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INSURANCE LITIGATION |
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LIFE, DISABILITY AND HEALTH INSURANCE BAD FAITH IN THE '90s: PROMISES MADE, PROMISES BROKEN
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I. INTRODUCTION At the heart of insurance bad faith cases, based on breach of the implied covenant of good faith and fair dealing in an insurance policy, is the notion that the insured purchased and paid for a promise of future insurance payment in order to secure peace of mind. Typically, insurance bad faith cases have involved an insured being forced to sue in order to secure the benefit of their bargain in the form of a defense under or benefits provided by an insurance contract. The basic premise of first party bad faith, and its origins in California, are discussed and analyzed in Gruenberg v. Aetna Ins. Co. (1973) 9 Cal.3d 566; see also deVries and Scott, Establishing Bad Faith, INSURANCE SETTLEMENT HANDBOOK (James Publ. 1993). Over time, top management positions in insurance companies, and now managed care companies, have been filled by financial managers, not marketing types and not insured or patient advocates. The internal operations and structure of insurance companies are beginning to face, and will continue to face, in the 1990s an increasing scrutiny to which they have never been exposed before, and increasingly the details will support legal accountability as fiduciaries and joint venturers, in addition to other remedies, including class actions. Federal law, the McCarren-Ferguson Act in particular, has protected the insurance industry from most anti-trust scrutiny and left regulation of insurance to the states, where financial scrutiny has been limited. Under statutory accounting and reporting the primary focus is on testing the adequacy of an insurance company's aggregate reserves or surplus against aggregate potential risk. This approach is markedly different from generally accepted accounting principals (GAAP) which presents a more accurate picture of the detailed financial operations of an insurance company and the policies it issues. Rating services, such as A.M. Best and Standard & Poor's, which are very important in this competitive industry, are moving to require that GAAP accounting be fully disclosed by companies for rating purposes. Economic forces and structural changes within the insurance industry in the United States in the 1970s and 1980s are driving new potentially abusive practices that have also engendered new and different types of bad faith litigation in the '90s. This article will introduce and discuss some of the more important forces and changes and resulting bad faith claims, other than duty to defend and claim denial cases, which also remain prevalent. II. LIFE INSURANCE A. Relevant Background TThe life insurance that most people were familiar with into the 1970s was what is now called "traditional life insurance," consisting mainly of whole life insurance policies and term insurance policies. These policies traditionally involved a fixed promise of a specific death benefit and a fixed or increasing premium that was expected to be paid for the life of the insured in order to keep the policy in force. Such policies were sold by different types of insurance companies, including mutual companies in which the policyholders ostensibly had certain proprietary rights in the company, fraternal organizations, and stock insurance companies where the policy was non-participating and the policyholders bought a product without any proprietary interest. The distribution system for the sale of insurance policies involved captive agents employed by the company, independent contractor agents that were part of an organized and unified agency system, independent agents and brokers representing multiple insurers and also direct mail and telephone sales with no agent involvement. Substantial changes occurred in the 1970s with the introduction of what are called "non-traditional insurance products." Among these were such policies as level premium dividend-based policies, blended whole life and term policies, and "universal life insurance." There are many variations of these products, but they tend to share some basic features that are important in distinguishing them from traditional products. First, the policies feature a cash account managed by the insurance company that does not merely represent a cash value of the policy to be paid to the insured on surrender of the policy before death, less a surrender charge. Instead, the cash value that accumulates and is maintained in the policy can also affect the duration and amount of premiums on the policy and also the death benefit amount on the policy, in addition to its surrender cash value. Second, additions to the cash value of the policy are a function not just of the premiums paid, but also, depending on the structure of the policy, either dividends shared by the company with the policyholder, interest credited to the policy, return on investments dedicated to the particular block of policies, or a combination of these things. Third, mortality assumptions, reflected as a mortality charge against the policy and costs of insurance, reflected as expenses charged against the policy, are not used only as a basis for pricing premiums at the time of policy issue only, but may also be changed by the insurance company and directly affect (usually lower) the cash value of the policy periodically and regularly throughout the life of the policy. TToday, non-traditional life insurance products, such as universal life, variable life and annuities, account for two-thirds of life insurance companies reserves, while traditional products account for only one-third. In addition, almost 50% of life insurance company premium income and deposit receipts today come from annuity sales, not from what we typically think of as insurance. In the distribution or marketing of life insurance policies, sales are typically commission driven. That is, historically in the life insurance industry, insurance companies pay selling agents a commission based on the net first year premium; this commission is called the Net Annualized First Year Commission (NAFYC). In addition, depending on the level of sales of the agent there are also additional bonuses, allowances and other incentives based on sales production paid in the first year. As a rule of thumb, NAFYC is limited to 50% or 55% for any life insurance company that does business in New York. Any life insurance company that does business in New York is called a "New York Company," which distinguishes it from insurance companies that, while they may sell in most other states, do not sell life insurance in New York State. The "non-New York companies" have no statutory limit on the commissions they can pay agents selling their policies. It is not untypical that the combination of commissions, bonuses, allowances and other incentives can result in the expenses associated with the sale of a life insurance policy in the first year (acquisition costs) exceeding the first year premium that the company receives from the sale. In addition, selling agents usually get additional renewal commissions each subsequent year the policy stays in force. Sales competition in the life insurance industry is both complex and aggressive. The primary factors that affect life insurance competitiveness are premium pricing, which may directly affect consumer behavior, and commission structure, which can directly affect agent behavior. With the advent of dividend sensitive and interest or investment sensitive insurance products in the 1970s and 1980s, return on investment within insurance policies and "credited interest" rates within insurance policies dramatically changed the marketing of life insurance. Stated simply, with the rise of return rates on treasury bills, bonds, CD's (certificates of deposit), REITs (real estate investment trusts) and mutual funds, and with a sense of increasing security in such