Issue Analysis 89 – A Recipe for Escalating Insurance Premiums: Third-Party ‘Bad Faith’ Liability and the Royal Globe Debacle
In California and several other states, a movement is underway to enact legislation that would allow accident victims to sue the insurance company of the person allegedly responsible for their injuries. In California, the movement is known by the shorthand term, “Royal Globe”—the name of a 1979 state Supreme Court decision that authorized lawsuits of this kind for nearly a decade. The current effort to resurrect Royal Globe-type lawsuits by statute is being led by California’s trial lawyers, who no doubt remember the 1980s as a time when they were able to extract millions of dollars from insurance policyholders thanks to Royal Globe’s “third-party bad faith” rule.
In states such as Texas, where lawsuits of this kind have never been permitted, the proposals are known as “third-party bad faith” bills.1 The idea is to create a new and unprecedented form of insurance litigation by means of a single legislative act. Proponents contend that such legislation is needed to prevent the mistreatment of accident victims by insurance companies who otherwise have little incentive to respond sympathetically to the plight of people who are not their customers.
This, of course, is not the first time that private litigation has been touted as an alternative form of business regulation, prompting skeptics to fret about the unintended consequences of policing economic transactions by means of “adversarial legalism.”2 Nevertheless, an apparent backlash against the trend toward deregulation begun in the 1980s has spawned a renewed interest in litigation among devotees of the regulatory state. As former Labor Secretary Robert Reich has noted approvingly, “The era of big government may be over, but the era of regulation through litigation has just begun. Regulation is out. Litigation is in.”3
In this case, however, it is unnecessary to speculate about the nature or likelihood of the unintended consequences of regulation through litigation. The experience of California between 1979 and 1988—the state’s Royal Globe era—demonstrates conclusively that permitting third-party “bad faith” lawsuits against insurance companies (a) redefines the relationship of insurer to insured, to the detriment of the latter; (b) changes fundamentally the nature of liability insurance; and (c) imposes enormous costs on both insurance companies and consumers. In considering legislation to authorize such lawsuits, policymakers must weigh the costs to consumers of third-party bad faith bills against any potential benefits.
The insurer’s duty. Liability insurance protects policyholders from the risk of being held responsible for someone else’s injury or loss. As with any form of insurance, the cornerstone of liability insurance is the insurance contract—the written agreement between policyholder and insurer that sets forth the rights, duties, and obligations that the parties bear in relation to each other. The standard contract for liability insurance makes three principal demands of the insurer. First, in the event of a claim against the policyholder, the insurer has a duty to defend the policyholder by investigating the claim, and challenging its validity in court if circumstances warrant. Second, assuming the claim is valid, the insurer has a duty to indemnify the policyholder—that is, to reimburse the injured party for losses sustained as a consequence of the policyholder’s conduct. And finally, the contract carries an implicit promise of good faith and fair dealing on the part of the insurer.
Although it may not seem immediately obvious, the insurer’s “duty to defend” is as important to the insurance enterprise as are its duties to indemnify the policyholder and to act in good faith. By defending the policyholder against non-meritorious claims, the insurer preserves both the policyholder’s good reputation before the community, and incidentally, his favorable risk profile. Abrogate the duty to defend, and the policyholder’s premium will escalate as he becomes an easy target for spurious (but uncontradicted) allegations of harmful conduct.
It happened in California. The landmark California Supreme Court case of Royal Globe Insurance Company v. Superior Court of Butte County4 was brought by a woman injured in a “slip and fall” at a food store. She had previously sued to recover damages stemming from the accident, but that matter was not before the Court in Royal Globe. Rather, the justices were asked to decide whether she could bring an additional lawsuit directly against the food store’s insurance company for violating the state Unfair Trade Practices Act, which requires insurers to deal with claimants in good faith.
The Unfair Trade Practices Act gave explicit authority to the state insurance department to investigate complaints of “bad faith” on the part of insurers, and to apply sanctions against violators. Nevertheless, a majority of the justices in Royal Globe felt that this was not a sufficient deterrent. In a decision handed down on March 29, 1979, the Court upheld the validity of private, third-party lawsuits as a means of “enforcing” the bad-faith element of the Unfair Trade Practices Act. In doing so, the Court in effect amended the statute to create a new cause of action that could be brought by any plaintiff pursuing a personal injury claim. As a practical matter, Royal Globe gave trial attorneys enormous leverage over defendants and their insurers. Lawyers representing plaintiffs in personal-injury actions were able to obtain excessive or unwarranted settlements, simply by threatening to bring a second “bad faith” lawsuit for punitive damages against the defendant’s insurance company.
