The Effect of Bad-Faith Laws on First-Party Insurance Claims Decisions

Abstract

This Article represents the first empirical study of the effects of bad-faith laws on claims decisionmaking by insurance companies. One of the most notable and debated developments in the law of tort and insurance since the 1970s has been the recognition in many states of an extracontractual cause of action against insurers for the bad-faith denial of a claim filed by an insured for benefits allegedly due under the policy. We examine whether the existence of this remedy affects the amount, timing, or allocation of payments to insureds made in the “shadow of the law” of bad faith. We drew on the 1992 closed claims database developed by the Insurance Research Council compiling thousands of closed claims under automotive insurance policies by over 60 insurance companies. These claims include many categories of payments; we concentrated on claims for uninsured motorist coverage (UM) or underinsured motorist coverage (UIM) because these are categories of “first-party” insurance to which the extracontractual bad faith remedy applies in states that allow such a remedy. Although a majority of states recognizes a remedy for bad faith, 15 states within the IRC database did not recognize bad faith claims. Thus, by controlling for other variables that could affect payment - including significance of injury, tort reform measures, attorney involvement, and others - we could determine whether the existence of a bad faith remedy affects the timing, amount, or allocation of insurance payments for UM or UIM claims. The study shows that the presence of a bad faith remedy is tied to higher claims payments for claims. In addition, the higher overall settlements apply both to the economic and to the noneconomic aspects of the damages underlying the claims. Further, and somewhat surprisingly, we found that bad faith laws are associated with a greater increase in settlement amounts when plaintiffs are not represented by an attorney.

Keywords: bad faith, insurance

JEL Classification: K13, K41