The relationship between an insurance company and its policyholder is not simply a commercial transaction — it carries legal obligations of good faith that exist alongside the contractual terms of the policy. When an insurance company fails to meet these obligations — by unreasonably denying a legitimate claim, dragging out claims handling without justification, offering substantially less than a claim is worth without a reasonable basis for the low offer, or otherwise subordinating the policyholder’s interests to the company’s financial interests in an unreasonable way — it may be liable for insurance bad faith. In serious cases, bad faith claims can expose insurers to damages that exceed the policy limits that would otherwise cap the insurer’s liability, making bad faith an important legal concept for policyholders in disputed claims situations.
First-Party vs. Third-Party Bad Faith
Bad faith claims arise in two different insurance contexts. First-party bad faith involves a policyholder’s claim against their own insurance company — a homeowner whose property damage claim is unreasonably denied, a disability insurance claimant whose legitimate claim for benefits is delayed or denied without adequate investigation, or an underinsured motorist (UIM) claimant whose own auto insurer refuses to pay a fair value for injuries that exceed the at-fault driver’s coverage. These first-party situations involve the direct contractual relationship between insured and insurer, which carries express and implied obligations of good faith.
Third-party bad faith arises when an insurer defending its insured against a liability claim fails to act in good faith toward the insured — most critically, when it refuses a reasonable settlement demand within policy limits and exposes the insured to an excess judgment. If a liability insurer rejects a reasonable settlement demand within the policy limits and the case goes to trial resulting in a verdict that exceeds the policy limits, the insured faces personal liability for the excess. The insurer that created this exposure through bad faith failure to settle may be required to pay the entire judgment, including the excess above the policy limits.
What Constitutes Bad Faith
Bad faith does not mean every disagreement about a claim’s value or every claim denial that turns out to be incorrect. An insurer acting in bad faith is typically one that: fails to conduct a reasonable investigation of the claim, denies a claim without a reasonable basis, delays claims handling unreasonably without justification, makes settlement offers substantially below fair value without a reasonable explanation, fails to communicate relevant policy information to the insured, or interprets policy language in an unreasonably narrow way that defeats the policyholder’s reasonable coverage expectations. The distinction between a wrong decision and a bad faith decision is that a wrong decision is one a reasonable insurer might make through legitimate disagreement; a bad faith decision is one no reasonable insurer would make, or one made for improper reasons.
Damages in successful bad faith cases can include the original claim amount, consequential damages that resulted from the insurer’s failure to pay (the medical bills you couldn’t pay because insurance wrongfully denied coverage, the business losses from a delayed commercial claim), emotional distress, and in some states, punitive damages designed to deter egregious insurer conduct. The availability and extent of these extra-contractual damages varies significantly by state, with some states having explicit bad faith statutes that create private rights of action and others addressing bad faith through common law tort principles.