Recently I was discussing bad faith and notice procedures with attorney Phil Loree Jr., an expert on reinsurance and arbitration issues and author of the the Loree Reinsurance and Arbitration Forum blog.  I thought this was a timely conversation as it reinforced the concepts regarding procedures and the potential risks when they are not in place. As with my recent post regarding the breakdown of procedures in a insurance agent’s office, the cost of failing to have proper policies in place was at issue (see my article Failing to document files can be costly).

Phil reminded me of the seminal case of  Unigard Security Insurance Company Inc v. North River Insurance Company 4 F3d 1049 (1993). The case established the rule that an insurance company can be held to have committed bad faith for lack of notice to a reinsurer if there was a showing of recklessness or gross negligence. The court found that the failure to implement a policy to notify reinsurers could be an example of a willful disregard of the risk to the reinsurer and would be considered gross negligence.

Unigard and the proposition of bad faith

A high level of good faith is owed to reinsurers

The Court in Unigard first began by defining the level of good faith owed by an insurer to their reinsurer:

“…the duty of good faith requires the ceding insurer to place the reinsurer ” ‘in the same [situation] as himself [and] to give to him the same means and opportunity of judging … the value of the risks.’ ” [citation omitted] …Nevertheless, because information concerning the underlying risk lies virtually in the exclusive possession of the ceding insurer, a very high level of good faith–whether or not designated “utmost”–is required to ensure prompt and full disclosure of material information without causing reinsurers to engage in duplicative monitoring. [citation omitted]. The question, then, is what good faith requires of a ceding insurer in the notice context.”

The establishment of the bad faith standard

The court continued to establish a standard for bad faith that is differentiated from simple negligence:

“… we do not think simple negligence in not disclosing a material fact constitutes bad faith. … Virtually every material non-disclosure will be the result of at least negligence, and, if bad faith and negligence are equated, no showing of prejudice would ever be required.

We thus think that the proper minimum standard for bad faith should be gross negligence or recklessness. If a ceding insurer deliberately deceives a reinsurer, that deception is of course bad faith.”

Lack of procedures alone can be deemed reckless

With the standard established as gross negligence or recklessness, the court discussed how the failure of implementing proper notification procedures was essentially a reckless act:

“However, if a ceding insurer has implemented routine practices and controls to ensure notification to reinsurers but inadvertence causes a lapse, the insurer has not acted in bad faith. But if a ceding insurer does not implement such practices and controls, then it has willfully disregarded the risk to reinsurers and is guilty of gross negligence. A reinsurer, dependent on its ceding insurer for information, should be able to expect at least this level of protection, and, if a ceding insurer fails to provide it, the reinsurer’s late loss notice defense should succeed.”

To have procedures or not, that is the question

There is an ongoing debate in the insurance industry about maintaining claim policy manuals as a potential risk in a bad faith action. The view is that if you have specific written procedures, and your claims staff does not follow them, then that could be used against them in a bad faith action. Here a court specifically states that failing to have procedures could be considered bad faith in the reinsurance notice situation. Recently, Claims Magazine discussed the very topic in an article by Kevin Quinley, Putting Procedures In Writing (Claims Magazine, 1/5/2010).  I agree with the general proposition from the article:

In terms of bad-faith worries and claim manuals, it is often better to explain one miscue than to tell a judge or jury that the insurer has nothing in writing for claim personnel to use as their guide, and that there are no minimum performance requirements.

Whether in the Unigard example above, or in the recent award against the agent I previously commented on, failing to have procedures or follow them can have a costly outcome. Claim handlers need some kind of guidelines to understand expectations, and to establish a baseline to measure performance. When handlers are trained on good practices, and are measured on those practices for compliance through and internal review or audit program, risks are diminished.

Focusing on good claims practices will not only lower exposure to bad faith, but will help reduce leakage, lower expenses and improve customer service.