Lawyers Guide to Insurance Bad Faith Claims

In the course of the last several years, Mike Abourezk and the Abourezk Law Firm have been involved in numerous insurance bad faith cases, including Bergonzi v. Central States Health and Life Company of Omaha (settled for $20 million dollars) and Torres v. Travelers' Insurance Company (verdict: $12 million) and others. As a result of these efforts, we have briefed and argued most of the issues that are typically encountered in insurance bad faith actions. The following article is a series of excerpts from those briefs, organized into applicable topic areas. We hope that this article will help when you litigate insurance bad faith cases.

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II. NATURE OF INSURANCE BAD FAITH LAW

A. South Dakota Supreme Court Cases

Bad faith insurance law is premised on the legal principle that there is an implied covenant of good faith and fair dealing in every insurance contract that prohibits either party from preventing or injuring the other party's right to receive the benefits of the contract. See Trouten v. Heritage Mut. Ins. Co., 632 N.W.2d 856, 862(S.D. 2001). A claim for bad faith is an action in tort and is wholly separate from the contractual claim for policy limits. Champion v. United States Fidelity&Guaranty Co., 399 N.W.2d 320, 322-23 (S.D. 1987).

In 1969, the South Dakota Supreme Court discussed a legal principle that established a standard for insurer good faith conduct. In Kunkel v. United Security Ins. Co. of New Jersey, 168 N.W.2d 723 (S.D. 1969), the Court recognized that "the insured's interests must be given 'equal consideration' with those of the insurer, or as it is often expressed 'at least equal consideration.'" Id. at 726 (emphasis added), citing Farmers' Insurance Exchange v. Henderson, 82 Ariz. 335, 313 P.2d 404 (Ariz 1957); Brown v. Guarantee Ins. Co.,155 Cal. App. 2d 679, 319 P.2d 69, 66 A.L.R. 2d 1202 (Cal. App. 2 Dist.1958). See also Trouten v. Heritage Mut. Ins. Co., 632 N.W.2d at 864.

Later, in Champion v. United States Fidelity&Guaranty Co., 399 N.W.2d 320 (S.D. 1987), the Court adopted a two-prong test to prove bad faith. That test required: (1) the absence of a reasonable basis for denial of policy benefits and (2) the knowledge or reckless disregard of a reasonable basis for denial. In explaining the test, the court emphasized that a claim must be properly investigated and subjected to reasonable evaluation and review:

"It is appropriate, in applying the test, to determine whether a claim was properly investigated and whether the results of the investigation were subjected to a reasonable evaluation and review...."

Id. at 323-24, quoting Travelers Ins. Co. v. Savio, 706 P.2d 1258, 1275 (Colo.1985).

The Court elaborated further:

" Implicit in that test is our conclusion that the knowledge of the lack of a reasonable basis may be inferred and imputed to an insurance company where there is a wreckless disregard of a lack of a reasonable basis for denial or a wreckless indifference to facts or to proofs submitted by the insurer."

Id. at 324 (emphasis added).

It also stated:

"Under these tests of the tort of bad faith, an insurance company, however, may challenge claims which are fairly debatable and will be found liable only where it has intentionally denied (or failed to process or pay) a claim without a reasonable basis."

Id. In that same year, the Supreme Court held:

"[a] covenant is implied in an insurance contract that neither party will do anything to injure the rights of the other in receiving the benefits of the agreement. This covenant includes a duty to settle claims without litigation in appropriate cases."

Helmbolt v. LeMars Mut. Ins. Co., Inc., 404 N.W.2d 55, 57 (S.D. 1987) (emphasis added) (citations omitted).

In Helmbolt, the Supreme Court emphasized that an insurer did not give equal consideration to the interests of insureds when it forced the insureds "to endure the rigors and uncertainties of trial." Id. at 58.

Subsequent Court decisions have affirmed the bad faith test described in Champion and reinforced the principle that insurers who fail to fairly and adequately investigate insurance claims are acting in bad faith. In Walz, the Court held:

Whether Insurer acted in bad faith in conducting an inadequate investigation or failing to review case law is a question of fact for the jury. Isaac v. State Farm Mut. Auto. Ins. Co., 522 N.W.2d 752, 758 (S.D. 1994) (citation omitted). The issue is determined based upon the facts and law available to Insurer at the time it made the decision to deny coverage. Id. ...Isaac instructs us to look not only to the facts, but also to the law available to the insurer at the time it made the decision to deny coverage. (emphasis added).

Walz v. Fireman's Fund Ins. Co., 556 N.W.2d 68, 70-71, citing Isaac v. State Farm Mutual Insurance Co., 522 N.W.2d 752, 758 (S.D. 1994); see also Harter v. Plains Ins. Co., 579 N.W.2d 625 (S.D. 1998); Sawyer v. Farm Bureau Mutual Ins. Co., 619 N.W.2d 644 (S.D. 2000).

In 1997, the Court added new language to the bad faith test adopted in Champion. It stated: "[F]or proof of bad faith, there must be an absence of a reasonable basis for denial of policy benefits [or failure to comply with a duty under the insurance contract] and the knowledge or reckless disregard [of the lack] of a reasonable basis for denial . . .". (emphasis added). Julson v. Federated Mut. Ins. Co., 562 N.W.2d 117, 119 (S.D.1997). The addition of the words "or failure to comply with a duty under the insurance contract" is significant. It means that bad faith can involve circumstances where a claim was not actually denied--circumstances where an insurer failed to comply with a duty to an insured under the insurance contract.

In Trouten v. Heritage Mut. Ins. Co., the Court held that a third-party beneficiary to a commercial general liability insurance policy could not be sued for insurance bad faith. Despite this conclusion, Trouten is noteworthy because the Court acknowledged the disparity that exists between insurer and insured: "Furthermore, the relationship of insurer and insured is inherently unbalanced; the adhesive nature of insurance contracts places the insurer in a superior bargaining position." 632 N.W.2d at 863, quoting from Egan v. Mutual of Omaha Ins. Co., 24 Cal.3d 809, 169 Cal.Rptr. 691, 620 P.2d 141 (1979). Specifically, the Court said:

As one commentary has noted, "The insurer's obligations are ... rooted in their status as purveyors of a vital service labeled quasi-public in nature. Suppliers of services affected with a public interest must take the public's interest seriously, where necessary placing it before their interest in maximizing gains and limiting disbursements.... [A]s a supplier of a public service rather than a manufactured product, the obligations of insurers go beyond meeting reasonable expectations of coverage. The obligations of good faith and fair dealing encompass qualities of decency and humanity inherent in the responsibilities of a fiduciary. Insurers hold themselves out as fiduciaries, and with the public's trust must go private responsibility consonant with that trust."

Id.

The quasi-public status of insurers is particularly apparent in worker's compensation and automobile insurance coverages such as uninsured motorist(UM) and underinsured motorist insurance (UIM). Of course, the public service aspect of insurance is not limited to these types of insurance.

B. South Dakota Statutes

As indicated below, a number of South Dakota statutes dictate an insurance company's responsibilities to its insureds. Some of these statutes are as follows:

1. Unfair Trade Practices

S.D.C.L. § 58-33-67 defines "Unfair or deceptive practices in dealing with insured." Subsection (1) of the statute requires insurers to acknowledge and act within thirty days upon communications with respect to claims. Therefore, it is an unfair practice and a violation of South Dakota statute for an insurance company to fail to answer letters and phone calls seeking payment of a claim. Under this subsection, an insurer must adopt and adhere to reasonable standards for the prompt investigation of claims. S.D.C.L. § 58-33-67 (1).

Subsection (3) of the statute provides that it is an unfair practice and a violation of South Dakota statute for an insurance company to fail to give a prompt and reasonable explanation of the basis for denial of a claim or a compromise settlement. S.D.C.L. § 58-33-67 (3).

Under Subsection (4) of the statute, it is an unfair practice and a violation of South Dakota statute when liability has become reasonably clear under one portion of the insurance policy coverage to influence settlements under other portions of the insurance policy coverage. S.D.C.L. § 58-33-67 (4).

There is no private right of action under the Unfair Trade Practices Act. S.D.C.L. § 58-33-69. However, there are numerous cases that say that these statutes help define industry standards or practices and can be admitted into evidence for that purpose. See, e.g., Ingalls v. Paul Revere Life Ins. Co., 561 N.W.2d 273(N.D. 1997); Walston v. Monumental Life Ins. Co., 923 P.2d 456 (Idaho1996).

2. Uninsured and Underinsured Motorist Insurance

S.D.C.L. § 58-11-9 provides that no motor vehicle liability insurance policy may be issued in South Dakota unless uninsured motorist coverage is provided. The statute provides in pertinent part:

No policy insuring against loss resulting from liability imposed by law for bodily injury or death suffered by any person arising out of the ownership, maintenance, or use of a motor vehicle may be delivered or issued for delivery in this state with respect to any motor vehicle registered or principally garaged in this state, ..., unless coverage is provided therein ... for bodily injury or death equal to the coverage provided by such policy for bodily injury and death, for the protection of persons insured thereunder who are legally entitled to recover damages from owners or operators of uninsured motor vehicles and hit-and-run motor vehicles because of bodily injury, sickness, or disease, including death, resulting therefrom.... (emphasis added).

S.D.C.L. § 58 11 9.4 specifies that no motor vehicle liability insurance policy may be issued in South Dakota unless underinsured motorist coverage is provided. S.D.C.L. § 58 11 9.4 provides in pertinent part:

No motor vehicle liability policy of insurance may be issued or delivered in this state with respect to any motor vehicle registered or principally garaged in this state,..., unless underinsured motorist coverage is provided therein at a face amount equal to the bodily injury limits of the policy. (emphasis added).

Since S.D.C.L. § 58-11-9 and S.D.C.L. § 58 11 9.4 are intended to protect motorists from the losses attributable to uninsured and underinsured drivers, an insurer's bad faith handling of these claims can thwart public policy.

3. Worker's Compensation

In cases involving worker's compensation, there are a number of statutes that establish an insurer's responsibilities to an injured worker. For instance, S.D.C.L. § 62-5-20 provides that the insurer will pay the entire cost of the employee's loss and then seek reimbursement from the insured employer for the amount of the deductible.

S.D.C.L. § 58 20-4 provides that every policy of worker's compensation insurance, issued or delivered in South Dakota by an authorized insurer, will cover separately and for a separate consideration, all the liabilities which are imposed upon an insurer by the provisions of the title "Worker's Compensation."

Under S.D.C.L. § 58-20-5, every policy of worker's compensation insurance will cover the entire liability of the employer to his employees covered by the policy or contract.

S.D.C.L. § 58-20-6 provides that no worker's compensation insurance policy will be issued unless it contains an insurer's agreement that it will promptly pay to the person entitled to compensation all installments of the compensation that may be awarded or agreed upon. Under the statute, the insurer's obligation will not be affected by any default of the insured after the injury. The agreement will be construed to be a direct obligation by the insurer to the person entitled to compensation, enforceable in his name.

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III. INSTITUTIONAL BAD FAITH

A. Generally

There are two different types of evidence in bad faith claims. The first type involves only the actions of the claims personnel and seeks to show that their actions were outrageous and caused damage to the plaintiff. The second type of evidence is called "institutional bad faith." "Institutional bad faith" is a corporate philosophy, implemented in a series of procedures, that emphasizes minimizing insurance claims to the detriment of policyholders. In a law review article tracing the evolution of bad faith law in South Dakota, Professor Baron of the University of South Dakota discussed "institutional bad faith." He "noted that a larger sphere of 'institutional bad faith' appears to be evolving-situations where insurers can invoke broad policy decisions (such as knocking off a few extra dollars for charges being in excess of 'reasonable and customary' charges) and those insurers remain relatively secure in generating significant across-the-board gains in the bottom line, without ramification or adverse litigation." Rodger M. Baron, When Insurance Companies Do Bad Things: The Evolution of the "Bad Faith" Causes of Action in South Dakota, 44 S.D. L.Rev. 471, 491 (1998/1999).

B. Institutional Bad Faith Case

Hawkins v. Allstate Insurance Co., 733 P.2d 1073 (Ariz. 1987), is an example of an institutional bad faith case. In Hawkins, the Arizona Supreme Court upheld a $3.5 million punitive damage verdict in a bad faith action against Allstate, where the actual damages to the individual plaintiff were less than a few thousand dollars. In fact, the punitive damage award was based largely on actual damages of $35.

The proof in Hawkins involved evidence that, in every case of "total loss" to an automobile, Allstate had instructed its claims adjustors to deduct $35 from the payment of the claim as a "cleaning fee," without regard to whether the car was clean to begin with. The company taught the adjustors that deductions like this would rarely be contested by individual customers, because it was such a small amount of money, but that taking this deduction over and over again in thousands of claims would generate millions of dollars to the company. The Arizona Supreme Court upheld the jury verdict of $3.5 million in punitive damages.

C. Insurer Policies and Practices

In order to understand Hawkins and cases like it, it is helpful to examine the underlying insurer policies and practices that create institutional bad faith. An insurance company sets various types of financial goals for the payment of claims and devises ways of tracking these goals. Then the company tracks what percentage of claims are successfully denied or closed without payment. Insurer goals are expressed in a number of ways:

(1.) In the reporting of financial information such as combined loss ratios¹ of claims that are closed without payment;

(2.) In communications between the home office, regional and other staff that discuss goals;

(3.) In performance evaluations that measure employees' achievement of company goals, rewarding them when goals are met with bonuses, promotions or salary increases;

(4.) In reports from supervisors to their employees; and

(5.) In company training materials, newsletters, videotapes, and other publications distributed to help employees achieve these goals.

D. Rule of Equal Consideration

Of course, there is nothing illicit in the setting of financial goals and strategies in the context of ordinary business management. However, a problem occurs when these strategies are used by companies handling fiduciary-like transactions-insurance transactions. Fiduciary transactions are governed by different rules. As explained above, the first rule of conduct governing insurance transactions is that a company will give at least equal consideration to the interests of the claimant. Kunkel v. United Security Ins. Co. of New Jersey, 168 N.W. 2d at 726.

Courts have condemned the setting of insurance company goals when they affect the payment of claims. For instance, in Albert H. Wohlers and Co. v. Bartgis, 969 P.2d 949(Nev. 1999), the Nevada Supreme Court upheld a finding of bad faith because of a direct pecuniary interest in optimizing the insurer's financial condition by keeping claims costs down. When an insurer knowingly communicates goals to its employees that conditions them to minimize claims, that violates the rule requiring an insurer to give equal consideration to an insured's interests. Evidence of insurer goals that adversely affect the payment of claims establishes knowledge in a bad faith action.

E. Overcoming Insurer "Mistake" Defense

Of course, even when there are clear acts of institutional misconduct, the habitual insurer response is that the insurer "made a mistake" or "did not mean to wrongfully deny the claim." To rebut these claims, a plaintiff must show either: (1) a pattern of misconduct-that it happens all the time, or (2) that the insurer's conduct demonstrated an overarching intent that focused on denying or minimizing claims payments. Generally, discovery in a bad faith action will explore the insurer's policies or practices that involve institutional bad faith.

¹"Combined ratio" is the amount of claims paid plus loss adjustment expenses divided by premiums.

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IV. EQUAL CONSIDERATION

A. South Dakota Cases

As discussed above, a basic principle of bad faith insurance law is that an "insured's interests must be given 'equal consideration' with those of the insurer, or as it is often expressed 'at least equal consideration.'" Kunkel v. United Security Ins. Co. of New Jersey, 168 N.W.2d at 726. In Helmbolt v. LeMars Mut. Ins. Co., 404 N.W.2d at 58, the South Dakota Supreme Court held that an insurer could not "ignore its duty of good faith for the purpose of protecting its own interests." Thus, an insurer acts in bad faith when it fails to give equal consideration to the interests of its insured.

B. Other Jurisdictions

Other jurisdictions have agreed, explaining the duty of equal consideration that insurance companies owe to their policyholders. For instance, in Egan, the California Supreme Court held: "For the insurer to fulfill its obligation not to impair the right of the insured to receive the benefits of the agreement, it again must give at least as much consideration to the latter's interests as it does its own. Egan v. Mutual of Omaha Ins. Co., 169 Cal. Rptr. at 695 (citations omitted). In another California bad faith case, the court concluded: "an insurer's conduct is judged based, on whether, given the circumstances, the insurer unreasonably withheld benefits due under a policy. That conduct is unreasonable if inconsistent with placing the insured's interests above those of the insurance company and its stockholders." McCormick v. Sentinel Life Ins. Co., 200 Cal. Rptr. 732, 739 (Cal. App. 2 Dist. 1984).
In Tank v. State Farm Fire and Casualty Co., 105 Wash.2d 381, 386, 715 P.2d 1133, 1136 (1986), the Washington Supreme Court held:

Thus, an insurance company's duty of good faith rises to an even higher level than that of honesty and lawfulness of purpose towards its policyholders: an insurer must deal fairly with an insured, giving equal consideration in all matters to the insured's interests. (emphasis in original).

In Rawlings v. Apodoca, 726 P.2d 565(Ariz. 1986), the Arizona Supreme Court said:

...the evidence supports the conclusion that for its own profit Farmers breached its duty to play fairly with its insureds and to give their legitimate interests equal consideration. Those legitimate interests of the insureds arose out of the very event against which Farmers sold protection.

Id. at 573.

In that case, the court aptly noted: "It does, however, entitle the insured to insist that, to serve its own interests, the insurer not provide the promised protection with one hand while destroying the very objects of the relationship with the other." Id. at 571.

