This is one of a series of articles under the by line “Butler Pappas on Bad Faith” originally published in Mealey's Litigation Report: Insurance Bad Faith Vol. 18, #16 (December 21, 2004). © Copyright Butler Pappas 2004.

I.   Preface

Business considerations, specifically unpredictable claim volume, has increased the use of Third-Party Administrators (“TPAs”) and Independent Adjusters (“IAs”) to investigate, adjust, and even deny claims. It is not unusual these days for TPAs and IAs to be given settlement and even denial authority with essentially no insurer oversight or ratification. What are the possible consequences of such “out-sourcing?” More importantly, how can an insurer protect itself against such consequences?

For the last 35 years extra-contractual damages exposure resulting from insurer “bad-faith” has shaded every claim adjustment and litigation settlement. This shadow of “bad-faith” is ubiquitous.

All “bad-faith” is defined by the insurer's conduct. Insurers have spent millions of hours and hundreds of millions of dollars training and educating their employees so as not to commit “bad-faith.” Such large bureaucracies have created even larger bureaucracies to provide oversight and supervision to prevent against such “bad-faith” conduct from occurring. All this has evolved as a result of the effect “bad-faith” claims have in the increased settlement value of insurance claims. Good-faith claim handling is good business. Therefore, profit-seeking insurers are willing to spend million of dollars and million of hours to ensure that its employees handle claims in good-faith.

How much time, however, do such prudent insurers spend ensuring that their TPAs and IAs are properly trained to handle their insureds' claims in good faith? Do such insurers invite the TPAs and IAs to their in-house/training programs? What information is provided to the TPA and IA to ensure that they are fully informed as to the insurer's claim standards in the investigation and adjustment of its insureds' claims? How is the ethical culture of claims handling developed over many years within an insurer's claims department transferred to the TPAs and IAs? What hierarchy is established to provide oversight, supervision, and checks and balances over the conduct of the TPAs and the IAs in the investigation and adjustment of the claims submitted to the insurer? What does the insurer require from the TPA and IA, if anything, in order to be allowed to adjust its insureds' claims? Does the insurer's inquiry and requirements go no farther than rate and capacity?

II.   The Non-Delegable Duty Of Good-Faith

In order to understand the significance of these questions, it is essential to acknowledge the following fact: The insurer is responsible for the adjustment of its claims.

The Supreme Court of Oklahoma in the case of Wathor v. Mut. Assur. Administrators, 87 P. 3d 559 (Okla. 2004) held that a “special relationship” exists between an insurer and its insureds stemming from the quasi-public nature of insurance. This Court found that there was an unequal bargaining power between insurer and insured, and the potential for an insurer to unscrupulously exert that power at a time when the insured is particularly vulnerable. Most importantly, the Supreme Court of Oklahoma found that this special relationship creates a non-delegable duty of good faith and fair dealing on the part of the insurer. This non-delegable duty means that an insurer cannot escape it by delegating tasks to third parties, such as TPAs and IAs. An insurer cannot avoid liability for breach of the duty of good faith and fair dealing by delegating its responsibility to an independent contractor. This law is essentially universal throughout our country.

In the case of Hale v. F.A. Richard & Assocs., Inc., 756 So. 2d 1261 (Ct. App. La. 2000), a Louisiana Appellate Court found that the insurer's nonperformance of its insurance contract, even when such nonperformance results from the delegated decision-making authority of its TPA, remains the insurer's responsibility and obligation. See also Baugh v. Parish Government Risk Mgmt. Agency, 715 So. 2d 645 (Ct. App. La. 1998). Moreover, Louisiana Stat. § 3036(b) states that “It shall be the sole responsibility of the insurer to provide for competent administration of its programs.” Other states have similar statutes. See, Missouri Stat. § 376.1084(2) (“It is the sole responsibility of the insurer to provide for competent administration of its programs.”); W. Virginia Code § 33-46-7(b) (“It is the sole responsibility of the insurer to provide for competent administration of its programs.”); and N. Carolina Gen. Stat. § 58-56-26(b) (“It is the sole responsibility of the insurer to provide for competent administration of its programs”).

Simply put, an insurer cannot shield itself from “bad-faith” extra-contractual exposures by delegating claims handling to third-parties. In fact, such out-sourcing may actually increase such exposures.

