Michael Sean Quinn, Ph.D., J.D., C.P.C.U, Etc.

Insurance bad faith is very exciting in Texas. Whether in its common law version or in its statutory version, it is not a contract but is a tort instead, or is at least tort-like.  (It is “tort-like” when it involves alleged or actual violations of relevant portions of the Texas Insurance Code. 

In the Supreme Court of Texas case of USAA Texas Lloyds Co. v. Menchaca, 14-0721 (Tex. April 7, 2017), the primary issue was “whether an insured can recover policy benefits as actual damages caused by an insurer’s statutory violation absent a finding that the insured had a contractual right to the benefit under the policy.” 

(It must be noted that this commentary is devoted to what has come to be called Menchaca I. There was a rehearing. This opinion was withdrawn, and a new, revised opinion was issued in 2018. USAA Tex. Lloyds Co. v. Menchaca, 545 S.W. 3d (Tex. 2018). This second opinion has come to be called Menchaca II. The “new” version, decided in response to a motion for rehearing, the court “unanimously reaffirmed the legal principles and rules announced in” Menchaca I. The court said in Menchaca II that what was written after the grant of rehearing was devoted to the procedural effect of those principles on the Menchaca case. In Menchaca II, the divided court is trying to clear up confusion resulting from its decisions which had been regarded as confusing for some years. 

Menchaca, I Answer: “No!,” generally speaking, said the court on the basis of the statute and past decisions, but this case involved procedural complications, said the court and so the case was sent back to the trial court.

Lawyers who practice insurance law have been “dancing together in joy” in a lot of places, but especially in courthouse lobbies.  The festivities are not based upon the achievement of justice, however, but on the fact that many insurance lawyers seem convinced that the results, in this case, will general new case after new case.  

(From a cynical point of view, I don’t understand the dancing since this will cut the litigation work for lawyers that represent insurance companies in litigation over the long haul, though it will give them a larger number of victories in the short term. The same may be true for coverage lawyers who do not handle the litigation, again, over the long haul but not the short term.)

Maybe I’m being uncharitable. Maybe they are excited because the Court announced five (5) separate rules for governing that are seeking to clarity its precedents “address[ing] the relationship between contract claims under an insurance policy and tort claims under the Insurance Code.” This might make pleading and briefing more coherent.

(I suppose I should admit that I am squeamish about court created and ordered widespread rules. It feels to me like an abandonment of the common law system and the adoption of the European “civil law” system.  Not that the European system is all bad. German criminal procedure is far better than ours. But “universal rules” ordained by a court rather than a legislature (including congress) break down the separation of powers, not that I think courts should be weak about interpreting statutes in new ways required by historical, cultural, and economic change!)    

So let’s take a look at the case. 

This was a Hurricane Ike case. Gail Menchaca’s house in Galveston Texas sustained damages. USAA sent an adjuster to inspect; he concluded that the damage was less than the deductible. Upon request, USAA sent a different adjuster to take another look. It did, but he too thought the damages were within the range of the deductible. The insured sued the insurer for breach of the insurance contract by failing to pay, plus statutory bad faith, plus attorney fees. 

Unlike most insurance cases, the case was tried. In Texas, most if not all jury trials in civil cases involve the jury being asked specific questions, the judge giving the jury instructions, and the jury answering the questions in accordance with the instructions it has been given. Lots of things can go wrong here, e.g.,  

  • a party or the parties ask wrong questions or fail to ask the right ones; 
  • questions are badly formulated; 
  • party or parties do not object in the right way; 
  • a judge has given wrong instructions or fails to give the right ones; 
  • the jury goes bonkers. 

Here’s what went wrong in this case: 

Question #1 asked if USAA failed “to comply with the terms of the insurance policy [contract] with respect to the claim for damages filed by Gail Menchaca resulting from Hurricane Ike.” “No” was the jury’s answer.

Question #2 asked whether USAA engaged in various “unfair or deceptive practices,” including whether USAA refused “to pay a claim without conducting a reasonable investigation with respect to” the claim under the insurance policy. “Yes” was the jury’s answer. 

