Miller and McCarthy

The analysis, conclusions, and opinions expressed in these materials are not intended to be legal advice. The facts of each case are unique, and these materials are for professional education use only.

* Although the Texas Legislature has enacted a ‘new’ Texas Insurance Code effective April 1, 2005, it is merely a non-substantive recodification of the ‘old’ Texas Insurance Code, but with section numbering rather than article numbering. For consistency of analysis of court opinions, the authors refer to the same ‘article’ references set forth in each court opinion. The authors will be happy to send a copy of the disposition table showing each article’s corresponding new section number at the reader’s request.

The purpose of a reservation of rights letter is to allow the insurer to provide a defense for its insured while it investigates coverage issues. J.E.M. v. Fid. & Cas. Co. of New York, 928 S.W.2d 668, 673 (Tex. App.—Houston [1^st Dist.] 1996, no writ). An insurer does not determine its duty to defend based on the causes of action alleged; rather, the insurer makes its determination based on the facts alleged in the pleadings of the underlying suit coupled with the language of the policy provisions. Id., citing Heyden Newport Chem. Corp. v. Southern Gen. Ins. Co., 387 S.W.2d 22, 24-25 (Tex. 1965). An insurer may offer to defend an insured subject to a reservation of its rights if the petition against the insured includes both covered and non-covered claims. Am. Eagle Ins. Co. v. Nettleton, 932 S.W.2d 169, 174 (Tex. App.—El Paso 1996, writ denied). Under such circumstances, an insurer’s offer to defend an insured subject to a reservation of rights is not a breach of the insurer’s duty to defend. First Gen. Realty Corp. v. Maryland Cas., 981 S.W.2d 495, 501 (Tex. App.—Austin 1998, pet. denied).

A reservation of rights may also be appropriate when the insured must answer suit before the insurer has an opportunity to determine whether the claim asserted against the insured is covered under the policy. Costley v. State Farm Fire & Cas. Co., 894 S.W.2d 380, 384-85 (Tex. App.—Amarillo 1994, writ denied) (no breach of duty by insurer who offered to defend with reservation of rights because answer due five days after notification of suit).

An insurer’s reservation of its rights must be timely to be effective. Rhodes v. Chicago Ins., a Div. of Interstate Nat., 719 F.2d 116, 120 (5th Cir. 1983). When a defense is undertaken through a valid reservation of rights, the insurer may withdraw its defense when it becomes clear there is no coverage under the policy. Katerndahl v. State Farm Fire & Cas. Co., 961 S.W.2d 518, 521 (Tex. App.—San Antonio 1997, no pet.). However, if the document reserving the insurer’s right to withdraw states that the insurer will give the insured reasonable notice before withdrawing, the insurer must do so. W. Cas. & Sur. Co. v. Newell Mfg. Co., 566 S.W.2d 74, 76 (Tex. Civ. App.—San Antonio 1978, writ ref’d n.r.e.). To be reasonable, the notice must be given when the insurer learns of the policy defense or as soon thereafter as is reasonable. Providence Wash. Ins. v. A & A Coating, 30 S.W.3d 554, 556-57 (Tex. App.—Texarkana 2000, pet. denied) (holding insurer liable for insured’s defense costs because insurer either gave no notice of intent to withdraw defense or waited seven months after learning of defense, until two days before suit settled, to give notice). Moreover, the notice should be given at a point when the insured can still take appropriate measures to defend itself. Id. at 557, quoting Newell Mfg., 566 S.W.2d at 77.

In order to be effective, a reservation of rights letter must be received by the insured. Scottsdale Ins. Co. v. Sessions, 331 F.Supp. 2d 479, 490-91 (N.D. Tex. 2003). In Texas, “when a letter properly addressed and with postage prepaid is mailed, a presumption of fact (rebuttable of course) arises that it was duly received by the addressee.” Id. at 491, quoting Southland Life Ins. Co. v. Greenwade, 138 Tex. 450, 159 S.W.2d 854, 857 (1942). To establish proof of this presumption, the insured must show evidence of the address to which the notice was mailed and evidence of prepayment of postage for the mailing. Id. Failing to establish these two requirements can lead to a finding that the letter was not actually received. See id. (holding insured failed to provide proof required for creation of presumption because evidence did not establish address of insured or that postage was prepaid).

Waiver/Estoppel of Coverage Defenses When Defending Without Reservation of Rights: The “Wilkinson Exception.”

When an insurer assumes or continues the defense of the insured without issuing a reservation of rights letter or obtaining a non-waiver agreement, the insurer may waive or be estopped from raising its policy coverage defenses if it has sufficient knowledge of facts indicating there may be no coverage under the policy. Farmers Tex. County Ins. Co. v. Wilkinson, 601 S.W.2d 520, 521-22 (Tex. App.—Austin 1980, writ ref’d n.r.e.); see also Tull v. Chubb Group of Ins. Co., 146 S.W.3d 689, 694 (Tex. App.—Amarillo 2004, no pet.). This rule is known as the “Wilkinson exception” because the general rule is that the doctrines of waiver and estoppel may not be used to create insurance coverage when none exists under the terms of the insurance policy. See Tex. Farmers Ins. Co. v. McGuire, 744 S.W.2d 601, 602-03 (Tex. 1988); State Farm Lloyds, Inc. v. Williams, 791 S.W.2d 542, 550 (Tex. App.—Dallas 1990, writ denied). A case does not fall within the Wilkinson exception unless the insured was prejudiced by the insurer’s continued defense of the insured without a reservation of rights or a non-waiver agreement. See Employers Cas. Co. v. Tilley, 496 S.W.2d 552, 559 (Tex. 1973); Tull, 146 S.W.3d at 695; Paradigm Ins. Co. v. Tex. Richmond Corp., 942 S.W.2d 645, 652-653 (Tex. App.—Houston [14th Dist.] 1997, writ denied) (holding insurer did not waive policy defenses when it filed answer on insureds’ behalf and sent insured reservation of rights letter fifteen days later).

The Wilkinson exception exists to protect the insured from the potential or actual conflict of interest that might arise between the insurer and the insured. Williams, 791 S.W.2d at 550. A conflict of interest may arise when the insurer defends the insured while simultaneously formulating and bolstering its coverage defenses against the insured. Tilley, 496 S.W.2d at 559. In addition, another policy underlying the Wilkinson exception is that an insured who has accepted a defense by the insurer has given up the right to control its own defense. Williams, 791 S.W.2d at 550. An insured may also be harmed by the insurer’s conduct of the defense if the insurer refuses to accept a settlement offer and a judgment for a higher amount is eventually rendered against the insured. See Williams, 960 S.W.2d at 786 (holding insured harmed by insurers refusal to settle case for policy limits of $600,000 when jury returned verdict against insured for $4.25 million). In such a case, the insurer’s defense without a reservation of rights deprives the insured of the opportunity to reject the qualified defense, assume its own defense, and accept the settlement offer. See id.

In Tull, cited above, Shaffer was operating an automobile owned by her employer (“Chase”) when she was involved in a collision with Tull. 146 S.W.3d at 691. At the time of the accident, Shaffer was not performing work for Chase, had her boyfriend riding as a passenger, and was intoxicated. Id. Chase had an automobile insurance policy with Federal Insurance Company (“Federal”) and Federal paid for Tull’s property damage and entered into negotiations with Tull to settle the matter. Id. at 691-92. Tull brought suit against Shaffer for injuries sustained in the accident but the suit did not name Chase as a defendant. Id. at 692. Federal hired an attorney to defend Chase “in the litigation filed against their driver, Melissa Schaeffer [sic].” Id. Tull was unable to obtain personal service on Shaffer and, with permission of the trial court, served her by substituted service to her father’s home address. Id. Federal sent a reservation of rights letter to Shaffer at her father’s address eighteen months after suit was filed. Id.

Two years after filing suit, Tull obtained a default judgment against Shaffer for $654,200.21. Id. In an effort to recover judgment, Tull filed suit against Federal and against his own automobile insurer (“Farm Bureau”) for uninsured motorist coverage. Id. Federal filed a counterclaim seeking declaratory judgment that it had no obligation to defend or indemnify Shaffer. Id. at 693. Federal moved for summary judgment on its counterclaim and Farm Bureau argued Federal was prevented by estoppel or waiver from denying coverage because it assumed the defense with knowledge of non-coverage issues. Id. The trial court granted Federal’s summary judgment motion. Id.

The Amarillo Court of Appeals found Federal’s actions, undertaken before Shaffer was served and before limitations expired, were not evidence that Federal undertook the defense of Shaffer. Id. at 695. Moreover, the court determined Farm Bureau was not prejudiced by Federal’s conduct because prejudice to Farm Bureau could not substitute for prejudice to Shaffer for the purposes of the Wilkinson exception. Id. Thus, Federal was not estopped from asserting its non-coverage defense and the Amarillo Court affirmed the judgment of the trial court. Id. at 699.

An insurer may use one of two ways to reserve its rights to assert coverage defenses at a later date while continuing to defend the insured: (i) a “reservation of rights letter;” or (ii) a “non-waiver agreement.”

A reservation of rights letter is a letter sent by the insurer notifying the insured of the coverage defenses the insurer may at some point rely on to deny coverage and that its defense of the insured will not waive these defenses. See J.E.M., 928 S.W.2d at 672-74. If the insured does not respond to the reservation of rights letter by refusing the defense under reservation of rights, the insured’s silence will amount to consent and the insurer will not be estopped to raise its coverage defenses or be deemed to have waived its defenses. See Newell Mfg., 566 S.W.2d at 76.

A “non-waiver agreement” is a bilateral agreement signed by the insurer and insured that expressly provides that the defense of the suit by the insurer, or other conduct of the insurer, will not result in a waiver of the rights of the insurer under the policy. Id. An insurer will not be deemed to have waived its rights under the policy when the insurer and its insured enter into a non-waiver agreement setting forth the rights reserved by the insurer and informing the insured that the future actions of the insurer will not waive the insurer’s rights or admit any obligations under the policy. Stonewall Ins. Co. v. Villarreal, 591 F.2d 345, 347 (5th Cir. 1979).

A reservation of rights will not be extended by implication beyond its exact terms. Newell Mfg., 566 S.W.2d at 76. Thus, a reservation of rights that is ambiguous must be construed strictly against the insurer and liberally in favor of the insured. Wilkinson, 601 S.W.2d at 523. A reservation of rights letter must sufficiently inform the insured of the insurer’s position. J.E.M., 928 S.W.2d at 672. The reservation of rights should specifically set forth the defenses on which the insurer may rely and should disclose any potential conflict of interest that may arise when a defense attorney has been retained to represent the insured while being compensated by the insurer. Id. at 673-74.

In J.E.M. v. Fidelity & Casualty Company of New York, the First Court of Appeals found the following reservation of rights letter to be sufficient:

As you know, per our discussion of November 5, 1992, we represent Fidelity & Casualty Company, the insurance carrier for [the defendants] under the above captioned policy. You may also be aware that we have been asked to investigate and defend a claim involving the above captioned. The purpose of this letter is to inform you with respect to its investigation of this matter, or any claims arising out of it, the negotiation, settlement of any claims, or in the undertaking of the defense in the lawsuit, Fidelity & Casualty reserves the right to assert any and all defenses it may have as to the claims alleged against you. According to the Plaintiff’s Original Petition, sexual offenses against the plaintiff are believed to have occurred one or more times in 1977, 1978, and 1979. Your policy of insurance with Fidelity & Casualty Company, as stated above, was from 9/5/90 to 9/5/91. Consequently, you would have no insurance coverage for any of the allegations regarding [J.E.M.] because the allegations occurred outside of your policy effective dates. We would instruct you to immediately place Farmers Insurance Company on notice of this claim as those policies were in effect during that time. . . . The petition also alleges intentional acts and we wish to advise you that any covered allegations which are the result of any intentional act will not be covered. Please refer to your Homeowners Policy Coverage D Exclusions – Coverage D shall not apply: (5) To bodily injury or property damage caused intentionally or at the direction of the insured[.] The petition also alleges damages as a result of sexual acts. I wish to direct you [sic] attention to Coverage D – Personal Liability Exclusions – Coverage D shall not apply: (11) To bodily injury or property damages which arises out of the transmission of sickness or disease by an insured through sexual contact. We also wish to advise you that the petition does not pray for damages in a specific amount and may result in a verdict in excess of your policy limits of $50,000. We therefore wish to advise you that you may, at your own expense, retain outside counsel to oversee you in this litigation. We are not suggesting you do so but merely advising you of your right. We additionally reserve our right to file a Declaratory Judgment action at any time prior to or after the conclusion of this litigation. We will continue to provide a defense to you until these coverage issues are resolved. In the meantime we will be researching the aforementioned coverage issues and will advise you immediately of our determination of coverage and if we will continue to provide you with a defense.

