Kirk v. Mount Airy Insurance , 134 Wash. 2d 558 ( 1998 )

Johnson, J.

The United States District Court, pursuant to RCW 2.60, certified the following question to this court:

Does the holding in Safeco Ins. v. Butler, 118 Wn.2d 383[, 823 P.2d 499] (1992), apply under a policy of professional liability insurance if the insurer fails to provide a defense to the insured in bad faith? If Butler applies, what remedies are available to the insured against the insurer?[¹]

The starting point of our analysis requires us to assume bad faith has been established. The tort of bad faith has been recognized by this court. Safeco Ins. Co. of Am. v. Butler, 118 Wn.2d 383, 393-94, 823 P.2d 499 (1992). This cause of action acknowledges that the business of insurance affects the public interest and that an insurer has a duty to act in good faith. RCW 48.01.030.² The tort of bad faith recognizes that traditional contract damages do not provide an adequate remedy for a bad faith breach of contract because an insurance contract is typically an agreement to pay money, and recovery of damages is limited to the amount due under the contract plus interest. 15A George J. Couch et al., Couch Cyclopedia of Insurance Law § 56:10, at 17 (2d ed. 1983). In order to establish bad faith, an insured is required to show the breach was unreasonable, frivolous, or unfounded. Wolf v. League Gen. Ins. Co., 85 Wn. App. 113, 122, 931 P.2d 184 (1997). Bad faith will not be found where a denial of coverage or a failure to provide a defense is based upon a reasonable interpretation of the insurance policy. Transcontinental Ins. Co. v. Washington Pub. Utils. Dists.’ Util. Sys., 111 Wn.2d 452, 470, 760 P.2d 337 (1988). The failure to defend without this requisite showing does not constitute bad faith, trigger a presumption of harm, or allow coverage by estoppel.

I

The duty to defend arises whenever a lawsuit is filed against the insured alleging facts and circumstances arguably covered by the policy. 7C John Alan Appleman, Insurance Law and Practice § 4681, at 16 (Walter F. Berdal ed., rev. ed. 1979). The duty to defend is “one of the main benefits of the insurance contract.” Butler, 118 Wn.2d at 392. Although an insurer has a broad duty to defend, alleged claims which are clearly not covered by the policy relieve the insurer of its duty. State Farm Gen. Ins. Co. v. Emerson, 102 Wn.2d 477, 486, 687 P.2d 1139 (1984). “The key consideration in determining whether the duty to defend has been invoked is whether the allegation, if proven true, would render [the insurer] liable to pay out on the policy. It is not the other way around.” Farmers Ins. Co. v. Romas, 88 Wn. App. 801, 808, 947 P.2d 754 (1997). The certified question requires us to assume the claim against the insured alleges facts giving rise to the insurer’s duty to defend, and the duty was breached.

The general rule regarding damages for an insurer’s breach of contract is that the insured must be put in as good a position as he or she would have been had the contract not been breached. Greer v. Northwestern Nat’l Ins. Co., 109 Wn.2d 191, 202-03, 743 P.2d 1244 (1987). In the failure-to-defend context, recoverable damages include: (1) the amount of expenses, including reasonable attorney fees the insured incurred defending the underlying action, and (2) the amount of the judgment entered against the insured. Greer, 109 Wn.2d at 202. In Greer, we stated an insurance company that wrongfully refuses to defend an insured’s claim is liable for the amount of the judgment entered provided the act creating liability is a covered event and provided the amount of the judgment is within the limits of the policy. Greer, 109 Wn.2d at 202-03. However, Greer does not resolve the question before us because Greer did not address damages and liability when the insurer refuses to defend in bad faith.

II

The existence of bad faith removes us from the general rule. The certified question does not ask us to resolve a simple breach of contract; rather, we are confronted with the intentional abuse of a fiduciary relationship. The bad faith requires us to set aside traditional rules regarding harm and contract damages because insurance contracts are different. In Butler, under the reservation of rights context, we held there is a rebuttable presumption of harm for an insurer’s bad faith breach of contract. Butler, 118 Wn.2d at 389-90. We are asked whether the rule established in Butler applies to the question before us here.

Although a showing of harm is an essential element of an action for bad faith handling of an insurance claim, we imposed a rebuttable presumption of harm once the insured meets the burden of establishing bad faith. Butler, 118 Wn.2d at 389-90. In Butler, the court broadly stated, “we presume prejudice in any case in which the insurer acted in bad faith.” Butler, 118 Wn.2d at 391. The certified question requires us to assume the insurer acted in bad faith; therefore, we must assume harm.

The rebuttable presumption of harm recognized in Butler stems from the insurer’s duty to act in good faith, which was extensively discussed in Tank v. State Farm Fire & Cas. Co., 105 Wn.2d 381, 715 P.2d 1133 (1986). In Tank, we stated the duty of good faith requires fair dealing and equal consideration for all matters related to the insured’s interests. Tank, 105 Wn.2d at 386. In Tank, we noted a reservation of rights defense provides a valuable service to an insured, but also recognized the potential for abuse if the defense was undertaken in bad faith. Tank, 105 Wn.2d at 390-91. While Tank firmly established an insurer’s heightened obligation to act in good faith, Tank did not address a remedy because we found no breach of this duty.