III.   The Law Of Agency

Moreover, there is a second essential fact to understand: The conduct of such third parties and independents in the investigation, adjustment, and denial of claims under the law of agency is imputed to the insurer. See, Elfstrom v. New York Life Ins. Co., 432 P. 2d 731 (Cal. 1967). The conduct of the TPA or IA is, even if wrongful and unknown to the insurer, deemed to be the conduct of the insurer. The insurer's extra-contractual exposures are wholly dependent upon the competence of its independent vendors. See generally, Richard K. O'Donnell, Imputation of Fraud and Bad Faith: The Role of the Public Adjuster, Co-Insured and Independent Adjuster, 22 Tort and Ins. Law Journal 662, Summer 1987.

The scenario is precarious. Insurers increasingly have thousands of TPAs and independents dealing directly with their insureds and claimants in the investigation, adjustment, and decision-making concerning its claims. Such conduct is imputable to the insurer. That is, if these agents commit “bad-faith” it is deemed as if the insurer has committed “bad-faith.” This is so even if the insurer had no knowledge of such conduct. In fact, arguments can and have been made that the insurer's failure to supervise the conduct of its TPAs and IAs sufficient to detect that “bad-faith” conduct in time to terminate or correct it, is itself evidence of the insurer's “bad-faith” against its insured.

Thus, by definition, insurers may face substantial exposure to “bad-faith” claims arising from the conduct of others over which it has little control. Ironically, “control” that the insurer intentionally “out-sourced” to better manage its costs. Of course this costs “justification” simply feeds the “bad-faith” claim. The argument goes that the carrier sacrificed its insured to increase its profit-margin. What can insurers do to mitigate such exposures?

IV.   Preventive Maintenance

First, insurers can establish a protocol providing some checks, balances, supervision, and oversight over the TPAs and the IAs on a claim by claim basis. Obviously, the more the oversight, the less the business benefit to the “out-sourcing” itself. Presumably, the greater the oversight, the less the risk of “bad-faith” exposure. This is a cost-benefit analysis and a business decision that each insurer must make dependent upon the proven competence of their TPAs and IAs and their past and present relationship. Note, most TPAs and IAs do an excellent and ethical job in the adjustment of insurance claims. If they didn't, they wouldn't be in business very long. But also note, sadly, in our litigious society, the fact that someone does their job well and honestly does not preclude them from being sued – especially for “bad-faith.”

Second, an insurer can mitigate these exposures with an agreement between the insurer and the TPA or the IA. Such an agreement should be in writing and should be enforceable under the laws of the particular state in which the claims are being adjusted. Subject to those laws, the agreement should provide that the TPA and IA will indemnify the insurer for any and all damages the insurer suffers as a result of the negligence or wrongful conduct of the TPA or IA. This agreement should specifically encompass “bad-faith” consequential damages, as well as punitive damages. Moreover, once again, if the local law allows, the agreement should obligate the TPA or IA to pay for and provide a defense to the insurer against such “bad-faith” actions against the insurer that are based upon the conduct of the TPA or IA, whether or not such claims have merit. Of course, the predicate to such an agreement would be to ensure that the TPA and IA have sufficient insurance coverage to provide for a full defense and full indemnification, including any possible punitive damage award. Settlement authority should remain in the control of the insurer.

Even assuming the above protective safeguards are taken, “bad-faith” claims against an insurer based upon the conduct of the insurer's TPAs and IAs is problematic. First, the lawsuit is typically against the insurer, not the TPA or IA. The judgment will be against the insurer. The publicity will be against the insurer. The use of such a judgment in other claims will be against the insurer. These are consequences that no defense and indemnification agreement can cure.

Notwithstanding such precautions, there is a pragmatic problem in the settlement of such claims. Typically the TPA or IA will contend that they did nothing wrong and therefore no settlement should occur. The insurer, on the other hand, even if it agrees with the TPA or IA, in an attempt to avoid the negative publicity and the possible “run away jury verdict” may choose to settle the claim, sometimes for a substantial amount. The TPA and IA then argue, however, that they are not liable for such settlement dollars, in that the insurer was not liable for those dollars because the TPA and IA did nothing wrong. Through the course of such a litigation the TPA and IA will object to any settlement, believing that the insurer will still settle the claim, yet that TPA or IA may still maintain its non-liability for such damages. On the other hand, the insurer, although wanting to resolve a claim on a compromised basis, may find itself pressed to try the case in order to ensure that it is fully indemnified by the TPA or IA.

Many headaches can be avoided, and many business relationships sustained, if insurers, TPAs, and IAs put considerable thought into their written agreements addressing how such possible claims against them will be handled, who will be responsible for what, and exactly how their differences will be resolved.

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