Based upon the court’s ruling in J.E.M., the best practice for the insurer is to author a reservation of rights letter that: (i) identifies the policy; (ii) informs the insured the insurer will provide a defense under a reservation of rights; (iii) identifies specific policy provisions which may result in non-coverage; and, if applicable, (iv) informs the insured they have the right to secure independent counsel because there may exist liability in excess of the policy limits. See id. at 674.

Many insurance policies give the insurance company the right to direct the defense of litigation arising from claims covered by the policy. A liability insurer is obligated to defend a suit if the facts alleged in the pleading would give rise to any claim within the coverage of the policy. Utica Nat’l Ins. Co. v. Am. Indemnity Co., 141 S.W.3d 198, 201 (Tex. 2004). Whether an insurer is obligated to defend the insured is a question of law to be determined by the court. Fielder Road Baptist Church v. GuideOne Elite Insurance Co., 139 S.W.2d 384, 387 (Tex. App.—Fort Worth 2004). An insurer’s duty to defend is determined solely by the allegations in the live pleading and the language of the insurance policy. Id. This is known at the “eight corners rule.” Id. at 388. The language of the pleadings is considered in light of the policy provisions. Id. The facts asserted in the pleadings are considered true, regardless of what the parties may actually know or believe. Id. Under the eight corners rule, the facts alleged in the live pleading are given a liberal interpretation, the legal theories are not given weight, and all doubts concerning the duty to defend are resolved in favor of the insured. Id. If the facts alleged in the live pleading, taken as true, would potentially state an event covered by the policy, then the duty to defend is triggered. Northfield Ins. Co v. Loving Home Care, Inc., 363 F.3d 523, 528 (5^th Cir. 2004). Further, even if only one of multiple events alleged in the live pleading are potentially covered by the policy, the duty to defend is triggered. Id.

The duty to defend is not affected by facts learned before suit, uncovered during the course of litigation, or the actual outcome of the case. Fielder Road, 139 S.W.3d at 388. Simply put, if the live pleading does not alleged facts within the scope of coverage, then the insured is not within the terms of the policy. If the live pleading does allege facts within the scope of coverage, then the insurer has the duty to defend. Further, under the eight corners rule, once the insured has triggered the duty to defend, the insurer has the burden to show that the plain language of a policy exclusion or limitation allows the insurer to avoid coverage of all claims. Northfield, 363 F.3d at 528.

In the Fielder Road case, the church held a CGL policy from GuideOne. The policy covered the time period March 31, 1993 through March 31, 1994, and had a sexual misconduct clause. In June of 2001, “Jane Doe” filed a sexual misconduct lawsuit against the church and Charles Patrick Evans. Doe alleged in her suit that “at all material times herein from 1992 to 1994, Evans was employed as an associate youth minister and was under Fielder Road’s direct supervision and control when he sexually exploited and abused Plaintiff.” The church demanded GuideOne provide a defense to the church and indemnify the church for any judgment or settlement. GuideOne provided a defense subject to a reservation of rights.

In September of 2001, GuideOne filed suit against the church, seeking a declaratory judgment that GuideOne did not have the duty to defend or the duty to indemnify the church in the underlying sexual misconduct suit. During this suit, the church filed a “stipulation” that Charles Patrick Evans was a part-time intern in the church’s youth department on November 14, 1991, became a part-time associate in the youth department on January 1, 1992, and left the church’s employ on or about December 15, 1992. He did not work for the church after that date. He was officially removed as a member of the church in February of 1993.

Both the church and GuideOne filed motions for summary judgment. GuideOne asserted that Jane Doe had “artfully” pleaded facts to bring her claims within the coverage of GuideOne’s policy and asserted it could use extrinsic evidence regarding Evans’ employment to rebut the allegations and show there was no coverage. The trial court ruled that GuideOne did not have a duty to defend the church. On appeal, the trial court’s judgment was overturned. The appellate court ruled the eight corners rule applied and that any exceptions to the rule were not implicated by the circumstances of the case. The appellate court took the allegations of the live pleading as true, compared them to the coverage provided by the policy, and concluded the stipulation was not admissible to determine whether GuideOne had a duty to defend. The court ultimately concluded that GuideOne had a duty to defend the church in the underlying litigation. The appellate court sent the coverage case back to the trial court to consider the church’s request for costs and attorney’s fees.

Only in rare instances is extrinsic evidence used to show there is no duty to defend; extrinsic evidence meaning in this context any evidence beyond the facts alleged in the live pleadings. Id. Those limited circumstances include:

These are fundamental issues that may be resolved without making a determination of the truth or falsity of the allegations contained within the pleading. Id. The court may also consider extrinsic evidence in instances where:

2. the live pleading does not contain sufficient facts to allow a determination that the events complained of are covered by the policy.

Extrinsic evidence can only be used to determine coverage, not to determine if the insured is liable as alleged by the plaintiff. Id. As shown in the Fielder Road case, even if facts develop during the case that show that the insurer does not have a duty to indemnify, the pleadings are the trigger for the duty to defend. Even if the plaintiff is “creative” in its pleading and alleges facts that appear to be calculated to trigger coverage, the insurance company cannot avoid its duty to defend if the facts alleged describe a covered event. Id.

The Northfield case is another illustration of allegedly “creative” pleading by a plaintiff that resulted in the triggering of the duty to defend. Loving Home Care, Inc. was in the business of providing in-home nannies for child care. Loving Home had a commercial professional liability and commercial general liability insurance policies issued by Northfield. One of Loving Home’s nannies fatally injured the Barrows’ baby daughter. The nanny was eventually sentenced to seven years in prison after being convicted of first-degree injury to a child. The Barrows sued Loving Home. In the Barrow’s initial pleadings, they had included allegations that the nanny had engaged in criminal and/or intentional behavior. However, in their third amended petition, the Barrows had removed all allegations regarding criminal or intentional conduct. The third amended petition did include an allegation that the nanny had negligently caused the injuries to the Barrows’ daughter. In the suit on the coverage issue, the trial court ruled that Northfield had a duty to defend based on the facts alleged in the third amended petition. The appellate court upheld the trial court’s ruling, holding the petition pleaded facts that brought the case within Northfield’s coverage and that it would not consider extrinsic evidence to the contrary. The appellate court also stated that even if extrinsic evidence were considered, the evidence did not fit into any of the recognized exceptions to the eight corners rule.

In Texas, the duty to defend is separate and distinct from the duty to indemnify. Utica, 141 S.W.3d at 203. Even if the insurance company breaches its duty to defend, the party seeking indemnity has the burden to prove coverage if the insurer contests coverage. Id. The duty to defend is broader than the duty to indemnify. Northfield, 363 F.3d at 528. The determination of whether a claim is covered by a particular insurance policy often turns on the resolution of fact questions that are not settled until the underlying litigation is concluded. Utica, 141 S.W.3d at 203-04. It is these facts, not the allegations contained in the live pleadings, which trigger the duty to indemnify. Northfield, 363 F.3d at 529. Generally, these issues cannot be resolved until after the completion of the underlying litigation. Id.

The terms of an insurance policy, when unambiguous, are given their plain, ordinary, and generally accepted meaning unless the policy itself shows the terms have been used in a technical or different sense. Fielder Road, 139 S.W.3d at 390. Ambiguities and exclusions are strictly construed against the insurer. Northfield, 363 F.3d at 529. To determine the scope of coverage, the policy as a whole is examined to ascertain the true intent of the parties. Utica, 141 S.W.3d at 202. If the language in dispute is an exclusion to coverage, the court must adopt the interpretation of the exclusion urged by the insured as long as that interpretation is not unreasonable. Id. The court will adopt an insured’s not unreasonable interpretation even if the insurer’s interpretation appears to be more reasonable or a more accurate reflection of the parties’ intent. Id.

The Utica case illustrates these concepts. Utica provided insurance to the Mid-Cities Surgi-Center. David Wayne Thomas was employed by Mid-Cities, and during his employment, he stole narcotics from the surgical center. It appeared Thomas stole the narcotics by withdrawing the drugs from glass ampoules, injecting the drugs into his body, then refilling the ampoules with saline solution. Thomas resealed the packaging to cover up his crime. It further appeared that Thomas used the same syringe for his crimes and that he spread his Hepatitis C to other Mid-Cities patients. The patients sued Mid-Cities, alleging, among other things, that Mid-Cities negligently failed to secure its narcotics and negligently exposed patients to contaminated medication.

Mid-Cites was originally defended by its professional liability carrier, but this carrier became insolvent, and the defense was assumed by the Texas Property and Casualty Insurance Guarantee Association. After a series of twists and turns, Mid-Cities’s general liability carrier at the time of the litigation filed suit against TPCIGA and Utica, the carrier of Mid-Cities’s CGL policy at the time of the alleged infection, seeking reimbursement for the costs of settling the underlying case and judgment apportioning responsibility for the costs of defending the underlying case.

Utica asserted that policy exclusions in the CGL policy took them out of coverage. One of these exclusions was for professional services. The exclusion covered “bodily injury . . . due to rendering or failing to render any professional service.” TPICGA argued the language was meant to prevent overlap between the CGL and Mid-Cities’s professional malpractice policy. TPICGA also argued the exclusion would only come into play if there was an allegation that the insured violated a professional standard of care and that failing to secure a narcotics cabinet was not a violation of a professional standard. The Supreme Court of Texas held that TPICGA’s interpretation of the exclusion was not unreasonable and, therefore, the exclusion did not apply. As a result, Utica had to pay its share of the costs of defense. However, the Supreme Court declined to determine whether Utica had a duty to indemnify, and sent the case back to the trial court to make that determination.

Under Texas law, there is a distinction between “separate and independent” causation and “concurrent” causation when a plaintiff is injured by both covered and excluded events. Utica, 141 S.W.3d at 204. Under separate and independent causation, both the covered event and the excluded event operated independently to cause the plaintiff’s injury. Id. In that instance, the insurer must provide coverage despite the exclusion. Id. An example of this situation occurred when a hospital was sued for failing to secure windows and to properly supervise a patient. This patient committed suicide, and the courts determined that both failures proximately caused the suicide and, therefore, the professional exclusion did not apply. Under concurrent causation, the excluded and covered events combine to cause the plaintiff’s injury. Id. In this instance, the exclusion applies, and there is no coverage. Id. For example, if the failure to follow corporate safety standards was necessarily derivative of excluded negligent driving claim, then the exclusion applied. In Utica, the Supreme Court sent the case back to the trial court to make a determination of whether the plaintiffs’ infections were caused by a violation of a professional standard of care. This fact issue had to be resolved before a determination could be made regarding the duty to indemnify.

When the insurance policy gives the insurer the right to conduct the insured’s defense, that right generally includes the authority to select the attorney who will defend the claim and to make other decisions that would otherwise be vested in the insured as the named party in the suit. Northern County Mutual Ins. Co. v. Davalos, 140 S.W.3d 685, 688 (Tex. 2004). The right is not absolute, and certain circumstances may preclude an insurer from exercising its right to control the defense. Id. These circumstances include disputes over the existence or scope of coverage. Id. In these instances, the insurer will typically issue a reservation of rights letter. When the facts to be determined in the underlying suit are the same facts upon which coverage depends, then the resulting conflict of interest precludes the insurer from conducting the defense. Id.

Other examples of circumstances precluding an insurer from controlling the defense are:

1. when the defense tendered is not a complete defense under the circumstances in which it should have been;

2. when the attorney hired by the insurance company acts unethically and, at the insurer’s direction, advances the insurer’s interests at the expense of the insured’s;

3. when the defense provided would not, under the applicable law, satisfy the duty to defend, and;

4. when, though the defense is otherwise proper, the insurer attempts to obtain some type of concession from the insured before it will defend.

The most recent case on this subject is the Davalos case. In that case, Davalos was injured in an accident in Dallas County. Davalos, a resident of Matagorda County, sued the driver of the other car in Matagorda County. The other driver and his wife then sued Davalos and another person in Dallas County over the same incident. When Davalos was sued in Dallas County, he turned that case over to the attorneys handling the Matagorda County litigation. These attorneys answered the Dallas suit and then moved to transfer the Dallas case to Matagorda County. Northern County Mutual Insurance Company, which covered Davalos, was not notified of the Dallas County litigation until after the Matagorda County attorneys began working on the Dallas County case.

