Construction Project Documentation: Explaining Business Records Exception to the Rule Against Hearsay

Wendy Wendrowski | International Law Office | January 30, 2017


Given the critical role of written documentation in resolving construction claims – whether inside or outside of the courtroom – it is essential that companies adequately train the individuals who create written documentation. Depending on experience and training, the average worker on the project management or quality control team may not be aware of the best practices for creating written documents that may later be used to prove, or disprove, entitlement to additional time or money. These employees are also unlikely to be aware of the business records exception to the rule against hearsay and the requirements that must be satisfied before a written document may be used as evidence in trial. This update outlines the best practices for generating and preserving construction records to avoid evidentiary challenges to company records if a construction claim is litigated.

Rule against hearsay

State and federal courts prescribe standards, commonly known as the ‘rules of evidence’ to ensure the credibility and authenticity of documentary evidence offered at trial. One such rule – the rule against hearsay – provides that a statement that is made or created outside of the courtroom generally cannot be admitted into evidence in a trial to prove that something happened (or did not happen).(1) Such statements are viewed as inherently unreliable because:

  • they were not made under oath or under penalty of perjury;
  • they were not stated or shown to a judge or jury; and
  • the speaker or writer was not available to be questioned about the statement.(2)

Business records exception

Written business records may be admissible in court, even if the author of the document is not available to explain the document’s meaning, under the exception to the rule against hearsay for ‘records of a regularly conducted activity’ (more commonly known as the business records exception). Under the business records exception, a document relating to an event affecting a business organisation will not be excluded from evidence, even though the individual creating the document is not available to testify, if it was created:

  • by someone with knowledge of the event;
  • near the time when the event occurred;
  • as part of a regular activity of the business entity; and
  • under trustworthy conditions.(3)

To increase the likelihood that business records will be admissible in court when needed, companies should relay the following tips to the project managers and quality control personnel who are likely to prepare and maintain these documents.

Create document at or near time of incident

In order for a document to be classified as a business record, it must have been created at or near the time when the event being documented took place. Generating documents at or near the time of the event increases the reliability of the information contained in the document, as the memory of the person recording the information will not have faded with the passage of time. In practice, writers need to record information about an event on the same date that the event occurred. For example, a daily field report that summarises an on-site conversation about the discovery of an unknown site condition will have little value if the information about the conversation was written down a week or so after the conversation took place. Similarly, a letter identifying an event that occurred must be prepared and sent on the date that the event occurred or, at the latest, the following day. If too much time passes between the occurrence of the event and the writing of the letter, the accuracy of the information may be scrutinised more closely or dismissed outright and the letter could possibly be excluded from evidence under the rule against hearsay.

Document creator should be knowledgeable

Documents should be written by an individual who actually knows about the matter being described in the document. Although the business records exception technically permits a document to be based on information that was provided by an individual with knowledge, if the document simply contains information that was reported by a third person, the party challenging the admission of such a document may succeed in preventing the document from coming into evidence.(4) For example, if the project manager writes a letter based on what the project superintendent has told him, the letter is likely to be viewed as less reliable since it reflects the project manager’s interpretation of what the superintendent told him. Such a document in all likelihood will not be treated as a business record, unless the project manager or superintendent is available to provide testimony to demonstrate that the information is reliable.

A better practice is for the document to be written by a person who has seen or experienced what the document is about – for example:

  • a first-hand witness; or
  • someone who has personal knowledge of the subject of the document.

However, for this requirement to be met, the people in the field need to know how to efficiently and consistently create different types of construction documents and such knowledge comes only from successful training, supervision and practice.

Prepare document in regular course of business

In order for the business records exception to apply, the document needs to be created as part of the regular practice of the business. For example, if the contractor intends to offer evidence in the form of daily field reports prepared by the project superintendent, the project superintendent must have prepared similar daily field reports for every day of the project and must have regularly recorded similar types of information. More specifically, if daily field reports are prepared for every day of the project and those daily field reports regularly record the weather conditions, the daily field reports are likely to be admitted as business records to prove what the weather was like at the project site on one or more days in question and to support a contractor’s weather delay claim. On the other hand, if the same field reports fail to consistently provide information about materials delivered to the project site, they will not likely be admitted as business records to prove that certain materials were delivered to the project site on a specific date.