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V. GOOD FAITH INVESTIGATION AND MEDICAL INFORMATION

In the guise of "medical cost containment, " insurers have established goals to deny or minimize medical claims. These goals are implemented through medical claim review procedures that are performed either by medical providers, insurance company personnel or third-party vendors. Often, the insurer will order an independent medical examination (IME), which is conducted by a medical provider who has an ongoing relationship with the insurer and whose reports typically favor the insurer. At other times, medical claim reviews may be conducted by an insurance company employee whose performance is measured by the employee's ability to reduce medical costs. Also, medical utilization review companies, whose sole objective is to cut medical costs for their clients, are used by insurers.

A. Insurer Consideration of All Available Information

Frequently, an insurer will disregard proof of a claimant's medical injury and expenses, including proof furnished by a claimant's treating physician. However, courts have held that good faith and fair dealing require an insurer to consider all relevant medical information when investigating an insured's claim. For instance, in Athey v. Farmers Ins. Exchange, 234 F.3d 357 (8th Cir. 2000), a South Dakota diversity case, the Eighth Circuit Court of Appeals concluded there was sufficient evidence to support the jury's verdict of bad faith and punitive damages. Relying on South Dakota law, it found that there was ample evidence that the insurer had ignored proofs of losses incurred by the insured.

In another insurance bad faith case, a California court found that the insurer had failed to conduct any investigation whatsoever even though the information was readily available from the insured's doctor. In McCormick v. Sentinel Life Ins. Co., 200 Cal. Rptr. at 742, the court said:

Here, Sentinel likewise failed to investigate the claim by consulting with McCormick's treating physician. Although presumably one phone call to the doctor would have supplied the omitted information Sentinel offers no explanation for why it did not offer this course of action.

See also Egan v. Mutual of Omaha Ins. Co., 169 Cal. Rptr. 691 (Cal. 1979) (failure of a disability insurer to properly investigate insured's claim by having insured examined by a doctor of their choice or by consulting with insurer's treating physician was bad faith).

In Mariscal v. Old Republic Life Ins. Co., 50 Cal. Rptr.2d. 224 (Cal. App. 2 Dist. 1996), the court found that the insurer's failure to seek evidence when an automobile accident caused a fatal heart attack could be a breach of good faith and fair dealing. In Mariscal, the insurer did not bother to call the treating physician to clarify the meaning of his words, did not understand medical terms or conditions, and did not consult with its own doctor. Moreover, the insurer's claims representatives testified that the insurer ignored evidence that supported coverage and did not fulfill its duty to investigate further.

Relying strongly on the rule of equal consideration that an insurer owes to its insured, the court said:

The issue here is whether Old Republic considered all the information reasonably available to it at the time that it denied the claim, and whether that information provided a basis for coverage. Old Republic had a duty to thoroughly investigate the circumstances An insurance company may not ignore evidence that supports coverage. If it does so, it acts unreasonably towards its insured and breaches the covenant of good faith and fair dealing.

Id. at 227-28 (internal citations omitted).

The Court stressed that an "insurer may not just focus on those facts which justify denial of the claim." Id. at 227.

In Aetna Life Ins. Co. v. LaVoie, 505 So.2d 1050 (Ala. 1987), insureds brought an action against a health insurer for bad faith refusal to pay a claim. In affirming a jury verdict in favor of the insureds, the court said:

Clearly, it was Aetna's responsibility to marshall all of the medical facts with regard to Mrs. La Voie's claim before its refusal to pay. The items which were absent from the file, the progress notes and the nurses' notes, were conceded by Aetna's own witnesses to be of critical importance in the review of any medical file where the reasonable necessity of hospitalization is in issue. (emphasis in original).

Id. at 1052-53.

Continuing, the court concluded:

Once the bad faith has occurred, once the duty to use good faith in considering insurance claims has been breached, the insurance company cannot later seek to justify its denial by gathering information it should have had in the first place. "An insurer purchases insurance and not an unjustified court battle when he enters into the insurance contract."

Id. at 1053, citing Gulf Atlantic Life Ins. Co. v. Barnes, 405 So.2d. 916, 925 (Ala. 1981).

B. Biased or Incompetent Medical Claims Reviews

The use of biased or incompetent medical claim reviews establishes wrongful intent in a bad faith action. Increasingly, courts have recognized that medical claim reviews conducted by persons that are biased or incompetent lead to predictably arbitrary claim decisions. In Athey v. Farmers Insurance Exchange, 234 F.3d 357 (8th Cir. 2000), an insured was injured in an automobile accident by an uninsured (UI) driver and, subsequently, brought a diversity action against Farmers for breach of contract and bad faith. Farmers had requested an independent medical examination (IME) of Athey. After the doctor performing the IME recommended that Athey stop all medical and chiropractic treatment, Farmers terminated Athey's no fault benefits. During the trial, the jury heard evidence that Farmers' attorney had recommended the doctor who conducted the IME because of his bias-he had a reputation for regularly recommending the termination of medical treatment for patients who had suffered back injuries. A jury found Farmers liable for breach of contract and bad faith. Upon appeal, the Eighth Circuit Court of Appeals found there was sufficient evidence to support the district court's rulings, including admission of the IME evidence.

The following ERISA actions are based on a fiduciary relationship similar to the fiduciary-like relationship existing between insurers and insureds. Generally, the plan administrators involved in these actions are insurers. The arbitrary and capricious standard under ERISA is analogous to the reasonableness standards applied in bad faith insurance cases. In Nagle v. Electronic Data Systems Corp., 193 F.R.D. 94, 111 (W.D. N.Y. 2000), a former employee brought an ERISA action against her employer and the plan administrator Metlife. During discovery, the employee requested information about the relationship between Metlife and the doctor it used to conduct an examination of the plaintiff. The court held that plaintiff's discovery requests were relevant: "Whether a medical advisor to a plan administrator exercises independent judgment or functions as an arm of the administrator is relevant to the issue of arbitrary decision making as are the credentials of such advisors." (emphasis added). Id. at 111, citing Bedrick By and Through Humrickhouse v. Travelers Insurance Company, 93 F.3d 149, 153-54 (4th Cir.1996).

In Bedrick, another ERISA action, the Court commented:

To put it charitably, we think it abundantly clear that Dr. Pollack at least 'unconsciously' put the financial interest of Travelers above her fiduciary duty to Ethan.

Bedrick By and Through Humrickhouse v. Travelers Insurance Company, 93 F.3d at 154.

In discussing another biased medical review, the court said:

Moreover, Dr. Robbins... views himself as a 'supporter' of Travelers 'legal department' and 'field office.' He has not seen patients in seven years, and he admitted that he is not familiar with textbooks or treatises on cerebral palsy. His opinion was based on a single medical journal article, which is uncited here.

Id.

C. Paper Reviews

Courts have repeatedly held that paper reviews of medical records, by consultants who do not actually examine the patient, are entitled to little credence. See Nelson v. Heckler, 712 F.2d 346 at 348 (8th Cir. 1983) ("We have held that such reports 'deserve little weight in the overall evaluation of disability.'"); Woo v. Delux Corp., 144 F.3d 1157 at 1161 (8th Cir. 1998) (The Court held that a claims administrator had reached a decision of non-compensability without reflection and judgment, when it relied upon a review of medical records by a consultant which contradicted the conclusions reached by treating physicians.) In one such decision, the Eighth Circuit Court of Appeals held that:

. . . to attempt to evaluate disability without personal examination of the individual and without evaluation of the disability as it related to the particular person is medical sophistry at its best.

Landess v. Weinberger, 490 F.2d 1187, 1190 (8th Cir. 1974); See also Nelson v. Heckler, 712 F.2d 346 at 348 (8th Cir. 1983).

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VI. DELAY IN CLAIM PAYMENT

A. Cases

The eventual payment of a plaintiff's claim does not extinguish the wholly separate tort claim of bad faith. The South Dakota Supreme Court specifically embraced this principle in Champion when it concluded:

. . .an insurer's violation of its duty of good faith and fair dealing constitutes a tort, even though it is also a breach of contract. Such tortious conduct is demonstrated where there is unreasonable delay in performing under a contract, including delays in settlement under a liability policy. (emphasis added).

Champion v. USF&G, 399 N.W.2d at 322, citing 16 J.A. Appleman and J. Appleman, Insurance Law and Practice, § 8878.15 at 422-24 (1981).

In an intentional tort case involving a contract, Grynberg v. Citation Oil&Gas Corp., 573 N.W.2d 493 (S.D.1997), the state Supreme Court scoffed at the argument that it is a sufficient remedy to permit the intentional tortfeasor who is a party to a contract to simply pay back what is owed under the contract. In discussing punitive damages, the Court said:

In the so-called breach of contract actions that smack of tort we do not think it is enough just to permit the defendant to pay that which the contract required him to pay in the first place. If this were the law, defendant has all to gain and nothing to lose. If he is not caught in the fraudulent scheme, then he is able to retain the resulting dishonest profits. If he is caught, he has only to pay back that which he should have paid in the first place.

Id. at 502.

Continuing, the court concluded:

To hold otherwise would give parties to a contract a license to steal. The twin purposes of punitive damages-deterrence and punishment-are well served in a contract where one party commits an intentional tort.

Id..

Grynberg involved the intentional torts of fraud and deceit, but its reasoning applies to any intentional tort case, including insurance bad faith cases.

Other jurisdictions agree with the rationale expressed in Champion and Grynberg. For instance, in Rawlings v. Apodoca, 726 P.2d at 572, the Arizona Supreme Court stated:

Thus, in first-party cases also, the insured's eventual performance of the express covenant-by paying the claim-does not release it from liability for bad faith.

Continuing, the Court said:

Failure to perform the express covenant to pay the claim is not the sine qua non for an action for breach of the implied covenant of good faith and fair dealing. (emphasis in original).

Id. at 573.

Finally, the Court said:

The implied covenant is breached whether the carrier pays or not, when its conduct damages the very protection or security which the insured sought to gain by buying insurance.

Id. See also Deese v. State Farm Mutual Auto. Ins. Co., 838 P.2d 1265 (Ariz. 1992) (fact that insurer ultimately paid claim did not relieve it of potential liability for bad faith based on its use of improper claims practices); Ania v. Allstate Ins. Co.,161 F.Supp.2d 424, 430 (E.D. Pa. 2001) (bad faith applies equally to unreasonable delay in payment-for all practical purposes, delay functions as equivalent of denial); Maduff v. Life Ins. Co. Of Va., 657 F.Supp. 437 (N.D. Ill. 1987) (defendant's motion to dismiss denied because defendant had not justified its failure to pay the plaintiff-two and one-half month delay could be vexatious and unreasonable).

B. South Dakota Statutes

There are several South Dakota statutes that relate to the payment of claims. S.D.C.L. § 58-20-6 provides that no policy of insurance shall be issued unless it contains an agreement of the insurer to promptly pay to the person entitled to compensation all installments of the compensation that may be awarded or agreed upon. (emphasis added).

S.D.C.L. § 58-33-67 (1) requires insurers to acknowledge and act within thirty days upon communications with respect to claims. (emphasis added).

S.D.C.L. § 58-33-67 (3) provides that it is an unfair practice and a violation of South Dakota statute for an insurance company to fail to give a reasonably prompt and reasonable explanation of the basis for non-payment of a claim.

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VII. ATTORNEY-CLIENT PRIVILEGE AND WORK-PRODUCT

A. Strict Construction of Privilege

Courts frequently state that the attorney-client privilege is to be strictly construed. This is because it is viewed as an exception to the general evidentiary rule of Anglo-American law that any witness with knowledge of the facts may be called to testify about what he or she knows. This general principle of full disclosure leads to a reluctance to suppress the truth, even under a claim of attorney-client privilege. See United States v. Nixon, 418 U.S. 693, 710 (1974) ("exceptions to the demand for every man's evidence are not lightly created nor expansively construed, for they are in derogation for the search for truth."); Diversified Industries, Inc. v. Meredith, 572 F.2d 596, 602 (8th Cir. 1978) (The Court observed: "While the privilege, where it exists, is absolute, the adverse effect of its application on the disclosure of truth may be such that the privilege is strictly construed."); N.L.R.B. v. Harvey, 349 F.2d 900, 907 (4th Cir. 1965) (the court quoted the following with approval: "the privilege remains an exception to the general duty to disclose. Its benefits are all indirect and speculative; it obstruction is plain and concrete . . . it is worth preserving for the sake of a general policy, but is nonetheless an obstacle to the investigation of truth. It ought to be strictly confined within the narrowest possible limits consistent with the logic of its principle."); 8 Wigmore, Evidence, § 2292 at 554 (McNaughton Rev. Ed 1961).

B. Burden of Proof on Party Asserting Privilege

Courts have uniformly held that the burden is on the party claiming the privilege to state specifically and establish to the court's satisfaction the facts supporting each of the requisite elements of the privilege. See F.T.C. v. Lukens Steel Co., 444 F.Supp. 803, 806 (D.C.D.C. 1977); International Paper Company v. Fibreboard Corp., 63 F.R.D. 88, 94 (D. Del.1974)(an improperly asserted claim of privilege is no claim of privilege at all a party resisting disclosure on the grounds of attorney-client privilege must by affidavit show sufficient facts as to bring the identified and described documents within the narrow confines of the privilege).

C. Documents Prepared by Insurer in Regular Course of Business

Documents prepared by an insurer while processing and investigating a claim are a matter of claims handling, which is the ordinary business of insurance. Courts have held that documents prepared in the regular course of business are not protected by attorney-client privilege or work-product. In Simon v. G.D. Searle&Co., 816 F.2d 397 (8th Cir. 1987), the Eighth Circuit Court of Appeals provided a test for determining whether documents are protected by work product immunity. In Simon, the Eighth Circuit said:

[T]he test should be whether, in light of the nature of the document and the factual situation in the particular case, the document can fairly be said to have been prepared in or obtained because of the prospect of litigation. But the converse of this is that even though litigation is already in prospect, there is no work product immunity for documents prepared in the regular course of business rather than for purposes of litigation. (emphasis added).

Id. at 401, citing 8 C. Wright, A. Miller, Federal Practice and Procedure, § 2024, at 198-99 (1970) (footnotes omitted); See Diversified Indus., Inc. v. Meredith, 572 F.2d 596, 604 (8th Cir. 1977), on rehearing, 572 F.2d. at 606 (8th Cir.1978 en banc).

In Mission National Insurance Co. v. Lilly, 112 F.R.D. 160 (D. Minn. 1986), the insurer had hired a law firm to perform its claims investigation function. In that case, the court concluded that documents related to the factual investigation of a claim including non-legal opinions and thoughts about facts, as compared to legal or trial matters, were discoverable. The court said:

Because the documents of plaintiff include non-legal opinions and thoughts about the facts, as opposed to legal or trial matters, such "mental processes" are properly treated as part of the ordinary business of the insurer.
Id. at 164.

In Harper v. Auto Owners Ins. Co., 138 F.R.D. 665 (S.D. Ind 1991), the court considered whether insurer documents were produced "in anticipation of litigation" and, consequently, covered by work-product. The court said:

Based on this review of the law, the Court concludes that Fed.R.Civ.P. 26(b)(3) requires that a document or thing produced or used by an insurer to evaluate an insured's claim in order to arrive at a claims decision in the ordinary and regular course of business is not work product regardless of the fact that it was produced after litigation was reasonably anticipated.

Id. at 663.

Continuing, the court explained:

It is presumed that a document or thing prepared before a final decision was reached on an insured's claim, and which constitutes part of the factual inquiry into or evaluation of that claim, was prepared in the ordinary and routine course of the insurer's business of claim determination and is not work product.

Id.

Then the court noted that:

A report produced to prepare for litigation, but used, in fact, to assist in the investigation or evaluation of a claim in the ordinary course of business, should be treated as if its creation were actually so motivated. Such an approach best comports with the purpose of the work product rule and best reflects the realities of insurance practice while avoiding difficult and unnecessary evidentiary disputes over intangible motivations and uses, and eliminating a possible incentive for obstructionist assertions. (emphasis added).

Id. at n. 3.

Thus, in Harper, the court clearly held that a document used by an insurer to arrive at a claims decision is not work product even though it was produced after litigation was anticipated. Other courts have rejected the application of the attorney work-product doctrine to documents prepared in the ordinary course of business or for non-litigation purposes. See St. Paul Reinsurance Company Ltd. v. Commercial Financial Corp., 197 F.R.D. 620 (N.D. Iowa 2000); Holton v. S&W Marine, Inc., 2000 WL 1693667 (E.D. La. Nov.9, 2000); United States Fidelity&Guaranty Co., v. Braspetro Oil Servs. Co., 2000 WL 744369,*9 (S.D. N.Y. June 8, 2000); Disifore v. Mail Contractors of Am., Inc., 196 F.R.D. 410, 413-14 (D. Kan. 2000).

D. Overcoming Privilege by Showing Substantial Need

Even if insurer documents satisfy the elements of attorney-client privilege or the work-product doctrine, the privilege is not absolute and can be overcome by a showing of substantial need. Knowledge is an essential element in a bad faith insurance action. As discussed above, in Champion v. United States Fidelity&Guaranty Co., the state Supreme Court adopted a two-prong test to prove bad faith. That test required: (1) the absence of a reasonable basis for denial of policy benefits and (2) the knowledge or reckless disregard of a reasonable basis for denial. In explaining the test, the court said:

"It is appropriate, in applying the test, to determine whether a claim was properly investigated and whether the results of the investigation were subjected to a reasonable evaluation and review."

399 N.W. 2d at 323-24, quoting Travelers Ins. Co. v. Savio, 706 P.2d 1258, 1275 (Colo.1985).

In Mission National Insur. Co. v. Lilly, the court examined whether the insured had shown a substantial need to overcome work product and said:

Here, as in APL Corp. v. Aetna, defendant needs to know, in order to assert both its defense and counterclaim, what the insurer knew at the time of the claim denial. The issue being the state of the insurer's knowledge, it becomes apparent that plaintiff has all the relevant information under its control. For this compelling reason, then, the claim of work product is overcome.