Northern told Davalos that it did not want to hire the Matagorda County attorneys to defend the Dallas County case and that it opposed his motion to transfer the Dallas County case to Matagorda County. Northern provided Davalos with an attorney to defend the Dallas County case. Northern further suggested that liability protection might be jeopardized if the Matagorda County attorneys did not abandon the motion to transfer venue and withdraw from the case. Northern told Davalos he could pay for his own attorney and that Northern would cooperate to the extent it did not jeopardize the defense. The Matagorda County attorneys did not withdraw from the case and, ultimately, Davalos refused Northern’s defense.

As things turned out, the Matagorda County litigation was eventually transferred to Dallas County, although it was not combined with the existing Dallas County litigation. Further, Northern settled the first Dallas County litigation, obtaining a full and final release for Davalos in that case.

While the first Dallas County case was working itself out, Davalos sued Northern in Matagorda County, asserting Northern had breached its duty to defend, had acted in bad faith, and had violated the Texas Insurance Code. Northern lost at the trial court and before an intermediate court of appeals. However, the Supreme Court of Texas ruled for Northern. The Court stated that Northern’s action did not deprive Davalos of a defense attorney’s independent counsel on any issue. Had Davalos accepted the attorney provided to him by Northern, Davalos still could have submitted the venue issue to the provided attorney for independent determination. The Court noted the provided attorney has an unqualified loyalty to the insured and is required to protect the interests of the insured, even if those interests might be compromised by the insurance company’s insurance. The choice of where to defend a claim is a strategic decision that must be made in conducting the defense of the insured and would ordinarily not have an impact on the insurance company’s legitimate interests under the policy. Therefore, Northern fulfilled its duty to defend when it offered counsel for the first Dallas County case

The duty to defend is determined by the facts of the live pleading and the policy language, regardless of extrinsic evidence to the contrary. Only in limited circumstances can extrinsic evidence be used to challenge coverage, and only in situations where extrinsic evidence concerns coverage, not ultimate liability of the insured. The duty to indemnify is not as broad as the duty to defend, and is determined by the facts ultimately revealed by the underlying litigation. The scope of coverage is determined by the language of the policy. Exceptions to the policy will be construed in favor of the insured, and not unreasonable constructions of exclusions made by the insured will be favored over the interpretations of the exclusion made by the insurer. Ordinarily, an insurer with the right to defend a claim will be able to select the attorney who will defend the claim. This right is not absolute, and under certain circumstances, conflict will prevent the insurance company from selecting defense counsel.

Whether an insurer has the right to conduct its insured’s defense is a matter of contract. Northern County Mut. Ins. Co. v. Davalos, 140 S.W.2d 685, 688 (Tex. 2004). The right to conduct the defense includes the authority to select the attorney who will defend the claim and to make other decisions that would normally be vested in the insured as the named party in the case. Id., citing State Farm Mut. Auto Ins. Co. v. Traver, 980 S.W.2d 625, 627 (Tex. 1998). However, when a conflict of interest exists, an insurer may not insist upon its contractual right to control the defense. Id.

Ordinarily, the existence or scope of coverage is a basis for disqualifying the conflict. Id. In a typical coverage dispute, an insurer will issue a reservation of rights letter, which creates a potential conflict of interest. Id. Additionally, an insured may rightfully refuse to accept the insurer’s defense when: (1) the defense tendered is not a complete defense under the circumstances; (2) the attorney hired by the insurer acts unethically and, at the insurer’s direction, advances the interests of the insurer at the expense of the insured; (3) the defense would not, under the governing law, satisfy the insurer’s duty to defend; or (4) the insurer seeks to obtain some type of concession from the insured before it will defend. Id. at 689.

A lawyer owes an unqualified loyalty to his client and “neither his personal interests, the interests of other clients, nor the desires of third persons should be permitted to dilute his loyalty.” Tilley, 496 S.W.2d at 563 (Johnson, J., concurring). It is “impermissible under the Texas Disciplinary Rules of Professional Conduct for a lawyer to agree with an insurance company to restrictions which interfere with the lawyer’s exercise of his or her independent professional judgment in rendering such legal services to the insured/client.” Tx. Ethics Op. 533 (September 2000). Examples of impermissible limitations imposed by an insurance company’s litigation/billing guidelines are:

2. What, if any, legal research may be conducted by the lawyer in defense of the insured;

4. Whether the defense counsel may investigate the claims made against the insured;

6. Whether any motions, including, motion[s] to dismiss or for summary judgment, may be filed; and

7. Whether the lawyer or a paralegal should engage in the preparation of various documents.

Id. Notwithstanding the above limitations, insurers may place reasonable requirements related to third-party payment for legal representation, such as “when to submit statements for legal services rendered or similar routine matters not affecting the actual representation of the client.” Id.

In the end, the guiding principle for determining whether the insurer’s litigation/billing guidelines are permissible is whether the guidelines in any way limit the lawyer’s ability to freely exercise his independent professional judgment in rendering legal services to the client. Id.

The defense of a lawsuit covered by liability insurance involves a “tripartite” relationship consisting of the insured, the insurer, and the defense counsel. Am. Home Assur. Co., Inc. v. Unauthorized Practice of Law Comm., 121 S.W.3d 831, 833 (Tex. App.—Eastland 2003, pet. granted). As a result of this tripartite relationship, a national debate has ensued regarding whether the use of staff counsel by insurance companies constitutes the unauthorized practice of law by corporations. See id. at 833-34. The argument for limiting the use of staff attorneys by insurance companies is “based on the syllogism: (1) a corporation cannot practice law; (2) staff attorneys, whose sole client is the insured, are agents of the insurance corporation; and (3) therefore, the insurance company is practicing law.” Id. at 836.

In a case of first impression, the Eastland Court of Appeals held the “[u]se of staff attorneys to represent insureds does not violate the current Texas Rules [of Professional Conduct]” and “is not the unauthorized practice of law” by a corporation. Id. at 846. That court determined the insurance company was not partaking in the unauthorized practice of law because the attorney was representing the insured as well as the insurance company’s direct financial interest. Id. at 846. In coming to this conclusion, the Eastland court noted “the purpose of an insurance company is to indemnify its insureds for a fee. When the insurance company provides a staff or outside attorney to the insured, it is seeking to protect its own interests.” Id. at 842. Moreover, that court found the purpose behind prohibiting the unauthorized practice of law is to protect the public from the mistakes of those who are not properly trained and licensed to practice law. Id. at 845. Because staff attorneys are properly trained and licensed to practice law they do not meet the purpose of the law and should not be precluded from representing insureds. Id.

Chapter 42 of the Texas Civil Practice & Remedies Code, as implemented by Rule 167 of the Texas Rules of Civil Procedure, penalizes parties who reject reasonable settlement offers. For any action filed on or after January 1, 2004, Texas courts must award litigation expenses actually paid or for which the offeror is obligated to pay against a party who rejects a settlement offer made under Rule 167. Tex. Civ. Prac. & Rem. Code Ann. ß 42.004(a) (Vernon Supp. 2004); Tex. R. Civ. P. 167.1 (including offers to settle counterclaims, cross-claims, or third-party claims). Recoverable litigation expenses include court costs, reasonable fees for not more than two testifying experts, and reasonable attorney’s fees directly related to the case. Tex. Civ. Prac. & Rem. Code ß 42.001(5); Tex. R. Civ. P.167.4(c).

A claimant may not initiate the application of Rule 167; rather, the rule only applies to a cause of action when a defendant first files a written declaration invoking it. Tex. R. Civ. P. 167.2(a); see also Tex. Civ. Prac. & Rem. Code ß 42.002(c). Once invoked, however, litigation costs may be assessed against either the claimant or the defendant based on an offer or counter-offer made under the rule. Tex. R. Civ. P. 167.4(a); see also Tex. Civ. Prac. & Rem. Code ß 42.004(a). The rule applies only between a defendant who invokes the rule and the claimant against whom the rule is invoked; however, the rule does not apply to offers made at mediation or arbitration. Tex. R. Civ. P. 167.7. Therefore, the rule does not apply to other parties, other claims, or even to offers relevant to the claim itself that were not specified as invoking the rule. Id.

Pursuant to Rule 167.2(b), a settlement offer must: (1) be in writing; (2) state that it is made under Rule 167 and Chapter 42 of the Texas Civil Practice and Remedies Code; (3) identify the party or parties making the offer and the party or parties to whom the offer is made; (4) state the terms by which all monetary claims (including any attorney fees, interest, and costs that would be recoverable up to the time of the offer) between the offeror or offerors on the one hand and the offeree or offerees on the other may be settled; (5) state a deadline no sooner than fourteen (14) days after the offer is served by which the offer must be accepted; and (6) be served on all parties to whom the offer is made. Tex. R. Civ. P. 167.2(b); see also Tex. Civ. Prac. & Rem. Code ß 42.003. Moreover, the offer must not include non-monetary or other claims to which the rule does not apply. Tex. R. Civ. P. 167.2(d).

An offer may not be made before the filing of a defendant’s declaration or within sixty (60) days after the appearance in the case of the offeror or offeree, whichever is later. Id. at 167.2(e). Further, the offer may not be filed within fourteen (14) days of the date the case is set for conventional trial. Id.

An offer must be accepted by written notice served on the offeror before it is withdrawn and before the deadline for acceptance. Id. at 167.3(b). An offer must be held open for a minimum of fourteen (14) days. Id. at 167.2(b)(5). Once withdrawn, the offer cannot be accepted or be the basis for awarding litigation costs. Id. at 167.3(a). An offer may be rejected if a written rejection is timely served on the offeror, or if the offer is neither withdrawn nor accepted. Id. at 167.3(c). A rejection based on a condition determined to be unreasonable will not support an award of costs. Id. at 167.2(c). An offer is deemed reasonable unless the offeree objects to a condition by written notice to the offeror before its acceptance deadline. Id. Rejection of follow-up or counter-offers supports litigation costs only if the rejected offer is more favorable to the offeree than any prior offer. Id. >at 167.2(f).

A trial judge has no discretion to apply Rule 167; rather, Rule 167 provides that a party shall recover litigation costs where the judgment is significantly less favorable to the rejecting party when compared to the settlement offer. Tex. R. Civ. P. 167.4(a); see also Tex. Civ. Prac. & Rem. Code ß 42.004(a). A judgment is significantly less favorable when it is less than 80% of an offer rejected by a claimant or more than 120% of an offer rejected by a defendant. Tex. R. Civ. P. 167.4(b); see also Tex. Civ. Prac. & Rem. Code ß 42.004(b). Recoverable litigation costs are limited to those incurred after the date the offer was rejected. Tex. Civ. Prac. & Rem. Code ß 42.004(c); Tex. R. Civ. P. 167.4(a). As a result, an offeree might choose to wait as long as possible before rejecting an offer. Therefore, it is imperative that the offeror specifically limit how long to leave the offer open beyond the fourteen (14) day statutory minimum.

One of the first publicized uses of the statute and rule was in the insurance defense case of Andrade v. Ankur, in Travis County. In Andrade, the plaintiff was struck and seriously injured by a car as she crossed an intersection. See John Council, The Perils of Loser Pays: H.B. 4 Rule Unpopular With Defense Lawyers, Tex. Lawyer, October 11, 2004, at 1. The plaintiff filed a personal-injury suit and demanded $14,500.00 to settle the case. Id. at 18. The defendant invoked Rule 167 and offered to settle the matter for $12,000.00. Id. The jury awarded the plaintiff $29,819.00. Because the award amounted to well over 120 percent of what the defense offered, the defense was responsible for the plaintiff’s litigation costs. Id.; see also Tex. R. Civ. P.167.4(b). Consequently, instead of paying the $2,500.00 difference, the defendant paid the full $29,819.00, plus $16,407.00 in litigation costs. See John Council, The Perils of Loser Pays: H.B. 4 Rule Unpopular With Defense Lawyers, Tex. Lawyer, October 11, 2004, at 18.

