The insurance relationship is contractual, but when policyholders claim insurers failed to honor their obligations, they typically invoke the tort of "bad faith." When courts try to explain this anomaly, they cite features of insurance making it uniquely important that parties respect each other's interests. Courts often say these features make the duty of good faith "reciprocal." Twin City v. Country Mutual Insurance, 23 F.3d 1175, 1180 (7th Cir. 1994); Charter Oak Fire Insurance v. Blue Sky Partnership, 2001 WL 1178318 (Conn. Super. Aug. 30, 2001). But this reciprocity has its limits because courts typically will not permit insurers to assert a tort claim for consequential damages based on a policyholder's breach of that duty. State Auto Property & Cas. v. Hargis, 785 F.3d 189 (6th Cir. 2015); Kransco v. American Empire, 2 P.3d 1 (Cal. 2000).

This imbalance warrants another look, because recent developments provide policyholders with new ways to prejudice their insurers' interests. Several courts have held that a reservation of rights divests an insurer of control over settlement. E.g.,Babcock & Wilcox v. American Nuclear Insurers, 76 A.3d 1 (Pa. 2015). Where an insured fails to cooperate in its defense, therefore, the insurer confronts the Hobson's choice of either (a) issuing a reservation, and thereby forfeiting the ability to block a collusive settlement; or (b) assuming full responsibility for an impaired defense. Several courts have also found novel bases for establishing a breach of the insurer's duty to defend, see, e.g., World Harvest Church v. Grange Mutual Casualty, 2013 WL 6843615 (Ohio Ct. App. 2013); Great Divide Insurance v. Carpenter, 79 P.3d 599 (Alaska 2003), and they have done so at a time when the penalties for breach of that duty are increasing.Employers Ins. of Wausau v. EHLCO Liquidating Trust, 186 Ill.2d 127 (1999) (breaching insurer estopped from asserting coverage defenses). Insureds that have previously laid traps for bad faith, such as time-limited demands, will now seek to manipulate insurers into alleged breaches of the duty to defend.

In these contexts, the possibility of recovering consequential damages from the insured would not just afford relief for actual policyholder bad faith; it could also restore the strategic balance between the parties as they jockey for position during the course of defending a claim.

Wood v. Lady Duff-Gordon, 222 N.Y. 88 (1917), introduced the idea that all contracts contain an implied covenant of good faith and fair dealing, which imposes substantive obligations not expressly stated in the contract. In Hilker v. Western Auto Insurance, 204 Wis. 1 (1930), this idea was used to impose liability for an excess judgment, based on the insurer's failure to investigate or attempt to settle a claim against its insured. As the concept migrated to the first-party context, courts spoke of "a cause of action in tort for breach of an implied covenant." Gruenberg v. Aetna Insurance, 9 Cal.3d 566 (1973). Eventually, states created statutory claims for "bad faith" or "unfair claim settlement practices"; these claims sound in tort and they generally allow insureds to recover consequential damages.

Because the duty of good faith is "reciprocal," insurers have occasionally been permitted to pursue bad-faith claims against policyholders. E.g., Sargent v. Johnson, 551 F.2d 221 (8th Cir. 1977); Endurance American Specialty Insurance v. Lance-Kashian & Co., 2010 WL 3619476 (E.D. Cal. 2010). But even these courts have explicitly rejected the idea that insurers have a "reciprocal" right to recover tort-style consequential damages. Kransco v. American Empire, 2 P.3d at 9 ("the insured's duty of good faith … and the remedies available to the insurer … are fundamentally and conceptually distinct from the insurer's reciprocal duty. … An insured's breach of the covenant is not a tort").

The theoretical barrier preventing insurers from recovering consequential damages has a flaw: consequential damages sometimes are available for breach of contract. The rule goes back to Hadley v. Baxendale, 9 Exch. 341 (1854), which held that contract plaintiffs may recover such damages "as may reasonably be supposed to have been in the [parties'] contemplation … at the time they made the contract, as the probable result of … breach." In 2008, New York's Court of Appeals applied the same formula in holding that an insured could recover consequential damages from an insurer for its alleged bad-faith denial of a business-interruption claim. Bi-Economy Market v. Harleysville, 10 N.Y.3d 187 (2008).