112 F.R.D. at 164, citing APL Corp. v. Aetna Casualty&Surety Co., 91 F.R.D. 10, 14 (D.C. Md. 1980).

Continuing, the court said:

[T]here is a sufficient basis to conclude that defendant does not have ready access to much of the primary information....Such reasons are adequate for overruling an assertion of the work-product doctrine.

Id., citing In re: Murphy, 560 F2d 326, 334 (C.A.. Minn. 1977).

Courts have been loathed to allow an insurance company to hide behind attorney-client privilege or work-product when a policyholder requests discovery of insurer documents relating to a claim. As one court said:

"The logical absurdity of the [insurer's] position is that, under its theory, the amendments to the discovery rules which were believed to be a liberalization of the scope of discovery would be a foreclosure of discovery of almost all internal documents of insurance companies relating to the claims of insureds. We do not believe that Rule 26 (b) (3) was designed to so insulate insurance companies merely because they always deal with potential claims. If this were true, they would be relieved of a substantial portion of the obligations of discovery imposed on parties generally that are designed to insure that the fact finding process does not become reduced to gamesmanship that rewards parties for hiding or obscuring potentially significant facts."

CIGNA INA/Aetna v. Hagerman-Shambaugh, 473 N.E. 2d 1033, 1039 (Inn. App. 3 Dist.1985), quoting Thomas Organ Company v. Jadranska Slobodna Plovidba 54 F.R.D. 367, 373 (N.D. Ill. 1972).

In Silva v. Fire Ins. Exchange, 112 F.R.D. 699 (D. Mont. 1986), the court concluded:

The time-worn claims of work product and attorney-client privilege cannot be invoked to the insurance company's benefit where the only issue in the case is whether the company breached its duty of good faith in processing the insured's claim.

Id., 699-700.

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VIII. DISCOVERY OF CLAIMS FILES

A. Generally

The best way to unearth evidence of the day-to-day activities of claims personnel who handled a claim is to look at the insured's claims files.² Claims files are not only important to show the activities of individual claims adjusters, they are also an important source of information about the daily activities of claims supervisors. Supervisor instructions will appear in the daily activity logs or diaries of the supervisors. Among these daily entries, evidence can be found about how supervisors instructed claims personnel to behave. This type of information can provide evidence that an insurance company is engaging in systematic efforts to improve the financial results of the company to the detriment of insurance claimants.

B. Cases

Courts have recognized a plaintiff's need to have access to claim file documents in first-party bad faith actions. In Silva v. Fire Ins. Exchange, the court observed that: "Under ordinary circumstances, a first-party bad faith claim can be proved only by showing the manner in which the claim was processed, and the claims file contains the sole source of much of the needed information." 112 F.R.D. 699, citing Brown v. Superior Court in and for Maricopa County, 670 P.2d 725, 734 (Ariz.1983).

In Brown, the court held that the portions of the claim file that explained how the company processed and considered the plaintiffs' claims and why the insurer rejected the claims were relevant to the issues. Brown v. Superior Court in and for Maricopa County, 670 P.2d at 734. Explaining its reasoning the court said, "Further, bad-faith actions against an insurer, like actions by client against an attorney, patient against doctor, can only be proved by showing exactly how the company processed the claim, how thoroughly it was considered and why the company took the action it did. Id., citing APL Corporation v. AETNA Casualty&Surety Co., 91 F.R.D.10, 13-14 (D. Md. 1980).

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²However, claims personnel are often trained to be aware that the claims files are later subject to discovery, and that the negative comments conceding insurance coverage or compromising the company's position should be avoided. Employees are even trained to put "self-serving" statements in claims files, in case litigation arises.

IX. DISCOVERY OF CLAIMS MANUALS AND PROCEDURE GUIDES

Claims manuals and procedure guides demonstrate the procedures to be followed by an insurance company's personnel in adjusting claims. This category of discovery may include supervisor manuals and manager manuals that describe their duties in supervising personnel involved in handling insurance claims; employee handbooks used by employees to guide their actions; documents or manuals relating to quality control audits and indexes of forms; and manual or educational materials used in addressing claims. It may also include policy interpretation documents which describe the standards, criteria or procedures that employees use to determine the scope of insurance policy terms.

These type of materials can be extremely relevant in a bad faith action because claims manuals and procedure guides often show that insurers deliberately train personnel to minimize claims and elevate the insurer's financial interests above the interests of insureds. As indicated above, this type of conduct violates the "equal consideration" rule that applies to bad faith actions. Kunkel v. United Security Ins. Co., 168 N.W.2d at 726.

A. Insurer Misuse of Claims and Other Training Materials

Insurer mis-use of claims and other training materials is best understood by looking at specific examples. The following list outlines some of the training manuals and materials that have been used by one major property and casualty insurer, State Farm Mutual Automobile Insurance Company.

1. In one training seminar entitled "Negotiating Skills for the Claims Professional", State Farm instructs its adjustors that "s(he) who has control of the dollars is in a position of Power! If you are in a position of power, use it! If you are in a position of no power, delay."

2. Personnel manuals showed that State Farm creates goals for adjustors in the payment of claims. Adjustors that achieve the goals are rewarded with salary increases and bonuses.

3. State Farm sponsored contests among claims adjustors, awarding cash prizes and trophies to those who paid the least in claims.

4. One State Farm operations guide instructed that "The claim superintendent should not overlook the opportunity to strengthen his file by creating self-serving correspondence."

5. State Farm internal directives repeatedly instructed employees to destroy anything that could be used as evidence against State Farm in bad faith lawsuits.

6. Statdeyte Farm's "Auto Claim School" training manual instructs claims adjustors to "Take good notes-take pride in your workbook-keep it for six months, then destroy it."

7. One State Farm operations manual, instructed claims personnel to ask embarrassing personal questions of claimants:

Most of us consider our income, our debts, our domestic problems, how we spend our money, whether we are keeping another women, and things of this nature to be very personal. We don't like other people asking us questions about these things, and, under normal circumstances, we don't go around asking other people those questions, however, when we're faced with what we think is a fraudulent claim or where a punitive damage count is in a lawsuit, these matters become extremely important to the successful defense of a claim. If the insured is paying the expenses of keeping some woman in an apartment, that may be extremely personal business, especially if he is married, but if he submits a claim to us, or charges that we are guilty of conduct for which we should be punished, it is also our business.

B. Cases

Courts have held that claims manuals, procedural guides and other documents which show company policies or procedures in handling claims are relevant and admissible in bad faith actions. For instance, in finding that the insured was entitled to discovery of instructions to sales personnel and claims manuals, one federal court recognized this judicial reasoning:

" [W]hen dealing with a complicated organization, such as a large insurance company, knowing what the internal understanding was might inferentially have some bearing on what the external manifestation was likely to have been . . . and from a discovery point of view that, it seems to me, is sufficient justification for including these documents."

Champion Intern Corp. v. Liberty Mut. Ins Co., 129 F.R.D. 63, 67 (S.D.N.Y. 1989), (citation omitted). See also Miel v. State Farm Mutual Automobile Insurance Co., 185 Ariz. 104, 912 P.2d 1333 (Ariz. App. Div.1 1995) (claims manuals and discussions of claims handling in automobile liability insurer's in-house newsletter found relevant in bad faith action-addressed insurer's approved policies and procedures for handling claims); State Farm Mutual Automobile Insurance Co. v. Engelke, 824 S.W.2d. 747 (Tex.App.1992) (no abuse of discretion to require an insurer to provide all documents, manuals and training materials used in training insurer's claims handling personnel); Vining on Behalf of Vining v. Enterprise Financial Group. Inc., 148 F.3d. 1206(10th Cir. 1998) (evidence of insurer's training manual was admissible).

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X. DISCOVERY OF PERSONNEL FILES

A. Pay for Performance

Before discussing the applicable law governing discovery of personnel records in bad faith actions, it is helpful to understand why non-party personnel files are important in a bad faith case. As explained earlier, an insurance company sets financial goals for denying or underpaying claims. The company will institute a variety of corporate programs that reward claims personnel for minimizing claims and, conversely, will punish them when they fail to minimize claims payments. In other words, the job performance of claims personnel is linked to their pay. This conduct is illustrated in the company policy of one insurer, Farmers' Group, Inc. In 1993, Farmers implemented a new program to make certain that claims personnel understood this pay for performance policy. The program is called "Partners in Progress."

This is how the "Partners in Progress" program operates. Under the program, all employees, including claims handlers, meet with their supervisors at regular intervals to agree on company goals for the upcoming time period. At the end of the period, the employee again meets with his or her supervisor to review whether these goals were met. If the goals were met, the employee receives a favorable rating, such as "Exceeds Expectations," or "Meets Expectations." When goals are not satisfied, then the employee receives a rating of "Below Expectations." The ratings assigned to an employee have a direct correlation with the level of compensation provided to that employee. As the Partners in Progress manual states:

YOUR PERFORMANCE WILL LINK TO YOUR PAY

You should be compensated according to how well you perform in critical performance areas. By rewarding achievers, we put ourselves in a position to develop future leadership and to accomplish our critical company business goals. On the other hand, if performance fails to match expectations, your compensation will reflect that.

This performance management program is designed to link to our pay system. You can expect that your individual performance ratings will play a key role in determining your pay level for the year.

B. Good performance and Minimizing Aggregate Claims Payments

Good performance is equated directly with minimizing aggregate claims payments. This fact is best understood by reviewing excerpts from actual performance evaluations of Farmers' claims handlers or their supervisors:

As you enter your second year as BCM [Branch Claims Manager], your enthusiasm for the job continues unabated ....Overall costs are down in liability, collision, UM and med. pay. In 1994, Tucson B7 came in second in the BCO [Branch Claims Office] contest....you will continue to have many challenges for 1995 and 1996. We need to get a handle on costs and you must communicate that need to your people....I am very happy with your performance, keep up the good
work. (emphasis added).
You have not only maintained indemnity costs at inflationary levels, but you have made a significant reduction in your costs. This is a very good result....Exceeds expectations.

While overall indemnity costs³ fell in 2001 compared to 2000, individual line results varied greatly, exceeding several targets. Your rating in this area is guided by these mixed results. (emphasis added).⁴

Your costs have increased 41 % while BCO [Branch Claims Office] costs increased 23 % ...below expectations.

As demonstrated by these excerpts from Farmers' performance evaluations, an insurance company devises ways to track the actual achievement of its financial goals to minimize claims payments. These goals are discussed in the personnel records of its employees, including claims personnel.

C. Production Allowed When Legitimate Need for Discovery

Courts uniformly hold that although production of non-party employee files is not a step which the court undertakes lightly, such files are routinely produced when there is a legitimate need for discovery. For instance, in Cardenas, Judge Tunheim upheld the magistrate's order compelling discovery of thirteen individual personnel files in a case alleging employment discrimination. Cardenas v. Prudential Insurance Company of America, 2003 WL 244640 (D. Minn. 2003). The court throughly discussed this issue, and found that "courts have customarily allowed a wide discovery of personnel files." See also Onwuka v. Federal Express Corp., 178 F.R.D. 508 (D. Minn. 1997); Lyoch v. Anheuser-Busch Co. Inc., 164 F.R.D. 62, 68-69 (E.D. Mo. 1995); Miles v. Boeing Co., 154 F.R.D. 112, 115 (E.D. Pa. 1994); Willis v. Golden Rule Ins. Co., 1991 WL 350038 at *3 (E.D. Tenn. August 5, 1991).

Numerous other courts have similarly overruled confidentiality claims and ordered production of personnel files, so long as a moving party can demonstrate that relevant information might be obtained. Weahkee v. Norton, 621 F.2d 1080 (10th Cir. 1980); EEOC v. Kansas City So. Railway, 2000 WL 33675756 (D.Kan.2000); Cason v. Builders First Source-South East Group, Inc., 159 F.Supp. 2d 242 (W.D.N.C. 2001); Watts v. Kimmerly,1996 WL 911254 (W.D.Mich.1996); Mason v. Stock, 869 F.Supp. 828 (D. Kan.1994); Jepsen v. Florida Bd. of Regents, 610 F.2d 1379 (5th Cir. 1980); Beach v. City of Olathe, 2000 WL 969808 (D. Kan. 2000); Walters v. Breaux, 200 F.R.D. 271 (W.D. La.2001); Williams v. Bd of Cty Commissioners, 2000 WL 823909 (D. Kan. 2000); Ladson v. Ultra East Parking Corp.,164 F.R.D. 376 (S.D.N.Y. 1996).

D. Trade Secrets and Protective Orders

Generally, insurers will object to the production of employee personnel files. They object on the grounds that the personnel records are confidential, proprietary or constitute a trade secret. Of course, there is no absolute privilege for confidential, proprietary or trade secret information. Paulsen v. Case Corp., 168 F.R.D. 285, 289(C.D. Cal.1996).

In Paulsen, a federal court stated:

The defendant corporation, moreover, has not shown the requested information to be a trade secret or similar confidential information. Rather, defendant corporation has merely made these claims as conclusory assertions. If defendant corporation believes that disclosure of this information might be harmful, it must explain its objections. Id., citing Nestle Foods Corp. v. Aetna Casualty and Surety Co., 135 F.R.D.101,104 (D.N.J.1990) or seek a protective order under Rule 26 (c) rather than refuse to produce the documents.

Id.

"To resist disclosure under Rule 26(c)(7), a person must first establish that the information is a trade secret, or other confidential research development, or other commercial information and then demonstrate that its disclosure might be harmful." American Maplan Corp. v. Heilmayr, 2001 WL 1718366, at 2 (D.Kan. 2001) (NO. 00-2512-JWL), citing Centurian Indus. Inc. v. Warren Steurer&Assos., 665 F.2d 325-326 (10th Cir 1881); See also Federal Open Market Committee v. Merrill, 443 U.S. 340, 362, 99 S.Ct. 2800, 2813, 61 L.Ed. 2d 587 (1979); Gohler v. Wood,162 F.R.D. 691(D.Utah 1995).

S.D.C.L. § 37-29-1(4) provides that a trade secret is:

Information including a formula, pattern, compilation, program, device, method, technique or process that: (i) derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use; and (ii) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.

In determining whether information is a trade secret for discovery purposes, courts have considered these factors:

(1) The extent to which the information is known outside the business;
(2) The extent to which it is known by employees and others involved in the business;
(3) Measures taken to guard the secrecy of the information;
(4) The value of the information to the holder and his competitor;
(5) The amount of effort or money to develop the information; and
(6) The ease or difficulty with which the information could properly be acquired or duplicated by others.

See D.D.S., Inc. v. Lucas Aerospace Power Transmission Corp., 182 F.R.D. 1(N.D.N.Y. 1998), citing Wright, Miller and Marcus, 8 Fed. Practice&Procedure, Civ. 2d, § 2043.
1. Cases

According to commentators who have analyzed court decisions on this subject,
genuine trade secrets are "a very narrow category of records." Morrison, Protective Orders, Plaintiffs, Defendants and the Public Interest in Disclosure, 24 U.Rich.L.Rev. 109, 111, 118 (1989). Courts uniformly hold that no protective order will be entered unless the moving party (1) establishes that the specific information to be covered by the order falls within the protected categories, and then (2) demonstrates that its disclosure might be harmful to the moving party. Iowa Beef Processors, Inc. v. Bagely, 601 F.2d 949, 954, n.5 (8th Cir.1979); Centurion Industries Inc. v. Warren Steurer&Associates., 665 F.2d 323, 325(10th Cir. 1981). Those who seek to avoid disclosure of commercial information by a protective order bear a heavy burden of demonstrating that disclosure will work a clearly defined and very serious injury. Citicorp v. Interbank Card Assoc., 478 F.Supp. 756 (D.C. N.Y. 1979). A protective order inhibiting liberal discovery must issue only on a specific showing that the information is such that its disclosure should be restricted and that the party disclosing it will be harmed by disclosure. Johnson Foils, Inc. v. Huyck Corp., 61 F.R.D. 405 (D.C.N.Y. 1973).

If the moving party fails to demonstrate the manner in which it will be placed at a competitive disadvantage by disclosure of the information, then it is not entitled to a protective order. Essex Wire Corp. v. Eastern Electric Sales, 48 F.R.D. 398 (D.C. Pa.1959).

2. The Public Interest

Clearly, the payment of insurance claims does not involve trade secrets. Insurance companies are required by law to pay claims. There is no "competitive advantage" involved in paying claims properly, and the methods of paying claims can easily be duplicated. Insurance companies are required to keep detailed records of all claims activities, and make them available for examination by the Department of Insurance upon demand. S.D.C.L. § 58-3-7.4. They are required to agree to these examinations before they are granted a license to do business in South Dakota. The Department issues reports detailing its findings of insurance company examinations, which become public 30 days after the report has become final. S.D.C.L. § 58-3-14. The entire subject of paying insurance claims is a matter of state regulation and public scrutiny. Thus, it is heavily imbued with a public interest.

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³ "Indemnity payments" means claim payments.

⁴ This excerpt is from the performance evaluation of a high ranking Farmers' claims manager. Because of the "mixed results" relating to the amount of claims payments made by his subordinates in 200l, the claims manager received a performance rating of "Below Expectations."

XI. CONFIDENTIALITY AGREEMENTS

Insurers often ask plaintiffs in bad faith actions to stipulate to confidentiality agreements. Many plaintiffs' counsel routinely enter into confidentiality agreements with corporate defendants in the mistaken belief that such an agreement will facilitate the free flow of discovery. However, those courts which are astute enough to actually apply the rules do not always approve of such agreements.