As shown by Andrade, a defendant whose litigation costs are being paid by an insurance carrier has no incentive to invoke Rule 167. “The risks are especially high in cases in which a plaintiff wants to settle in an insurance coverage case where the plaintiff’s demand is on the high end of the defendant’s policy limits.” Id. Unless the insurer agrees to pay any potential litigation costs for which the insured defendant might become responsible, it could actually be a conflict of interest for the defendant’s attorney to invoke Rule 167. See id.; see also See Mikal C. Watts and Alex M. Miller, HB 4 – One Year Later, Page Keeton Civil Litigation Conference, October 28-29, 2004, at 5. The conflict occurs because the defendant would face potential personal liability for costs that exceed policy limits if the defendant lost on the offer of settlement issue. See id. The end result is Rule 167 should rarely be used in insurance defense cases.

Standing is required to bring a common law bad faith claim, and without evidence of a contract between the insured and insurer, there is no duty of good faith and fair dealing. Mid-Century Ins. Co. v. Boyte, 80 S.W.3d 546 (Tex. 2002). The duty only extends to the insurer, and its agent does not owe a duty of good faith. Natividad v. Alexsis, Inc., 875 S.W.2d 695 (Tex. 1994).

The duty of good faith and fair dealing is a non-delegable duty that applies only between the parties to the contract. The insurer does not owe a duty of good faith and fair dealing to a third party claimant. Maryland Ins. Co. v. Head Indus. Coatings & Servs., 938 S.W.2d 27 (Tex. 1996). An insurer may be liable for common law bad faith if it (1) denied or delayed payment of the insured’s claim and (2) knew or should have known that coverage for the claim was reasonably clear. Universe Life Ins. Co. v. Giles, 950 S.W.2d 48 (Tex. 1997).

The phrase ‘reasonably clear’ does not mean ‘completely certain.’ Minnesota Life Ins. Co. v. Vasquez, 133 S.W.3d 320 (Tex. App.—Corpus Christi 2004, pet. filed May 2004). Whether an insurer knew that coverage was reasonably clear depends on its actual knowledge of facts giving rise to a liability under the insurance policy. Giles, 950 S.W.2d at 57 (clear that insured’s claim was covered based upon carrier’s receipt and reliance upon insured’s medical records and letters from doctor); Vasquez, 133 S.W.3d at 329 (liability reasonably clear upon receipt of death certificate and medical examiner’s report). The ‘should have known’ that coverage was reasonably clear is based upon what the carrier would have known if it had satisfied its duty to investigate. State Farm Fire & Cas. Co. v. Simmons, 963 S.W.2d 42 (Tex. 1998)(investigation was biased and unreasonable); Viles v. Security Nat’l Ins. Co., 788 S.W.2d 566 (Tex. 1990)(denied coverage before proof of loss statement was due). Also, an insurer cannot shield itself from bad faith liability by investigating a claim in a manner calculated to construct a pretextual basis for denying the claim. Simmons, 963 S.W.2d at 44 (engaged in investigation designed to establish circumstantial evidence of claimant’s motive and opportunity to set fire); State Farm Lloyds v. Nicolau, 951 S.W.2d 444 (Tex. 1997)(reliance on engineering reports which were not objectively prepared was pretext for denying claim). Generally, when an insurer has a reasonable basis for denying the claim, its liability under the policy is not reasonably clear. State Farm Lloyd’s v. Maldonado, 935 S.W.2d 805 (Tex. App.—San Antonio 1996), rev’d in part on other grounds, 963 S.W.2d 38 (Tex. 1998)(interpreting ‘reasonably clear’ language in art. 21.21, ß 4(10)(ii)).

Like common-law bad faith, to sue under article 21.21, the plaintiff must establish that it has standing. Crown Life Ins. Co. v. Casteel, 22 S.W.3d 378 (Tex. 2000). An insured or beneficiary of an insurance policy has standing to sue under art. 21.21. A third-party with a tort claim against the insured lacks standing to sue the insurer directly under art. 21.21. Allstate Ins. Co. v. Watson, 876 S.W.2d 145 (Tex. 1994). A representative of the estate of the decedent who purchased the policy does not have standing to sue under art. 21.21. Mendoza v. American Nat’l Ins. Co., 932 S.W.2d 605 (Tex. App.—San Antonio 1996, no writ).

An insurance company may be vicariously liable for the acts of its employees or agents under art. 21.21, ß 2(a). Also, an independent claims adjuster may be liable as a defendant in a claim under art. 21.21. Casteel, 22 S.W.3d at 385 (adjuster may act as the common-law agent of insurance company). Article 21.21, ß 2(a) extending liability to adjusters modifies the common law rule that adjusters cannot be sued for a common law breach of duty of good faith and fair dealing. Id.

Section 4(1) prohibits making, issuing, circulating, or causing to be made, issued, or circulated any estimate, illustration, circular, or statement misrepresenting, for example, the following: (a) the terms of any policy: State Farm Fire & Cas. Co. v. Gros, 818 S.W.2d 908 (Tex. App.—Austin 1991, no writ)(agent misrepresented that home was insured against mudslide damage); or (b) the benefits or advantages promised by any policy: Maccabees Mut. Life Ins. Co. v. McNiel, 836 S.W.2d 229 (Tex. App.—Dallas 1992, no writ)(agent misrepresented that policy would cover employees not actively at work).

Section 4(10), which was added in 1995 to codify a policyholders’ ‘Bill of Rights,’ includes the following:

· ß 4(10)(a)(i): Misrepresenting to a claimant a material fact or policy provision relating to the coverage at issue;

· ß 4(10)(a)(ii): Not attempting in good faith to bring about a prompt, fair, and equitable settlement of a claim once the insurer’s liability becomes reasonably clear. Nicolau, 951 S.W.2d at 448 (some evidence carrier denied claim without reasonable basis or any effort to objectively determine whether its liability had become reasonably clear); Giles, 950 S.W.2d at 55 (ß 4(10)(a)(ii) now establishes standard for common law bad faith actions as well).

· ß 4(10)(a)(ii) also allows for a failure to reasonably settle a third party claim against the insured under Rocor Int’l v. National Un. Fire Ins. Co., 77 S.W.3d 253 (Tex. 2002)(this is a separate claim from breach of Stowers duty). Under Rocor, the duty to settle under ß 4(10)(a)(ii) is triggered when the policy covers the claim, the liability of the insured is reasonably clear, the third party presented the insurer with proper settlement demand within policy limits, and the terms of the demand are such that a reasonable insurer would accept it. (i.e. adopting Stowers standard as applied under art. 21.21).

· ß 4(10)(a)(iv): Not promptly giving a policyholder a reasonable explanation, based on the policy as it relates to the facts or applicable law, for the insurer’s denial of a claim or for the offer of a compromise settlement claim.

· ß 4(10)(a)(v)(A): Not affirming or denying coverage of a claim to a policyholder within a reasonable period of time.

· ß 4(10)(a)(v)(B): Not submitting a reservation of rights letter to a policyholder within a reasonable period of time.

· ß 4(10)(a)(vi): Refusing, failing to make, or unreasonably delaying an offer of settlement under applicable first-party coverage on the grounds that other coverage may be available or that third-parties are responsible for the damages suffered, except as may be specifically provided in the policy.

· ß 4(10)(a)(viii): Refusing to pay a claim without conducting a reasonable investigation.

· ß 4(11)(b): Leaving out a material fact, so that other statements are rendered misleading. Herrin v. Medical Protective Co., 89 S.W.3d 301 (Tex. App.—Texarkana 2002, pet. denied);

· ß 4(11)(c): Making a statement in a way that would lead a reasonably prudent person to a false conclusion about a material fact: Herrin, 89 S.W.3d at 309;

· ß 4(11)(e): Not disclosing any matter required by law to be disclosed; Herrin, 89 S.W.3d at 309.

· Policy proceeds wrongfully withheld, up to policy limits. Vail v. Texas Farm Bur. Mut. Ins. Co., 754 S.W.2d 129 (Tex. 1988).

· Personal injury damages for mental anguish if there is an express finding that the defendant acted knowingly. Art. 21.21, ß 16(b)(1)-(3); State Farm Life Ins. Co. v. Beaston, 907 S.W.2d 430 (Tex. 1995). “Knowingly” is defined as “actual awareness of the falsity, unfairness, or deception of the act or practice made the basis for a claim for damages under art. 21.21.” Tex. Ins. Code art. 21.21, ß 2(c). “Actual awareness” may be inferred where objective manifestations indicate that a person acted with actual awareness. Id.

· If the plaintiff proves and obtains a finding from the jury that the defendant acted knowingly, the plaintiff can also recover, in addition to the actual damages, an award of twice the amount of actual damages (i.e. a total of three times the amount of actual damages). Lawyers Sur. Corp. v. Royal Chevrolet, Inc., 847 S.W.2d 624 (Tex. App.—Texarkana 1993, writ denied).

· Plaintiffs cannot recover punitive damages in art. 21.21 cases because Chapter 41 of the Civil Practice and Remedies Code providing for punitive damages expressly excludes actions brought under Tex. Ins. Code Chapter 21. Tex. Civ. Prac. & Rem. Code ß 41.002(d).

Ida Mae Giles, age 61, underwent heart bypass surgery about three months after she obtained health insurance from The Universe Life Insurance Company. Universe denied Giles's claim for payment of her medical bills on the ground that the policy did not cover her heart condition because she had received treatment for it before Universe issued the policy. Universe based its denial on four alleged facts. First, Giles's hospital records stated that she had had a two- or three-year history of recurrent chest pain. Second, the same records stated that she had a positive history of heart disease. Third, other medical records reflected that for years before the policy issued Giles had been treated with Mevacor and Lorelco, two drugs used to lower blood cholesterol. Fourth, Giles's medical records indicated that she suffered from atherosclerosis, a condition that must have developed over several years.

When Giles learned why Universe had denied coverage, she asked two of her physicians to write to Universe to clarify her medical records. The physician whose notes stated that Giles had suffered chest pain for some years explained that the statement resulted from a transcription error, and that in fact, Giles had suffered chest pain for only two or three weeks before her surgery--the entire time being after her insurance policy issued. The physician who had prescribed Mevacor and Lorelco explained that he had given them to Giles for hypercholesteremia, not for hypertension or heart problems. The medical record indicating that Giles had a positive history of heart disease actually stated that Giles "has never had any history of heart problems.... She has a positive history of heart disease with a mother who recently had coronary artery bypass grafting.... She does not smoke, has no history of hypertension or diabetes, but has had an elevated cholesterol in the past...." Taken in context, the "positive history" only referred to family history. It thus became clear that Giles was not treated for heart problems until a few weeks before surgery, after the policy issued, and that the policy covered her claim.

Universe never questioned Giles's physicians' credibility in clarifying her medical history and never insinuated that they misstated her history to help her with her insurance claim. Nevertheless, Universe persisted in denying Giles's claim until it received a letter from her attorney, about ten months after the surgery, demanding payment of Giles's medical bills and $1,500 attorney fees. Several weeks later Universe paid some of the medical bills, but it refused to pay about $2,000 of charges it considered unreasonable, and it refused to pay any attorney fees.

Giles then sued Universe and two related companies. After a jury trial, the district court rendered judgment for Giles on a verdict that Universe had breached its duty of good faith and fair dealing and assessed $75,000 damages for mental anguish and $500,000 punitive damages. The Supreme Court affirmed the bad faith findings, reversed the punitive damages award, and established a new standard of law for common law bad faith claims.

The old standard was that “An insurer breaches its duty of good faith and fair dealing when the insurer had no reasonable basis for denying or delaying payment of a claim, and the insurer knew or should have known that fact." Under the old standard, courts were having a hard time reviewing the legal sufficiency of evidence to support bad faith findings. The problem was this: A plaintiff in a bad-faith case under the old standard had to prove the absence of a reasonable basis to deny the claim, a negative proposition. Yet, under the no-evidence standard of review, an appellate court had to resolve all conflicts in the evidence and draw all inferences in favor of a bad-faith finding. Because the reviewing court had to give no weight to the insurer's evidence of a reasonable basis for the denial or delay in payment of a claim, no judgment could ever be reversed on appeal for want of evidence because there would never be any evidence of a reasonable basis. And this is exactly what was happening—no common law bad faith verdicts were being overturned on appeal for lack of evidence.

The Court set out to create a new standard that would allow appellate courts to review the evidence supporting any bad faith findings at trial. The court began by reviewing the policy reasons for the tort of common law bad faith. In the insurance context a special relationship arises out of the parties' unequal bargaining power and the nature of insurance contracts which would allow unscrupulous insurers to take advantage of their insureds' misfortunes in bargaining for settlement or resolution of claims. The duty is also to prevent insurers from acting arbitrarily. "Unscrupulous", "arbitrary", and "taking advantage" are not synonyms for negligence. They require, not merely misfeasance, but malfeasance.

