasoned that by holding the insurer liable to indemnify on the mere "possibility" of coverage perceived from the face of the complaint--the standard applicable to the duty to defend--the court would be enlarging the bargained-for coverage as a penalty for breach of the duty to defend, and this it cannot do. (Servidone Construction v. Security Ins. Co., supra, at 424.)

As to the burden of proof, again New York is in accord with California holding that once it is determined that the insurer has breached its duty to defend, and the insured thereafter concludes a reasonable settlement, the burden is on the insurer to establish that the loss was not covered by the policy. (Servidone Construction v. Security Ins. Co., supra, at 421.)

Interestingly, on this issue the First Appellate district of Illinois sides with the insurer. The court placed the burden on the insured to establish how its settlement related to the periods in which coverage was available. (Fidelity & Casualty Co. of New York v. Mobay Chemical Corp. (1992) 625 N.E.2d 151, 159.)

As for the attorneys fees incurred to obtain policy benefits, New York, Illinois, Texas, Colorado and Washington allow the insured to recover such fees under a breach of contract theory contrary to California's position on this issue.

In New York, however, recovery is limited. The only time these fees would be recoverable by the insured in New York is if the insurer brought the declaratory relief action thus forcing the insured into a defensive posture. In such case, the expense of defending the declaratory judgment arises as a direct consequence of the insurer's breach of its duty to defend the tort actions. "Hence, the expense is a compensable damage sustained by insured." (Johnson v. General Mutual Insurance Co. (1969) 24 N.Y.2d 42, 50.)

In Illinois, Texas, and Colorado recovery does not depend on whether the insured is in the offensive or defensive position. An Illinois federal appellate court reasoned that attorneys fees expended for initiating a declaratory relief action against the insurer are consequential damages caused by the insurer's breach. Thus, where an insurer breaches its duty to defend its insured and thereby forces the insured to bear the burden of initiating a declaratory relief action, the insured can recover attorneys' fees incurred from bringing such action. (Green v. J.C.Penney (1986) 806 F.2d 759, 765-766.)

In Texas, appellate courts have found that all reasonable expenses of prosecution of the claim for wrongful refusal to defend, whether by the insured or the claimant-creditor or assignee, including attorneys fees and court costs are recoverable damages for an insurer's breach of its duty to defend. (Texas United Ins. Co. v. Burt Ford Enterprises (1986) 703 S.W.2d 828, 835; Whately v. City of Dallas (1988) 758 S.W.2d 301, 309.)

Likewise, in Colorado, the damages for failure to defend include the attorneys fees and other necessary and reasonable litigation expenses arising from the insured's breach of contract claim filed against its insurer. (Sims v. Transamerica Title (1992) 835 P.2d 565, 572.)

In Washington, the only time attorneys fees incurred in defending a declaratory judgment action brought by the insurer are recoverable is if the insurance policy contains a clause providing for reimbursement of "expenses incurred at the company's request." (Smith v. Ohio Casualty (1984) 678 P.2d 829, 831.)

The Supreme Court of Oregon is in accord with California on the nonavailability of emotional distress damages for breach of contract. The court in Farris v. USF&G ((1979) 587 P.2d 1015), stated the generally accepted rule that emotional distress caused by pecuniary loss resulting from breach of contract is not recoverable. The fact that the insureds were upset and worried over the financial implications of the cost of defense and the payment of any judgment that might be secured against them was not compensable absent a tort cause of action. (Farris v. USF&G, supra at 1016-1017.)


FACTOR THREE: Bad Faith Liability If Coverage And Otherwise

Although California generally holds there can be no bad faith where coverage does not exist, only one state surveyed has specifically addressed bad faith, the absence of coverage and the duty to defend.

In Brenner v. Lawyers Title Ins. Corp.((1990) 240 Va.185, the court concluded specifically that there can be no bad faith in refusing to defend where there is no coverage under the policy. Under this logical approach, the issue of whether a defense obligation arises from a "potential" for coverage is irrelevant. If, in fact, no coverage exists under the policy, an insurer cannot be liable for bad faith failure to defend. If the bad faith allegation is based on the insurer's unreasonable refusal to defend and that refusal is later determined to have been appropriate since no coverage exists under the policy, it reasonably follows that an insurer cannot be liable for bad faith. However, not every jurisdiction approaches this issue so logically.