In fact, confidentiality agreements have been overturned many times even where they were based on a stipulated agreement of both parties. See Jepson Inc. v. Makita Electric Works, 30 F.3d. 854 (7th Cir. 1994) (stipulated protective order was improperly issued. Even where the parties stipulate, the court must independently determine whether the requirements of 26(c) are satisfied, although in this case there is no indication that the magistrate judge did so).

The Third Circuit Court of Appeals has commented that: "disturbingly, some courts routinely sign orders which contain confidentiality clauses without considering the propriety of such orders or the countervailing public interests which are sacrificed by the orders." Pansy v. Burough Of Stroudsburg, 23 F.3d 772, 785 (3d Cir.1994); See also AETNA Casualty Ins.Co. v. George Hyman Const. Co., 155 F.R.D.113 (D.C. Pa. 1994) (proposed stipulation which would allow each party to designate documents as "confidential" did not meet requisite good cause standard of discovery rule; parties failed to show with specificity that disclosure would cause defined and serious injury upon a party or that there was a need to protect a party or third persons from annoyance, embarrassment, or oppression; and the method by which documents were to be afforded protection, i.e., each party self selecting documents, resulted in judicial discretion yielding to private judgment).

In another case, a Wisconsin District Court held that the parties in an employment discrimination action failed to show good cause necessary for issuance of a stipulated protective order. The parties stipulation broadly stated that they sought to protect information pertaining to all personnel files or confidential personnel related documents called for by plaintiff's discovery requests. Makar-Wellbon v. Sony Electronics, 187 F.R.D. 576 (D.C. WI 1999). In yet another case, a Wisconsin District Court again held that the court would not enter a protective order despite the parties' stipulation, holding that the court must independently determine if good cause for such an order exists, and the parties in the instant case did not show that there was a reason for the order. David J. Frank Landscape Contracting, Inc. v. La Rosa Landscape, 199 F.R.D. 314 (D.C. WI 2001). Similarly, the Sixth Circuit Court of Appeals also has held that a blanket protective order, granting confidentiality to all documents that the parties deemed confidential, was improper. The Sixth Circuit held that the district court could not properly abdicate its responsibility to oversee the discovery process. Procter&Gamble Co. v. Bankers Trust Co., 78 F.3d 219(6th Cir. 1996). See also Citizens First Nat'l Bank v. Cincinnati Ins. Co.,178 F.3d 943 (7th Cir.1999) (The district court went too far in accepting the parties' stipulation that all materials they deemed confidential should be filed under seal. The district judge has a responsibility to make a good cause determination about such protection under its order); Cumberland Packing Corp. v. Monsanto Co., 184 F.R.D. 504 (D.C. N.Y. 1999) (The proposed stipulated protective order failed adequately to protect the public's interest in accessing judicial documents and monitoring the federal courts. As a result, good cause did not exist to approve such an order. The proposed order would have covered all discovery material or trial testimony and evidence, and permitted sealing so long as a party believed "in good faith" that it contained proprietary information); see also Miller, Confidentiality, Protective Order and Public Access to Courts, 1991, 105 Harv. L. Rev.427, 492, "Judges must guard against any notion that the issuance of protective orders is routine, let alone automatic, even when the application is supported by all the parties."

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XII. DISCOVERY OF INTERNAL INCENTIVE PROGRAMS

A. Generally

Information about an insurer's internal incentive programs is discoverable in a bad faith action. Because an insurer's incentive programs reflect its institutional policies and practices, information about these programs is highly relevant. Evidence about these programs can prove the insurer's state of mind or intent regarding claims handling. As discussed earlier, insurance companies establish incentive programs that reward employees for achieving company financial goals. For claims personnel, this means denying or minimizing claims.

B. Example of Actual Program

In order to understand the effect of an insurer incentive plan on claims personnel, it is helpful to review the details of an actual program. For instance, Farmers Insurance Group, Inc. has instituted a number of employee incentive programs. One program is called "Quest for Gold." It was implemented by Farmers in 1998. Quest for Gold is a contest in which Farmers pays cash prizes and bonuses to the personnel of the Branch Claims Offices that perform best in achieving various predetermined goals. In 1999, the ND/SD Branch Claims Office excelled in the Quest for Gold contest, and achieved a silver medal entitling each of the Bismarck Branch Claims Office (BCO) personnel to a share of the cash prizes.

One of the goals used in the contest rules is the reduction of "combined loss ratio."An insurer's "loss ratio" is the ratio of:

Claims Paid
Premiums Collected

The "combined ratio" is the ratio of:

Claims Paid +Loss Adjustment Expenses
Premiums Collected

Obviously, the efforts of claims personnel cannot affect the premiums collected. So the only factors in the combined ratio that claims personnel can affect are claims payments and expenses. Of these two, claims payments hugely outweigh the amount that can be saved on paper clips and other administrative expenses. Therefore, when a company demands that claims personnel strive to affect combined ratio, it means that they will cut claim payments. In effect, claims personnel are pitted against each other in a contest where the objective is to reduce the aggregate amount paid out in claims, in order to reduce the overall ratio.

C. Cases

Courts have consistently held that it is wrong for insurers to pay their employees more for paying claimants less. An institutional bad faith case, decided by the Arizona Supreme Court, illustrates how salaries and bonuses paid to claims representatives were influenced by what the representatives paid out in claims. In Zilisch v. State Farm Mutual Auto. Insurance Company, 995 P.2d. 276 (Ariz. 2000), the plaintiff produced evidence at trial that State Farm set arbitrary claim payment goals for its claims personnel. Promotions and salary increases for claims personnel were based on reaching these goals. Upon appeal, the Court upheld a punitive damage award against State Farm stating, "Thus, 'an insurer may be held liable in a first party case when it seeks to gain unfair financial advantage of its insured through conduct that invades the insured's right to honest and fair treatment' " Id. at 279-80, quoting Rawlings v. Apodaca, 151 Ariz. 149, 156, 726 P.2d 565, 572 (1986). See also Albert H. Wohlers and Co. v. Bartgis, 969 P.2d 949 (Nev.1999) (The Nevada Supreme Court upheld a finding of bad faith because of a direct pecuniary interest in optimizing insurer's financial condition by keeping claims costs down.).

The Eighth Circuit Court of Appeals considered the issue of insurer incentives and claims reviewers in the case of Armstrong v. Aetna Life Ins. Co., 128 F.3d 1263 (8th Cir.1997). In Armstrong, a claimant sued for wrongful denial of health benefits under ERISA. Evidence was admissible that the insurer/plan administrator provided incentives and bonuses to its claims reviewers based on criteria that included claim savings. The Court found that the evidence of incentives showed abuse of discretion by the insurer/plan administrator.

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XIII. DISCOVERY OF CORPORATE PHILOSOPHY

A. Generally

Insurance companies like other businesses adopt corporate philosophies that influence the behavior of their claims personnel who are expected to implement the company's philosophies in the handling of claims. An insurance company's philosophies may be reflected in its newsletter or in inter-company memorandum; in videotapes or written training materials; in Codes of Ethics and by-laws; in documents stating management's philosophy; and in speeches and presentations.

B. Relevancy

Discovery of this information is particularly relevant in a bad faith action because it shows the insurer's attitude towards claims handling. For instance, one insurer, State Farm published an employee newsletter entitled "Obiter Dictum." In that newsletter, the President of the company exhorted his claims handlers to "focus" their claim investigations "on the company's best line of defense." This statement was made despite the fact that the law requires a fair investigation that gives equal consideration to the rights of the insured, not a one sided investigation that just looks for ways to deny a claim. He told them that they were the company "big spenders" and admonished them "to spend State's Farm's money as if it were your own."

The State Farm newsletter also contained a story of an adjuster who had settled a case of disfigurement to a child for $10,000 when the company had actually reserved $50,000. The adjuster had saved the company money, "sparing the child from a trial." The newsletter contained countless other illustrations of the company's attitudes such as one article entitled "Honor Thy Father and Thy Mother, but Not the Subpoena." Again, the company advocated that employees break the rule of "equal consideration" that the company owed its insureds. Thus, company newsletters and other related materials can be highly relevant in showing whether a company fostered an attitude that encouraged treating claimants unfairly.

Videotapes can be another source of information describing corporate philosophies. This is demonstrated by a videotape of a speech made at a national meeting of State Farm claims supervisors. At that meeting, the company's legal counsel bragged, "We can tie plaintiffs up in motions for weeks and months. It's the old 'mad dog defense tactic,' but it works." In another statement in that same video-taped speech, counsel told the claims handlers that "there is nothing more important than protecting the company's treasury." He told them how important it is to prepare witnesses, because "truth is illusory," and in preparing for trial "we create a memory for the person."

Evidence of corporate philosophy--that an insurer has repeatedly extolled the virtues of denying or minimizing claims payments is extremely useful in establishing knowledge. Revealing corporate philosophy can negate the habitual insurer response that wrongful conduct was an isolated incident or a mistake.

Additionally, evidence of corporate philosophy will be probative of whether the insurer conducted a fair and reasonable investigation. An insurer's corporate philosophy will affect the way claims personnel investigate claims. Claims personnel who have been conditioned by a corporate philosophy that emphasizes profitability through minimizing or denying claims cannot be expected to conduct a fair and reasonable investigation as required by law.

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XIV. DISCOVERY OF LOSS RESERVES

A. Generally

Loss reserves are an insurer's estimate of the amount an insurer may be required to pay on a particular claim. Maryland Casualty Co. v. U.S., 251 U.S. 342, 350 (1920). They represent the amount anticipated to be sufficient to pay all obligations for which the insurer may be responsible under the policy with respect to a particular claim. Lipton v. Superior Court, 48 Cal. App. 4th 1599, 1613, 56 Cal.Rptr. 2d. 341, 343 (Cal. App. 2 Dist. 1996).

B. Relevancy

Evidence of reserves is relevant in a bad faith action because reserves demonstrate knowledge, a requisite element of bad faith. If an insurer alleges a good faith belief that there was no insurance coverage, the amount of loss reserves set on a claim can contradict this allegation, showing the insurer's knowledge that there was coverage.

Courts have held that loss reserves are relevant and discoverable when a cause of action against an insurer involves insurance coverage. For instance, in Kirchoff v. American Cas. Co. of Reading, Pennsylvania, 997 F.2d. 401 (8th Cir. 1993), the Eighth Circuit Court of Appeals examined the relevancy and admissibility of loss reserve evidence. In Kirchoff, a jury found the insurer liable of bad faith and awarded punitive damages. During the trial, evidence that the claims representative, Millford, had valued plaintiff's claim at $300,0000 but offered only $8,000 was admissible. Upon appeal, the Court stated, "Clearly, if Jane Millford valued Kirchoff's claim at $300,000 but offered only $8,000 to settle Kirchoff's claim, evidence of that valuation was relevant to the issue of whether CNA's settlement offers were made in good faith. The District Court did not abuse its discretion in receiving such evidence." Id. at 405. Thus, loss reserves have been held to be relevant and admissible in bad faith actions against insurers.

In another bad faith action, a California court concluded that at least for discovery purposes that loss reserves related to claims could be relevant in bad faith actions against insurers. Lipton v. Superior Court, 48 Cal. App. 4th at 1605. The court observed that in a case where the insurer had denied coverage and refused a defense that "the fact that a reserve had been set by the insurer might well be relevant to show that the insurer must have had some knowledge that a potential for coverage existed." (emphasis in original). Id. at 1614, citing Samson v. Transamerica Ins. Co., 30 Cal. 3d. 220, 240 (1981), 178 Cal. Rptr. 343, 636 P. 2d. 32; and Miller v. Elite Ins.Co., 100 Cal.App. 3d. 739, 753 (1980), 161 Cal. Rptr. 322. In referring to reserves, the court further explained: "The evaluation of a case made by an insurer, whether compelled by law or business prudence, is information which might well lead to discovery of evidence admissible on any number of issues which commonly are presented in bad faith actions." Id.

The Colorado Supreme Court has reviewed the discovery and admissibility of loss reserves in Silva v. Basin Western Inc., 47 P.3d. 1184 (Colo. 2002). The Court observed, "In a first-party claim, the establishment of reserves and settlement authority could be relevant and reasonably calculated to lead to admissible evidence regarding whether the insurance company adjusted a claim in good faith or made a prompt investigation, assessment, or settlement of a claim." Id. at 1193, citing Weitzman v. Blazing Pedals, Inc., 151 F.R.D. 125, 126 (D. Colo. 1993) (other citations omitted). "The scope of discovery has thus been traditionally broader in first-party disputes between an insured party and his or her insurer." Id., citing Weitzman v. Blazing Pedals, Inc., 151 F.R.D. at 126. "Reserves have been correspondingly more likely to be discoverable in such actions." Id.

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XV. DISCOVERY OF OTHER ACTS OF SIMILAR CONDUCT

A. Evidence of First-Party Bad Faith and Wrongful Intent

Evidence of other acts of similar conduct establishes elements of first-party bad faith and wrongful intent. In a bad faith action, an insurer's other acts of similar conduct is important evidence in proving the defendant's state of knowledge. In Novak v. McEldowney, 655 N.W.2d 909 (SD 2002), the South Dakota Supreme Court discussed other acts evidence. While evidence of other acts may not be used to prove a defendant's character, "[i]t may, however, be admissible for other purposes, such as proof of motive, intent, preparation, plan, knowledge, identity, or absence of mistake or accident." Id. at 913.

In Novak, the Court emphasized that S.D.C.L. § 19-12-5 is a rule of inclusion. Id. In that case, the Court stressed that "one legitimate purpose of the use of other acts evidence under S.D.C.L. § 19-12-5 is intent." Id. at 914. In Novak, the Court stated: "Moreover, admission of the evidence is favored under S.D.C.L. § 19-12-5, and the judicial power to exclude such evidence should be used sparingly. Id. at 913, citing State v. Wright, 1999 SD 50, 15, 593 N.W. 2d at 799.

The Court reiterated its earlier ruling in Veeder v. Kennedy, 1999 SD 23, 43, 589 N.W. 2d 610, 620. In Veeder, the Court approved the admission of evidence that the defendant, in an alienation of affections case, had previously engaged in an affair with yet another married woman, and stated that:

[Plaintiff] claims that the evidence was relevant in proving intent. We agree. Alienation of affections is an intentional tort and it was necessary for [plaintiff] to prove intent to proceed with his case. SDCL 19-12-5 specifically recognizes 'intent' may be proved by 'evidence of other wrongs or acts ' As the defendant rarely admits the crucial element of intentional wrongful conduct, it must be established by the plaintiff and proved by circumstantial evidence to avoid being non-suited. (emphasis omitted).

Id.

In another state Supreme Court case, State v. Wright, 593 N.W.2d 792, 802 (S.D. 1999), the Court held that even in the absence of express testimony from the defendant to the effect that his actions in harming his son were the result of "mistake," evidence of other incidents of excessive discipline were admissible to show lack of mistake, because these other incidents provided the only method by which the jury could get a sense of his state of mind.

B. Evidence of Pattern of Practice of Wrongful Claims Handling

In institutional bad faith cases, courts allow evidence of other acts evidence in order to show a pattern of practice of wrongful claims handling, wrongful intent, and lack of mistake. While the issue has not had occasion to arise in a reported South Dakota Supreme Court decision, reported decisions abound in other jurisdictions that have the same bad faith law as South Dakota. For instance, in Colonial Life&Accident Ins.Co. v. Superior Court, 647 P.2d. 86 (Ca. 1982), the California Supreme Court allowed discovery of other claims handling incidents by the same adjustor that handled the plaintiff's claim, and summarily discarded the defendant insurer's relevancy objection as follows:

Colonial's suggestion that the discovery of other insureds whose claims were negotiated by Sharkey will not yield relevant, admissible evidence, is patently meritless.

Id. at 89. Then the California Supreme Court elaborated further:

While proof of a knowing violation will make plaintiff's job that much easier, in cases where a knowing violation is difficult to establish, knowledge can be proved circumstantially. Discovery aimed at determining the frequency of alleged unfair settlement practices is therefore likely to produce evidence directly relevant to the action.

Id. at 90. Finally, the Court stated:

Without doubt, the discovery of the names, addresses and files of other Colonial claimants with whom Sharkey attempted settlements is relevant to the subject matter of this action and may lead to admissible evidence.

Id.

In Hawkins, discussed above, the Arizona Supreme Court similarly allowed the admission of other claims handling behaviors by the defendant in order to assist in establishing intent, as well as in establishing a case for recovery of punitive damages. In Hawkins, the Arizona Court commented:

We note that unless the defendant is willing to take the stand and admit its 'evil mind,' the plaintiff must prove entitlement to punitive damages with circumstantial evidence. Thus, whether the defendant intended to injure the plaintiff or consciously disregarded the plaintiff's rights may be suggested by a pattern of similar unfair practices.

Hawkins v. Allstate Insurance Co., 733 P.2d. at 1081, citing Colonial Life&Accident Ins. Co. v. Superior Court, 647 P.2d at 86, 90 (Ca.1982).

Another example of admission of other claims evidence in a bad faith case is found in Vining on Behalf of Vining v. Enterprise Financial Group. Inc., 148 F. 3d. 1206, 1218-19 (10th Cir. 1998). The Tenth Circuit upheld the admission of other claim evidence holding that it was clearly relevant to the question of how the defendant acted in that case and that FRE 406 (habit) clearly provided for its admission.

In Owens-Corning Fiberglass Corp. v. Allstate Ins. Co., 660 N.E. 2d 765 (Ohio Com. Pl. 1993), the insured filed a motion to compel discovery in a coverage dispute over underlying asbestos products' liability claims. In that case, the insured requested materials from any lawsuits or arbitration concerning asbestos coverage. The court held that the requested information was relevant to the defendants' intentions as to asbestos coverage and that "it will shed light on how the defendants have approached other asbestos issues." Id. at 767.