The presumption of harm recognized in Butler is merely an application of the principle discussed in Tank. The rebuttable presumption of harm applies to the question before us because a bad faith breach of the duty to defend wrongfully deprives the insured of a valuable benefit of the insurance contract, and leaves the insured faced with the difficult problem of proving harm. Without the rebuttable presumption of harm, the insurer could defend its position under the following contract theory—even if there were a duty to defend, our bad faith breach did not cause injury to the insured because ultimate liability was found to be outside the scope of coverage. While the insurer is hable for attorney fees for the breach of the duty to defend under this contract theory, the insured is still confronted with the difficult task of establishing either: (1) that coverage under the policy would have been available, or (2) that liability against the insured would not have been found if the insurer had defended the claim in good faith. The rebuttable presumption of harm must be applied because an insured should not be required to prove what might have happened had the insurer not breached its duty to defend in bad faith; that obligation rightfully belongs to the insurer who caused the breach. Butler, 118 Wn.2d at 390. The disadvantage we sought to prevent in Butler applies equally in this case.³

Ill

Where an insurer acts in bad faith in failing to defend, Butler and other Washington cases recognize that coverage by estoppel is one appropriate remedy. Butler, 118 Wn.2d at 393. The amicus curiae suggests that Butler, and its remedy of coverage by estoppel, was wrongly decided. Amicus argues if a jury or a court find that liability rests outside the scope of coverage, any bad faith on the part of the insurer did not cause harm, and the insurer cannot be found liable. This argument misses the point. The insured and the insurer contracted for insurance. One of the benefits to this insurance contract is that the insurer will provide a defense when a claim arises alleging facts that may be covered by the contract. In this case the insurer breached the contract by failing to provide a defense in bad faith. The insured did not receive the benefit of the bargain, and we assume the insured was harmed by the bad faith breach. We feel it is appropriate to estop the insurer from arguing a coverage defense when the insurer breached the contract in bad faith. In such a situation any claim that should have been defended, but was not, will create liability for the insurer to pay at least policy limits.

Once the insurer breaches an important benefit of the insurance contract, harm is assumed, the insurer is estopped from denying coverage, and the insurer is liable for the judgment. The insurer who in bad faith refuses to acknowledge its broad duty to defend is no less liable than the insurer who accepts the duty to defend under a reservation of rights, but then performs the duty in bad faith.

When dealing with an insurance contract, we cannot focus solely on the contractual aspect of the relationship, and we must take into account the purpose of creating a bad faith cause of action. Butler, 118 Wn.2d at 393-94. The duty to defend is broader than the duty to indemnify, so the duty to defend may be triggered without exposing the insurer to coverage liability. Safeco Ins. Co. of Am. v. McGrath, 42 Wn. App. 58, 61, 708 P.2d 657 (1985). When the insurer breaches the duty to defend in bad faith, the insurer should be held liable not only in contract for the cost of the defense, but also should be estopped from asserting the claim is outside the scope of the contract and, accordingly, that there is no coverage. The coverage by estoppel remedy creates a strong incentive for the insurer to act in good faith, and protects the insured against the insurer’s bad faith conduct. Butler, 118 Wn.2d at 394.

The application of the Butler rule to the present case makes clear the distinction between the legal consequences for a good faith and a bad faith refusal to defend. If we failed to apply the remedy acknowledged in Butler to this question, we would erode any incentive for an insurer to act in good faith. Without coverage by estoppel and the corresponding potential liability, an insurer would never choose to defend with a reservation of rights when a complete failure to defend, even in bad faith, has no greater economic consequence than if such refusal were in good faith. The requirement of acting in good faith cannot be rendered meaningless.

CONCLUSION

In this case, as in Butler, the insurer’s bad faith action creates the need to presume harm and apply the coverage by estoppel remedy. The fact that Butler involved a reservation of rights defense does not prohibit the rules developed in Butler from controlling the answer to this certified question.

Smith, Guy, Madsen, Talmadge, and Sanders, JJ., concur.

1 Order and Certification to the Washington Supreme Court, U.S. District Court (Western), No. C96-1971Z, at 1 (June 26, 1997).

2 RCW 48.01.030: “The business of insurance is one affected by the public interest, requiring that all persons be actuated by good faith, abstain from deception, and practice honesty and equity in all insurance matters. Upon the insurer, the insured, their providers, and their representatives rests the duty of preserving inviolate the integrity of insurance.”

3 The insurer can easily avoid all of these issues by defending with a reservation of rights. When that course of action is taken, the insured receives the defense promised and, if coverage is found not to exist, the insurer will not be obligated to pay.