What Does It Take To Show Bad Faith?  Insurer’s Invocation of Policy Exclusions To Deny Coverage Not Clear and Convincing Evidence of Bad Faith

10.16.2013

In a recent opinion discussing an insurance coverage dispute, the federal Third Circuit Court of Appeals reversed in part and affirmed in part the District Court’s grant of summary judgment in favor of the two insurance companies.  In U.S. Fire Ins. Co. v. Kelman Bottles, 2013 WL 5303261 (3rd Cir. Sept. 23, 2013), both insurers denied coverage for losses caused by a catastrophic leak in a glass melting furnace.  The Third Circuit held that although the insurance companies had improperly relied upon policy exclusions to deny coverage, their actions did not support a claim of bad faith.

The Kelman Bottles (“Kelman”) factory houses and operates a glass melting furnace that typically contains about 220 tons of molten glass stored a temperatures ranging from 2300 to 2800 degrees Fahrenheit.  On March 15, 2011, a leak in the furnace rapidly turned into a catastrophic event—the furnace spewed molten glass for several hours, causing damage to the furnace itself and to other equipment at the plant.

Kelman had purchased two insurance policies to cover risks associated with the furnace: (1) an “All Risk” policy with U.S. Fire Insurance Co. (“U.S. Fire”); and (2) and “Equipment Breakdown” policy with Continental Casualty Co. (“Continental”).  The “All Risk” policy with U.S. Fire provided coverage for any “Covered Causes of Loss,” which coverage was defined as “Risks of Direct Physical Loss unless the loss is . . . excluded.”  The policy also contained a section titled “Additional Coverage Extensions,” which provided coverage for loss or damage from molten material, among other things.  Kelman’s “Equipment Breakdown” policy with Continental provided coverage for any breakdown to “Covered Equipment,” which included the furnace.  The policy defined “Breakdown” as a “sudden and accidental direct physical loss to ‘Covered Equipment.’” 

After the March 15, 2011 incident, Kelman filed claims with both U.S. Fire and Continental.  U.S. Fire denied coverage based on the policy’s Inherent Vice Exclusion, Wear and Tear Exclusion, and Design Defect Exclusion.  Continental also denied Kelman’s claim on the grounds that the leak did not constitute a “Breakdown” within the definition of the policy.  In denying coverage, both insurance companies relied on the fact that all glass melting furnaces occasionally leak because their design requires gaps to accommodate the large expansions and contractions associated with the high temperature of molten glass. 

Subsequently, U.S. Fire filed a declaratory judgment action seeking the court to declare that it had no obligation to insure Kelman for the damages and losses suffered in the March 15, 2011 furnace incident.  Kelman counterclaimed against U.S. Fire, asserting claims for breach of contract and bad faith.  Kelman then joined Continental and asserted a breach of contract claim against it.  Both insurers filed motions for summary judgment arguing that Kelman was not entitled to coverage under their respective policies and thus they did not breach their contracts.  Kelman filed a cross-motion for summary judgment asserting that both U.S. Fire and Continental were liable under the policies. 

In granting summary judgment for U.S. Fire, the District Court held that the loss in question fell under the Inherent Vice Exclusion, and thus, it also was not covered under the Additional Coverage Extensions.  According to the District Court, because Kelman had admitted that molten glass was an inherent risk to operating the furnace, the loss fell within the inherent risk exclusion.  The Third Circuit disagreed, finding that the court erred in concluding that the loss occurred as a result of the molten glass leak.  As the Third Circuit explained, the glass furnace’s susceptibility to leaks is not the type of loss causation that should invoke the Inherent Vice Exclusion.  The furnace was designed to leak, but that did not prevent it from functioning properly.  The leaking of molten glass from a glass melting furnace is common and natural and therefore, part of the furnace’s inherent functioning, not an inherent vice. 

Because the Third Circuit found that there was an issue of material fact regarding whether the loss was covered under Continental’s “Equipment Breakdown” policy, it held that the District Court erred in granting summary judgment to Continental.  The District Court reasoned that because Kelman expected leaks to occur, the loss in question was not “sudden and accidental” and thus was not covered.  The District Court, however, erroneously based its holding on a finding that Kelman expected the leaks.  But whether or not a leak was expected is not indicative of whether the loss was “sudden and accidental.”  Evidence in the record suggested that factual issues remained as to what risks of loss and damage Kelman expected and whether the incident was sudden and accidental. 

Notwithstanding the reversal of summary judgment on Kelman’s breach of contract claim, the Third Circuit affirmed the District Court’s grant of summary judgment for U.S. Fire on Kelman’s bad faith claim on the basis that Kelman had not shown clear and convincing evidence of bad faith.  Kelman argued that U.S. Fire deliberately ignored facts supporting its claim of coverage, refused to evaluate coverage under the appropriate policy provisions, refused to reevaluate its position, and forced Kelman to exhaust its financial resources.  As the Third Circuit explained, the fatal defect in Kelman’s bad faith claim was that it relied on the absence of evidence of good faith rather than clear and convincing evidence of bad faith.

In denying coverage to Kelman, U.S. Fire construed its Inherent Vice Exclusion too broadly.  The furnace’s susceptibility to leaks was not the type of loss causation that should have triggered the Inherent Vice Exclusion.  Even so, the Third Circuit found that the invocation of exclusions, without more, would not allow a jury to find by clear and convincing evidence that U.S. Fire’s denial of the claim was unreasonable or that U.S. Fire knew or recklessly disregarded its lack of a reasonable basis to deny the claim.  This case highlights the heightened evidentiary standard that must be met in order to prove bad faith.  An insurer’s invocation of exclusions, alone, will not support a bad faith claim.

Jaime Wisegarver is an associate in the Litigation Section, where she handles a variety of civil and commercial matters, including insurance recovery litigation and counseling. For more information, please contact Jaime at (804) 771-5634 or jwisegarver@hf-law.com.