In another case, Moore v. American United Life Ins. Co., 197 Cal. Rptr. 878 (Cal. App. 1984), the court held that the claim handling of a non-party was admissible to show a pattern of practice of unreasonable actions by the insurer.
C. Evidence of Recidivism and Right to Punitive Damages

Courts uniformly hold that evidence of recidivism is relevant and admissible to establish the plaintiff's entitlement to punitive damages, as well as to determine the extent of punitive damages necessary to deter future misconduct. In reviewing punitive damages cases, the South Dakota Supreme Court has held that in it is relevant to show that the defendant has a proclivity to repeat the wrongful conduct. For instance, in Schaffer v. Edward D. Jones&Co.(SchafferII), 552 N.W.2d. 801, 813 (S.D.1996), the Court held that a major purpose of punitive damages is to deter future misconduct of a similar nature.

In a case where the defendant sees nothing wrong with its conduct, and thereby implies his willingness to repeat that conduct, a higher award is needed to deter future misconduct. In Schaffer II, the court outlined such an instance:

Jones attempted to argue to the jury that 'we sold at low risk and WE WOULD DO IT AGAIN based on those factors.'...Not surprisingly, in response, Schaffer argued to the jury:

Why are punitive damages necessary? You heard the testimony of the people at Edward D. Jones and every witness they brought here that said they would do it all over again....And they will, unless somebody tells them...no you're not going to do this to anybody down the road.

Id. at 812-13.

Continuing, the Court said:

This trial strategy by Jones allowed the jury to conclude Jones showed no remorse for its acts which had already been found to be fraudulent and that Jones intended to repeat the same conduct in the future. In Hulstein, we upheld a very substantial punitive award under the rationale that "this award should be a clear signal that companies caught practicing deliberate fraud will be severely punished. This is the nature of punitive damages." 203 N.W.2d at 892. Punitive damages may properly be imposed to further a State's legitimate interests in not only punishing unlawful conduct but also to deter its repetition.

Schaffer II at 813 (emphasis added) (citation omitted).

Again in Veeder v. Kennedy, the Court addressed the concern regarding recidivism in the analysis of punitive damages:

As in Schaefer II, here the defendant showed no remorse for his acts and so told the jury. "Punitive damages may properly be imposed to further a State's legitimate interests in not only punishing unlawful conduct but also to deter its repetition." (emphasis added).

589 N.W. 2d at 622 34, citing Schaefer II, 1996 SD 94 at 35, 552 N.W. 2d. at 813 (citing BMW v. Gore, 517 U.S. at 116, S.Ct. at 1595, 134 L. Ed. 2d. at 882).
Extending this reasoning in Grynberg v. Citation Oil&Gas Corp., 573 N.W.2d 493 (S.D. 1997), the South Dakota Supreme Court reasoned that a proper punitive damage award must take into account not only the harm that has occurred to the plaintiff, but also the harm that might result to other victims if similar misconduct is not deterred.

"Punitive damages should bear a reasonable relationship to the harm that is likely to occur from the defendant's conduct as well as the harm that actually has occurred .It is appropriate to consider the magnitude of the potential harm as well as the possible harm to other victims that might have resulted if similar future behavior were not deterred."

(Italics in original) Grynberg at 508 n.14, quoting Schaefer II.

In a more recent case, Roth v. Farner-Bocken Co., 667 N.W.2d 651 (SD 2003), the Court discussed the United States Supreme Court's guideposts for awarding punitive damages. The Court noted that the first guidepost required an examination of the "'degree of reprehensibility of the defendant's misconduct.'" (emphasis added). Id. at 48, quoting State Farm Mut. Auto Ins. Co. v. Campbell, 123 S.Ct. 1513, 1520, (citing BMW v. Gore, 517 U.S. 559, 575).⁵

Continuing, the Court said that in applying the reprehensibility guidepost a consideration is whether:

"The harm caused was physical as opposed to economic; the tortious conduct evinced an indifference to or a reckless disregard of the health and safety of others; the target of the conduct had financial vulnerability; the conduct involved repeated actions or was an isolated incident; and the harm was the result of intentional malice, trickery, or deceit, or mere accident." (emphasis added).

Id., quoting State Farm Mut. Auto. Ins. Co. v. Campbell, 123 S.Ct. 1513, 1521.⁶
In Roth, the Court found Pulla v. Amoco Oil Co., 72 F.3d 648 (8th. Cir. 1995) persuasive. Id., citing Pulla at 660. The Court noted that in Pulla the Eighth Circuit had "focused on the fact that there was no evidence that the conduct reflected a company policy or practice." Id. Adopting the Pulla rationale, the Court found that the defendant's conduct in Roth was not intentional because there was no evidence that the conduct reflected a company policy or practice. (emphasis added). Id. at 52. Thus, in view of the Roth decision, plaintiffs in bad faith cases must obtain evidence of an insurer's policies or practices, not only to prove elements of bad faith but also to prove punitive damages.

⁵ In State Farm Mut. Auto. Ins. Co. v. Campbell, the United States Supreme Court reiterated its prior ruling in BMW of North America, Inc. v. Gore, 517 U.S. 559 (1996). In BMW, the Court said that: "the most important indicium of the reasonableness of a punitive damage award is the degree of the reprehensibility of the defendant's conduct." Id. at 575.

⁶ In BMW v. Gore, the United States Supreme Court addressed the issue of recidivism, explaining:

Certainly, evidence that a defendant has repeatedly engaged in prohibited conduct while knowing or suspecting that it was unlawful would provide relevant support for an argument that strong medicine is required to cure the defendant's disrespect for the law. (citation omitted). Our holdings that a recidivist may be punished more severely than a first offender recognize that repeated misconduct is more reprehensible than an individual instance of malfeasance.

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XVI. DISCOVERY OF REINSURANCE AND INSURANCE AGREEMENTS

A. Generally

In an action by an insured based on denial of coverage or bad faith, an insured often requests discovery of other insurance held by the insurer, including reinsurance, loss pooling agreements, corporate liability or bonds purchased by the insurer to provide protection to the company or its officers and directors for errors and omissions, directors' and officers' liability, RICO, negligence, fraud or bad faith claims handling.

Reinsurance is defined as: "[A] special form of insurance obtained by insurance companies to help spread the burden of indemnification. A reinsurance company typically contracts with an insurance company to cover a specified portion of the insurance company's obligation to indemnify a policyholder in the event of a valid claim." Excess&Casualty Reinsurance Association v. Insurance Commissioner of the State of California, 656 F.2d. 491, 492 (9th Cir. 1980). "Because a reinsurer's liability 'follows the fortunes' of the original insurer as to liability of claims, it is generally required by the reinsurance agreement itself that the original insurer notify the reinsurer of claims for which it may become liable, and to keep the reinsurer informed as the claims investigation and/or negotiation process progresses." 17 Couch on Insurance 3d., Agreements and Communications with Reinsurer, § 251:30 (updated 2002).

B. Relevancy

Courts have found discovery of reinsurance materials relevant and discoverable. In National Union Fire Ins. Co. of Pittsburgh, Pa. v. Continental Illinois Corp., 116 F.R.D.78, (N.D. Ill. 1987), a federal court held (1) that pre-and post-issuance communications between the insurers and their reinsurers were discoverable and (2) that the reinsurance agreement was relevant and discoverable. In that case, the Court said:

Insurers attempt to show the irrelevance of their reinsurance agreements by discussing the various types of reinsurance and arguing that, because of the nature of their reinsurance agreements, their reinsurers did not take part in assessing the risk before issuing the Policies or in contesting coverage later. But the things Insurers do not talk about are more telling than what they discuss. There can be no question they communicated (pre-or post-issuance or both) with their reinsurers about the Policies. Regardless of the legal nature of the reinsurance arrangements, those communications are relevant.

Id. at 83.

Then the Court said:

For Movants [insureds] to understand the significance of these communications, the reinsurance agreements may be needed and are thus relevant. They surely could lead to the discovery of admissible evidence-the low threshold of Rule 26(b)(1).

(Clarification added). Id.

Finally, the Court concluded that even if this were not the case that reinsurance agreements are discoverable under Federal Rule 26(b)(2):

That literal reading of Rule 26 (b)(2) conforms entirely to the policy considerations underlying the Rule, which was added in 1970 because (Advisory Committee Note): 'Disclosure of insurance coverage will enable counsel for both sides to make the same realistic appraisal of the case so that settlement and litigation strategy are based on knowledge and not speculation.'

Id. at 84-85.

Other courts have agreed with the National Union decision. For instance, in determining the scope of Federal Rule 26(b)(2), the Eighth Circuit Court of Appeals concluded:

We cannot agree with Searle that Rule 26(b)(2) forecloses discovery of any insurance document beyond the agreement. First the language of the rule itself plainly is not preclusive. Second, the advisory committee expressed concern, at least as to the indemnity agreements, that Rule 26(b)(2) not be interpreted to protect insurance information from discovery when that information is relevant under Rule 26(b)(1). We hold therefore that insurance documents that are not discoverable under Rule 26(b)(2) remain discoverable in accordance with Rule 26(b)(1).

Simon v. G.D. Searle&Co., 816 F.2d. 397, 404(8th Cir. 1987).

In Stonewall v. National Gysum Co., 1988 WL 96159, *5-6 (S.D.N.Y. 1988) discovery of reinsurance information was permitted. The insured in that case argued that reinsurance information was relevant because it might reflect an insurer's understanding of the risk underwritten; the insurer's notices of claims to their reinsurers; and an understanding of underlying claims and admissions that the claims were covered.
In another case, Clark v. Interstate National Corp., 486 F.Supp. 145 (D.C. Pa. 1980), a bad faith action was brought against an insurer for its refusal to settle within policy limits. The court held that reports or other communications by insurers to their reinsurers concerning the insured's claim were relevant and discoverable. The court held further that the reinsurance agreement to which the insurer was a party was relevant on the issue of what the insurer perceived and how it evaluated the case.

In Owens-Corning Fiberglass Corp. v. Allstate Ins. Co., 660 N.E.2d. 765 (Ohio Com. Pl. 1993), the insured and liability insurers filed cross-motions to compel discovery in a coverage dispute over underlying asbestos product-liability claims. The court held that the insured was entitled to discovery of reinsurance-related materials. The insured had argued that if the insurer had intended to cover asbestos liability, these intentions would be reflected in increased reinsurance coverage. The court found that the reinsurance related materials were relevant to whether the insurer believed that these policies covered asbestos claims against the insured.

S.D.C.L. § 15-6-26(b)(2) is very similar to its federal counterpart, Federal Rule 26(b)(2). Pursuant to S.D.C.L. § 15-6-26(b)(2), " [a] party may obtain discovery of the existence and contents of any insurance agreement under which any person carrying on an insurance business may be liable to satisfy part or all of a judgment which may be entered in the action or to indemnify or reimburse for payments made to satisfy the judgment. Information concerning the insurance agreement is not by reason of disclosure admissible in evidence at trial " Thus, S.D.C.L. § 15-6-26(b)(2) permits discovery of reinsurance and other insurance agreements held by an insurer, at least as to indemnity agreements.

C. Directors' and Officers' Liability Insurance

"Directors' and Officers' liability coverage mirrors other professional liability insurance in that it is designed to protect corporate officials from loss in the event a claim is made against them in their official capacities. Coverage may be provided either to the corporation which indemnifies its directors or officers or it may be extended directly to the individuals involved." 9 Couch on Insurance 3d., Directors and Officers, § 131:31 (updated 2003).

The same reasoning that applies to discovery of reinsurance and other insurance agreements applies to discovery of directors' and officers' liability insurance agreements. S.D.C.L. § 15-6-26(b)(2) permits the discovery of directors' and officers' liability insurance agreements as well as other agreements purchased by the insurer to protect and indemnify its company or directors and officers. Since a corporation acts through its officers, employees and agents, provisions in directors' and officers' insurance agreements may prove agency, ownership or control. These agreements may contain provisions requiring adequate notice of potential claims or other provisions that may provide or lead to admissible evidence of an insurer's state of mind or knowledge regarding coverage.

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XVII. INSURERS' USE OF S.D.C.L. § 21-1-1.4 TO PRECLUDE DISCOVERY

A. Generally

Often, when punitive damages are asserted in a bad faith action, insurers assert that discovery regarding any of the plaintiff's claims should be precluded until a hearing has been held pursuant to S.D.C.L. § 21 1 4.1. However, S.D.C.L. § 21 1 4.1 does not preclude discovery of relevant information necessary to establish plaintiff's underlying substantive claims of bad faith. The following discussion examines the applicable law and policy underlying S.D.C.L.§ 21 1 4.1:

S.D.C.L.§ 21 1 4.1 provides:

In any claim alleging punitive or exemplary damages, before any discovery relating thereto may be commenced and before any such claim may be submitted to the finder of fact, the court shall find, after a hearing and based upon clear and convincing evidence, that there is a reasonable basis to believe that there has been willful, wanton or malicious conduct on the part of the party claimed against.

S.D.C.L.§ 21 1 4.1 does not preclude discovery of relevant information that relates to the underlying subject matter of plaintiff's causes of action. Punitive damages are not a cause of action, but simply an added element of the recovery on the underlying causes of action and assert entitlement to an additional element of damages. (See Justice Sabers' dissent in Risse v. Meeks, 585 N.W.2d 875, 882 (S.D. 1998)). The insurer interpretation of the statute confuses discovery related to the remedy of punitive damages with discovery needed to establish the
elements of the underlying claims of an insurance bad faith action. This interpretation would preclude any discovery on a bad faith claim prior to a 21 1 4.1 hearing and would produce the absurd result of requiring the plaintiff to prove his bad faith case before being allowed to conduct discovery on the case.

B. Scope of Civil Discovery and S.D.C.L. § 21 1 4.1

The insurers' application of S.D.C.L. § 21 1 4.1 is inconsistent with the liberal construction rationale underlying civil discovery. The scope of civil discovery under S.D.C.L. § 15 6 26(b) is that parties may obtain discovery regarding any matter, not privileged, which is relevant to the subject matter of the pending action. Information is discoverable even though it may be inadmissible at trial when the requested information is reasonably calculated to lead to discovery of admissible evidence. See State By and Through Dept. of Transportation v. Grudnik, 243 N.W.2d 796, 797 (S.D. 1976).

In Kaarup v. St. Paul Fire and Marine Ins. Co., the Court affirmed its decision in Grudnik, stating that the scope of pretrial discovery should be broadly construed. 436 N.W. 2d 17, 19 20 (S.D1989), citing Hickman v. Taylor, 329 U.S. 495, 67 S. Ct. 385, 91 L.Ed 451(1947) and Grudnik at 797.

Quoting from Hickman, the Court stressed that all relevant matters are discoverable unless privileged:

No longer can the time honored cry of "fishing expedition" serve to preclude a party from inquiring into the facts underlying his opponent's case. Mutual knowledge of all relevant facts gathered by both parties is essential to proper litigation. To that end, either party may compel the other to disgorge whatever facts he has in his possession. The deposition discovery procedure simply advances the stage at which disclosure can be compelled from the time of trial to the period preceding it, thus reducing the possibility of surprise. But discovery, like all matters of procedure, has ultimate and necessary boundaries.

Id., quoting Hickman v. Taylor, 329 U.S. at 507, 67 S. Ct. at 392, 91 L.Ed. at 460.

C. Legislative Intent

The legislative history of S.D.C.L. § 21 1 1.4 is described in a South Dakota Law Review article by Robert E. Driscoll entitled Statutory Restrictions on the Discovery and Trial of Punitive and Exemplary Damage Claims in South Dakota, 33 SD L.Rev. 247, 250 51 (1988).

The article indicates that S.D.C.L. § 21 1 1.4 was part of a legislative response to a perceived "litigation crisis." Introduced on behalf of the Governor, at the urging of the South Dakota Medical Association, the statute was a response to physicians' concerns that punitive damage claims were being used to harass doctors by compelling production of income tax records, net worth statements, and other financial information. It was intended to establish an appropriate threshold which insured a reasonable basis for claiming punitive damages.

Judicial statements regarding the purpose of the statute accord with the legislative intent to protect financial information from disclosure. In Ammann v. Massey Ferguson, Ltd., 933 F.Supp. 840 (D.S.D.1996), the Court said:

This Court agrees with the concurrence of former Supreme Court Justice Wuest in Brandriet v. Norwest Bank South Dakota, N.A., 499 N.W.2d 613 (S.D. 1993), that the obvious purpose of S.D.C.L. § 21 1 1.4 is to prevent discovery as to income tax records, net worth statements, and other financial information of a defendant without first demonstrating that there is a reasonable basis to believe that punitive damages are warranted, (Vreugdenhil v. First Bank of South Dakota, N.A., 467 N.W.2d 756, 760 (S.D.1991)), or that there is a prima facie case of punitive damages, (Flockhart v.Wyant, 467 N.W.2d 473, 475 (S.D. 1991)); the statute adds nothing to South Dakota substantive law. (emphasis added).

Id. at 842.

Justice Wuest, in his concurring opinion in Brandriet, had stated that "S.D.C.L. § 21 1 1.4 was enacted to prevent the harassment of defendants by compelling production of income tax records, net worth statements, and other financial information by insuring the claimant has a reasonable basis for the punitive damage claim." Brandriet v. Norwest Bank South Dakota,
N.A., 499 N.W.2d at 619, citing Dahl v. Sittner, 474 N.W.2d 897, 901 02 (S.D.1991); Robert E. Driscoll, Statutory Restrictions on the Discovery and Trial of Punitive and Exemplary Damage Claims in South Dakota, 33 S.D. L.Rev. 247, 251 (1988).