To deter such conduct, the Court recognized the bad-faith tort only in the first-party context. A first-party claim is one in which an insured seeks recovery for the insured's own loss. The Court declined to extend the bad-faith cause of action to the third-party context, in which an insured seeks coverage for injuries to a third party.

The two primary forms of damages available under the common law tort of bad faith meant to deter illicit conduct by carriers include punitive damages and mental anguish damages. As to punitive damages, the Court made it extremely difficult to justify them: “[o]nly when accompanied by malicious, intentional, fraudulent, or grossly negligent conduct does bad faith justify punitive damages." The plaintiff in a bad faith case must therefore prove that "the insurer was actually aware that its action would probably result in extraordinary harm not ordinarily associated with breach of contract or bad faith denial of a claim-- such as death, grievous physical injury, or financial ruin." The Court reiterated that punitive damages in Texas bad faith cases will be limited to highly unusual and particularly egregious situations, as they should be.

The Court also wanted to closely scrutinize mental anguish awards. In most bad faith cases, plaintiffs may not recover mental anguish damages unless they introduce "direct evidence of the nature, duration, and severity of their mental anguish, thus establishing a substantial disruption in the plaintiffs' daily routine." This standard ensures that the jury is provided "with adequate details to assess mental anguish claims." In the context of bad faith actions, mental anguish damages will be limited to those cases in which the denial or delay in payment of a claim has seriously disrupted the insured's life.

After reviewing why the tort of bad faith exists, and how difficult damages are to recover under it, the Court reworked the legal burden on the plaintiff so appellate courts could perform an evidentiary review. The Court chose to adopt the “reasonably clear” standard already set forth in Tex. Ins. Code art. 21.21 ß 4(10)(a)(II). The Court stated that this change should help (1) juries determine the fact issue of “reasonably clear”; (2) appellate courts in their review of the jury’s findings on the issue; and (3) make the statutory and common law bad faith standards consistent.

The Court stated that the “reasonably clear" standard now recasts the liability standard in positive terms, rather than the old negative formulation. And under the new standard, an insurer will be liable if the insurer knew or should have known that it was reasonably clear that the claim was covered. The Court noted that, under the new standard, an insurer will not escape liability merely by failing to investigate a claim so that it can contend that liability was never reasonably clear. Instead, an insurance company may also breach its duty of good faith and fair dealing by failing to reasonably investigate a claim. Finally, the Court refused to make “reasonably clear” an issue for the court, and instead relied upon the constitutional Texas open courts provisions to leave bad faith inquiries to the jury when both the plaintiff and insurer have presented conflicting evidence.

The Supreme Court noted that the trial court had submitted the case under the "no reasonable basis" standard. But the Court held that, under either that standard or the "reasonably clear" standard, there was some evidence to support the jury's finding that Universe acted in bad faith. Universe had the following reasons why it had a reasonable basis for continuing to deny Giles’s claim:

The denial of the claim as a pre-existing condition was justified because the undisputed medical records revealed that Mrs. Giles had "a positive history of heart disease," that she had probably suffered a heart attack that was caused by atherosclerotic cardiovascular disease, that the atherosclerotic cardiovascular disease was an illness that had been medically treated with Mevacor, and that she had received treatment for this illness within the twelve months preceding the issuance of the policy. The Mevacor and Lorelco that were prescribed as a treatment for an illness that was later positively diagnosed as atherosclerosis, constituted medical care or treatment within the exclusionary language of the policy.

Giles's medical records did not say that she had "a positive history of heart disease"; they said she had "a positive history of heart disease with a mother who recently had coronary artery bypass grafting." Two sentences before, the same record states: "She [Giles] has never had any history of heart problems." The medical records do not reflect that Giles was treated for heart disease before her insurance coverage became effective. While she had been treated for high cholesterol for some time, Universe points to no evidence that such treatment was tantamount to treatment for heart disease. In fact, all the evidence was to the contrary.

The Court stated that, from the medical records, it should have been reasonably clear to Universe that Giles's claim should be paid. Universe did not argue that the records were unreliable; to the contrary, Universe relied on them. The Court also noted that there was no evidence of any need for further investigation after Giles's physicians wrote to Universe. Giles's physicians clarified her medical records within four months of her surgery. Coverage of the claim was reasonably clear by then, yet Universe continued to deny coverage for an additional seven months. The jury could have logically concluded that Universe denied Giles's claim without a reasonable basis and that its purported reliance on Giles's medical records was a mere pretext.

The Court found no evidence to support the award for punitive damages. Punitive damages can be awarded for bad faith only when an insurer was actually aware that its actions involved an extreme risk--that is, a high probability of serious harm, such as death, grievous physical injury, or financial ruin--to its insured and was nevertheless consciously indifferent to its insured's rights, safety, or welfare. The record reflected that medical care providers repeatedly asked Giles about payment of her bills. Although Giles testified that these inquiries caused her great distress, there was no evidence of the type of risk required for punitive damages. Though Universe may have been aware of Giles's distress, there was no evidence that Universe's claims decision was likely to cause any extreme risk to Giles.

The Court recognized that, by defining specific types of conduct or situations which do or do not give rise to bad-faith liability, the courts can begin to give the certainty and predictability to the tort that it must have and has not yet acquired. From the concurring opinions and analysis in Giles, some additional tests and leanings of the Court may be gleaned to help determine ‘reasonably clear’ to achieve the goal of more certainty:

· A simple disagreement among experts about whether the cause of the loss is one covered by the policy will not support a judgment for bad faith. A case of this type is not bad faith, even though the insured's experts testify that the insurer's position was unreasonable. By the same token, the mere fact that an insurer can adduce expert testimony to support its position may not insure it from liability if the testimony is pretextual.

· It would be particularly offensive for an insurance company to appreciate the fact that the claim should be paid, but to refuse to do so on the slim hope that it might succeed in defending a lawsuit brought to collect the proceeds. Such conduct is precisely the kind of conduct that the tort of bad faith should reach because it serves no useful purpose and is destructive to the insured.

· The Court cited the prior case of Lyons as an example of failing to show evidence of bad faith. The plaintiff in Lyons insisted her report showing that the damage to her house was covered by her insurance policy was some evidence that her insurer acted in bad faith by not paying the claim. The Supreme Court held that evidence of coverage is not evidence of bad faith. The claimant cannot prove bad faith by simply parsing through the information available to the insurer and pointing only to those pieces of information suggesting coverage. She must take all of the information available to the insurer and present some evidence that no reasonable insurer would have denied or delayed payment of her claim based on that information. In Lyons, the insurer had before it not only the plaintiff's expert's report demonstrating coverage, but also its own expert's reports demonstrating no coverage. The plaintiff's bad faith claim failed because she presented no evidence to the jury that, based on all the information before the insurer, no reasonable insurer would have denied coverage. For example, there was no evidence before the jury that "the reports of [the] experts [indicating noncoverage] were not objectively prepared, or that [the insurer's] reliance on them was unreasonable."

Guillermo Casta‚eda, Sr. applied for medical insurance with Provident American Insurance Company in May 1991. He sought a policy that would cover the entire family. During the application process, Guillermo Casta‚eda, Sr. failed to disclose that just two days before he applied for the policy, Guillermo, Jr. had received medical attention from a physician for jaundice, anemia, and suspected hepatitis. The daughter had received medical treatment for jaundice and hepatitis several years prior to the date her father applied for health insurance.

Provident American issued a policy to the family effective June 17, 1991. The policy contained two relevant limitations: (1) it did not cover expenses resulting from a sickness that "manifests" within thirty days of the policy's effective date; and (2) it excluded diseases or disorders of certain internal organs, including the gallbladder, unless the loss occurred more than six months after the policy's effective date.

Less than thirty days after the issuance of the policy, the family learned that a relative had been diagnosed with hemolytic spherocytosis (HS), a hereditary condition that causes misshapen blood cells. The spleen destroys these cells, which causes the sufferer to exhibit anemia, jaundice, and gallstones. Because the disease is hereditary, it was suggested that the Casta‚edas be tested for HS. Denise and Guillermo, Jr. had exhibited yellow skin all of their lives, and on July 20, 1991, the third day after the thirty-day period expired, they were taken to a physician who diagnosed them that same day with HS and referred them to a blood specialist. They saw the hematologist two days later, and he concurred in the HS diagnosis. Two weeks later, Denise and Guillermo, Jr. each had their spleen and gallbladder surgically removed.

The Casta‚edas submitted claims to Provident American, which were denied. Provident American first asserted (1) the six-month policy exclusion for disorders of the gallbladder but (2) later denied the claims on the basis that HS had manifested within thirty days of the policy's effective date.
Denise Casta‚eda sued Provident American, alleging violations of article 21.21.

The jury found article 21.21 violations that were “knowingly” committed and awarded more than $ 50,000.00. On appeal, the Supreme Court reversed, found no article 21.21 breach, and applying the new Giles standard, held there was no evidence that Provident American denied Casta‚eda's claim without a reasonable basis or after its liability had become reasonably clear.

The Court acknowledged that, at varying times, Provident American gave varying reasons for denying Denise Casta‚eda's claim, but all were grounded in a “common nucleus of facts.” Provident American cited a policy provision that excluded coverage for a sickness or disorder involving the gallbladder unless the loss occurred more than six months after the date the policy went into effect. Provident American also relied on policy provisions that limited coverage to an illness or disease that first manifested more than thirty days after the policy went into effect. At least one Provident American employee thought that the claim also could have been denied based on the pre-existing condition provision of the policy, although that clause was never invoked.

The Court reiterated that showing only a bona fide coverage dispute does not demonstrate that there was no reasonable basis for denying a claim. By the same token, evidence of a coverage dispute is not evidence that liability under the policy had become reasonably clear. Thus, when medical evidence is conflicting, liability is not reasonably clear, and it cannot be said that the insurer had no reasonable basis for denying the claim unless the medical evidence on which the insurer based its denial is unreliable and the insurer knew or should have known that to be the case. In support of its holding, the Court cited Connolly v. Serv. Lloyds Ins. Co., 910 S.W.2d 557 (Tex. App.—Beaumont 1995, no writ)(holding that the carrier established its good faith as a matter of law when summary judgment evidence demonstrated a bona fide controversy regarding the need for back surgery and the carrier relied on a report that surgery was not necessary); and Ramirez v. Transcontinental Ins. Co., 881 S.W.W2d 818 (Tex. App.—Houston [14ht Dist.] 1994, writ denied)(holding that an insurer had conclusively established a reasonable basis for denying a claim when it relied on an expert's opinion, even though another expert had expressed a conflicting opinion).

The Court revisited its opinion in Nicolau where it upheld a bad faith finding and concluded that there was evidence of no reasonable basis to deny the claim in that case because the carrier had either relied on an expert's report that the carrier knew "was not objectively prepared" or because "the insurer's reliance on the report was unreasonable." But the Court contrasted those facts with the facts in Castaneda and stated that there was no evidence that any of the information on which Provident American ultimately relied in denying coverage was "not objectively prepared" or that reliance on the information was unreasonable. The medical records revealed that just three days after the thirty-day waiting period expired, Denise Casta‚eda saw a physician and was diagnosed with a hereditary blood disorder. Two weeks later, she underwent surgery to remove her spleen as treatment for this condition. During surgery it was confirmed that her disorder had caused gallstones, and her gallbladder was also removed.

The evidence also showed that Denise Casta‚eda and her brother had exhibited symptoms even before their father applied for the policy. Casta‚eda's father wrote to Provident American, providing facts that supported a conclusion that the disease had manifested before the end of the thirty-day period and that there was no coverage. Guillermo Casta‚eda, Sr. wrote that, days before he applied with Provident American for a policy, his son's school nurse noted that his son was "drastically jaundice [sic] and lethargic;" she recommended that Guillermo Casta‚eda take his son to a physician, and he did. During the thirty-day waiting period, the Casta‚edas received a call from Denise's uncle who informed them he had been diagnosed with "Congenital Spherocytosis and a Splenectomy was performed." Castaneda Sr. also wrote that “The physicians warned that every member of my wife's family with jaundice symptoms must be examined." "So as Denise and [her brother] had their skin a little yellow throughout their whole lifes [sic], both were checked and diagnosed ... July 20, 1991 [three days after the end of the thirty-day waiting period]." The Court held that there was no evidence calling into question Provident American's reliance on this information or its reliance on medical records and on communications with Denise Casta‚eda's physicians.