Documents do not qualify as business records if they have been created specifically for litigation.(5) In other words, the purpose of the document must be to address a business issue that exists at the time of writing rather than simply to prove a point at trial. This issue corresponds with the requirement that a document be created at or near the time of the event being discussed in the document; if the record is created at or near the time of the event being discussed, it is less likely to have been created solely for litigation purposes.

Keep document on file

The business records exception mandates that the record be kept in the course of a regular business activity. This may translate to a requirement that the document be maintained in an organised filing system, which is thought to increase the reliability of the document.(6) To comply with this requirement, the field personnel should identify:

  • all types of document being prepared on the project;
  • whether the records will be maintained as hard-copy (paper) documents or electronic (computer) documents;
  • where they will be kept; and
  • who is to organise and keep them.

As with any type of work, more work on construction projects is being performed electronically. Technology is changing the way that construction projects are being documented and the way that project documentation is being stored. New technology needs to be taken into account when evaluating the different types of documents that exist and the storage requirements for those documents. Effective as of December 1 2015, the Federal Rules of Civil Procedure were amended to address the obligation for companies to preserve and maintain electronically stored information. While the previous rule stated that a party could not be penalised by the court for the destruction of electronically stored information that had been “lost as a result of the routine, good-faith operation of an electronic information system”, the new rule requires companies, upon becoming aware of potential claims, to “take reasonable steps to preserve” electronically stored information or face penalties if electronic information is deleted.(7) Such ‘reasonable steps’ typically include, at a minimum:

  • notifying employees that they must not delete electronic information after the date the company learns of potential claims; and
  • discontinuing programs that automatically delete electronic information, such as emails, after a certain period of time.(8)

Companies should have in place a procedure identifying the length of time after project completion for which project files must be stored before they may be destroyed. As record retention policies vary from company to company, it is important that all employees understand company policy. Moreover, document retention policies must address both hard-copy files and electronically stored information. In most instances, the timeframe for project document retention correlates with applicable timeframes within which a lawsuit may be filed. For example, in those locations mandating that a lawsuit based on a breach of contract be filed within five years of the breach of contract, an appropriate document retention policy may require that project documents be retained for at least five years after expiration of the warranty period.


When it comes to resolving claims that arose during a construction project, companies do not want to discover that field personnel failed to record relevant information concerning actual or potential construction claims. Proving or disproving a claim will be very difficult if a company is required to rely on the memories of its project personnel, especially if those project personnel have left the company. Accordingly, companies will benefit by confirming that their field personnel know what written documents they need to prepare during a construction project, as well as by training their employees to comply with the requirements of the business records exception to the rule against hearsay. If a claim is litigated, it is essential that a company possesses business records to support its assertions at trial. In addition, the preparation of accurate business records may help a company to resolve project issues before they become claims, since the other party may be less likely to challenge a claim when the undisputed facts are laid out in black and white.

In litigation, courts attempt to render accurate decisions based on their consideration of all relevant facts. To do so, they strive to admit into evidence only those documents that accurately reflect what actually happened. In evaluating whether a business record is accurate, courts determine whether that record satisfies the requirements of the business records exception to the rule against hearsay:

  • Was the record created by someone with knowledge of the event?
  • Was the record prepared near the time when the event occurred?
  • Was the record generated as part of a regular activity of the business entity?
  • Was the record produced under trustworthy conditions?

Accordingly, companies that want their business records admitted into evidence to support their claims must ensure that their project documentation complies with these requirements. The tips set forth in this update will assist in this endeavour.