In Dahl, the Court indicated that " [t]he purpose of the statute is to prevent the use of claims for punitive damages as a means for harassment, by establishing a threshold to insure that there is a reasonable basis for such claims." Dahl v. Sittner, 474 N.W. 2d at 901 02, citing Driscoll, Statutory Restrictions on the Discovery and Trial of Punitive and Exemplary Damage Claims in South Dakota, 33 S.D. L.Rev. at 251.

D. Timing of S.D.C.L. § 21 1 1.4 Hearing

There is no requirement that the hearing pursuant to S.D.C.L. § 21 1 1.4 be a pretrial hearing. A recent South Dakota Supreme Court decision, Boomsma v. Dakota, Minnesota&Eastern R.R. Corp., 651 N.W.2d 238 (S.D. 2002), discussed the timing of the hearing. In Boomsma, the Court held "there is no requirement that the required hearing take place before trial; it may be held at the close of evidence." Id. at 246., citing Kieser v. Southeast Properties, 566 N.W.2d 833 (S.D. 1997). The holding in Boomsma relates to the issue of whether punitive damages should be submitted to the jury. However, the Court's decision would apply equally to discovery under S.D.C.L. § 21-1-1.4.

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XVIII. BURDEN OF PROOF REQUIRED TO ESTABLISH PUNITIVE DAMAGES

A. S.D.C.L. § 21-1-4.1

As discussed above, S.D.C.L. § 21-1-4.1 requires an evidentiary finding by the court prior to submitting a punitive damage claim to the trier of fact. However, although an evidentiary finding is required under S.D.C.L. § 21-1-4.1, the burden on the plaintiff has been held to be lower than the level of proof, which must be established to the trier of fact. It is essentially a "prima facie case for punitive damages." Case v. Murdock, 488 N.W.2d 885, 891 (S.D.1992).

S.D.C.L. § 21-1-4 "does not establish a clear and convincing evidence standard but merely requires clear and convincing evidence to show a reasonable basis. The clear and convincing language merely modifies the "reasonable basis" language to make a prima facie showing that punitive damages may be in order. (emphasis in original and added). Shippen v. Parrott, 506 N.W.2d 82, 87 (S.D. 1993).

B. S.D.C.L. § 21-3-2

S.D.C.L. § 21-3-2 authorizes the award of punitive damages and applies to intentional torts such as insurer bad faith. It specifies in pertinent part:

In any action for the breach of an obligation not arising from contract, where the defendant has been guilty of oppression, fraud, or malice, actual or presumed the jury, in addition to the actual damage, may give damages for the sake of example, and by way of punishing the defendant.

If there is evidence of "oppression, fraud or malice," punitive damages are appropriate. Kjerstad v. Ravellette Publications, Inc., 517 N.W.2d 419, 425 (S.D. 1994). The malice required for an award of punitive damages in a bad faith case may be either actual or presumed. Isaac v. State Farm Mutual Auto. Ins. Co., 522 N.W.2d. at 761. Actual malice is a positive state of mind, evidenced by a positive desire and intention to injure another, actuated by hatred or ill will. Dahl v. Sittner, 474 N.W.2d 897, 900 (S.D. 1991). "Presumed, legal malice, on the other hand , is malice which the law infers from or imputes to certain acts." Id. (citation omitted). Although a person may not act out of hatred or ill will, presumed malice is present when a person acts willfully or wantonly to the injury of others. It implies the act complained of was conceived in the spirit of mischief or criminal indifference to civil obligations. Id. "A claim for presumed malice can be shown by demonstrating a disregard for the rights of others." Isaac v. State Farm Mutual Auto. Ins. Co., 522 N.W.2d. at 761, citing Case v. Murdock, 488 N.W.2d at 891(citing Flockhart v.Wyant, 467 N.W.2d at 475).

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XIX. STANDARD OF REVIEW OF PUNITIVE DAMAGES

A. South Dakota Supreme Court

In Fritzmeier v. Krause Gentle Corporation, the South Dakota Supreme Court reiterated its five-factor test to determine whether punitive damages are appropriate or excessive. 669 N.W. 2d.699,709 (S.D. 2003), citing Leisinger v. Jacobson, 651 N.W.2d 693, 696 (S.D.2002) (citing Grynberg v.Citation Oil&Gas Corp., 573 N.W.2d 493,504 (S.D. 1997)). The five-factors delineated by the Court are:

(1) The amount allowed in compensatory damages,
(2) The nature and enormity of the wrong,
(3) The intent of the wrongdoer,
(4) The wrongdoer's financial condition, and
(5) All of the circumstances attendant to the wrongdoer's actions.

Id.

In discussing these factors, the Court said that "[t]he first factor is the amount allowed in compensatory damages." Id. Although there must be a reasonable relationship between punitive damages and compensatory damages, the Court stressed that there is "'no precise mathematical ratio between' the two." Id., citing Leisinger v. Jacobson, 651 N.W.2d at 700. It also noted that in Campbell, the United States Supreme Court stated that the amount of the award should be based on the individual facts and circumstances of the case. Id., citing State Farm Mut. Auto. Ins. Co. v. Campbell, 123 S.Ct. 1513, 1524 (U.S. 2003).

In examining the second factor, the nature and enormity of the wrong, the court said that an appropriate consideration is the defendant's actions relating to the potential harm inflicted on other victims and not only the present victim if not deterred. Id. at 710, citing Roth v. Farner-Bocken Co., 667 N.W.2d 651,668 (S.D.2003) (citation omitted).

To evaluate the third factor, the intent of the wrong doer, the Court said:

From intent, we determine 'the degree of reprehensibility of the defendant's conduct,' which is viewed as probably the most important indication of the reasonableness of the punitive damage award.

Id., citing Veeder v. Kennedy, 589 N.W.2d 610, 621 (S.D. 1999) (quoting Schaffer v. Edward D. Jones&Co.(Schaffer II)), 552 N.W.2d 801, 812 (S.D.1996).

Moreover, the Court repeated its admonition that "[t]rickery and deceit are more reprehensible than negligence." Id., quoting Veeder at 621.

In reviewing the fourth factor, the consideration of the wrongdoer's financial condition, the Court looked at both net income and net worth. Id.

Analyzing the fifth factor, consideration of all circumstances, attendant to the wrongdoer's actions, the court cited Schaffer II. It noted that in Schaffer, it had focused on the availability of other sanctions and whether a less drastic remedy could achieve the goal of deterring future misconduct. Id., citing Schaffer II, 552 N.W.2d at 814.

B. Eighth Circuit Court of Appeals

In addressing whether a South Dakota punitive damage award is excessive, the Eighth Circuit Court of Appeals has been guided also by the five-factor test. Jones v. Swanson, 341 F.3d 723, 736-37 (8th Cir. 2003). In Jones v. Swanson, the Eighth Circuit said that "when determining if a state law damage award is excessive, state case law guides our inquiry." Id. at 736, citing England v. Gulf&Western Mfg. Co., 728 F.2d 1026, 1029 (8th Cir.1984).

In that case, the court said:

South Dakota has adopted a five-factor test to determine whether an award of punitive damages is appropriate or excessive....In applying South Dakota precedent we consider,
1. The amount allowed in compensatory damages,
2. The nature and enormity of the wrong,
3. The intent of the wrongdoer,
4. The wrongdoer's financial condition, and
5. All of the circumstances attendant to the wrongdoer's actions.

Id. at 736-37 (Internal citations omitted), citing Schaffer v. Edward D. Jones&Co., 552 N.W.2d 801, 809 (S.D.1996).

Moreover, the court emphasized:

Under South Dakota law, a jury's verdict should not be set aside except in those extreme cases where it is the result of passion or prejudice or where the jury has palpably mistaken the rules of law by which damages in a particular case are to be measured.

Id. at 736, citing Itzen v. Wilsey, 440 N.W.2d 312, 313-14 (S.D. 1989) (citing S.D. Codified Laws § 15-6-59(a)(5)).

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XX. SMALL COMPENSATORY DAMAGES AND PUNITIVE DAMAGES

A. Generally

Punitive damages may not be awarded absent an award of compensatory damages. Olson-Roti v. Kilcoin, 653 N.W.2d 254 (S.D. 2002). However, the fact that compensatory damages are small will not preclude an award of punitive damages. Indeed, in the recent United States Supreme Court decision of State Farm Mut. Auto. Ins. v. Campbell, 123 S.Ct. 1513 (U.S. 2003), the court addressed this issue.

B. Campbell

In Campbell, the Court said that the ratio of permissible punitive damages to compensatory damages may be much higher in cases where the compensatory damages are small or hard to detect:

... because there are no rigid benchmarks that a punitive damages award may not surpass, ratios greater than those we have previously upheld may comport with due process where "a particularly egregious act has resulted in only a small amount of economic damages." ( . . . a higher ratio might be necessary, where 'the injury is hard to detect or the monetary value of non-economic harm might have been difficult to determine'). (emphasis in original).

Id., 123 S.Ct. at 1524., quoting BMW v. Gore, 517 U.S. at 582.

C. South Dakota Supreme Court and Other Cases

Clearly, the possibility of potential harm may justify a large punitive damage award even though compensatory damages are small. In Roth v. Farner-Bocken Co., 667 N.W.2d 652, 668 (S.D. 2003), the South Dakota Supreme Court relied on the Eighth Circuit Court of Appeals decision in Pulla v. Amoco Oil Co., 72 F.3d 648 (8th. Cir. 1995). In Pulla, the Eighth Circuit had been influenced by the United State's Supreme Court decision in TXO regarding the potential harm of tortious conduct. Id. at 668, 62, citing Pulla, 72 F.3d. at 659-60.

In determining whether a punitive damage award bore a reasonable relationship to actual damages in TXO, the United States Supreme Court said:
It is appropriate to consider the magnitude of the potential harm that the defendant's conduct would have caused to its intended victim if the wrongful plan had succeeded, as well as the possible harm to other victims that might have resulted if future behavior was not deterred. (emphasis in original).

Id. at 668-69, quoting TXO, 509 U.S. at 460, 113 S.Ct. at 2722.

In TXO, the United States Supreme Court quoted this passage with approval:

For instance, a man wildly fires a gun into a crowd. By sheer chance, no one is injured and the only damage is a $10 pair of glasses. A jury reasonably could find only $10 in compensatory damages, but thousands of dollars in punitive damages to teach a duty of care. We would allow a jury to impose substantial punitive damages in order to discourage future bad acts.

Id. at 63 (emphasis in original), quoting TXO, 509 U.S. at 459-60, 113 S.Ct. at 2711 (citation omitted).

The rationale expressed in TXO, adopted by the Pulla and Roth Courts, is persuasive when compensatory damages are small in a bad faith action, but the potential for harm is great. It is also consistent with the purpose of awarding punitive damages in South Dakota "to punish the wrongdoer and deter others from wrongdoing." See Hoff v. Bower, 492 N.W.2d 912, 915 (S.D. 1992).

In Trouten v. Heritage Mut. Ins. Co., the South Dakota Supreme Court provided a "good analysis" that justifies punitive damages in bad faith actions where compensatory damages are small but the potential harm is great:

In the present context, the principal purpose is to deter acts deemed socially unacceptable and, consequently, to discourage the perpetuation of objectionable corporate policies.... Traditional arguments challenging the validity of exemplary damages lose force when a punitive award is based on this justification. The special relationship between the insurer and the insured illustrates the public policy considerations that may support exemplary damages in cases such as this.

632 N.W.2d at 863, quoting Egan v. Mutual of Omaha Ins. Co., 24 Cal.3d 809, 169 Cal. Rptr. 691, 620 P.2d. 141 (1979).

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XXI. STATE FARM V. CAMPBELL

Since the United States Supreme Court decided State Farm Mutual Ins. Co. v. Campbell, 123 S.Ct. 1513 (U.S. 2003), insurers have distorted this decision. They have used Campbell to thwart discovery requests by plaintiffs for relevant information that is discoverable in bad faith actions. Additionally, they have argued that Campbell limits punitive damages in bad faith actions. In order to rebut insurer arguments regarding Campbell, it is necessary to thoroughly understand the decision and its applicability.

A. Evidence That Can Be Introduced in State Court Actions

First, Campbell did not, in any way, address the evidence that is relevant or admissible in a state court bad faith action. In fact, the Campbell appeal did not even arise out of the bad faith proceeding because the trial court in Campbell had bifurcated the trial. The bad faith issue was tried first and the compensatory and punitive damages were tried later in the second phase of the trial. It was the second phase of the trial, pertaining to punitive damages, that State Farm appealed. Id. at 1518. The Supreme Court did not overturn the $1 million bad faith verdict at all. Therefore, the holdings in Campbell had nothing to do with the scope of admissible evidence in a bad faith action.

In Campbell, the issue before the Supreme Court was: " the measure of punishment, by means of punitive damages, a State may impose upon a defendant in a civil case." Id. at 1517. Campbell related only to the scope of constitutionality permitted evidence admitted solely for the purpose of punishing a defendant. The Supreme Court held that based on the evidence that a $145 million punitive damage award was excessive and exceeded due process constraints.

Campbell said that a state court cannot impose punitive damages upon a defendant based upon conduct which occurred in another state, unless that conduct has a nexus to the specified harm suffered by the plaintiff inside the venue state. Although the Supreme Court held that lawful out-of-state conduct cannot be used for purposes of enhancing punitive damages, the court noted specifically that this same kind of evidence from other states can be admissible in order to demonstrate that the defendant's conduct in the present case was deliberate, so long as a cautionary instruction is used:

Lawful out-of-state conduct may be probative when it demonstrates the deliberateness and culpability of the defendant's action in the state where it is tortious, but that conduct must have a nexus to the specific harm suffered by the plaintiff. A jury must be instructed, furthermore, that it may not use evidence of out-of-state conduct to punish a defendant for action which was lawful in the jurisdiction where it occurred.

Id. at 1522-23.

B. Specific Evidence Introduced in Campbell

To understand the Campbell holding, it is important to understand the specific evidence introduced in that case. In Campbell, the bad faith portion of the case had already been completed when the jury heard evidence of State Farm's conduct in the second phase of the trial. The evidence consisted of many anecdotal instances of individual claim handling from a number of other states. This evidence was offered only in respect to punitive damages since the bad faith portion of the trial had been completed. The trial court did not use any cautionary instructions, limiting use of the evidence to bad faith or to deliberateness, since the jury had already determined bad faith in the first phase of the trial. Therefore, the evidence could only go to enhance punitive damages. The Supreme Court held that this kind of "out-of-state" evidence could not be used to enhance punitive damages. The Court reasoned that a state has no constitutionally permissible interest in punishing the defendant for conduct that occurred in another state, which is not directly connected with the harm inflicted upon the plaintiff in the state where the case is venued.

Another problem with the evidence submitted in Campbell during the second phase relates to the fact that the underlying bad faith case involved a third party lawsuit against State Farm's insured. The bad faith action was predicated on State Farm's failure to adequately protect their insured in the third party suit. However, most of the evidence offered by the Campbells, of company wide programs to reduce claims payments, did not relate to third party automobile insurance claims, but related instead to first party claims.

There are different standards of conduct in a third party claim, since the insurance company is in an adversarial relationship with the third party and owes no fiduciary-like duties to a third party opponent in litigation. See Trouten v. Heritage Mutual Ins. Co., 632 N.W.2d at 864. However, an insurance company owes a much higher duty to claims submitted by its own insured in a first party context. Id. For instance, the Court specifically noted, in discussing State Farm's PP&R policy that:

Evidence pertaining to the PP&R policy concerns State Farm business practices for over 20 years in numerous states. Most of these practices bore no relation to third party automobile insurance claims, the type of claim underlying the Campbell's claim against the company....Relying in large part on the extensive evidence concerning the PP&R policy, the court concluded that State Farm's conduct was reprehensible.

Id. at 1519.

C. Evidence of Insurers' Nationwide Policies

Insurers have argued that Campbell precludes a plaintiff in a bad faith action introducing evidence of an insurer's nationwide policies, including policies to reduce claims payments. This is not what the Court said. In Campbell, the Supreme Court said: "A Defendant's dissimilar acts, independent from the acts upon which liability is premised, may not serve as the basis for punitive damages." Id. at 1523. Because there was no evidence of similar conduct offered in Campbell, the only relevant evidence was the evidence that harmed the Campbells. Conversely, if there had been evidence of similar conduct it could have been introduced for purposes of enhancing punitive damages. Campbell merely says that the plaintiff must make a showing of a nexus between a nationwide policy and the harm suffered by the specific individual.

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XXII. COMPENSATORY DAMAGES FOR EMOTIONAL DISTRESS

A. Generally

Insurers often request that any evidence of damages for emotional distress be excluded at a trial for insurance bad faith. They argue that under South Dakota law no damages for emotional distress may be recovered unless a plaintiff establishes the requirements of either intentional or negligent infliction of emotional distress. This argument confuses the standard for recovery of emotional distress damages, as an element of damages, with the entirely separate torts of negligent or intentional infliction of emotional distress.

As the cases outlined in the following discussion will illustrate, the basic rules governing recovery of emotional distress damages are as follows:

·Damages for emotional distress may be recovered in a negligence action only where there are physical injuries;

·Damages for emotional distress may be recovered in a case of intentional tort without proof of physical injuries;

·Where no independent tort is alleged aside from infliction of emotional damages, damages for emotional distress can be recovered only where the defendant's conduct was "outrageous," and the emotional distress is "severe."

This third category, above, is the separate tort of intentional infliction of emotional distress. Development of this tort came about as a result of cases where the defendant had not committed any of the recognized intentional or negligent torts, but had still caused damages by intentionally inflicting emotional distress. The courts began to recognize this as a separate cause of action, but only where the conduct is "outrageous," and the results are "severe".

These requirements do not apply, however, where the defendant has committed another independent tort, such as bad faith, and the emotional distress claim is only an element of the damages attendant to that tort, as opposed to being the basis for the entire cause of action.

