Sometimes an insurer declines coverage in either a first- or third-party context, and later, a court determines that this declination was in error and that coverage existed. Not infrequently in such circumstances, the policyholder asserts that the insurer did not conduct a thorough investigation prior to the declination and thus breached the implied covenant of good faith and fair dealing.

When an insurer fails to conduct an investigation that would have uncovered facts supporting the possibility of coverage, the insurer may be imputed with knowledge of those facts. Safeco Ins. of America v. Parks, 170 Cal. App. 4th 992 (2009). Interesting questions are presented where, during discovery in the ensuing bad faith litigation, the insurer discovers new facts that tend to support the denial of coverage. In such event, can an insurer rely on these new facts in arguing that its denial was reasonable and in good faith? The law is not entirely clear, and insurers and insureds - not surprisingly - may reach different conclusions.

The Insurer's Perspective

As mentioned above, the penalty for an insurer's failure to investigate is charging the insurer with knowledge of information supporting coverage that it would have discovered had it conducted a more thorough investigation. The arguable logical converse of this is that facts consistent with the insurer's investigation, but undiscovered until litigation on a bad faith claim, should be allowed to support the reasonableness of the insurer's declination. In determining bad faith, the only relevant question for the jury is whether the insurer's "failure to investigate" would have revealed facts triggering its duty only "[w]here an insurer denies coverage but a reasonable investigation would have disclosed facts showing the claim was covered[;] the insurer's failure to investigate breaches its implied covenant." Parks, 170 Cal. App. 4th at 1008.

This line of reasoning holds that, if the insurer would not have learned any additional facts had it conducted a more thorough investigation, then there are no facts to be imputed to it and its decision to deny coverage did not breach the covenant of good faith and fair dealing - regardless of the scope of investigation the insurer actually undertook. Under this logic, as long as the initial determination to deny coverage was reasonable, the insurer has no further duty to investigate. Gunderson v. Fire Ins. Exchange, 37 Cal. App. 4th 1106 (1995).

This reasoning can also be extended to allow insurers to admit later-discovered evidence consistent with the insurer's original denial. What constitutes a thorough investigation is inherently a subjective enterprise. It is often difficult for an insurer to determine when to stop its investigation. It is a better rule to require the insured to bring information to the insurer to prove that its claim is covered under the insured's duty to cooperate. The rigors of litigating a bad faith case will inevitably lead to the discovery of new facts, and these facts (or lack of facts) should be admitted to show that the insurer's original denial was adequate, particularly when the facts later discovered are consistent with the position taken by the insurer in denying the claim. Any other conclusion would simply be punitive to the insurer and would lack the necessary element of causation.

The Policyholder's Perspective

Allowing an insurer to use information it failed to obtain during an investigation, but later learns during bad faith litigation, to attempt to prove that its denial was reasonable would wrongfully give the insurer the benefit of information that it deliberately ignored when it made its coverage decision.

An insurer has a duty to conduct a thorough investigation - considering even facts and coverage theories that the insured has not identified - before it makes its coverage decision. For this reason, the reasonableness of the insurer's decision is determined as of the time it was made, not on the basis of information the insurer later learns. An insurer simply may not base its defense of a bad faith action on information acquired from a subsequent investigation or discovery.

The rule imputing insurers with knowledge of facts that support coverage, but not facts that would tend to show the insurer's coverage decision was reasonable, does not unfairly favor insureds over insurers. It simply judges the reasonableness of an insurer's decision to deny coverage based on the information that the insurer itself determined was sufficient to support its coverage denial without allowing it to ignore facts that support coverage. KPFF v. California Union Ins., 56 Cal. App. 4th 963, 973 (1997).

Allowing an insurer to reap the benefits of an investigation it did not conduct would be both unfair to the insured and encourage the insurer to conduct less than a thorough investigation in the first place. The insurer would know that any evidence - whether actually known to it or not when it makes its coverage decision - would be at its disposal in defense of a later bad faith claim. Insurers should be encouraged - not discouraged - from conducting thorough investigations in good faith before they make their coverage decisions.

Conclusion

A bad faith claim for failure to recognize coverage in first- or third-party contexts requires an examination of the totality of the circumstances of an insurer's denial of an insured's claim. From the insurer's perspective, a case can be made that this analysis allows a court or jury to consider facts that support the insurer's decision to deny coverage, even facts the insurer did not know at the time the decision was made. These facts form part of the circumstances and are relevant in determining whether an investigation was reasonable.

Policyholders, in contrast, can argue that after-acquired evidence should not be admitted in a bad faith, failure-to-investigate case because the only relevant question is whether the insurer's conduct at the time the decision was made was objectively reasonable. While undiscovered bad facts may be admitted to an insurer's detriment, insureds are free to argue that undiscovered facts tending to support the insurer's coverage position should not be admitted to prove that an insurer's investigation was reasonable.

We expect these issues to become more sharply addressed as courts continue to wrestle with the required scope of investigations and application of the genuine dispute doctrine in third-party cases