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By Joseph J. Sheehan
Aggressive investigation of suspect claims can save insurers millions of dollars that might otherwise be paid out to arsonists, thieves and other scam artists. Yet such investigations can raise tricky issues and, if not handled properly, create a risk of bad faith liability if conclusive evidence of fraud is not uncovered. Insureds can claim that they suffered emotional distress or other damages because they were falsely accused of criminal or fraudulent activity, or harassed by investigators, or had their privacy invaded, or because the insurer failed to settle third party claims against them. It is important for insurers to understand the legal standards that apply in this area, and conduct their investigations accordingly.
Insurers regularly confront several key issues in connection with suspect claims: how strong must the evidence of fraud or other grounds be before the insurer is justified in denying the claim; what must the insurer do, or not do, in investigating the suspected fraud to avoid potential bad faith liability; and when is the insurer justified in delaying resolution of a claim in order to conduct further investigation? This article discusses the legal principles that bear on these issues.
In virtually every jurisdiction, there is no liability for bad faith if there is no coverage. See, eg., California Shoppers, Inc. v. Royal Globe Ins. Co., 175 Cal. App. 3d 1 (1985). Thus, if the insurer successfully exposes and defeats the fraudulent claim, it ordinarily will be insulated from liability for bad faith (though not necessarily for separate misconduct, such as improper surveillance).
The problem occurs if the insurer shoots and misses, ie., denies a claim as fraudulent (or for related reasons, such as material misrepresentations by the insured), but ultimately is unable to persuade a fact finder that the claim is not valid. In these cases, there is definite potential for a “bad faith” claim, ie., a claim for extra-contractual damages in excess of policy limits. The insurer can be liable, for example, for damages for emotional distress, based on an alleged breach of the covenant of good faith and fair dealing, even if the insurer did not engage in any outrageous conduct. Gruenberg v. Aetna Insurance Co., 9 Cal. 3d 566 1973).
Of course, at the outset of the suspect claims investigation, the insurer frequently does not know for certain whether the claim is fraudulent, or what evidence of the fraud it will be able to uncover. Even at the conclusion of the investigation, the insur whether a judge or jury will find its evidence of fraud persuasive. Thus, it is important for insurers always to handle suspect claims with an eye on preventing possible bad faith liability if fraud cannot be proven.
Suspect claims can be first party claims (eg., fire at a home or business, theft of property, uninsured motorist) or third party claims (eg., auto accident, slip and fall). Most jurisdictions do not allow third party claimants to assert “bad faith” causes of action against the insurer. The focus here is therefore on potential bad faith liability to insureds, in the context of first party claims.
In almost every jurisdiction, where a first party claim is fairly or reasonably debatable, an insurer that denies the claim cannot be liable for extra-contractual “bad faith” damages, even if it turns out that the denial was incorrect. See, eg., Hanson v. Prudential Ins. Co., 783 F.2d 762, 766 (1986)(California law). However, even if the grounds for denying benefits is theoretically tenable, the insurer is not insulated from bad faith liability where reliance on the defense is grossly unreasonable and simply a shield to avoid payment of benefits. Gourley v. State Farm Mutual Auto. Ins. Co., 217 Cal. App. 3d 1111 (1990).
When an insurer reasonably concludes, based on the evidence developed during the investigation, that the insured perpetrated or participated in the loss, it is entitled to deny the loss on this basis, even if there is no “smoking gun” proof of the insured’s guilt. E.g. Harrison v. Nationwide Mutual Fire Ins. Co., 580 F. Supp. 133, 134 (E.D. Pa. 1983); Watson v. State Farm Fire & Casualty Co., 461 N.E. 2d 57, 58 (Ill. App. 1984); Conti v. Republic Underwriters Ins. Co., 782 P.2d 1357, 1362 (Okla. 1989).
In Harrison, for example, the investigation revealed that the fire at the plaintiff’s home was intentionally set, that there was no forcible entry into the home, and that plaintiffs were suffering financial difficulties at the time of the fire. The Court held under these circumstances the insurer had reasonably suspected the plaintiffs of knowledge of or responsibility for the arson and could not as a matter of law be held liable for emotional distress damages.
One critical responsibility of the insurer in the claims process is to conduct a thorough investigation and base its decision on all of the reasonably available evidence. This includes an obligation to inquire fully into any evidence that might support the claim. E.g., Egan v. Mutual of Omaha Ins. Co., 24 Cal. 3d 809, 819 (1979), cert. den. 445 U.S. 912 (1980). Thus, for example, it is a breach of the covenant of good faith and fair dealing for an insurer to fail to interview a witness identified by the insured as materially supporting his claim. Frommoethelydo v. Fire Insurance Exchange, 42 Cal. 3d 208 (1986). However, the lengths to which the insurer must go are not unlimited, but ableness. For example, where the in-house adjusters have familiarity with analyzing the financial data relevant to a claim, the insurer has no obligation to consult with an independent accountant. Cabell Elec. Co. v. Pacific Ins. Co., 655 F. Supp. 625, 629 (S.D. Miss. 1987).