(1) Under the Federal Rules of Evidence, ‘hearsay’ is defined as: “a statement that: (1) the declarant does not make while testifying at the current trial or hearing; and (2) a party offers in evidence to prove the truth of the matter asserted in the statement.” FR Evid 801(c). “Hearsay is not admissible unless any of the following provides otherwise: a federal statute; these rules; or other rules prescribed by the Supreme Court.” FR Evid 802. State rules of evidence and case law establishing those rules are similar. Cal Evid Code Section 1200; Presley v Commercial Moving & Rigging, Inc, 25 A3d 873 (DC Ct App 2011); Ga Code Sections 24-8-801(d) and 24-8-802; Il Evid R 801 and 802; Md R 5-801 and 5-802; Devon S v Aundrea B-S, 924 NYS2d 233, 236 (NY Fam Ct 2011); Tx R Evid 801 and 802; and Va S Ct R 2:801 and 2:802.

(2) Courts require witnesses to testify under oath, through their personal presence at trial and subject to cross-examination, so that the fact-finder can evaluate:

  • whether the witness accurately perceived what is being described;
  • whether the witness retained an accurate memory of that perception;
  • whether the witness’s testimony accurately conveys the memory retained; and
  • whether the witness’s testimony is sincere. (2 McCormick on Evid Section 245 (June 2016 update)). If a witness cannot be evaluated by the fact-finder, the rule against hearsay and its exceptions come into play to ensure that these factors are evaluated through other means.

(3) Federal Rule of Evidence 803 identifies exceptions to the rule against hearsay. The rule states:

The following are not excluded by the rule against hearsay, regardless of whether the declarant is available as a witness:

(6) Records of a Regularly Conducted Activity. A record of an act, event, condition, opinion, or diagnosis if: (A) the record was made at or near the time by or from information transmitted by someone with knowledge; (B) the record was kept in the course of a regularly conducted activity of a business, organization, occupation, or calling, whether or not for profit; (C) making the record was a regular practice of that activity; (D) all these conditions are shown by the testimony of the custodian or another qualified witness, or by a certification that complies with Rule 902(11) or (12) or with a statute permitting certification; and (E) the opponent does not show that the source of information or the method or circumstances of preparation indicate a lack of trustworthiness.

F R Evid 803. See also Cal Evid Code Section 1271; DC S Ct R Civ Proc R 43-I; Ga Code Section 24-8-803(6); Il Evid Rule Section 803(6); Md R 5-803(b)(6); NYCPLR Section 4518; Tx R 803(6); Va S Ct R 2:803(6).

(4) Agricultural Insurance Co v Ace Hardware Corp (214 FSupp2d 413, 415-16 SDNY 2002) – a portion of an accident report prepared by the project superintendent who did not witness the accident but simply recorded information provided by witnesses does not fall within the business record exception. However, the witness presenting the business records for admission at trial:

need not have been the record’s creator or have any personal knowledge of the contents of the record; rather, the witness need only have personal knowledge of the manner in which the records were prepared“.

Concept General Contracting Inc v Asbestos Maintenance Services Inc (346 SW3d 172, 181 Tex App 2011) – the owner of the subcontractor permitted to authenticate, as a business record, documentation and photographs demonstrating extra work despite the owner lacking personal knowledge of the work performed (citation omitted). See also Green Construction Co v Department of Transport (643 A2d 1129 Pa Commw Ct 1994) the witness need not have personal knowledge of the individual entries in a business record (here, master diaries) “[a]s long as someone in the organization has personally observed the event recorded, the evidence should be admitted”. Indeed, a document may still qualify as a business record even if prepared by someone outside of the organisation, if the party preparing the record had a duty to prepare the document accurately. Houston Shell & Concrete Co v Kingsley Constructors Inc (987 SW2d 184, 186 Tex App 1999) – concrete test core results prepared by the state and an independent testing laboratory were sufficiently authenticated to constitute the subcontractor’s business records.

(5) See, for example, Carrie Contractors Inc v Blount Const Group of Blount Inc (968 FSupp 662, 666 MD Ala 1997) – accounting records prepared almost 17 months after the events in question to assist in settlement discussions did not qualify as business records and were excluded from evidence.