According to Illinois, damages for bad faith refusal to defend include the full amount of a judgment entered against the insured regardless of policy limits. (Green v. J.C.Penney, supra, at 761.) And as we have seen, since a unjustified refusal to defend results in a policy limit judgment regardless of coverage, a bad faith refusal to defend accordingly results in the full amount of the judgment regardless of coverage.

In Texas, an insurer may incur liability for bad faith even though the policy does not cover the insured's claim. In Republic Ins. Co. v. Stoker ((1993) 367 S.W.2d. 74), the insurer based a denial of uninsured motorist coverage on the erroneous assumption that the insured was more than 50 percent at fault when in fact such coverage was validly precluded because there had been no contact between the uninsured vehicle and the insured's vehicle. The court held that when an insurer's investigation does not include inquiries generally considered essential, or where it applies erroneous standards of fault and liability, the insurer's denial of a claim can be an independent breach of its duty of good faith and fair dealing, even where another reason for denying the claim is later discovered to justify the denial.


FACTOR FOUR: The Texas Survey

As recently as February 2, 1994, the Supreme Court of Texas handed down a decision that clarifies the standards governing the imposition of punitive damages in the contest of bad faith insurance litigation. In Transportation Ins. Co. v. Moriel ((1994) 37 Tex.Sup.J. 450), the court found that Texas law recognizes that a bad faith case can potentially result in punitive damages for intentional, malicious, fraudulent, or grossly negligent conduct.

The Texas court having performed a jurisdictional survey concluded that there is not yet any uniformity among states concerning the proper test for punitive damages in a bad faith case. However, no jurisdiction has a gross negligence standard identical to Texas. Texas allows the imposition of punitive damages when an insurer has acted with such an entire want of care as to establish the act or omission was the result of actual conscious indifference to the rights, safety, or welfare of the person affected. (Transportation Ins. Co. v. Moriel, supra, 1994 Tex. LEXIS 23, 26.)

The Texas court also found that many states including California have raised the evidentiary burden for punitive damages from a "preponderance of the evidence" to "clear and convincing evidence." Colorado specifically requires proof beyond a reasonable doubt. The court concluded, however, that notwithstanding the support in other jurisdictions, the usual preponderance standard would remain the law in Texas. (Transportation Ins. Co. v. Moriel, supra, 1994 Tex. LEXIS 23, 67-70.)


CONCLUSION

Although a liability carrier may refuse to defend a claim which is not covered, declination of the defense is not without risk. Generally speaking, if the insurer has a "reasonable", although mistaken, belief in no obligation to defend, bad faith damages will be limited in most jurisdictions, and the insurer's liability will be confined to the attorney's fees incurred to defend the insured in the underlying action.

However, if the insurer declines coverage, even though it has a reasonable basis for doing so, and is wrong in doing so, and if in fact the policy provides coverage, the insurer runs a serious risk of some bad faith liability.

All jurisdictions require a thorough investigation into the facts surrounding whether a defense should be afforded. This is the best "insurance" for avoiding bad faith exposure. Some states provide that such minimal effort as simply requesting a coverage opinion from outside counsel fulfills this obligation. If the insurer has case law supporting its position, and if the coverage issue is "genuinely debatable", the possibility for avoiding bad faith for refusal to defend are considerably enhanced.

The spectrum of damages in this area ranges all the way from attorney's fees alone incurred in defending the underlying action to traditional bad faith damages for emotional distress, economic injury, other consequential damages and punitive damages. One theme from the case law is clear: the scope of damages is directly related to the culpability of the insurer's conduct. The more culpable the conduct (including the manner in which the insurer handles the declination of the defense), the greater the liability.

Great care must therefore be taken at the initial stage of the litigation when the defense is tendered. The insurer must investigate thoroughly. If it declines the defense, and if its position is supported by credible legal authority, its chances of limiting its exposure to contract damages (attorney's fees in the underlying action), and avoidance of bad faith liability (i.e., tort liability as distinguished from contract liability), are greatly enhanced.