Question #3 asked the jury to determine Ms. Menchaca’s damages which resulted from either the breach of contract (Question #1) or from statutory violations (Question #2). The jury entered $11,350.00 as the amount owed. 

The jury was instructed to calculate the damages as “the difference, if any, between the amount USAA should have paid Gail Menchaca for her Hurricane Ike damages and the amount she was actually paid.

The mistake, in this case, is easy to see. Once Question #1 is answered “No.” No other question should have been answered. Texas law has been clear for a long time that there being coverage is a necessary condition for any sort of insurer bad faith, though it is not sufficient.  In other words, but for the judges’ error in how the case was submitted to the jury, this would have been a simple case.

Unfortunately, the trial judge ignored the “No” answer to Question #1, entered judgment for Menchaca based upon Questions #2-3, and the court of appeals affirmed.

Before the Supreme Court, both parties agreed that Menchaca could not recover contract damages. Menchaca argued, however, that “what it should have paid” (“WSHP”), irrespective of contract coverage, can constitute a method of determining bad faith damages, even where there has been no jury finding that the insurance contract was breached. The fact is that the law of bad faith “supplements” the terms of the contract. It does not contradict or undermine it.

(Of course, in a commonsensical, ordinary language, there is always bad faith if the insurer conducts its claims handling in an unreasonable and therefore unacceptable way, which might mean anything from negligent adjustment practice to fraud.  The thing is –something that has not been grasped is that not all acts (or series of acts and omissions) which constitute bad faith cause damages. Consider medical malpractice. A doctor operates on Pat and does a terrible job, but Pat was certain to die anyway very shortly after the surgery, and doctor’s negligence caused no pain, e.g., because Pat never regained consciousness. (Admittedly, the “caused no pain” is a different concept in the context of insurance adjustment than it is in medical malpractice.)

What happened here is that counsel for the plaintiff stitched together its WSHP argument our of remarks here and there in two decades of Supreme Court decisions took them out of context and stumbled into appellate courts. (It may be that lawyers themselves were the principal source of the confusion as to the result of articles written in such places as the JOURNAL OF TEXAS INSURANCE LAW.)

That easily could have been the end of the case. The court decided to clarify its own history, however, but formulating 5 “new” “replacement rules.”** (If the court actually thinks that lawyer will not try and tinker with those rules by citing the “replaced opinions,” it is in for some frustrating years.) 

**This is MSQ’s phrase, not the court’s.

First Rule (R-1) (“The General Rule”). “[A]s a general rule, an insured cannot recover policy benefits as damages for an insurer’s statutory violations[,] if the policy does not provide the insured  a right to receive those benefits.”

Court’s Comment. This is the long established rule of Texas Supreme Court cases.  

Quinn’s First CommentNotice that this rule has nothing to do with breach of contract by the insurer. In effect, in says only that a necessary condition for an insured to have a right to policy benefits under the insurance policy, i.e., under the contract of insurance, is that the insurance policy or contracts specified a right to such benefits. Insurance companies have “always” thought that insurer bad faith (IBF) required a breach of the contract by the insurer, and this seems correct, intuitively and at first blush anyway, 

Quinn’s (Second) Comment. As formulated here this is an elegant rule, as it stands. It is also a theoretically possible way to “revise” insurance policies so as to bring bad faith within a policy as a new kind of coverage–implied terms or warranties  If this were to happen in a given policy, it would be a practical way to wipe out bad faith as a “supplementary” solution.  

I’ve often thought that many of the components of common law bad faith law could be construed as implied terms (maybe even warranties or the like) of insurance contacts anyway. This would neatly extend the statute of limitations for insurer-bad-faith-in-  claims-handling causes of action. It also fits with a well established principle of insurance adjuster ethics: “Look for coverage.” (This is a principle that I first learned from experienced adjusters in the 1980s. With one exception, no one has ever contradicted it whether in litigation, dialogue, or Q & A sessions after lectures have been given.) 

Second Rule (R-2) (“The Entitled-to-Benefits Rule”). “[A]n insured who establishes a right to receive benefits under the insurance policy can recover those benefits as actual damages under the Insurance Code if the insurer’s statutory violation causes the loss of the benefits.”