(6) Bishop v Shaw (978 So2d 568, 572-73 La Ct App 2008) – third-party invoices received, processed and maintained in company files are incorporated business records that may be used to prove the amount of damages; and International Brotherhood of Elec Workers v United Pacific Ins Co (573 A2d 270, 272-273 RI 1990) certified payroll records prepared by a third party but maintained by the company in a file folder and relied upon by the company constituted admissible business records.

(7) Specifically, the former text of Federal Rule of Civil Procedure 37(e) (effective prior to December 1 2015) provided that:

Absent exceptional circumstances, a court may not impose sanctions under these rules on a party for failing to provide electronically stored information lost as a result of the routine, good-faith operation of an electronic information system.

The new version of Rule 37(e) is significantly more detailed and states:

If electronically stored information that should have been preserved in the anticipation or conduct of litigation is lost because a party failed to take reasonable steps to preserve it, and it cannot be restored or replaced through additional discovery, the court:

(1) upon finding prejudice to another party from loss of the information, may order measures no greater than necessary to cure the prejudice; or

(2) only upon finding that the party acted with the intent to deprive another party of the information’s use in the litigation may:

(A) presume that the lost information was unfavorable to the party;

(B) instruct the jury that it may or must presume the information was unfavorable to the party; or

(C) dismiss the action or enter a default judgment.

FRCP 37(e) (effective December 1 2015).

(8) See, for example, Gonzalez-Bermudez v Abbott Laboratories PR Inc (2016 WL 5940199, *24 D Puerto Rico, October 9 2016), Virtual Studios Inc v Stanton Carpet Corp (2016 WL 5339601, *3, *10 ND Georgia, June 23 2016) and Matthew Enterprise Inc v Chrysler Group LLC (2016 WL 2957133, *2-*3 ND California, May 23 2016).

Subcontractor Exception to “Your Work” Exclusion Does Not Apply to Coverage Under Subcontractor’s Policy

Tred R. Eyerly | Insurance Law Hawaii | January 25, 2017

The Arizona Court of Appeals overturned the trial court’s determination that the general contractor was entitled to coverage under the subcontractor’s exception to the “Your Work” exclusion. Double AA Builders v. Preferred Contrs. Ins. Co., 2016 Ariz. App. LEXIS 294 (Ariz. Ct. App. Dec. 30, 2016).

Harkins Theatres hired Double AA Builders, Ltd. to serve as general contractor to build a theater complex. Double AA subcontracted with Anchor Roofing, Inc. to install the roof. Anchor was the “Named Insured” under a policy issued by Preferred Contractors Insurance Company, LLC. Double AA was an “Additional Insured” under the Preferred policy.

After the theater project was completed, the roof began to leak, causing damage to work performed by other subcontractors. Double AA replaced the roof and sued Anchor and Preferred seeking indemnification. Double AA sought to recover only the cost of replacing the roof, and not the cost of the damage to other property.

Preferred and Double AA filed cross-motions for summary judgment on the question of whether Double AA’s cost of replacing the roof was a covered loss under the policy. The court granted Double AA’s motion, concluding that coverage was triggered by an “occurrence” and “property damage,” and that the subcontractor exception clause removed the claim from the policy’s “your work” exclusion.

The Court of Appeals reversed. The exclusion removed from coverage “‘property damage’ to ‘your work’ arising out of it or any part of it and included in the ‘products completed operations hazard.'” The exception applied “if the damaged work or the work out of which the damage arises was performed on your behalf by a subcontractor.” “Your” and “your” meant “the Named Insured.” “Products completed operations hazard” was defined as “including all . . . ‘property damage’ occurring away from the premises you own or rent arising out . . . ‘your work.'”

Here, the exclusion applied because the case related only to Anchor’s defective work. The exception did not apply, however. The only Named Insured was Anchor, and Anchor performed the defective work itself – not through a subcontractor. The reference in the “subcontractor exception” to work “performed on your behalf by a subcontractor’ referred to work performed by a subcontractor of Anchor only – not to Anchor’s work performed as a subcontractor of Double AA. Because the policy defined “you” and “your” as the “Named Insured,” the exception applied when someone else did work as the named insured’s subcontractor, not when the named insured was a subcontractor. Double AA was an “Additional Insured”, not a “Named Insured” under the policy.