In New York, unlike most states, "there is no … cause of action in tort for an insurer's bad faith." Burkhart, Wexler & Hirschberg v. Liberty Insurance Underwriters, 859 N.Y.S.2d 901 (N.Y. Sup. Ct. 2008). Consequently, Bi-Economy created a route to consequential damages that had previously been closed, one which policyholders have eagerly traversed. E.g., Mutual Association of Administrators v. National Union Fire Ins. Co. of Pittsburgh, 2012 WL 4752439 (N.Y. Sup. Sept. 17, 2012) (financial burden of defending third-party claim allegedly destroyed insured's business after insurer breached duty to defend).

In this case, however, there is no theoretical barrier to insurers' following the same route, by arguing, for example, that the cost of litigating over a collusive settlement is a kind of harm that "may reasonably be supposed to have been in the [parties'] contemplation" when the policyholder expressly agreed not to settle without the insurer's consent.

In Kvaerner U.S. v. Kemper Environmental, 2006 WL 3064104 (W.D. Pa., Oct. 26, 2006), the court declined to dismiss insurer's claim for attorney fees based on collusive settlement. In Utica Mutual Insurance v. Century Indemnity, 2015 WL 4254074 (N.D.N.Y. May 11, 2015), the ruling allowed a reinsurer's claim against a primary insurer for fees and costs, based on an allegedly collusive settlement. The court in Fon v. Amica Mutual Insurance, 24 Mass. L. Rep. 1 (Mass. Super. Ct. 2008), allowed a claim for attorney fees based on an insured's submission of a fraudulent claim. And in Ohio National Life Assurance v. Davis, 803 F.3d 904 (7th Cir. 2015), the court ruled that the insurer could recover the cost of defending breach-of-contract claims from defendants who had purchased life insurance policies on the secondary market in connection with a conspiracy to defraud the insurer.

Consider the policyholder whose actions or demands in connection with the defense of a third-party claim potentially violate the duty to cooperate. Even if the insurer is reluctant to reserve its rights, for fear of losing control over the settlement, it can still argue that the litigation costs attributable to the policyholder's conduct are recoverable under a breach-of-covenant theory as a foreseeable consequence of the insured's bad faith. By asserting this position, the insurer can raise the potential cost of intransigence for the insured.

Some jurisdictions that refuse to allow insurers to sue policyholders in tort nevertheless allow an affirmative defense based on the insured's "bad faith." For example, in Kim v. Allstate, 153 Wash. App. 339 (Nov. 24, 2009), the court ruled that the insured's bad faith negated a bad-faith claim against the insurer.

Where courts choose not to recognize the affirmative defense, they often rely on the same reasoning they use to reject a tort of reverse bad faith. E.g., Wailua Assocs. v. Aetna Cas. & Surety, 183 F.R.D. 550 (D. Hawaii 1998). But other decisions suggest the affirmative defense might be a kind of consolation prize for the rejected tort. Bowlers' Alley v. Cincinnati Insurance, 2015 U.S. Dist. LEXIS 70090 (E.D. Mich., May 31, 2015) ("Although the failure to cooperate in the adjustment process may support the [insurer's] affirmative defenses, it will not provide a basis for affirmative relief").

These cases provide another reason for asserting that the insured's bad faith injured the insurer in ways that were foreseeable when the contract was made. Even if the argument falls short, it might still create a basis for reducing the insurer's exposure.

Connecticut has the building blocks for reverse bad faith. Insurance contracts contain implied covenants of good faith and fair dealing. Capstone Bldg. v. Am. Motorists Ins., 308 Conn. 760 (2013). Moreover, in Cifatte v. Utica First Insurance, 2014 WL 5099382 (Conn. Super. Sept. 5, 2014), the court, quoting 44A Am.Jur.2d, Insurance, §1737 (2014), wrote: "Consequential damages resulting from breach of [the] covenant of good faith and fair dealing may be asserted in the insurance contract context, so long as the damages were within the contemplation of the parties as [a] probable result of breach at the time of or prior to contracting."

On the other hand, Connecticut's view of what the duty of good faith actually requires is rather narrow. As the Capstone decision stated: "[V]iolations of express duties are necessary to maintain a bad faith cause of action." Accordingly, not every case of policyholder misconduct will present an opportunity to assert "reverse bad faith." But the theory is sound, and the right case is almost certain to come along soon. •

Republished with permission by the Connecticut Law Tribune.

Co-Authored by Joseph J. Blyskal