Court’s CommentThis rule is a “logical corollary to the general rule.”  The right to benefits was there–it existed under the contract–until the insurer  undermined or destroyed it. 

Quinn’s First Comment on R-2.  I do not understand why the EBR is a “logical corollary” of R-1. One proposition, q, is a logical corollary of another proposition, p, if and only if p entails q. (And usually, the word “corollary” is used when p is an axiom, or close to it. The reader may remember the first time she ever heard and studied that term. It was probably in plane geometry in high school.)

Quinn’s Second Comment on R-2. For many of us, it is difficult to see how R-2 and the traditional idea of insurer bad faith differ. Classically the concept went this way: there was a contract requiring payment by the insurer; some how the insurer ended up not doing it for some very poor reason other than a simple mistake; so there was a cause of action for something in excess of breach of contract, although there was a breach of contract, as well, since the insurer had not paid what it owed under the policy, a contract. Nobody wanted to talk about implied terms of the contract having been breached. I think the reason was that no one wanted insurer bad faith action to be treated as contract actions. That would create too many implied terms to argue about, and it would limit exemplary damages. 

Third Rule (R-3) (Benefits-Lost Rule). “[E]ven if the insured cannot establish a present contractual right to policy benefits, the insured can recover benefit as actual damages under the Insurance Code if the insurer’s statutory violation caused the insured to lose that contractual right.”  “[A]n insured who establishes a right to receive benefits under an insurance policy can recover those benefits as ‘actual damages’ under the statute[,] if the insurer’s statutory violation caused the loss of the benefits.”

Court’s Comment. An insurer might cause an insured to lose a contract right is several ways, e.g., by misrepresenting the content of the policy, by waiving or by being estopped from asserting its right to deny coverage, etc. 

Fourth Rule (R-4) (The Independent-Injury Rule). “[I]f an insurer’s statutory violation causes an injury independent of the loss of policy benefits, the insured may recover damages for that injury even if the policy does not grant the insured a right to benefits.” 

Court’s Comment.  “[A]n insurer’s extra-contractual liability is ‘distinct’ from its liability for benefits under the insurance policy.” 

First, if an insurer’s violation of the relevant statute causes an injury independent of–actually distinct from and not flowing from–benefits in the contract of insurance, then the insurer may have liability for that injury.” 

Second if, but only if, the insurer causes injuries to an insured actually independent of the benefits potentially available under the contract, the insurer may be liable for amounts in excess of policy limits.  Independent injury claims are rare. In fact, the Supreme Court has yet to see one, it said. 

So, how did the Supreme Court deal with the problems created by the procedural foul-up in the trial court?

Fifth Rule (R5) (“No Recovery Rule.”). “[A]n insured cannot recover any damages based on an insurer’s statutory violation if the insured has no right to receive benefits under the policy and sustains no injury independent of a right to benefits.” The Court describes this rule as a corollary of the other four (4) rules. 

Quinn’s Comment. These rules have been standard IBF rules in Texas for a generation. So what’s the big deal?

Q-Theory #1: it provides a meta-set of rules which will structure pleadings and briefing. 

Q-Theory #2: it will always bring breach-of-contract issues to the center–to their central place–in all insurance bad faith cases. 

This sets up a way to make bad faith cases much harder to prove since there are many prima facie ways to defeat breach of contract cases. Arguably, so a down-the-nose vision of the plaintiff’s bar goes, personal injury lawyers are not really “up to” handling breach of contract cases.   

So how did the court resolve the case? It went very roughly as follows:

Both of the courts below had mishandled Question #1. Although the Court did not quite say this, it implied that under the circumstances of this case, since Question #1 was supported by evidence and material to the jury’s verdict and therefore judgment, it had to figure in their decisions.  

So why didn’t the Court just decide the case? Under the circumstances of this case, if the insurer did not breach the contract, there could be no bad faith, although under quite different circumstances (that don’t apply here and which are unusual in any case), there could be insurer bad faith even though there was no breach of contract. 