Therefore, the “subcontractor exception” to the “your work” exclusion did not apply. The policy did not provide coverage to Double AA for repairing Anchor’s faulty workmanship.

District of Connecticut Reaffirms That Definition Of “Collapse” Is Unambiguous

Timothy Larsen | Property Insurance Coverage Insights | January 25, 2017

The United States District Court for the District of Connecticut recently reaffirmed its ruling that the term “collapse,” as defined by a homeowners insurance policy, is unambiguous and that the policy in question did not provide coverage for the alleged “cracking” and/or “bulging” of the insureds’ foundation walls.  In Alexander v. Gen. Ins. Co. of Am., 2017 U.S. Dist. LEXIS 5963 (D. Conn. Jan. 17, 2017), the court denied the plaintiffs’ motion for reconsideration, rejecting their argument that the policy’s definition of collapse is ambiguous. The court had previously granted the insurer’s motion to dismiss on the grounds that the policy’s definition of “collapse” is unambiguous and the policy’s language expressly excludes coverage for cracking or bulging.

The plaintiffs owned a home insured by the defendant. They claimed that, in May of 2015, they discovered a series of horizontal and vertical cracks in their basement walls. They eventually learned that this condition was caused by pyrrhotite, a mineral contained in certain concrete aggregate during the late 1980s and early 1990s. The plaintiffs made a claim for coverage under their insurance policy, and the defendant denied their claim on the basis that the condition of the plaintiffs’ foundation walls did not constitute a “collapse” as defined by the policy.

The policy provided limited additional coverage for “collapse,” defined as “an abrupt falling down or caving in of a building or any part of a building . . . .” Id. at *2. The policy also stated that a “building or any part of a building that is standing is not considered to be in a state of collapse even if it shows evidence of cracking, bulging, sagging, bending, leaning, settling, shrinkage or expansion.” Id. at *3. The plaintiffs argued that a “caving in” must be something other than a “falling down” or else the term would be superfluous. See 7/7/2016 Motion Hr’g Tr. at 3. The plaintiffs further argued that the term “caving in” is defined by a number of dictionaries to mean yielding or submitting to pressure, and that the inward bulging of the foundation walls showed that the walls had yielded or submitted to pressure. Id. The court rejected this argument, noting that the policy’s collapse definition explicitly excluded “bulging.” Id. at 3-4.

The court found that the plaintiffs failed to allege facts demonstrating that either a falling down or caving in had occurred. Alexander, 2017 U.S. Dist. LEXIS at *6. Noting that the plaintiffs did not present any evidence or controlling case law that would cause the court to reconsider its prior decision, the court held that no collapse had occurred within the meaning of the policy and denied the plaintiffs’ motion for reconsideration.

This decision may be useful to insurers litigating the issue of the meaning of “collapse” in property insurance policies.

No “Occurrence” Found Where Contractor Intentionally Performed Defective Work With The Hope It Would Not Cause Property Damage

Steven R. Inouye and George P. Soares | Gordon & Rees LLP | January 20, 2017

The California Court of Appeal, Fourth Appellate District, affirmed in part and reversed in part an order awarding an insurance company its $1 million policy limits used to settle a construction defect claim on behalf of an insured general contractor.

In Navigators Specialty Insurance Company v. Moorefield Construction, Inc., 2016 Cal. App. LEXIS 1132 (December 27, 2016), a building owner, JSL Properties, LLC (“JSL”), and a developer, D.B.O. Development No. 28 (“DBO”), sued a general contractor, Moorefield Construction, Inc. (“Moorefield”), for floor leaks which occurred at a Best Buy electronics store between 2003 and 2009. In its second amended complaint, JSL claimed that Moorefield had defectively installed flooring on top of a concrete slab despite knowing that the existing slab contained excessive moisture levels. Navigators Specialty Insurance Company (“Navigators”) defended Moorefield in the action subject to a reservation of rights under a commercial general liability insurance policy. The litigation settled for $1,310,000 of which Navigators contributed its $1 million policy limits.