In conducting its investigation, the insurer must be even-handed. Frommoethelydo v. Fire Insurance Exchange, 42 Cal. 3d 208, 214 (1986) (“insurer must give at least as much consideration to the interests of its insured as it gives to its own interests”). In addition, of course, the insurer must avoid engaging in any conduct that is illegal, tortious, or deceptive. Thus, for example, surveillance cannot be conducted in a manner that violates the prohibitions on intercepting or recording communications, or involves conduct that constitutes an invasion of privacy, infliction of emotional distress, or trespass. See, eg., Teague v. Home Insurance Co., 168 Cal. App. 3d 1148 (1985)(insurer liable for illegal entry into the plaintiff’s garage or vehicle during the course of surveillance); Noble v. Sears, Roebuck & Co., 33 Cal. App. 3d 654, 660 (1973)(insurer liable for unauthorized entry into plaintiff’s hospital room). Active deception of the plaintiff by the investigator also can create liability. See, eg., id. (obtaining witness address by trickery); Unruh v. Truck Insurance Exchange, 7 Cal. 3d 616 (1973) (enticing plaintiff into romantic liaison and rough physical activity). Similarly, any unfair structuring of medical tests or doctoring of records to lead to a particular result is improper. Younan v. Equifax, Inc., 111 Cal. App. 3d 498 (1980).
One interesting issue is the extent to which an insurer, in denying a claim as fraudulent, is entitled to rely on information that would not be admissible in evidence in a court proceeding. Courts have developed extensive evidentiary rules to delineate what testimony, documents or other items are admissible at trial. Although these rules are based largely on the perceived reliability of the proffered items, it does not necessarily follow that these same rules would apply to limit what an insurer can rely on in denying a claim. Rather, the ultimate test should be reasonableness.
For example, an insurer may be entitled to rely on results of a polygraph examination, even though they would be inadmissible at trial. Moss v. Nationwide Mutual Ins. Co., 493 N.E.2d 969,972 (Ohio App. 1985). A number of other courts similarly have held that insurers may rely on inadmissible evidence, at least as long as the denial is not solely based on such inadmissible evidence. E.g. id.; Britton v. Farmers Ins. Group, 721 P.2d 303, 316 (Mont. 1986). However, the insurer should not hinge its decision on unreliable information, as that would be unreasonable. A good guiding principle is whether an ordinary reasonable person would rely on such information in making decisions about a matter of importance in their work or personal life. See Frommoethelydo v. Fire Insurance Exchange, 42 Cal. 3d 208 (1986)(insurer entitled to rely on witness statement where no reason to believe witness is lying).
One special issue that comes up frequently concerns the legitimacy of relying on information pertaining to the ethnic backgrounds of the insured, claimants, and witnesses. It is not legitimate, and could be grounds for a finding of bad faith, for an insurer to rely on stereotypes in denying a claim. For example, an insurer may have had many fraudulent claims asserted by members of a particular ethnic group; but it cannot properly reject the claim of a particular insured of that ethnic group, or discount the insured’s credibility, for that reason. That would be stereotyping and failing to evaluate the particular claim on its own merits.
On the other hand, consideration of common ethnicity of many participants in a claim can be valid in some circumstances. For example, where a resident alien from Ghana claims to have been involved in an accident with another person who is claimed to be a total stranger, and that other person also is a resident alien from Ghana, and the location and circumstances of the accident do not suggest any particular reason for aliens from Ghana to have been congregating in that particular area, the insurer may be entitled to consider the statistical probability of such a chance encounter by two residents from Ghana. In one case handled by the author’s firm, we presented expert testimony on such an issue and obtained a defense verdict at trial.
In many respects, the claims investigation process is a mini-trial conducted by the insurer. The insurer’s job is to evaluate the claim, which means evaluating the evidence, similar to how a jury evaluates the evidence at a trial. Clearly, the insurer ought to be able to weigh the evidence and make the same sort of evaluative judgments as a jury, so long as it does so fairly and impartially. The insurer needs to exercise extra care in this area, however, as its fairness and impartiality can be impugned on the grounds of its financial interest in denying a claim.
