Insurer's denial of defense based on unsettled law was bad faith

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The Supreme Court noted that no Washington decision had decided whether an assault-and-battery exclusion also excluded coverage for post-assault negligence. The Court reviewed the split in non-Washington cases on the question. The Court chose to follow the rationale of non-Washington courts that had held that “arising out of” in an assault-and-battery exclusion did not apply to, and therefore did not defeat coverage for, allegations of post-assault negligence.

The lack of a controlling Washington decision on the subject also prompted the Supreme Court to hold that Alea should have given its insured the benefit of the doubt in deciding whether to defend, and that its failure to do so was unreasonable. The legal uncertainty whether Alea owed a duty to defend “works in favor of providing a defense to an insured,” the Court held, concluding that Alea had breached its duty to defend as a matter of law.

The Supreme Court went one step further and held that Alea’s refusal to defend was also bad faith as a matter of law. Historically, Washington courts have found bad faith only where the insurer’s conduct was unreasonable, frivolous, or unfounded. Alea therefore argued that its coverage position was one reasonable conclusion from the case law. The Court disagreed, holding that Alea should have provided a defense to Cafe Arizona because, under the split authorities from other states, it was arguable that it was legally entitled to a defense, and therefore should have resolved that question in favor of the insured.

Justice Susan Owens and three other justices dissented in part. Justice Owens agreed with the majority that as a matter of law, Alea owed Cafe Arizona a defense but disagreed that Alea’s conduct was bad faith as a matter of law. The duty to defend sounds in contract, but bad faith sounds in tort. Traditionally, Washington courts have found no bad faith if the insurer’s coverage denial was based on a reasonable interpretation of the policy. Justice Owens wrote, “I cannot conclude that Alea’s ... [coverage] determination, though incorrect, was unreasonable, frivolous, or unfounded in light of the existing case law.” Her dissent is consistent with the longstanding Washington rule that an insurer has a “right to be wrong.” That rule is now in doubt. Liability insurers in Washington should be concerned that this new case requires them to be entirely correct in denying a defense, because if they are wrong, a finding of bad faith is probable.