Conflict of interest. Royal Globe’s leveraging effect drove a wedge between insurers and their own policyholders. As noted earlier, the insurance contract obliges the insurer to defend the insured in the course of personal-injury tort litigation. Indeed, a portion of the liability insurance premium pays for the insurer’s representation of the policyholder in the event of a lawsuit. Under the Royal Globe regime, however, an insurer that honored its duty to defend its policyholder was in jeopardy of being sued for bad faith by parties seeking damages from the insured. Some have suggested that plaintiffs would be unlikely to prevail in cases where their attorneys simply equated a vigorous defense of the insured with bad faith toward the claimant—after all, skepticism in the face of a questionable claim is hardly evidence of “bad faith.” But in personal-injury cases, where emotional appeals on behalf of victims are commonplace, the distinction between due diligence and bad faith could be easily disregarded by lay jurors—and often was. The upshot in California was that third-party bad faith liability discouraged insurers from earnestly pursuing their duty to defend their policyholders—to the obvious detriment of the latter.
Inflated settlement demands, increased fraud, and more lawsuits. Plaintiff attorneys took full advantage of Royal Globe’s corrosive effect on insurers’ duty to defend policyholders. Seminars proliferated in the 1980s to teach lawyers how to use the threat of “Royal Globe liability” to increase insurance settlements. The trial bar was quick to catch on. Predictably, the resulting increase in settlement awards and litigation costs led to soaring premiums. In 1978, the bodily injury “pure premium” (the average cost for a bodily injury claim per insured vehicle) in California was $50, which was 156 percent of the 49 state average. By 1988, the California pure premium had increased to $184, or 222 percent of the 49 state average.5
The advent of third-party bad faith liability also served to exacerbate the problem of insurance fraud, a social ill that was already costing consumers dearly. To detect and deter insurance fraud, insurers must make a habit of carefully investigating dubious claims. But the prospect of being hit with a bad-faith lawsuit under Royal Globe created a powerful disincentive to uncover possible instances of fraud. Scam artists responded by committing more and costlier acts of insurance fraud. The Royal Globe doctrine was thus indirectly responsible for a substantial increase in fraudulent and inflated claims during its nine-year tenure.
Royal Globe overturned. In addition to forcing excessive settlement demands and increasing insurance fraud, third-party bad faith liability fueled an increase in the rate of lawsuit filings, and ultimately in premiums. According to a series of reports issued by the California Judicial Council, lawsuits over automobile bodily injury claims nearly doubled during the Royal Globe era. Citing these factors as well as Royal Globe’s shaky legal foundation, the California Supreme Court reversed itself in 1988 and overturned the Royal Globe decision. Both claim costs and the rate of litigation quickly fell to pre-Royal Globe levels, causing premiums to decrease as well.
Recent research has confirmed the existence of a positive and statistically significant relationship between Royal Globe-type doctrines and automobile insurance premiums. According to an econometric analysis performed by economist William G. Hamm, the presence in a state of a “weak” Royal Globe-type doctrine—defined as one that requires plaintiffs to demonstrate that an insurer violated the state’s bad-faith law as a general business practice—was associated with an average increase in automobile liability insurance premiums of approximately 6.4 percent, compared to states without third-party lawsuit doctrines, after controlling for other factors. Today, Florida, Massachusetts, Montana, and West Virginia have weak third-party lawsuit doctrines.
The effect on premiums is even more dramatic when a state adopts a “strong” third-party lawsuit doctrine—which requires plaintiffs merely to demonstrate a single violation of the state’s bad faith law. Kentucky currently has a strong third-party lawsuit doctrine, as did California during the Royal Globe era. In these circumstances, premiums increase by approximately 14.5 percent.6 Since Californians currently spend approximately $8.8 billion on automobile liability insurance premiums, reimposition of some form of the Royal Globe doctrine could therefore result in increased costs of between $560 million (under a “weak” state model) and $1.3 billion (under a “strong” state model).7
The present danger. Today, as thoughtful citizens and policy-makers have increasingly come to recognize that excessive litigiousness is a significant obstacle to increased prosperity, trial lawyers and their political allies would turn back the clock to the heyday of adversarial, lawyer-driven insurance settlement practices. If they succeed, the result will be higher insurance costs for millions of consumers. Moreover, the erosion of the insurer’s contractual duty to vigorously defend policyholders against questionable third-party liability claims will permanently alter the relationship between liability insurers and their customers, so that policyholders will be more vulnerable than ever to frivolous and non-meritorious damage claims. At the same time, organized insurance-fraud rings, already a scourge in California and other states, will see their fortunes rise as insurers come to regard aggressive fraud-detection efforts as hazardous to their bottom lines.
1Currently, five states—Florida, Kentucky, Massachusetts, Montana, and West Virginia—have laws authorizing third-party bad faith lawsuits similar to those permitted in California under Royal Globe.
2See Robert A. Kagan, “Adversarial Legalism and American Government,” in Marc K. Landy and Martin A. Levin, eds., The New Politics of Public Policy (Johns Hopkins University Press, 1995), pp. 88-118.
3Quoted in Tony Mauro, “Legal scholars defend concept,” USA Today, February 11, 1999, p. 6A.
423 Cal.3d 880, 153 Cal.Rptr. 842, 592 P.2d 329 (1979).
5William G. Hamm, “The Economic Effect of the Royal Globe Doctrine in California,” (report prepared for Californians For Affordable Insurance Rates, April 14, 1999), p. 6.
6Ibid. p. 8.
7Ibid. p. 10.