The Court rejected each of the following arguments by plaintiffs claiming article 21.21 violations for Provident’s (1) reliance upon an “improper” ground for denial; (2) changing its denial position multiple times which showed a pretextual ground for denial; (3) failure to communicate with the insured and (4) sending the insured an early pre-approval that was later retracted.

(1) The Court acknowledged that at least some individuals within Provident’s organization concluded that the gallbladder exclusion did not apply. The basis for denying the claim was then changed to the thirty-day provision discussed above, and the thirty-day provision was cited as the reason for denial to an inquiry from the Department of Insurance. However, many months after the claim had been denied because of the thirty-day provision, one of Denise Casta‚eda's physicians called Provident American to inquire once again why the claim had not been paid and was told that it was because of the six-month exclusion regarding the gallbladder. The Court assumed the worst--that the gallbladder exclusion was not a valid basis for denying coverage. But it held that not every erroneous denial of a claim subjects an insurer to liability. One of Provident’s employees did testify that it was "improper" to deny the claim based on the gallbladder exclusion, and all but the president of the company agreed that reliance on the gallbladder exclusion was misplaced. The Court held that “This testimony is evidence that Provident American denied the claim for the wrong reason, but it does not amount to evidence that no insurer could reasonably have denied the claim.”

In a previous case where bad faith was found, the insured alleged not only that there was evidence of coverage but also that the carrier's adjusters determined that his claim was compensable and advised the carriers to pay the claim. There was no evidence that anyone at Provident thought that Casta‚eda's claim was covered and should be paid. Every Provident employee, including the employee who concluded that reliance on the gallbladder exclusion was improper, testified that the claim nevertheless was not payable because of the thirty-day provision in the policy.

(2) Just because Provident gave different reasons for denying the claim at different times did not mean that there was some evidence that the denial was pretextual. In Nicolau, the Court concluded that there was some evidence that the carrier knew that the expert report on which it relied was of questionable validity. In Simmons, the Court concluded that there was evidence that the investigation was biased and outcome-oriented because there was evidence that the carrier knowingly and repeatedly ignored evidence that the insureds did not burn down their home and that they had no motive for arson. But the Court’s use of the term "pretextual" in Nicolau and Simmons did not mean that an insured is relieved from its burden of offering evidence that liability had become reasonably clear or that there was no reasonable basis for denying the claim. The use of the concept "pretextual" was another way of saying that there must be some evidence that there was no reasonable basis for denying the claim or that liability was reasonably clear. Here, there was no evidence that Provident ignored information that would lead a reasonable person to conclude that liability under the policy was reasonably clear or that there was no reasonable basis to deny the claim.

(3) Provident failed to respond to certain letters and phone calls during 1992, which was many months after Denise Casta‚eda's surgery. Provident had sent a letter on December 12, 1991 to Guillermo Casta‚eda, Sr. explaining the thirty-day waiting period and stating that "[u]pon receipt of the necessary information, we will gladly reopen this claim for possible disbursement of benefits." Provident subsequently received additional information, including the letter from Guillermo Casta‚eda, Sr. described above, and more correspondence from Denise Casta‚eda's physicians.

The result of the activity that occurred after Provident's December 1991 letter was that the claim still was not paid, and the physicians were told by Provident that it would not be paid. While Provident may not have communicated directly with the Casta‚edas, and the Court found its conduct less than exemplary, this did not amount to "failing to adopt and implement reasonable standards for prompt investigation of claims" or "failing to acknowledge with reasonable promptness pertinent communications with respect to claims."

Under Casta‚eda's theory, a carrier would be liable if it did not respond to each and every request for payment or inquiry by an insured or the insured's physician sent after the claim had been denied and the reasons for the denial had been explained. Nothing in the Insurance Code imposes liability on such a basis.

(4) Denise Casta‚eda claimed that by pre-approving her surgery, Provident represented that her condition was covered, and that when Provident American thereafter failed to pay her claim, this amounted to a violation of the Insurance Code. The pre-approval in this case was not a representation that is actionable under the Insurance Code. Nor was there any evidence that Casta‚eda relied on the pre-approval to her detriment.

At the time Provident authorized surgery, it had not been given material facts that were in the possession of the Casta‚edas and the physicians who treated Denise Casta‚eda. Provident did not know that Denise Casta‚eda had exhibited symptoms and had been treated for jaundice and hepatitis long before her father applied for the policy. Nor did it know that the hereditary disease HS had been diagnosed in another family member within the thirty-day waiting period or that Denise Casta‚eda's brother, Guillermo, Jr., also an insured, had been treated for jaundice, suspected hepatitis, and anemia just two days before their father met with Provident to apply for the policy. Under these circumstances, Provident's pre-authorization at most amounted to an uninformed conclusion on its part, based on what it knew from the insured and the insured's physicians, that Casta‚eda's blood disorder was a covered sickness, namely, that HS had not manifested prior to the end of the thirty-day waiting period or was not otherwise excluded. The pre-approval did not constitute a false, misleading, or deceptive act; a misrepresentation of the terms of an insurance policy; or an assertion with respect to insurance that was untrue. Casta‚eda's position, if accepted, would impose strict liability on carriers that are not given pertinent facts before a procedure is pre-approved and who later learn that they have a good faith, reasonable basis for denying coverage.

The Avilas brought suit in 1996 to recover damages allegedly caused to their family residence’s foundation by leaks from deteriorated sewer lines. The Avilas filed a claim with their insurance company, State Farm Fire & Casualty Company ("State Farm"), under their homeowners insurance policy. After investigating the matter, State Farm denied coverage and refused to pay the claim. Plaintiffs' sued for violations of the Texas Insurance Code Ann. Art. 21.21 and breach of the common law duties of good faith and fair dealing, and requested mental anguish damages.

State Farm asserted that (1) its denial of plaintiffs' claim was based on relevant policy exclusions which precluded coverage for plaintiffs' damages; (2) a bona fide factual dispute existed as to coverage in this case (i.e., whether the damage to the plaintiffs' residence resulted from an excluded cause); and (3) its liability was not reasonably clear when it denied plaintiffs' claim.

Plaintiffs replied that State Farm was liable because: (1) it did not perform a reasonable investigation of their claim; (2) it relied on the report of a biased engineer, and (3) it conducted an outcome-oriented investigation to deny payment of plaintiffs' foundation claim.

Applying Giles, the Court agreed with State Farm’s argument that it could not be held liable for bad faith because the denial of the Avilas' claim was based on its reasonable interpretation that the homeowners policy at issue did not provide coverage for foundation claims caused by a plumbing leak. Also relying upon the Supreme Court's ruling in Balandran, the Court held that liability was not "reasonably clear" at the time it denied the Avilas' claim because State Farm’s construction of the exclusion was reasonable. In further support thereof, the Court cited Oram v. State Farm Llloyds, 977 S.W.2d 163 (Tex. App.—Austin 1998, no pet.)(court held that the insurer did not breach its statutory duty of good faith to effectuate prompt, fair, and equitable settlement of a claim when liability has become reasonably clear, in light of the Fifth Circuit's adoption of the insurer's construction of policy and the Texas Supreme Court's acknowledgment that such construction was reasonable); United States Fire Ins. Co. v. Williams, 955 S.W.2d 267 (Tex. 1997)(an insurer cannot be held liable for bad faith simply because it misinterprets a rule); and Republic Ins. Co. v. Stoker, 903 S.W.2d 338 (Tex. 1995)(stating that as long as the insurer has a reasonable basis to deny or delay payment of the claim, even if that basis is erroneous, the insurer is not liable for bad faith).

The Court also disagreed with plaintiffs' allegations that State Farm acted unreasonably when it denied their claim on the basis that it conducted an outcome-oriented investigation of the claim and it relied on a biased expert report. Evidence establishing only a bona fide coverage dispute, as in this case, did not prove a claim for bad faith. Plaintiffs failed to produce evidence that the engineering reports relied upon by State Farm were not objectively prepared or that State Farm's reliance on them was unreasonable, or any evidence from which it could be inferred that State Farm knew or should have known that it acted unreasonably in denying the Avilas' claim.

The undisputed evidence showed that the Avilas reported their claim made the basis of the suit on December 27, 1993. On December 30, 1993, State Farm's claim representative assigned to the case sent the Avilas a letter acknowledging receipt of the claim and outlining the scope of the investigation. After the claim representative inspected the property, State Farm retained an independent plumbing company (Danco Plumbing Co.) to conduct a leak detection test on the sewer and water lines of the property. State Farm also retained an independent engineering company (GE Reaves Engineering) "to inspect the loss to the Premises and provide an opinion about whether the leak at the Premises caused or contributed to the structural damage noted at the Premises." Reaves Engineering inspected the premises on at least two occasions and submitted a report to State Farm based on its inspection and Danco's plumbing report. The Reaves' report concluded that the foundation damage at plaintiffs' residence was not caused by a plumbing leak. State Farm denied plaintiffs' claim based on its own investigation, the plumbing and the engineering assessments of the cause of the foundation damage, and the policy exclusions.

Subsequent to the denial of the claim, plaintiffs' counsel submitted a report prepared by an engineer retained by them (Dabney) as well as a report on some soil samples prepared by a plumber also retained by them (Burch). Upon receipt of this information, State Farm sent a letter to plaintiffs' counsel requesting a copy of Burch's complete soil report. Plaintiffs' counsel did not respond to this request. Even though State Farm's analysis of the reports submitted by plaintiffs found that they did not conflict with the Reaves' report, it nevertheless forwarded them to Mr. Reaves for his review. Mr. Reaves determined that the reports, and in particular the one submitted by Dabney, did not contradict his findings which would warrant a revision to his original report. Because the evidence demonstrated that Dabney's opinion was not in conflict with Reaves at the time the report was submitted to State Farm, the Court could not conclude that State Farm had inadequate or inconsistent information prior to denying plaintiffs' claim or that it acted unreasonably in relying on Reaves' report. By making this finding, the Court followed the line of cases which have held that evidence showing only a bona fide coverage dispute simply does not demonstrate an unreasonable basis for denying a claim.

The Court distinguished: (1) Nicolau, where there was evidence of no reasonable basis to deny plaintiffs' claim because the insurer had either relied on an expert's report that the carrier knew "was not objectively prepared," or because "the insurer's reliance on the report was unreasonable." 951 S.W.2d at 448; (2) State Fire & Cas. Co. v. Simmons, 963 S.W.2d 42 (Tex. 1998), where the testimony of the insurer's own experts, as well as its own internal documents, established the deficiencies in the company's review of the plaintiffs' claim (i.e., the plaintiffs' fire loss claim was immediately deemed "suspicious;" and the insurer failed to investigate the possibility of other potential suspects that might have started the fire); and (3) State Farm Lloyds v. Johns, 1998 WL 548887 No. 05-96-01039-CV, at *3-4, (Tex. App--Dallas Aug. 31, 1998, no pet. h.), where the insured submitted to her insurance company a conflicting expert opinion on the cause of her foundation damage and without further investigating the conflicting opinions rendered by the plaintiff s' expert and the company's expert, the company decided to nevertheless deny her claim. Finding no such evidence in this case, the Court also relied upon (1) Connolly v. Service Lloyds Ins. Co., 910 S.W.2d 557 (Tex. App.—Beaumont 1995, no writ)(holding that the carrier established its good faith as a matter of law when evidence demonstrated a bona fide controversy regarding the need for back surgery and the carrier relied on a report that surgery was not necessary); and (2) Ramirez v. Transcontinental Ins. Co., 881 S.W.2d 818 (Tex. App.-Houston [14^th Dist.] 1994, writ denied)(holding that an insurer had conclusively established a reasonable basis for denying a claim when it relied on an expert's opinion, even though another expert had expressed a conflicting opinion).

Finally, the Court found that State Farm did not violate the common law duty of good faith and fair dealing as a matter of law because there was a reasonable basis for the denial. And because the statutory and common law standards are now the same under Giles, a finding that there is no common law violation as a matter of law also eliminates the statutory claims alleged by plaintiffs. Muniz v. State Farm Lloyds, 974 S.W.2d 229 (Tex. App.—San Antonio 1998, no pet.)(finding that insurer had reasonable basis for denying claim served as res judicata to all claims, common law and statutory, predicated on good faith and on liability becoming reasonably clear and also to any claim that the insurer had engaged in unfair trade practices in forcing plaintiffs to sue to recover).