However, said the court, since our previous opinions on this general matter are confusing, we must give trial court–and the parties–another shot at the matter.  

I think the Court was wrong about its own history, I don’t find it really confusing at all, except on one point, and USAA should have won this case “in a walk”–the indubitable result if the case is tried again, assuming all the relevant facts have been set forth in the Supreme Court opinion. 

If there was any confusion, it was not in the Supreme Court’s past opinions. it was in the careless thinking and/or writing found elsewhere. Lawyers and judges seem to forget that insurance policies are contracts, and if one is to claim that there is coverage when the insurer says (or insists) that there is not, the complaint against the insurer is for breach of the contract of insurance.  What an insured buys under the contract is the right to receive “benefits” under the contract, if its provisions are otherwise met and if the amount is determined in accordance with the explicit or implied nature of that contract. 

Insurer bad faith arises if there has been an unreasonable breach of a contract of insurance (including its implied terms such as the so-called special relationship) by the insurer–the breach being of a certain legally prohibited sort, given the circumstances.  A useful analogy is that insurer bad faith is like professional malpractice in adjusting claims or fraud in adjusting claims.  It must be remembered at this point that contracts of insurance are a special category; they create a “special relationship” between the insurer and the insured. 

There was a second virtually trivial confusion in this case. Sometimes, in some courts a problem appeared to have arisen as to whether there was coverage under the policy. What must be remembered is that the word “coverage” is used in four different ways. (And that fourth way is nothing but a result of semantic ignorance.) 

(1) In contracts of insurance, there are several sections. At least one of them is often entitled “Coverage”;  at least one other is called “Exclusions”, and part of the “Declarations” section is a specification of the “deductible amount” and/or the “self-insured” amount.  Often, when one says that the policy grants coverage, one is using the term to apply to the “Coverage” section only. When the term “coverage” is used in “sense #(1),” there would be coverage, even if the loss was within the deductible. Consequently, there are confused contexts in which one can say that there is no coverage in this sense. Sense #(1) is about a provision of a policy in abstracto. It is not policy language thought of as having any connection with the concrete facts involved in a claim. 

(2) There is a second use of the term “coverage” and that is that the policy, when taken as a whole, does not “grant” coverage. This second sense of coverage would include the “Exclusion” section, the “Conditions” section, and the matter of the deductible(s), as well as “self-insured retentions.”  In this sense, there can be no coverage under the policy, even if there would be coverage in a section entitled “Coverage.” This second sense of the word is also something that is to be understood in abstracto.

(3) There is a third sense of the term “coverage,” I suppose, which one sees from time to time and that is that coverage includes policy limits. In this sense of the word, anything within policy limits would be “covered,” even if it was not actually covered in any other sense. 

(4) There is a fourth sense of the term “coverage,” and this is a concrete meaning. The issue is whether a thing or event is covered under the terms found in the policy. The topic is whether an X is or is not covered. A crucial part of adjusting (or handling) claims is to investigate
and draw conclusions as to whether there is coverage for X. When makes a coverage decision, one is deciding whether X has coverage or is covered. When claimed handlers look for coverage, they are looking to see if there are any Xs that have coverage. 

These are elementary confusions, however, not confusions caused by the law of court decisions.  There is, thus,  a slight sloppiness in industry lingo that creates ambiguous usage. All competent lawyers know this. This ambiguity–or distinction, or customary use of language–should have made no difference in this case. If the insured’s loss was within the deductible, then there was no coverage for her loss in the second sense of the word “coverage.” End of story. 

Well, it turned out not to be the end of the story. The Court granted a rehearing. The five principles (R-1–R-5) remain the same and are approved (re-accepted) by the Court unanimously. 

Unanimity stopped there, however, and several different views as to how the trial of the case should have been handled were set forth. In a way, the rehearing is really mostly about civil and appellate procedure and not so much about substantive insurance law.  

*Michael Sean Quinn, Ph.D., J.D., C.P.C.U. Etc.
Law Office of Michael Sean Quinn 
2112 Hartford Rd.
Austin, Texas 78703
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