In a bad faith case, a claim for compensatory damages for emotional distress arises out of the intentional tort of bad faith, and not the separate torts of either negligent or intentional infliction of emotional distress.

B. South Dakota Cases

For instance, in Athey v. Farmers Insurance Exchange, 234 F.3d 357 (8th Cir.2000), the Eighth Circuit Court of Appeals upheld an award of compensatory damages for emotional distress. Athey did not claim negligent or intentional infliction of emotional distress, and the court did not require proof of "outrageousness," "severe emotional distress" or "physical injury."

In Athey, the insured brought an action against his insurance company, alleging breach of contract and bad faith because of the insurer's refusal to pay an underinsured motorist claim. The Court found that the award for compensatory damages for emotional distress was supported by sufficient evidence. It specifically held: "To recover damages for emotional distress in South Dakota a plaintiff must establish that he sustained a pecuniary loss because of the bad faith of an insurer." Id. at 363, citing Kunkel v. United Sec. Ins. Co. of N.J., 168 N.W.2d 723, 734 (S.D.1969).

One of the factors that the Court found proved emotional distress was that Athey was forced to pay for his own medical treatment after his independent medical review and Farmers' termination of his no fault benefits. The Court concluded that "[t]he jury could reasonably find that the pecuniary loss that Athey endured caused him mental anguish." Id. Like Athey, most plaintiffs in bad faith actions endure a pecuniary loss when their insurers wrongfully deny or minimize their benefits. Juries can reasonably find that this pecuniary loss caused mental anguish and award compensatory damages for emotional distress.

In another recent South Dakota case, Roth v. Farner-Bocken Co., 667 N.W.2d. 651 (S.D.2003), the South Dakota Supreme Court discussed compensatory damages that included emotional distress. Roth involved an intentional tort--invasion of privacy. In that case, the court noted that " there was a substantial compensatory damage award of $25,000. The evidence indicates that Roth suffered only minor economic injuries. Moreover, Roth's damages, as supported by the evidence consisted of emotional distress, including feelings of anger, betrayal and devastation." Id. at 669-70. After reviewing the conduct of the defendant, the Supreme Court upheld the compensatory award, which it acknowledged was supported by evidence of emotional distress.

Historically, the South Dakota Supreme Court has allowed recovery of emotional distress as a component of compensatory damages. For instance, in Bean v. Best, 93 N.W.2d 403 (S.D. 1958), an action for false arrest and imprisonment, the Court explained: "From § 905, Restatement, Tort, we quote the following statement with approval. (d) 'A person who has a cause of action for a tort may be entitled to recover as an element of damages for that form of distress known as humiliation, that is a feeling of degradation or inferiority***'" Id. at 408.

Moreover, the Court has noted that recovery can be made for mental pain or mental distress when the tortfeasor's acts are intentional, willful, wanton or malicious. For instance, in Chisum v.Behrens, 283 N.W.2d 235 (S.D. 1979), the Court concluded that the applicable law could be summed up as follows:

"It is well established that damages for mental anguish or suffering cannot be sustained where there is no physical injury, ...unless there has been some conduct on the part of defendant constituting a direct invasion of the plaintiff's rights...or other like willful, wanton, or malicious conduct."

Id. at 240, quoting State Farm Mut. Auto. Ins. Co. v. Village of Isle, 122 N.W.2d 36, 41 (Minn. 1963).

In Wright v. Coca Cola Bottling Co. of Central South Dakota, Inc., 414 N.W.2d 608 (S.D.1987) the Court explained:

As to intentional torts, this court has held:

[T]hat recovery can be had for mental pain, though no physical injury results, when the following elements are present: the act causing anguish was done intentionally, the act was unreasonable, and the actor should have recognized it as likely to result in emotional distress.

Id. at 609, citing Chisum v. Bethrens, supra; First National Bank of Jacksonville v. Bragdon, 167 N.W.2d 381 (S.D.1969).

C. Other Jurisdictions

Other jurisdictions have allowed compensatory damages for emotional distress in bad faith actions without claims of negligent or intentional infliction of emotional distress. For instance, in an Iowa case, the Eighth Circuit Court of Appeals, held that damages for emotional distress were available to an insured in a bad faith case. Berglund v. State Farm Mut. Ins. Co., 121 F.3d 1225 (8th Cir. 1997).

On appeal, State Farm argued that the trial court improperly admitted evidence of the insured's emotional distress as an element of bad faith. However, the Eighth Circuit noted that Iowa already allowed damages for emotional distress as consequential damages against an insurer in first party bad faith cases. Id. at 1229, citing Nassen v. National States Ins. Co., 494 N.W.2d 231, 237-38 (Iowa 1002). The Court extended this same remedy to third party insureds saying: "[W]e believe the Iowa Supreme Court would permit Sally Bergelund to recoup emotional distress damages for State Farm's bad faith. Otherwise, the Bergelunds would not get a full recovery." Id.

In Nassen, the Iowa Supreme Court affirmed a judgment for damages for emotional distress. In that case, the court said:

It is, of course, difficult to arrive at a sum of money that fairly compensates for the trauma visited upon elderly persons by having their worldly possessions dissipated by extended care costs that they believe should be covered by insurance. We are convinced, however, that this is a situation capable of producing severe mental suffering. We conclude that the evidence was sufficient to support the damages awarded.

Id. at 238.

In Patel v. United Fire&Cas, Co., 80 F.Supp.2d 948 (N.D. Ind. 2000), an Indiana case, a federal district court held that bad faith was an intentional tort under Indiana law. Id. at 958. It further held that an insured may recover emotional damages where the insured has proved bad faith conduct by the insurer. Id. Analyzing an earlier decision by the Indiana Supreme Court, the Court said:

Thus, the Erie court expressly stated that in tort, "all damages directly traceable to the wrong and arising without an intervening agency are recoverable." The wholesale inability of a plaintiff to collect compensatory damages such as emotional damages in a bad faith tort action, as the defendant urges, thwarts Erie's purpose as well as the public policy behind the Indiana Supreme Court's recognition of the tort

Id. at 959 (Internal citation omitted), citing Erie Ins. Co. v. Hickman, 622 N.E.2d. 515, 519 (Ind.1993).

Continuing, the Court said:

This court is not alone in either its conclusion that the bad faith cause of action is an intentional tort or its conclusion that a finding of bad faith permits an insured to recover all damages, including emotional damages, proximately caused by the insurer's conduct. This has long been the law in numerous jurisdictions that have adopted bad faith causes of action.

Id., citing generally Shernoff, Gage&Levine, Insurance Bad Faith Litigation, § 7.04, (Matthew Bender 1999); Ashley, Bad Faith Actions, Liability And Damages, § 8.04 (West, 2d.Ed., 1997).

Then the Court noted decisions in other jurisdictions permitting damages for emotional distress in bad faith cases: "Gruenberg v. Aetna Insurance Co., 9 Cal.3d. 566, 108 Cal. Rptr. 480, 510 P.2d 1032 (1973) (permitting emotional distress damages in insurance bad faith case); Clausen v. National Grange Mut. Ins. Co., 730 A.2d 133, 140 (Del. Sup. 1997) ('An insurer who acts in bad faith in dealing with a claim may incur liability not only for damages under the policy but for uncovered economic losses of the insured, the insured's emotional distress damages, attorney's fees, and punitive damages.'); Ingalls v. Paul Revere, Life Insurance Group, 561 N.W.2d 273, 283(N.D. 1997) ('Because a primary consideration in purchasing insurance is the peace of mind and security it will provide, an insured may recover for any emotional distress resulting from an insurer's bad faith.'); Ballow v. PHICO Ins. Co., 878 P.2d 672 (Colo. 1994) (permitting recovery in bad faith claim based upon traditional tort principles of compensation for injuries actually suffered, including emotional distress); Universal Life Ins. Co. v. Veasley, 610 So.2d 290 (Miss. 1992) ('We have traditionally held that damages for mental anguish and emotional distress cannot be considered in the absence of a finding of an independent intentional tort separate from the breach of contract.')" Id. at 959-60.

In Ingalls v. Paul Revere Life Ins. Co., mentioned above, the court said:

An insurer's breach of its duties to an insured is likely to cause mental anguish:

It is inconceivable that a layman, unaccustomed to the courtroom and fearful of the entire judicial process, who is also subjected to financial pressures from a refusal of the insurer to discharge its commitments, will not be subjected to stress the precise effects of which are difficult to measure in exact terms but which, nevertheless, are present.

561 N.W.2d at 283, citing 16A John Alan Appleman and Jean Appleman, Insurance Law and Practice § 8878.55, p. 442 (Rev.Vol.1981).

Continuing, the Court said:

Thus, in a case of this kind, damages for mental anguish may be "'general' damages-'damages for a harm so frequently resulting from the tort that is the basis of the action that the existence of the damages is normally to be anticipated and hence need not be alleged in order to be proved.'"

Id., citing Marilyn Minzer et. al., Damages in Tort Actions § 1.01[3](1996), quoting Restatement (Second) of Torts § 904.

D. S.D.C.L. § 21-3-1 And Measure of Compensatory Damages

The strong case law precedent permitting an insured to recover compensatory damages for emotional damages in bad faith and other intentional torts is consistent with South Dakota statutory law. S.D.C.L. § 21-3-1 specifies the measure of compensatory damages that may be awarded in tort actions. The statute provides:

For the breach of an obligation not arising from contract, the measure of damages except where otherwise expressly provided by this code, is the amount which will compensate for all the detriment proximately caused thereby, whether it could have been anticipated or not. (emphasis added).

The right to damages in tort actions is based on a theory of full compensation for the injury sustained. Hoff v. Bower, 492 N.W.2d 912, 914 (S.D. 1992), citing Trautman v. Coffman, 166 N.W. 150-51 (S.D. 1918). Recoverable damages flow from the changed condition of the parties induced or brought about by the tort. Id. Under S.D.C.L. § 21-3-1, a plaintiff is entitled to compensation for all the detriment proximately caused by the an insurer's wrongful denial of benefits, including compensatory damages for emotional distress.

E. Proof of Negligent or Intentional Infliction of Emotional Distress

Finally, courts have analyzed the insurer's argument that emotional distress damages may be recovered in a bad faith action only if the torts of either negligent or intentional infliction of emotional distress are proved. In Farr v. Transamerica Occidental Life Ins. Co. of Ca., 699 P.2d 376 (Ariz. App. 1984), an Arizona appellate court addressed this issue. The court, said: "By referring to the separate tort of intentional infliction of emotional distress, where outrageous conduct is required, the appellants have confused the standard for damages recoverable in a claim for bad faith." Id. at 382. Then the Court explained:

In Gruenberg v. Aetna Insurance Co., 9 Cal.3d 566, 108 Cal. Rptr. 480, 510 P.2d 1032 (1973), the California Supreme Court held that once a plaintiff has proven a loss of property he can also recover damages for emotional distress. The court carefully delineated intentional infliction from emotional distress caused by an insurer's bad faith. The court rejected the suggestion that "[t] he conduct of the insured must be 'outrageous' or that the mental distress must be 'severe'." 9 Cal.3d at 579,108 Cal. Rptr. 489, 510 P.2d at 1041.

Id.

Continuing, the court said:

This was more recently explained in Richardson v. Allstate Insurance Co.,117 Cal. App.3d 8,13, 172 Cal. Rptr. 423, 426 (1981) where the court noted:

Breach of the implied covenant of good faith is actionable because such conduct causes financial loss to the insured, and it is the financial loss or risk of financial loss which defines the cause of action. Mental distress is compensable as an aggravation of the financial damages, not as a separate cause of action.

Id.

Thus, the argument that damages for emotional distress may only be awarded if the separate tort of either negligent or intentional infliction of emotional distress is proved does not accord with generally accepted legal principles. In an effort to prevail with this argument, insurers blur the fine line between emotional distress as a component of damages attendant to an intentional tort (such as bad faith) and recovery for the independent tort of intentional infliction of emotional distress where no intentional tort is alleged.

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XXIII. WORKER'S COMPENSATION AND EMPLOYER/INSURER BAD FAITH

Litigation of a bad faith action arising from a worker's compensation claim may involve issues that do not arise in other types of insurance coverage. Some of these issues are:

1. Whether the exclusive remedy provision in the South Dakota worker's compensation law precludes an employee from suing an employer for insurance bad faith.

2. Whether an employer that pays its own worker's compensation claims, but has not sought formal certification as a self-insurer, can be sued for insurance bad faith.

A. Exclusive Remedy

An employer/insurer may argue that it cannot be sued for bad faith because of the exclusivity provision of the worker's compensation law. There is no merit to this argument. Bad faith is an intentional tort. S.D.C.L. § 62-3-2, the exclusive remedy provision of the law, clearly excludes intentional torts from the scope of the statute. S.D.C.L. § 62-3-2 provides in pertinent part:

The rights and remedies herein granted to an employee subject to this title, on account of personal injury or death arising out of and in the course of employment, shall exclude all other rights and remedies of such employee,..., except rights and remedies arising from intentional tort. (emphasis added).

The seminal case of insurance bad faith involving the exclusive remedy provision of worker's compensation law is Champion v. United States Fidelity&Guaranty Co., 399 N.W.2d 320 (S.D. 1987). In Champion, the Supreme Court found this legal reasoning persuasive:

The Compensation Act should not be a 'shield' which will insulate those who would engage in intentional wrongdoing in the settlement and investigation of worker's claims. No one should be allowed intentionally and tortiously to cut off a claimant unilaterally for whatever purpose they choose and then hide behind worker's compensation exclusivity in assurance that the only retribution will come in the form of a compensation penalty paid for by society.

Id. at 323, quoting Hayes v. Aetna Fire Underwriters, 609 P.2d 257, 262 (Mont. 1980).
In Champion, the Court held "that the exclusivity provision of the Worker's Compensation Act does not bar an action by the employee against the insurance carrier for the commission of an intentional tort. The independent tort is not compensable under our Worker's Compensation Act and to extend immunity to compensation carriers for a separate injury to workers goes far beyond the intent of the act." Id., citing Southern Farm Bureau Cas. Ins. v. Holland, 469 So.2d 55 (Miss. 1984).

B. Bad Faith Actions Against Self-Insured Employers

In worker's compensation cases, it is important to determine whether an employer is self-insured or has acted as a self-insured for purposes of liability for bad faith. It is undisputed that in South Dakota self-insurers can be sued for the intentional tort of bad faith. See, e.g., Gilchrist v. Trail King Industries, Inc., 655 N.W.2d 98 (S.D. 2002); also Gilchrist v. Trail King Industries, Inc., 612 N.W.2d 10 (S.D. 2000) (Gilchrist I); Gilchrist v. Trail King Industries, Inc., 612 N.W.2d 1 (S.D. 2000) (Gilchrist II) (Employee sued self insured employer for bad faith in handling worker's compensation claim); Zuke v. Presentation Sisters, Inc., 589 N.W.2d 925 (S.D. 1999) ( Employee brought bad faith action against employer and employer's insurer. However, employee failed to exhaust administrative remedies); Arp v. AON/Combined Ins. Co., 300 F.3d 913 (8th Cir. 2002) (Injured employee sued his employer, the third-party administrator of his employer's worker's compensation program and his employer's worker's compensation insurance carrier for bad faith).

Other states also permit employees to sue their employer/insurers. For instance, the Colorado Supreme Court in the landmark case of Travelers's Ins. Co. v. Savio, 706 P.2d 1258 (Colo. 1985) applied bad faith law to "providers of insurance." In Mississippi, employees may sue their employers or insurers for bad faith. See Ray v. Travelers' Ins. Co., 1998 WL 433949 (N.D. Miss. 1998) ( Mississippi Supreme Court has held that a bad faith cause of action may be brought against an employer or insurance carrier and is not barred by exclusive remedy provision, citing Luckett v. Mississippi Wood , Inc., 481 So.2d 288 (Miss.1985)).

In McIlravy v. North River Ins. Co., 653 N.W.2d 323 (Iowa 2002), the Iowa Supreme Court said:

The second method by which a self-insured employer or employer's worker's compensation carrier may be penalized for a delay in payment of benefits is by a private cause of action for first-party bad faith. This cause of action arises from 'the knowing failure to exercise an honest and informed judgment' on the part of a defendant from whom the employee seeks compensation due to work-related injuries.

Id. at 328-29, citing Kiner v. Reliance Ins. Co., 463 N.W.2d 9, 12 (Iowa 1990) (citation omitted).

In Buote v. Verizon New England, 190 F.Supp.2d 693 (D. Vt. 2002), an employee brought an action against his self insured employer for bad faith handling of his worker's compensation claim. The Vermont Supreme Court held that material issues of fact did exist and that the employee could pursue the claim.

C. High Deductible Insurance Policies and Fronting Agreements

1. Generally

An employer's worker's compensation insurance policy may contain a "fronting agreement." Fronting agreements are a device used by self insurers to satisfy various financial responsibility laws, including the statutory requirements that employers purchase worker's compensation insurance. These agreements, on the surface, appear to provide insurance coverage. However, if one reads the side agreements and endorsements, most if not all of the coverage is excluded in one manner or another. Fronting agreements are a device used by self insurers to satisfy various financial responsibility laws, including the statutory requirements that employers purchase worker's compensation insurance.