The general rule is that claims for common law bad faith or article 21.21 violations render the entire claims file discoverable because the scope of discovery goes to the issue of the carrier’s claims investigation. Motors Ins. Corp. v. Fashing, 747 S.W.2d 13 (Tex. App.—El Paso 1988, no writ)(discovery relating to the filing and investigation of the insurance claim and material relating to the insurance company’s decision to either pay or not pay the claim generally admissible in bad faith but not breach of contract action). From a practical standpoint, this lead to the issue of whether the plaintiff could pursue bad faith discovery, i.e. the claims file, while the breach of contract suit was pending. Based upon the general rules requiring severance and abatement of the bad faith action until completion of the breach of contract suit, courts at first were abating discovery on the bad faith claim until the breach of contract claim was completed. Maryland Amer. Gen. Ins. Co. v. Blackmon, 639 S.W.2d 455 (Tex. 1982)(would be impossible to limit prejudicial effects of disclosing the entire claims file to the defense to the breach of contract claim). But over time, the courts began to allow more and more discovery on the bad faith action, even while it was abated pending the breach of contract action.

The reasons for allowing the discovery included the potential for years passing, witnesses dying, files being lost, and the fact that pretrial efficiency would be enhanced by allowing the discovery since many rulings by the court may affect both the breach of contract claim and bad faith claim. Texas Farmers Ins. Co. v. Cooper, 916 S.W.2d 698 (Tex. App.—El Paso 1996, orig. proceeding). The carriers responded that this was a waste of time and money because (1) the breach of contract action may render the bad faith claim moot and (2) the carrier may have to disclose confidential information from the claims file. See U.S. Fire Ins. Co. v. Millard, 847 S.W.2d 668 (Tex. App.—Houston [1^st Dist.] 1993, orig. proceeding).

Nevertheless, trial courts presently tend to allow discovery on the bad faith claims to move forward while the bad faith action is abated unless the carrier shows prejudice or forced waiver of attorney/client or work product privileges. See Bays v. State Farm, 1999 WL 68648 (N.D. Tex. 1999).

The Stowers duty is not activated by a settlement demand unless three prerequisites are met: (1) the claim against the insured is within the scope of coverage, (2) the demand is within the policy limits, and (3) the terms of the demand are such that an ordinarily prudent insurer would accept it, considering the likelihood and degree of the insured's potential exposure to an excess judgment. The settlement offer must include a full and unconditional release from all potential claims. Insurance Corp. of Am. v. Webster, 906 S.W.2d 77 (Tex. App.—Houston [1^st Dist.] 1995, writ denied)(offer conditioned on absence of other insurance was not sufficient Stowers demand). The Stowers duty to settle is only imposed on the insurer--agents, adjusters, or other parties can have no Stowers duty. American Centennial Ins. Co. v. Canal Ins. Co., 810 S.W.2d 246 (Tex. App.—Houston [1^st Dist.] 1991), rev’d in part on other grounds, 843 S.W.2d 480 (Tex. 1992). A surviving spouse or heir may bring the Stowers action on behalf of the deceased insured’s estate. Traver v. State Farm Mut. Auto Ins. Co., 930 S.W.2d 862 (Tex. App.—Fort Worth 1996), rev’d on other grounds, 980 S.W.2d 625 (Tex. 1998). A plaintiff in a Stowers action may recover the full amount of the underlying judgment, both the amount within the policy limits and the amount over the policy limits. State Farm Fire & Cas. Co. v. Gandy, 925 S.W.2d 696 (Tex. 1996).

Under equitable subrogation, a plaintiff insured’s excess insurer can bring a Stowers action on behalf of the plaintiff if the primary carrier failed to settle the claims within policy limits, an excess judgment was rendered against the insured in excess of the primary policy limits, and the excess insurer paid the judgment. Keck, Mahin & Cate v. National Un. Fire Ins. Co., 20 S.W.3d 692 (Tex. 2000).

The Court held that an insured may assert a claim under article 21.21 for the insurer's failure to reasonably attempt settlement of a claim against the insured, if (1) the policy covers the claim, (2) the insured's liability is reasonably clear, (3) the claimant has made a proper settlement demand within policy limits, and (4) the demand's terms are such that an ordinarily prudent insurer would accept it. The Court then applied this standard and held that the evidence in this case was legally insufficient to support liability under article 21.21 because there was no evidence that the claimant presented the insurer with a proper settlement demand within policy limits that an ordinarily prudent insurer would have accepted.

When construing statutes, the Court’s ultimate purpose is to ascertain the Legislature's intent. In determining that intent, the Court may look to the statute's underlying purpose. The Legislature has directed that article 21.21 "shall be liberally construed and applied to promote its underlying purposes as set forth in this section." Tex. Ins. Code art. 21.21, ß 1(b). The statute was enacted to protect insurance consumers by prohibiting unfair or deceptive practices in the business of insurance. Id. ß 1(a)

There is nothing in the statute's language or in its underlying purposes to support a conclusion that the Legislature intended to limit the statute's application to first-party claims when the insured has sustained actual damages as a result of unfair practices. Accordingly, an insured may assert an article 21.21 claim against its liability carrier for damages that it sustains as a result of the carrier’s unfair claim settlement practices.

The Court also defined when liability has become "reasonably clear" within the statute's meaning so that an insurer may be held liable for failing to reasonably and promptly settle a third party's claim against its insured. Neither the Insurance Code, nor the rules or regulations the Board has adopted thereunder, articulate when liability has become reasonably clear for purposes of triggering the insurer's duty to reasonably attempt settlement under the statute. There is nothing to indicate that the Legislature had in mind any standard other than the familiar Stowers standard, and there was merit to unifying the common-law and statutory standards in this context. Applying the familiar common-law standard promotes uniformity and prevents insurers from facing conflicting liability standards for failing to settle lawsuits filed by injured third-party claimants. Stowers has long defined an insurer's duty to its insured in attempting to settle third-party liability claims, and thus Stowers provides an appropriate framework for understanding and applying the statutory standard.

In sum, an insurer's liability may not be imposed under article 21.21 in the third-party claim context unless the insured shows that (1) the policy covers the claim, (2) the insured's liability is reasonably clear, (3) the claimant has made a proper settlement demand within policy limits, and (4) the demand's terms are such that an ordinarily prudent insurer would accept it. These elements comprise the statutory liability standard against which to measure legal sufficiency. Accordingly, there was no evidence that National Union was presented with a proper settlement demand, which was a prerequisite to article 21.21 liability.

The issue in this case is whether a claim for the breach of the duty to defend can give rise to a statutory claim under article 21.21; specifically, whether it can give rise to a claim under Article 21.21 ßß 4(10)(a)(i), (ii), (iv), (viii), and 4(11). In Rocor, the court specifically rejected the idea of limiting the statute's application to first-party claims. ("We see nothing in the statute's language or in its underlying purposes to support a conclusion that the Legislature intended to limit the statute's application to first-party claims ..."). There is nothing in the Rocor case suggesting that a party is not permitted to bring a duty to defend claim under article 21.21. Although Rocor involved the duty to settle, not the duty to defend, nothing shows that the Texas Supreme Court would rule differently in the duty to defend context.

Moreover, the Texas Supreme Court stated in Rocor that it could not "identify a principled basis upon which to draw a distinction between first-party and third-party claims when the insured has been directly injured as a result of its insurer's unfair claim settlement practices". The Court went on to say that "[t]he Legislature has directed that article 21.21 ‘shall be liberally construed and applied to promote its underlying purposes as set forth in this section.’” Tex. Ins. Code art. 21.21 ß 1(b). The statute was enacted to protect insurance consumers by prohibiting unfair or deceptive practices in the business of insurance. Id. With these principles in mind, and in the interest of furthering these objectives pursuant to Rocor, the Travelers Indemnity Court found that a private cause of action may be asserted under article 21.21 when an insurer breaches its duty to defend its insured.

In Ranger the Court stated that insurers have a duty of ordinary care that includes "investigation, preparation for defense of the lawsuit, trial of the case and reasonable attempts to settle." In the context of a Stowers lawsuit, evidence concerning claims investigation, trial defense, and conduct during settlement negotiations is necessarily subsidiary to the ultimate issue of whether the claimant's demand was reasonable under the circumstances, such that an ordinarily prudent insurer would accept it. But although an insurer does not have a duty to accept settlement demands in excess of policy limits or to make settlement offers, the insurer nonetheless has a duty to avoid unreasonable conduct in settlement negotiations. And while subsidiary in the Stowers context, evidence concerning claims investigation, trial defense, and conduct during settlement negotiations is still admissible in determining whether the carrier met its duty to avoid unreasonable conduct after being presented with a reasonable opportunity to settle within the policy limits.

Article 21.55 of the Texas Insurance Code sets forth deadlines by which an insurance company must respond to a claim. TIG Ins. Co. v. Dallas Basketball, Ltd., 129 S.W.3d 232, 239 (Tex. App.—Dallas 2004, pet. denied). A claim is defined under that article as a “first party claim made by a policyholder under an insurance policy or contract or by a beneficiary named in the policy or contract that must be paid by the insurer directly to the insured or beneficiary. Id. A wrongful refusal to pay a claim may be considered a failure to meet the requirements of article 21.55. Id. Before an insurer can be held liable for a violation of article 21.55, the plaintiff must show the insurer was obligated to pay the claim.

Under Article 21.55, the insurer is required to follow certain procedures and meet certain deadlines when it received, accepts, rejects, or pays an insurance claim. The elements of a cause of action for violation of article 21.55 are:

Only certain types of insurance are exempted from article 21.55. These are: workers’ compensation insurance, mortgage guarantee insurance, title insurance, fidelity, surety, or guaranty bonds, marine insurance (as defined by article 5.53 of the Texas Insurance Code), insurance for state employees under the state retirement system, employee benefit plans subject to ERISA, and insurance provided by an interstate shipper subject to the federal Carmack Amendment.

In addition to the damages in the amount of the claim, attorney’s fees, court costs, and 18% interest, a plaintiff that proves his claim under 21.55 is entitled prejudgment interest on the amount of the claim. Dunn v. Southern Farm Bur. Cas. Ins. Co., 991 S.W.2d 467, 478-79 (Tex. App.—Tyler 1999, pet. denied). The successful plaintiff is also entitled to post-judgment interest. The courts are divided as to whether prejudgment interest may be assessed on the 18% statutory penalty. Compare Dunn, 991 S.W.2d at 479 (not permissible) with Bekins Moving & Storage Co., 947 S.W.2d 568, 584 (Tex. App.—Texarkana 1997, no writ) (permissible).

There is a conflict in Texas courts as to what constitutes a first party claim under article 21.55. A first party claim is on in which the insured or beneficiary seeks recovery for its own loss. Universe Life Ins. v. Giles, 950 S.W.2d 48, 53 n.2 (Tex. 1997). A third party claim is one in which the insured seeks coverage for injuries to someone other than the insured. Id.

In the Dallas Basketball case, the facts were relatively undisputed, but the interpretation of article 21.55 was hotly disputed. In December 2000, the Dallas Mavericks were sued in two different class action suits. Both suits revolved around unsolicited advertisements sent by facsimile. The plaintiffs brought suit under the federal Telephone Consume Protection Act and one suit also alleged common law actions for trespass causing property damage and violations of the right to privacy. The Mavericks requested TIG provide defense and indemnification from the suits pursuant to the CGL policy and other policies issued to the Mavericks by TIG. TIG denied coverage for both cases. The Mavericks filed suit against TIG for allegedly breaching the insurance contracts, asserted TIG had violated article 21.21 of the Insurance Code, sought declaratory judgment on TIG’s obligation to defend and indemnify, and sought monetary damages for violation of article 21.55. The trial court decided that article 21.55 did apply to the Mavericks claims, but stated the interest penalty ceased to accrue on the date of the judgment against TIG. The case was appealed to the Dallas Court of Appeals

The Dallas Court of Appeals first concluded that the claims asserted by the plaintiffs in the facsimile advertisement cases were covered under TIG’s policies as they were advertising injuries covered under the CGL policy. TIG next argued the Mavericks’ request for defense was not a first-party claim for money to be paid directly to the insured and, therefore, article 21.55 was inapplicable. The Court of Appeals agreed with this argument, stating the “entire structure” of article 21.55 presumes a tangible, measurable loss suffered by the insured for which payment is sought payment from the insurance company. The Court concluded any attempt to apply the statute’s stricture for a claim for a defense was “unworkable” and, based on the language of the statute, “clearly unintended by the legislature.” The Court based its reasoning on the language of the statute.

