The Insurance Relationship as Relational Contract and the 'Fairly Debatable' Rule for First-Party Bad Faith
San Diego Law Review, Vol. 46, No. 3, p. 553, 2009
20 Pages Posted: 2 Dec 2009
Date Written: December 1, 2009
This article uses relational contract theory to discuss the standard to be applied to evaluate the behavior of insurance companies in first-party bad faith cases.
The article first briefly summarizes relational contract theory and describes the insurance contract as a prime example of a relational contract. It then describes the law of bad faith in first-party insurance cases-cases in which a policyholder alleges that the insurance company has violated the duty of good faith and fair dealing that is present in every contract and intensified in insurance contracts. The most widely adopted standard for bad faith is the “fairly debatable” test, under which an insurance company is liable only if it lacks a reasonable basis for denying benefits of the policy and knows or recklessly disregards the lack of a reasonable basis for denying the claim. Therefore, where a claim is “fairly debatable,” the company is held to have not acted in bad faith. Moreover, courts have created a procedural elaboration on the fairly debatable test, under which a policyholder who could not have established as a matter of law a right to summary judgment on the substantive claim is not entitled to assert a claim for an insurer’s bad-faith refusal to pay the claim.
The article argues that from the perspective of relational contract theory, the fairly debatable rule and the summary judgment elaboration are deeply flawed. Instead, negligence is a better rule because it recognizes that the relationship between the company and policyholder is one of security, in which the company has adopted a role of acting not as an adverse party to its insured, but in a responsible manner to give the insured the benefits it reasonably expects. A negligence rule also recognizes and deters the possibility of insurer opportunism in the area of claim practices. The rule also serves the broader social role of the insurance relation in providing indemnity and security for large numbers of people.
This article is a contribution to a symposium in memory of Professor Richard Speidel.
Keywords: contracts, contract law, insurance, insurance law, relational contract, bad faith
JEL Classification: K12, K13, K39
Suggested Citation: Suggested Citation