Navigators filed a declaratory relief lawsuit against Moorefield seeking a declaration that it had no duty to defend or indemnify the general contractor in the underlying construction defect action. Following a bench trial, the trial court issued a decision in favor of Navigators and against Moorefield. The trial court found that the flooring defects did not constitute an “occurrence” or accident under the policy. The trial court also held that Navigators had no duty to make any payments under the “supplementary payments” portion of the policy. Navigators received an award which required Moorefield to reimburse Navigators its $1 million policy limits contributed to settle claim.

The Court of Appeal agreed with the trial court that Navigators had no duty to indemnify Moorefield in the underlying action. The appellate court found evidence which established that Moorefield knew about the excessive moisture in the concrete slab and that it deliberately installed the flooring despite this known condition. Thus, the Court of Appeal held that no unexpected or unintended event constituted an “occurrence” to trigger an indemnity obligation under the policy. Moorefield and amicus curiae argued that construction defects could not be considered intentional conduct unless the contractor expected or intended its work to be defective and cause property damage. The Court of Appeal rejected that argument by stating, on the record before it, Moorfield knew about and intended to perform defective work with the hope it would not cause property damage. Even though Moorfield did not intend to cause property damage, the insured’s subjective belief was irrelevant.

However, the Court of Appeal reversed the portion of the trial court’s ruling which found that Navigators had no duty to make payments under the “supplementary payments” provision of the policy. The Court of Appeal determined that Navigators owed a duty to pay for attorneys’ fees and costs as part of the settlement because such amounts were recoverable under the construction contract and were awardable as taxed costs in litigation. Although no duty to indemnify existed, the appellate court found that Navigators was obligated to pay “supplementary payments” as part of its broader duty to defend.

The Court of Appeal also found that the trial court had improperly determined that the entire $1 million settlement payment was made for damages, rather than attorneys’ fees. The evidence indicated that JSL and DBO had only incurred $377,000 in damages related to the floor leaks. The appellate court further held that the trial court had committed prejudicial error in placing the burden of proof for this issue on Moorefield. Accordingly, the Court of Appeal remanded the case for a new trial seeking allocation of the settlement payment between damages and attorneys’ fees.

Click here for the opinion.

The opinion in Navigators Specialty Insurance Company v. Moorefield Construction, Inc., 2016 Cal. App. LEXIS 1132 (December 27, 2016), is not final. It may be withdrawn from publication, modified on rehearing, or review may be granted by the California Supreme Court. These events would render the opinion unavailable for use as legal authority in California state courts.

Moving Toward an Objective and Reversible Definition of Insurance Bad Faith

Burke A. Christensen | CLM Magazine | December 15, 2016

Should applicants for an insurance policy or those who file a claim for policy benefits be required to tell the truth? Should insurance companies be required to honestly and fairly investigate applicants and claimants? The answer to both questions should be equally, “yes.”

For insurance to work well, applicants, insurers, insureds, and claimants must act in good faith. Consumers rely upon an insurer to act in good faith and to keep its promises when an insured event occurs. The reverse also is true. In order to underwrite the risk, set a premium, create the policy, and pay valid claims, insurers must be able to rely upon the consumer to act in good faith.

For noninsurance contracts, the legal duty to act in good faith generally means little more than honesty, in fact. For insurance contracts, the law has imposed a higher good faith standard.

The duty of utmost good faith, previously known by its Latin name, uberrimae fidei, originated in marine insurance three centuries ago as a duty imposed upon insurance applicants, but it has since evolved so that this duty is now generally imposed only upon the insurer. This article will advance the position that it is in the best interests of both consumers and insurers that the obligation in the law to act in good faith be equally applicable to both insurers and insureds.

