When can an insured recover policy benefits as damages under the Insurance Code, potentially trebling what would otherwise be ordinary contract damages?  That question, which has divided Texas insurance lawyers for more than a decade, was tackled and largely resolved by the Texas Supreme Court in USAA Texas Lloyds Co. v. Menchaca, No. 14-0721, 2017 Tex. LEXIS 361 (April 7, 2017).

In Texas, an insurance carrier may be liable to its insured for breach of the insurance policy or for violations of statutory provisions that govern the manner in which insurers review and resolve claims for policy benefits.  Unlike contract-based claims, claims based on statutory violations – sometimes referred to as “bad faith” claims – allow the insured to recover treble damages if the insurer commits the violation knowingly.

This question of whether a policyholder can recover policy benefits as damages under the Insurance Code typically arises in two distinct scenarios.  The first, and the one at issue in Menchaca, occurs when a jury fails to find any breach of the insurance policy, but finds a violation of the Insurance Code and awards the same amount of damages that would have been owed under the policy had it covered the incident.  The second occurs when a jury finds both a breach of the policy and a breach of the Insurance Code and awards the same amount of damages for each.[1]  In that situation, the insured typically “elects” to recover the damages awarded under the Insurance Code to take advantage of treble damages.

Insurers complained that the first scenario forced them to pay policy benefits when there was no coverage, while the second allowed trebling of ordinary contract damages.

Two historical decisions from the Texas Supreme Court were at the center of complex and divergent interpretations as to whether policy benefits are available as damages for Insurance Code violations and, if so, when.

In Vail v. Texas Farm Bureau Mutual Insurance Co., 754 S.W.2d 136 (Tex. 1988), the Texas Supreme Court appeared to allow the recovery of policy benefits as damages for Insurance Code violations, stating that an insurer’s “unfair refusal to pay the insured’s claim causes damages as a matter of law in at least the amount of the policy benefits wrongfully withheld.”

Ten years later, however, in Provident American Ins. Co. v. Castañeda, 988 S.W.2d 189 (Tex. 1998), the Court held that extra-contractual damages were not recoverable because “none of the actions or inactions of [the insurer] was the producing cause of any damage separate and apart from those that would have resulted from a wrongful denial of the claim.” Castañeda appeared to recognize that alleged bad faith cannot constitute a producing cause of damage (i.e. “a cause … without which the damages would not have occurred”) when a breach of the policy alone has caused the same damages.

Castañeda was often cited as abrogating Vail and establishing a rule that damages were not available under the Insurance Code unless the code violations caused an “independent injury” separate and apart from the loss of policy proceeds.  For example, the Fifth Circuit concluded in In re Deepwater Horizon, 807 F.3d 689, 698 (5th Cir. 2015), that “decisions from the supreme court of Texas and Texas’s intermediate appellate courts arguably cast doubt on Vail’s continued vitality” and interpreted Castañeda “as setting out the opposite rule from that in Vail.” Id.

Faced with what it described as a line of decisions creating uncertainties in the law because of varying facts and circumstances, the Texas Supreme Court resolved to settle ongoing conflicts over the independent injury rule in Menchaca.

Menchaca is one of many coverage disputes arising after Hurricane Ike struck Galveston in 2008.  Following the hurricane, Gail Menchaca contacted her homeowner’s insurance company, USAA Texas Lloyds, and reported that the storm damaged her home.  After her claim was twice denied by USAA, Menchaca sued for breach of the insurance policy and for unfair settlement practices in violation of the Texas Insurance Code.   The case was tried to a jury.

• Question 1 of the jury charge addressed Menchaca’s breach-of-contract claim.  It asked whether USAA failed “to comply with the terms of the insurance policy with respect to the claim for damages filed by Gail Menchaca resulting from Hurricane Ike.” The jury answered “No.”
• Question 2 addressed Menchaca’s statutory claims.  It asked whether USAA engaged in various unfair or deceptive practices, including whether USAA refused “to pay a claim without conducting a reasonable investigation with respect to” that claim. As to that specific practice, the jury answered “Yes.”
• Question 3 asked the jury to determine Menchaca’s damages that resulted from either USAA’s failure to comply with the policy or its statutory violations, calculated as “the difference, if any, between the amount USAA should have paid Gail Menchaca for her Hurricane Ike damages and the amount that was actually paid.” The jury answered “$11,350.”

Both parties moved for judgment on the verdict.  The trial court entered judgment in favor of Menchaca and the court of appeals affirmed.  The Texas Supreme Court accepted the case to settle conflicts over “whether the insured can recover policy benefits based on jury findings that the insurer violated the Texas Insurance Code and that the violation resulted in the insured’s loss of benefits the insurer “should have paid” under the policy, even though the jury also failed to find that the insurer failed to comply with its obligations under the policy.”

In resolving the dispute, the Court outlined five rules that shape the contours of an insured’s ability to recover policy benefits as actual damages under the Insurance Code:

• The General Rule: First, an insured generally cannot recover policy benefits as damages for an insurer’s statutory violation if the policy does not provide the insured a right to receive those benefits.
• The Entitled-to Benefits Rule: Second, an insured who establishes a right to receive benefits under the insurance policy can recover those benefits as actual damages under the Insurance Code “if the insurer’s statutory violation causes the loss of the benefits.”
• The Benefits-Lost Rule: Third, even if the insured cannot establish a present contractual right to policy benefits, the insured can recover benefits as actual damages under the Insurance Code if the insurer’s statutory violation caused the insured to lose that contractual right.
• The Independent Injury Rule: Fourth, if an insurer’s statutory violation causes an injury independent of the loss of policy benefits, the insured may recover damages for that injury even if the policy does not grant the insured a right to benefits.
• The No-Recovery Rule: And fifth, an insured cannot recover any damages based on an insurer’s statutory violation if the insured had no right to receive benefits under the policy and sustained no injury independent of a right to benefits.

Id. at *11-12.  Applying these rules, the Court concluded that the trial court erred in disregarding the jury’s answer to Question 1 because the finding was neither unsupported nor immaterial.  Indeed, the finding would have precluded Menchaca from recovering policy benefits as damages under the Insurance Code based on the Supreme Court’s five guiding principles.  As a result, the Court reversed and remanded for a new trial.

The take away from Menchaca?  Damages recoverable under the Insurance Code must be carefully analyzed in terms of causation.   Under the first and third rules announced in Menchaca, if there is no coverage for the loss, policy benefits ordinarily will not be recoverable as damages under the Insurance Code.  The exception is when the Insurance Code violation somehow caused the policyholder to lose the benefits; that is, when there would have been coverage but for the Code violation. An example used by the Court is if the insurer misrepresented coverage.

Under the second rule, if there is coverage for the loss, policy benefits will be recoverable under the Insurance Code but, again, only if “’wrongful’ denial of a ‘valid’ claim for benefits results from or constitutes a statutory violation” as opposed to a mere breach of the policy.  Unfortunately, Menchaca does not explain clearly when a Code violation will in fact constitute a producing cause (i.e. a but-for cause) of the damages when the policy breach itself caused the same damages.  This ruling is likely to generate the most litigation and have the most potential benefit to policyholders.

The fourth rule is nothing new; a policy holder may recover for any independent injury apart from policy benefits caused by an Insurance Code violation.

And finally, if there is neither a right to receive benefits under the policy nor any independent injury, the policyholder will not be entitled to damages.

1] See, e.g., United National Insurance Co. v. AMJ Investments. LLC, 447 S.W.3d 1 (Houston [14th Dist.] 2014, pet. dism’d).