In order to reinforce that it is acting fairly and impartially in assessing the claim, the insurer should provide the insured with the opportunity to present any and all information in support of the claim, and to explain if possible any negative evidence developed by the insured, before finally deciding on the claim. See, eg., McCormick v. Sentinel Life Ins. Co., 153 Cal. App. 3d 1030. However, the insurer should have reasonable discretion with regard to the timing of such disclosures, based on the possibility that the insured otherwise might alter his testimony to conform to what the insurer has uncovered. Once complete statements have been taken from the insured and any witnesses, and the evidence otherwise pinned down, it can be a good idea to provide the tentative findings to the insured and allow the insured to respond. This will help protect the insurer from a subsequent claim that it did not consider all available evidence or interpret it properly.
Where there is strong evidence of fraud, the insurer can and probably should indicate this in a tentative denial letter to the insured and allow him to respond. In such circumstances, the insurer need not feel compelled to beat around the bush. As long as the letter goes only to the insured, there cannot legally be a defamation, as there is no “publication” to a third party. Moreover, in most jurisdictions, the insurer is legally obligated to explain the basis for denial to the insured. Where this is the case, there almost always is a defense of privilege to any claim that the insurer defamed the insured or caused emotional distress by allegations in the claim denial letter that the insured had engaged in some wrongful conduct such as arson, conspiring to stage an accident, lying about the manner or extent of the loss, etc.
Indeed, the courts have recognized that the insurer not only can cite the fraud or other misconduct of the insured in the denial letter, but also is entitled to report the insured to the authorities. Frommoethelydo v. Fire Insurance Exchange, 42 Cal. 3d 208 (1986)(rejecting claim that there was inadequate investigation prior to report to authorities on grounds that duty to report takes precedence over duty to investigate); Cummings v. Farmers Ins. Exchange, 202 Cal. App. 3d 1407, 1423 (1988). Where there is a statutory duty to report insurance fraud, the report is absolutely privileged so long as the information provided is accurate and complete, and even if the information is inaccurate, there is no tort liability unless the insurer acted with malice. Frommoethelydo v. Fire Insurance Exchange, supra.
The case of Frommoethelydo v. Fire Insurance Exchange, 42 Cal. 3d 208 (1986), is an excellent illustration of many of the principles discussed above. In that case, the insured’s home was burglarized, and allegedly certain stereo equipment was stolen. The insured presented what purported to be paperwork from the store showing purchase of the equipment prior to the burglary. However, the date on one document was written by hand, and the date on the other document was obliterated. An investigator for the insurer interviewed the salesman and sales manager of the store, but apparently not the cashier or credit manager. The sales people said that the insured had bought the equipment on a date after the burglary and asked for the backdated receipt, stating that he wanted to take the equipment abroad and avoid custom duties. The employees said that had provided the backdated receipt. Search of the store records showed no record of any transaction when the insured claimed to have purchased the equipment.
A recorded statement of the insured was scheduled, but one day before this, the insurer reported the suspected fraud to the Bureau of Fraudulent Claims. The insured walked out in the middle of the statement, claiming the questions were hostile and he was confused. The insurer then sent the insured a letter informing the insured about the information obtained from the store employees and asking the insured to return for questioning and bring any other documentation. Although the insured completed the examination, the claim was denied for lack of verification and fraud.
As a result of the insurer’s report, the insured was arrested and prosecuted for insurance fraud. After a time, however, the case was dismissed. Thereafter, the insured’s attorney informed the insurer about some new witnesses who could allegedly corroborate the insured’s purchase of the stereo equipment. The insurer did not interview these witnesses and declined to pay any money on the claim.
The insured then sued for bad faith and obtained a jury verdict of $250,000 for emotional distress and $1.25 million in punitive damages. This was reversed on appeal. The Court held as a matter of law that the report to the Bureau was privileged under the circumstances, that there was no malice by the insurer in making the report, and that the investigation by the insurer prior to the report was not inadequate. The Court also held, however, that it was a violation of the covenant of good faith and fair dealing for the insurer to fail to interview the new witnesses presented by the insured after the criminal dismissal, and remanded for trial on that issue. Frommoethelydo is an instructive case that should be reviewed by all SIU adjusters.
In conclusion, insurers handling suspect claims should:
1) investigate them diligently and thoroughly;
2) at all times act reasonably;
3) afford the insured a full opportunity to provide information supporting the claim and respond to the negative evidence;
4) evaluate the claim fairly and impartially based on reliable evidence; but
5) having done all that, not shrink from denying the claim where the investigation establishes it likely is fraudulent.
Joseph J. Sheehan is a partner in the law firm of Del Tondo & Sheehan, Los Angeles, California.
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