In the 17th century, if an English importer wanted to insure a shipment of goods coming to London from Italy, he would go to the Lloyd’s Coffee House in London and ask who would be willing to insure the shipment against loss at sea. The perils could be pirates, storms, faulty seamanship by the captain, shipwreck, or mutiny by the crew. The London underwriters had no ability to independently confirm the insurance applicant’s description of the risk: i.e., the ship’s condition, the nature and condition of the cargo, or the skill of the captain and crew. They had to rely on the statements of the applicant. Thus, the duty arose that the applicant for insurance must act in utmost good faith because the insurers were relying on a full and honest representation of the facts when they accepted the risk.

In marine insurance today, it remains the duty of an applicant to truthfully answer all questions posed by the insurer plus reveal all facts material to the risk. That duty to affirmatively disclose all material facts known to the applicant is not generally recognized in other forms of insurance. Though insurers today have a greater ability to check the honesty of the applicant’s responses, the applicant for insurance of all types should still be bound by the duty to tell the full and complete truth about any information material to the risk when inducing the insurer to accept a risk.

It is in the interests of both insurers and insureds that the same duty apply to those claiming benefits under an insurance policy. The Coalition Against Insurance Fraud estimates that there is $80 billion in fraudulent claims in the U.S. each year across all lines of insurance. This cost, plus the millions of dollars spent by insurers to investigate and detect insurance fraud, increases the cost of insurance for everyone.

The strength of a country’s insurance industry has a close relationship to the strength of its economy. If an equal application to both insurer and insured of the duty to act in good faith will strengthen the insurance industry and the economies in which they operate, then the law ought to reflect that.

The insurance principle states that insurance is a risk transfer mechanism under which the policy owner exchanges a small certain loss (the premium) for a large uncertain loss (the event insured against, e.g., death, illness, fire, accident, etc.). Unlike tangible products, such as hammers, cars, and clothes sold by manufacturers, an insurance company sells an intangible promise to pay benefits to or on behalf of its policyholders in the event of a covered loss.

Insurance exists to transfer risk. Risk is formally defined as uncertainty about outcomes, which can be positive or negative. Risk can be separated into business risk and hazard risk. Business risk (aka speculative risk) is that which is inherent in the operation of a business and presents the possibility of loss, no loss, or gain. It is generally not insurable because insurance is intended only to indemnify actual losses and not the failure to achieve a hoped-for gain. Hazard risk (aka pure risk) is that which results from exposure to accidental loss from such events as fire, wind, or illness. Hazard risk presents only the possibility of loss or no loss; there is no opportunity for gain. This risk is generally insurable.

Fundamentally, insurance is the combining of resources by the members of a pool. Each insured, as a member of the pool, has an equal interest that all applicants tell the truth when applying for insurance and when seeking benefits. An insurer can be envisioned as a money bucket that holds and prudently invests policy owner premiums in order to have sufficient cash to pay claims as they arise. If the insurer has a large number of insureds paying a proper premium, the more likely it is that the invested premiums and the investment returns will be adequate to pay all valid claims. But, if premiums are too low because applicants have made misrepresentations as to the nature of the risk they present to the pool or if the money in the pool is consumed by the payment of invalid or exaggerated claims, then all of the honest members of the pool will suffer.

When risks are properly disclosed and insurance is properly priced, then, based upon the law of large numbers and the insurance principle, insurance creates a near approximation of certainty for the pool of insureds and shifts the risk of loss from the few to the many. Bad faith actions by applicants, insureds, and claimants destroy this balance and threaten the ability of the pool to pay valid claims.

The law of large numbers states that, as the number of repetitions of an event increases, the deviation of actual experience from expected experience decreases. The smaller the deviation, the more predictable the anticipated losses. If you flip a coin 10 times, it is hard to predict how many times the coins will land on heads. If you flip the coin a million times, it is more likely that a prediction of 50 percent heads will be close to the observed amount. This law applies to tossing coins and to insuring risk. Applying this law to insuring property and lives creates predictability and permits insurability.

