Bargaining in the Shadow of the Law: How do 'Bad Faith' Laws Affect Insurance Settlements?

Abstract

This paper provides new evidence on the impact of bad faith liability on insurance settlements. Economic theory predicts that policyholders in states that recognize a private cause of action for insurer bad faith should receive more favorable claim settlements if bargaining is undertaken with the bad faith regime in mind. We test this hypothesis using data from individual automobile insurance claims settled during the time period 1977-1997, exploiting the variation that occurs from the different timing of states’ adoption of bad faith rules to identify the effect of bad faith liability on claim settlement amounts. We find that tort liability for insurer bad faith increases claim settlements, and that this increase is statistically significant even after accounting for changes in claimed loss amounts when bad faith liability is expanded. We find further that the impact of tort liability on settlement amounts is greatest for small claims, and that tort liability reduces the likelihood of claims being underpaid. These results provide supporting evidence that tort liability for first-party insurer bad faith has real consequences for claim settlement outcomes.