For instance, S.D.C.L. § 62-5-1 et. seq. requires that an employer in South Dakota must choose between three alternative methods of providing worker's compensation protection: (1) an employer may obtain worker's compensation insurance from a licensed insurer⁷ ; or (2) an employer may join an association of employers organized for the exchange of reciprocal insurance contracts for the purpose of indemnifying each other from loss under the worker's compensation law⁸ ; or (3) an employer that wishes to be self-insured must enter into contractual agreements with his worker's to provide a scheme of compensation benefits by the employer, and must also receive approval of the department.⁹

This third option involves very specific requirements. In order to be self insured, an employer is required to enter into contracts with all employees, and furnish satisfactory proof to the department of labor of the employer's financial ability to pay the compensation required by the worker's compensation act. S.D.C.L. § 62-5-5. A self insured employer also is required to furnish a bond, written by a surety company, and authorized by the division of insurance to write surety bonds, or cash, or a certificate of deposit, or a irrevocable letter of credit, in a total amount equal to the greater of: (1) $250,000; or (2) twice the amount of compensation claims paid by the employer during the preceding calendar year; or (3) the amount designated by the employer as a reserve for worker's compensation claims. S.D.C.L. § 62-5-10.

2. Nature of fronting agreements

Fronting agreements have been described in numerous court decisions. For instance,
an Ohio court of appeals characterized a "fronting agreement" as a method where a self-insured entity simply "rents" an insurance company's licensing:

In this case, the ACE policy includes a total deductible amount which is equal to the policy limits. Under the terms of the policy language, any administrative expenses including costs of defense in handling claims are also included as costs which accrue against the policy limits. This type of policy constitutes a "fronting agreement" which is a method of administering insurance claims by "renting an insurance company's licensing and filing capabilities in a particular state or states." (emphasis added) .

Kohntopp v. Hamilton Mutual Ins. Co., 2003 WL 21255940, 13-14 (Ohio App. 6 Dist. 2003) (Not reported in N.E.2d).

In Chicago Ins. Co. v. Travelers Ins. Co., 967 S.W.2d 35 (Ky. App. 1997), Travelers issued a general commercial liability policy to Walgreen Company. Walgreen admitted that the policy was a front, and was issued primarily for the purpose of providing a certificate of insurance to various municipalities and vendors:

The Traveler's policy is essentially a "fronting policy" pursuant to which Walgreen is self-insured for the $1,000,000.00 of coverage provided by the policy . . . In its brief, Walgreen admits that this is a "fronting policy" which essentially require[s] it to indemnify Travelers for any payment because the policy has a $1,000,000.00 deductible and a $1,000,000.00 coverage limit. (emphasis added).

Id.

Continuing, the court concluded:

Therefore, the policy effectively provides the terms of Walgreen's plan to be self-insured for $1,000,000.00. Walgreen explains that "[t]he policy was issued primarily for the purpose of providing certificates of insurance to various municipalities and vendors...."

Id.

In another case, Playtex FP, Inc. v. Columbia Casualty Co., 609 A.2d 1087 (Del.Super.1991), the Delaware court described the testimony pertaining to a fronting arrangement:

Northwestern was in the business of selling fronting programs. It helped large insureds with self-insurance type mechanisms, such as captive fronting arrangements, matching deductible, or large deductible programs, and some self insurance programs. . .. Stein has testified that the fronting concept was defined by Esmark in the marketing of its insurance program as an articulation of Esmark's self-insured retention, and stated that "Northwestern described their program as a deductible equals limits program. . .."

Id. at 1091.

Fronting policies can take a number of different forms. The common denominator, though, is that the insured still pays its own claims. The Delaware Court elaborates in the Playtex case as follows:

There is no common way of effectuating fronting policies. Deductible equals limits policies are one method. Esmark contends that the Northwestern fronting policy was accomplished with the use of two documents: a hold harmless agreement, and a deductible endorsement. The hold harmless agreement said there would be no losses reported under the policy, and if there were, Esmark would have to reimburse Northwestern for all of its expenses. . .. Under the deductible endorsement there was no risk transferred to the insurance carrier, as the deductible was to become part of the fronting policy and equal the limits. . ..

* * *

Dr. Joseph A. Fields (Fields), a second Columbia expert, testified that fronting arrangements are often done under a captive reinsurance agreement when the front is needed to secure a certificate of insurance for a regulatory or contractual purpose. Hold harmless agreements are used to make policies into fronts, typically when the insured has credit problems. (Emphasis added).

Id. at 1091.

3. Large Deductibles or Fronting Agreements Constitute Self-insurance

Many courts have examined this issue and have held that large deductibles or fronting arrangements actually constitute self insurance. For instance, in Air Liquide America Corp. v. Continental Casualty Co. v. CIGNA Property&Casualty Co., 217 F.3d 1272 (10th Cir. 2000), the Tenth Circuit Court of Appeals reached a similar decision. The court held that a trucking company's "fronting" liability policy, with a deductible equal to the policy limits, was actually a form of self-insurance and that the insurer acted merely as a surety for the insured's ability to satisfy a judgment.

In Straubhaar v. CIGNA Property&Casualty Co., an Ohio appeals court held that an employer who purchases a liability policy with a deductible equal to its liability limits was "self-insured" in the practical sense." 2002-Ohio-4791, 2002 WL 31040683 3 (Ohio App. 8 Dist.2002). See also Cincinnati Ins. Co. v. Torok, 787 N.E.2d 1257 19 (Ohio App. 7 Dist.2003) (holding that an employer was self-insured "in the practical sense" where there was a "reimbursement indemnification and security agreement" executed between the employer and the insurance provider).

In United States Gypsum Co. v. Admiral Ins. Co., 643 N.E.2d 1226 (Ill. App.1 Dist.1995), an Illinois Court of Appeals agreed with defendant Continental Casualty Company, when it argued that the plaintiff had only purchased "fronting" insurance, requiring reimbursement of all sums paid for defense or indemnification, and that the plaintiff was in effect self-insured. Id. at 1260.

As discussed earlier, in Chicago Ins. Co. v. Travelers Ins. Co., 967 S.W.2d 35 at n.1, the Kentucky Court of Appeals equated a fronting policy with a scheme of self-insurance. The court said that:
In fact, the Traveler's policy was nothing more than a "fronting policy" for Walgreen's self-insurance scheme. (emphasis added).

D. Employer's Lack of Certificate of Self-Insurance

An employer may argue that it has not received a certificate of self insurance, as required by S.D.C.L. § 62-5-4. Indeed, avoidance of such statutory requirements is one of the primary purposes of a fronting agreement. However, the employer may be the real party in interest for the payment of claims including cost of defense, and the involvement of the insurance company is simply a front.

The Eighth Circuit Court of Appeals, in Arp v. AON / Combined Ins. Co., 300 F.3d 913 (8th Cir. 2002), considered a similar situation. In that case, the Eighth Circuit allowed a bad faith claim to proceed against both the self-insured employer and the third party claim administrator. The self-insured employer in AON did not obtain a certificate of self-insurance from the Department of Labor. The Eighth Circuit nevertheless considered the employer to be self-insured and stated as follows:

[Employer] is self-insured for workers' compensation up to $500,000.00. Claims exceeding $500,000.00 are paid by Continental. At the time of James's accident, the administration of [employer's] workers' compensation program was managed by GAB, a third party administrator. (alteration added).

Id. at 915 n. 1.

Thus, an employer's failure to obtain formal self insured status is certainly not dispositive of a bad faith claim. The decision of the Wisconsin Supreme Court in Hillegass v. Landwehr, 499 N.W.2d 652 (Wis. 1993) is highly instructive. In that case, the Wisconsin court had to decide whether a self-insured employer would qualify as "other insurance" under the definition commonly found in insurance policies which subordinates its coverage to pay only after any "other insurance" has paid its limits. The Wisconsin court specifically noted that the employer had not applied for or received certification as a self-insurer under Wisconsin statutes. Nonetheless, the court held that the defendant had chosen to conduct itself as a self-insurer.

The court first discussed the definitions of "insurance:"

Black's Law Dictionary . . . defines "insurance" as "[a] contract whereby, for stipulated consideration, one party undertakes to compensate the other for loss . . . ." Similarly, Websters New Collegiate Dictionary (1980 ed.), defines "insurance" as "a contract whereby one party undertakes to indemnify or guarantee another against loss . . . ." Whether the contract is one of indemnity or liability, the critical element in both definitions is a contractual shifting of risk in exchange for premiums. . . .

Id. at 654-55.

Then the court said :

Whereas contractual insurance policies involve a third-party insurer underwriting the insured's risk in exchange for premium payments, self-insurers retain their own risk in exchange for not paying premiums. . .. In the words of the circuit court: "self-insurance is just a form of insurance . . ., the modifying term 'self' just indicates where it emanates. . .." (emphasis added).

Id. at 654-55.

In Hillegass, the Wisconsin court noted that employers are free to choose this type of fronting device by agreeing to reimburse their insurers for the first $1,000,000 rather than pay premiums on that risk. However, the Wisconsin court also held that employers who wish to retain their own risks and liabilities do so subject to the obligations and duties that arise from choosing to self-insure.

The court stated that:

Farmers asserts, and we agree, that it would be fundamentally unfair and contrary to legislative intent to permit companies such as Burlington Air Express to self-insure and thereby escape both the expense of premium payments and the possibility of being held liable as a primary insurer. See, e.g., White v. Howard, 240 NJ Super. 427, 573 A.2d 513 (A.D. 1990). As noted supra, the fact that the legislature permits companies to formulate the most efficient insurance coverage should not be misconstrued as a device to avoid liability by the self retention of risk. (emphasis in original and added).

Id. at 655-656.

Again, the Wisconsin court specifically stated that the employer in this case, Burlington Air Express, was not a certified self-insurer as specified by Wisconsin statute. Nevertheless, the court concluded that:

. . . permitting individuals to self-retain risk was not intended by the legislature to be a device by which self-insurers could escape the liabilities that would attach to third-party insurers.

Id. at 656.

⁷ S.D.C.L. § 62-5-2

⁸ S.D.C.L. § 62-5-3

⁹ S.D.C.L. § 62-5-4

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XXIV. INSURER OR SELF-INSURER DELEGATION OF CLAIMS HANDLING

Courts that have addressed this question have agreed that insurers cannot delegate their responsibilities. For instance, the Wisconsin Court of Appeals, in Majorwicz v. Allied Mutual Ins. Co., 569 N.W.2d 472 (Wis. App. 1997), upheld a trial court's submission of a jury instruction which stated that:

An insurer's duty to act in good faith in its dealings with its insured is non-delegable. An insurer cannot escape liability for bad faith by delegating its responsibilities to attorneys or other agents.

Id. at 523-24.

Therefore, the Wisconsin court held that the insurer remained liable for bad faith in investigating and negotiating a claim, despite the fact that it had directed others to perform these tasks. Id.

In Scott Wetzel Services, Inc. v. Johnson, 821 P.2d 804 (Colo. en banc 1991), the Colorado Supreme Court held that a self-insured employer can be sued for bad faith, and cannot avoid bad faith liability by contracting out its responsibilities:

We recognize that Safeway, as a self-insured employer, cannot relieve itself of its obligation of good faith and fair dealing by contracting out its responsibilities.

Id. at 811, citing Denny's Restaurant, Inc. v. Husson, 746 P.2d 63, 65 (Colo. App. 1987).

The Colorado court went on to hold that not only could the self-insured employer be held liable for bad faith, but so could the independent adjusting agency hired by the employer to handle claims. Id. at 811-813.

More recently, in Cary v. United of Omaha Life Ins. Co., 68 P.3d 462 (Colo. 2003), the Colorado Supreme Court issued another en banc decision again holding that a self-insured employer can be held liable for bad faith along with the third party administrator hired to handle claims.

And as discussed above, the Eighth Circuit Court of Appeals, in Arp v. AON / Combined Ins. Co., 300 F.3d 913 (8th Cir. 2002), allowed a bad faith claim, arising out of a worker's compensation action, to proceed against both the "self-insured employer" and the claim administrator.

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XXV. CONCLUSION

As in other types of litigation, an insurance bad faith case can become a factual labyrinth involving complex pieces of evidence. In order to focus the attention of a jury on key points, we emphasize rules of reasonable conduct for insurance companies, better known as Rules of the Road for Claims Handling.¹⁰

Some of these rules, including worker's compensation rules, are:

The insurer must treat the interests of the insured with equal consideration as it does its own interests. Kunkel v. United Security Ins.Co.of New Jersey, 168 N.W.2d 723 (S.D. 1969); Trouten v.Heritage Mut. Ins. Co., 632 N.W.2d 856 (S.D.2001).

Worker's Compensation is not an adversarial process. Sowards v. Hills Materials Co., 521 N.W.2d 649 (S.D.1994); Scissons v. City of Rapid City, 251 N.W. 2d 681 (1977).

It is part of the claims handler's job duties to help the insured with the claim. For instance, see S.D.C.L. § 58-12-1.

The company must promptly and thoroughly investigate every claim. S.D.C.L. § 58-33-7(1); S.D.C.L. 62-6-3; Champion v. United States Fidelitly and Guaranty Co., 399 N.W.2d 320 (S.D.1987); Isaac v. State Farm Mutual Ins. Co.,522 N.W.2d 752 (S.D. 1994); Walz v. Fireman's Fund Ins. Co., 556 N.W.2d 68 (S.D. 1996).

The company must be fair in its investigation of a claim. Eldridge v. Northwest G.F. Mut. Ins. Co., 221 N.W.2d 16 (S.D. 1974); Sawyer v. Farm Bureau Mut. Ins. Co.; 611 N.W.2d 644 (S.D. 2000).

Failure to conduct an investigation does not permit the company to deny the claim due to a lack of the same information that would have been known if they had investigated. Walz v. Fireman's Fund Insurance Co., 556 N.W.2d 68 (S.D.1996).

If payment is warranted, the company must promptly pay the claim. Champion v. United States Fidelity&Guaranty Co., 399 N.W. 2d 320 (S.D. 1987); see also S.D.C.L. § 58-33-67(1) and S.D.C.L. § 58-33-67(4).

Unless there is good reason not to, an insurance company should pay the claim. Champion v. United States Fidelity&Guaranty Co., 399 N.W.2d 320 320 (S.D.1987).

Denial of a claim should not be based on speculation. Champion v. United States Fidelity &Guaranty Co., 399 N.W.2d 320 (S.D.1987); Walz v. Fireman's Fund Insurance Co., 556 N.W.2d 68 (S.D.1996).

If a claim is denied, the company must promptly give an explanation in relation to the facts or law upon which it relies. S.D.C.L. § 58-33-67(3).

It would be improper for an insurer to tie in any manner claim personnel compensation to claim decisions or payments to insureds. Kunkel v. United Security Ins. Co. of New Jersey, 168 N.W.2d 723 (S.D.1969); Helmbolt v. LeMars Mut. Ins. Co., Inc., 404 N.W.2d 55 (S.D. 1987); Crabb v. Nat. Indem. Co., 205 N.W.2d 633 (1973).

The insurer has a duty to disclose all significant facts to the insured. Biegler v. American Family Mut. Ins. Co., 621 N.W.2d 592 (S.D.2001).

Detailed documentation must be contained in each claims file in order to permit reconstruction of the insurer's activities relative to each claim. S.D.C.L.§ 58-3-7.4.

Unless permitted by law or an insurance policy, it is an unfair claims practice to refuse to settle a claim of an injured claimant on the basis that the responsibility should be assumed by others. S.D.C.L. § 58-33-67(7).

The company cannot be recklessly indifferent to facts or proof submitted by an insured. Walz v. Fireman's Fund Insurance Co., 556 N.W.2d 68 (S.D.1996); Sawyer v. Farm Bureau, 619 N.W.2d 644 (S.D. 2000).

There is an implied covenant in every insurance contract that neither party will do anything to injure the rights of the other. This covenant includes the duty to settle claims without litigation in appropriate circumstances. Harter v. Plains Insurance Company, 579 N.W. 2d 625 (S.D.1998); Helmbolt v. LeMars Mut. Ins. Co., Inc, 404 N.W.2d 55 (S.D. 1987); Crabb v. Nat. Indem. Co., 205 N.W. 2d 633 (S.D.1973).

An insurer can commit bad faith by failing to perform an adequate investigation. Champion v. United States Fidelity&Guaranty Co., 399 N.W. 2d 320 (S.D.1987); Walz v. Fireman's Fund Insurance Co., 556 N.W.2d 68 (S.D.1996).

A company has a duty to understand the applicable case law before denying a claim. Walz v. Fireman's Fund Insurance Co., 556 N.W.2d 68 (S.D.1996).

In a worker's compensation case, a claimant has no obligation to give notice to his employer until the claimant, as a reasonable person, should recognize the nature, seriousness, and probable compensable character of the injury. Miller v. Lake Area Hospital, 551 N.W. 2d 817 (S.D.1996).

In a worker's compensation case, when the injury is gradual and progressive, the date of the injury is the date when pain prevents the injured employee from continuing work. Vaughn v. John Morrell, 606 N.W.2d 919(S.D. 2000); Tieszen v. John Morrell&Co., 528 N.W. 2d 401 (S.D. 1995).

An employer has a duty to provide necessary medical care to its employees for work- related injuries. S.D.C.L. § 62-4-1.

When an employer fails to provide that medical treatment, the claimant is within his/her rights to make suitable independent medical arrangements at the employer's expense. Cozine v. Midwest Coast Transport, 454 N.W.2d 548, 555 (1990).

Once notice has been given and a physician selected, or acquiesced to, the employer has no authority to approve or disapprove of the treatment rendered. Hanson v. Penrod Construction Co., 425 N.W. 396 (S.D.1988).

While these Rules of the Road may not be applicable in every case, pertinent rules can be used as guideposts at trial. These rules allow jurors to relate to insurance claims handling in much the same way that they relate to rules of the road for good driving. In other words, it provides them with standards for measuring an insurance company's conduct in handling a plaintiff's claim. More importantly, repeating these easily understood rules make it less likely that defense counsel will succeed in convincing jurors that the insurer's conduct was simply "a mistake."

¹⁰ Our thanks to Rick Friedman, Friedman, Rubin and White, the author of the Annotated Rules of the Road Master List.

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