Based upon underwriting, insurers select who or what will be insured and classify the selected risks so that the owner of each risk pays a premium actuarially equal to the risk presented to the pool of insureds. This can be done accurately and fairly only when applicants truthfully disclose all information they possess that is material to the risk.

While insurers could charge all insureds the same premium, it is fair that people who present a higher risk of loss (e.g., death for a male aged 90 or fire for a straw house) pay a higher premium than those who present a lower risk of loss (e.g., death for a female aged 20 or fire for a brick house).

Insurers set premiums by estimating the future in four categories, which are known in life and health insurance by the acronym MIX-P—which stands for the mortality (death) or morbidity (sickness), the peril insured against; the investment income anticipated to be earned on the premiums paid by policyholders over the life of the policy; the expenses anticipated to be incurred to operate the insurer; and the persistency of the policies sold. Persistency is the opposite of the lapse rate and estimates how many policies will be renewed at each succeeding renewal period. Bad faith actions by the consumer reduce the ability of insurers to predict the future in all four.

When a claim is received, the insurer attempts to determine which claims are valid. The insurer has a duty to its policyholders to pay valid claims. But the insurer has an equal duty to its policyholders to deny invalid claims. These two duties are different sides of the same coin and are equal in their importance to the ability of the insurer to fulfill the promises made to honest policy owners.

What is the difference for an insurer between acting in good faith and acting in bad faith? A review of the case law establishes that the many attempts to define when an insurer has acted in bad faith offer little consistency and that there is no universally accepted definition of the term.

The term “bad faith” applies to something worse than simply being negligent. It is bad behavior combined with bad intent, and scholars agree that bad faith requires a showing of more than that the insurer did something wrong. An accusation that an insurer acted in bad faith requires more than a showing that the insurer didn’t act in good faith.

A Proposal for an Objective Definition 

The law of bad faith arose as a result of bad acts by some insurers. These acts were viewed as intentionally wrong and caused courts and legislatures to create remedies for the parties injured by them. Consistent with this principle, the foundational element of a bad faith claim should be a showing of actual bad intent by the insurer. For example, the plaintiff should be required to show that the insurer acted with an intent to deny the plaintiff the benefits of the contract.

With that definition, bad faith moves away from negligence and closer to the definition of insurance fraud. This is appropriate. Fraud is an act committed with the intent to obtain something you would not get absent the intentional misrepresentation. Acting in bad faith is an act committed with the intent to gain something to which one is not entitled.

Bad faith is not, and should not be, merely a mistake, ordinary negligence, or error. Bad faith should not be established if the record shows that the insurer, through unintentional error, didn’t properly process the claim or did a less-than-thorough investigation. The law should recognize the reality that someone can be wrong without acting in bad faith.

There ought to be a requirement for a showing of some element of intentional behavior or at least a reckless disregard for the rights of the insured. Bad faith should be established if the record shows evidence of a knowing intent to evade the requirements of the contract or to improperly process the claim or to conduct an inadequate investigation.

It is suggested that a finding of bad faith is proper if the insurer acted in a manner that was arbitrary or capricious. However, the vagueness of these terms makes it hard to know in advance what will be deemed to be arbitrary or capricious. A clearer standard might be that, in order to have a finding of bad faith, there ought to be evidence that the insurer’s subjective mental state (meaning as it is displayed by the actions of its agents and employees) was based upon an intent to do the wrong thing or upon a reckless disregard of whether the action was wrong. Satisfying this requirement should be based upon facts or a reasonable inference based upon facts; not upon mere speculation.

A finding of bad faith also could be found based upon objective unreasonableness. This might be defined as: no reasonable person having the same duties, knowledge, and experience would have committed the acts in question. That definition also can be fairly applied to a duty of an applicant or a claimant to act in good faith with respect to the insurer.

Since insurers must rely upon consumers to tell the truth in order to create a fair insurance contract and consumers must rely upon insurers to perform the duties created by the contract, the standard for bad faith should be based on intent and be equally applicable to insurers as well as to applicants for insurance and claimants for policy benefits.