First, the Court noted that article 21.55 is entitled “Prompt Payment of Claims.” The Court concluded that a demand for defense under a liability policy is not a claim for payment, it is a demand that the insurance company provide a defense as required by the policy. There is no requirement to send a payment to the insured in response to a claim for defense.

Second, the Court focused on the definition of a claim under article 21.55. The definition requires that the claim be paid by the insurer directly to the insured or beneficiary. When providing a defense, the insurance company pays the attorney’s fees associated with the case to the attorney engaged to represent the insured. Thus, the insured does not receive a direct payment as required by the article’s definition of a claim.

Third, the Court looked to the deadlines and consequences imposed by article 21.55. Under that article, the deadline to accept or reject a claim begins running the date the company receives all information needed to secure proof of the insured’s loss. A claim for defense, however, does not necessarily reflect any legal expenses incurred or actual loses. Rather, it reflects only that the insured has been sued. Thus, the accept/reject deadline has no meaning when applied to a claim for defense. Further, the consequences for failing to meet article 21.55 deadlines revolve around the amount of the loss. A claim for a defense has no amount of loss on which the statutory penalty can be calculated.

While the Mavericks were forced to pay for their costs of defense in the facsimile advertising cases, their remedy is not a claim under article 21.55, but a claim for breach of contract. It was the breach of the contract, not the policies themselves, which required TIG to pay the Mavericks in this situation.

The Dallas Court recognized its holding regarding the applicability of article 21.55 to claims for defense was contrary to the holdings of other Texas state and federal courts. The cases listed are: Luxury Living, Inc. v. Mid-Continent Cas. Co., 2003 WL 22116202 (S.D. Tex. 2003); Primrose Operating Co. v. Nat’l Am. Ins. Co., 2003 WL 21662829 (N.D. Tex. 2003); Westport Ins. Corp. v. Atchley, Russell, Waldrop & Hlavinka, L.L.P., 267 F.Supp.2d 601 (E.D. Tex. 2002); Mt. Hawley Ins. Co. v. Steve Roberts Custom Buildings, Inc., 215 F.Supp.2d 783 (E.D. Tex. 2002); E & R Rubalcava Constr., Inc. v. Burlington Ins. Co., 148 F.Supp.2d 746 (N.D. Tex. 2001); N. County Mut. Ins. Co. v. Davalos, 84 S.W.3d 314 (Tex. App—Corpus Christi 2002). The Dallas Court then criticized the holding of those cases for their lack of analysis or for what the Dallas Court asserted was faulty analysis.

After the Dallas Court of Appeals, a State court, handed down its decision in Dallas Basketball, two federal district courts in Dallas issued opinions holding that article 21.55 does apply to claims for defense. The first opinion was Travelers Indemnity Co. v. Presbyterian Healthcare Resources, 313 F.Supp.2d 648 (N.D. Tex. 2004), written by Judge Solis of the Northern District of Texas. In this case, Presbyterian was sued by Lawrence Poliner, and Presbyterian allegedly placed Travelers on notice of the suit and requested coverage. A coverage dispute broke out between Travelers and Presbyterian, and Travelers sought declaratory judgment regarding the scope of its coverage. Presbyterian filed a counterclaim, asserting breach of the policy contract, violation of the duty of good faith and fair dealing, and violations of articles 21.21 and 21.55 of the Texas Insurance Code. Travelers moved to dismiss Presbyterian’s article 21.55 cause of action, contending the Supreme Court of Texas has not recognized a cause of action under article 21.55 for the failure to tender a defense. Presbyterian contended that other Texas courts considering the same issue had held the cause of action was viable. The federal court agreed with Presbyterian, relying on, in part, Rubalcava and Davalos. The court did not analyze the specific language of article 21.55, but merely relied on the holdings of the previous cases and agreed with Presbyterian that claims for defense were indeed included within the definition of a first-party claim.

The next opinion from the Northern District of Texas was Housing Auth. of City of Dallas v. Northland Ins. Co., 333 F.Supp.2d 595 (N.D. Tex. 2004), written by Judge Lindsay. In that case, the Dallas Housing Authority was sued for, among other things, wrongful employment practices. The DHA had a policy with Northland Insurance Company providing coverage for claims of wrongful employment practices. DHA forwarded the suit for Northland for defense and indemnity coverage. Six days before DHA was required to answer, it retained Strasburger & Price to defend it in the underlying case. Two days later, Northland acknowledged the claim and assigned Thompson, Coe to represent DHA in the underlying case. Two weeks later, Northland agreed to defend DHA in the lawsuit, subject to a reservation of rights. DHA requested that Strasburger continue to represent it in the underlying case, contending it was not happy with Thompson, Coe’s representation of DHA in the past. Northland denied the request, contending Thompson, Coe had more experience, charged lower rates, and was still handling DHA cases for Northland. DHA then requested that it be represented by any Northland-approved counsel other than Thompson, Coe. Northland countered by offering to pay a senior attorney at Strasburger to defend the case, but only at the lower, Thompson, Coe rate. DHA declined the offer. Strasburger successfully defended DHA in the underlying suit, and Northland did not pay any of the defense costs associated with the defense. DHA filed suit against Northland, asserting claims of breach of contract and violation of article 21.55 of the Texas Insurance Code. In regards to the article 21.55 claim, Northland asserted the article did not apply to claims for defense. Judge Lindsey acknowledged the Supreme Court of Texas had not answered the question of whether article 21.55 covers claims for defense. However, Judge Lindsey believed the Supreme Court had indicated how it might hold in a previous opinion, specifically, State Farm Fire and Caus. Co. v. Gandy, 925 S.W.2d 696, 714 (Tex. 1996). He further noted the Davalos, Westport, Mt. Hawley, Rubalcava, and Presbyterian courts had each concluded that claims for defense were claims under article 21.55. Northland pointed to the Dallas Court of Appeal’s holding in Dallas Basketball to support its contention. Judge Lindsey disagreed with the Dallas Court of Appeals, stating the Davalos and Gandy opinions indicated that, if the Supreme Court of Texas was to ultimately decide the issue, it would conclude that claims were defense were claims covered by article 21.55. Therefore, Judge Lindsey ruled that article 21.55 applied to DHA’s claim for defense from Northland.

In Fairfield Ins. Co. v. Stephen Martin Paving, L.P., 2003 WL 22005877 (N.D. Tex 2003), the paving company was sued by the widow of a worker killed while on the job. Fairfield carried both employer’s liability and workers compensation with the paving company. The widow sued the paving company for gross negligence (but not for intentional acts) for the death of her husband. Fairfield initially provided a defense to the paving company, but specifically reserved by letter the right to deny coverage for the costs of defense and indemnity. Fairfield contended that Texas public policy prevents the provision of insurance against damages arising from gross negligence and intentional acts.

The trial court, looking at the live pleading filed by the widow, concluded that some of the allegations were allegations of negligence (regardless of the legal theory pleaded) and, thus, the duty to defend was triggered. The trial court further concluded the language of the policy did not exclude punitive damages and, therefore, the policy covered both actual and punitive damages. The trial court noted the Supreme Court of Texas had not ruled explicitly on the issue of whether allowing punitive damages to be covered by liability insurance violated public policy. Therefore, the trial court followed existing Fifth Circuit precedent in Ridgway v. Gulf Life Ins. Co., 578 F.2d 1026 (5^th Cir. 1978), and ruled that insurance against punitive damaged did not violate Texas public policy.

The trial court’s rulings were appealed to the Fifth Circuit Court of Appeals. The Fifth Circuit recognized that its holding in Ridgway had been eroded by subsequent opinions from Texas intermediate courts of appeal. The Fifth Circuit believed the issue was significant under Texas law and, based on the conflicting holdings on the issue from the intermediate courts of appeal, it certified the issue to the Supreme Court of Texas. The specific question certified was” “Does Texas public policy prohibit a liability insurance provider from indemnifying an award for punitive damages imposed on its insured because of gross negligence?” The Supreme Court of Texas has agreed to hear the matter, but it has not yet issued its opinion on the question.

Waiver generally requires a showing that a party voluntarily surrendered known rights. See Stonewall Ins. Co. v. Villarreal, 591 F.2d 345, 347 (5th Cir. 1979).

Estoppel generally requires a showing that a party’s action or inaction prejudiced the complaining party. See Tilley, 496 S.W.2d at 560.

The term “court costs” is not defined in Chapter 42 or Rule 167, but the term probably has the same meaning as “costs” in Rule 131 and may include: (i) fees of the clerk and fees for service of process; (ii) fees of the court reporter for the original of stenographic transcripts necessarily obtained for use in the case, (iii) fees for masters, interpreters, and guardian ad litems; and (iv) other costs and fees as permitted by rules and statutes. See Tex. R. Civ. P. 131; see also Wallace v. Briggs, 348 S.W.2d 523, 527 (Tex. 1961) (expense of taking depositions considered an item of court costs). Conversely, costs do not include other matters such as postage or photocopying expenses. See Allen v. Crabtree, 936 S.W.2d 6, 8 (Tex. App.—Texarkana 1996, no writ) (disallowing such items as traveling expenses, bond premiums, delivery charges, long distance charges, postage, copying charges, and secretarial services).

“Defendant” is defined as any party from whom a claimant seeks recovery, including a counter-defendant, cross-defendant, or third-party defendant. See Tex. Civ. Prac. & Rem. Code ß 42.001(3); Tex. R. Civ. P. 167.2(a).

Note, it appears as if a defendant who obtains a “zero” verdict and judgment against the plaintiff cannot recover any litigation costs because the formula for capping the amount of recoverable litigation costs is based on damages recovered in the judgment. See Mikal C. Watts and Alex M. Miller, HB 4 – One Year Later, Page Keeton Civil Litigation Conference, October 28-29, 2004, at 5.

“Non-economic damages” are damages awarded for the purpose of compensating a claimant for physical pain and suffering, mental or emotional pain and anguish, loss of consortium, disfigurement, physical impairment, loss of companionship and society, inconvenience, loss of enjoyment of life, injury to reputation, and all other nonpecuniary losses of any kind other than exemplary damages. Tex. Civ. Prac. & Rem. Code ß 41.001(12).

“Exemplary damages” are damages awarded as a penalty or by way of punishment, but not for compensatory purposes; the term excludes economic and noneconomic damages. Tex. Civ. Prac. & Rem. Code ß 41.001(5).

“Economic damages” include compensatory damages intended to compensate a claimant for actual economic or pecuniary loss. Tex. Civ. Prac. & Rem. Code ß 41.001(4).

By way of example, if a defendant invokes Rule 167 and offers $50,000 to settle the case, and the jury’s judgment and verdict was $35,000, then the trial court must award the defendant's litigation costs against the plaintiff because the judgment was for less than 80 percent of the rejected offer. See Tex. R. Civ. P. 167.4(b) (emphasis added). If, however, the judgment was for $40,500, the trial court cannot award the defendant's litigation costs against the plaintiff because the judgment was for more than 80 percent of the rejected offer. See id.

Likewise, if the plaintiff offered to settle for $75,000 and the judgment was $100,000, the trial court must award the plaintiff’s litigation costs against the defendant because the judgment was for more than 120 percent of the rejected offer. See id. (emphasis added). Conversely, if the judgment was for $85,000, the trial court cannot award the plaintiff’s litigation costs against the defendant because the judgment was for less than 120 percent of the rejected offer. See id.

The Supreme Court of Texas later reversed the judgment of the Corpus Christi Court of Appeals in the Davalos case, but not on the issue of whether claims for defense are claims under article 21.55.

In a footnote, Judge Lindsey noted that Northland’s counsel in this case was also involved in the Rubalcava litigation. He further noted that in the instant case, counsel contended that article 21.55 was not applicable to a claim of defense, but in the Rubalcava case, counsel had taken the exact opposite position.

A negligence claim was not available to the widow, as she accepted workers compensation benefits and is subject to the comp bar. See generally Tex. Lab. Code ß 408.001.

If a federal appeals court is unsure of the answer to a question of state law, it may certify the question to the highest court of the relevant state for an opinion answering the question.