investments, persons with sufficient disposable income to purchase life insurance also had the opportunity for relatively safe investment returns that could outperform traditional insurance products. The non-traditional life insurance products, therefore, were designed to and were marketed in competition not just with other life insurance products, but with other financial investment products. This trend has continued through the late 1980s into the 1990s, with the advent of even more sophisticated investment related insurance products, called "variable life," in which the insured and insurer invest cash value from policies in such things as mutual funds, with substantially higher risk than traditional products and some earlier non-traditional products. Variable life products, because of their investment mechanisms, while they might not be directly designated as securities, require agents to register as securities dealers with the National Association of Securities Dealers (NASD). Traditionally, most life insurance companies have taken the position they cannot dictate sales behavior to agents and brokers. However, the ratings services are increasingly scrutinizing market conduct as a factor, on the liability side, in the ratings evaluation process. A. M. Best, for instance, has announced that it expects companies to develop and implement market conduct guidelines for their sales forces, whether the agents and brokers are "independent" or not. B. Problem Areas. The emerging areas of life insurance litigation developing as a result of the foregoing trends fall into two main subtypes, market conduct and negligent or predatory financial management practices. "Market conduct" is a term now widely used and accepted in the insurance industry to describe problems associated with the distribution and sale of life insurance, including such matters as agent misrepresentation, false and deceptive advertising and fraud in the design and description of insurance products. In life insurance, the key areas involving agent misrepresentation include misleading statements or sales presentations concerning the amount of premiums necessary to maintain a policy and incorrect interest rate and inflation projections in describing the future anticipated performance of a policy (either orally and/or in computer-generated "illustrations" or "ledgers.") One of the largest and most notable problems today is the fallout from insurance company marketing programs pushing what were characterized as "vanishing premiums." In a vanishing premium program or sale approach, the potential insured is sold life insurance based on a sales presentation, both oral and in writing, that indicates that while only certain cash values in the policy are guaranteed, the performance of the company, the return on projected investments, and the projected credited interest rates are such that after paying a quoted premium for a certain number of years, the cash value and returns in the policy will provide all the money necessary to maintain the death benefit for the insured's life. The essential problem with this type of program and sales presentation is that, in fact, life insurance policies, including the ones characterized as "vanishing premium" policies have premium requirements that in fact never vanish, and always have to be paid. In the final analysis, under these policies, the insured is actually the insurer of the cash value, not the insurance company. Another significant marketing abuse has involved misrepresentation by agents of the nature and purpose of the life insurance product, including hiding the very fact that what was being sold was life insurance. For instance, agents have been caught mischaracterizing universal life insurance policies as 401k retirement plans and variable life policies as mutual funds. Agent and company misconduct, primarily in the form of misrepresentation, has been uncovered in relation to what is called "replacement." Simply stated, replacement, in the life insurance context, means buying a new policy with the intent and understanding that an existing policy will be cancelled, or "replaced." Replacement is not necessarily bad in every situation, but a new policy issue typically carries with it a new contestability period for undisclosed conditions and new start up costs, together with the fact that the policyholder pays a surrender charge on the cancelled policy. Abuses of life insurance replacement are usually referred to as "mass replacement," "twisting" or "churning," depending on the factual setting. There are also potential tax problems and replacements often occur in the context of Internal Revenue Code 1035 like-kind exchanges. It has been estimated that as much as 40% of the life insurance currently in force in the United States is the result of replacement. The sale of universal life and other interest-sensitive or risk-based policies to fund future estate tax obligations has raised questions of the appropriateness of product design, development, marketing and selection. In other words, insurance funding of estate taxes that will not be imposed until years in the future present a unique risk of imposing unexpectedly high long-term premium costs on an estate given the unpredictable fluctuation of interest and investment return rates, and the risk inherent therein, in the interim. In the area of negligent or predatory financial management practices, the problems are complex, and they tend not to be immediately obvious because key financial information is not provided to the policyholders or to the company's agents or brokers in the ordinary course of business, and the information is also not required to be reported to regulators in most states. The form of financial mismanagement can vary with each company and with each type of policy, but typically involves a company raiding policyholders' cash values in order to meet unrelated financial obligations of the company that were not a part of or provided for in the insurance contract. Life insurance companies that had sold generous life insurance policies with low premiums based on overly optimistic projections of interest rates and investment returns found themselves in the second half of the 1980s and into the early 1990s with poor company financial performance combined with high insurance cost burdens. During that period of time high interest rates leveled off, then started to decline, and ultimately went into a free fall by the end of the 1980s. At the same time, the real estate, banking and savings and loan sectors went into dramatic decline, including major financial scandals. Housing, jobs and industrial productivity all went into a major recession. Insurance company financial portfolios were adversely affected, dividends dropped, credited interest rates dropped and the sales of new insurance products with the front-loaded commission structure in life insurance put pressure on insurance companies' financial bottom lines. This resulted in artificial manipulation of mortality charges and cost of insurance charges, the full magnitude of which nationally is only now beginning to be uncovered. In 1990, on another front, Congress passed what is referred to as the "DAC tax" legislation, which is not a direct tax but rather is a change in the way life insurance business acquisition costs are treated as tax deductions. Prior to "DAC," deferred acquisition costs projected over the life of a policy could be accelerated to be deducted from current year net premium income for purposes of determining the federal tax on net premium income. The DAC tax effect was to reduce the amount of deferred acquisition costs that could be taken against premium income in a given year and require that the balance be amortized over the projected life of policies with a resultant increase in prospective taxes. Life insurance companies took many different approaches to this change in tax liability which was intended to be a tax on life insurance company profits, and not a change in the structure or performance of specific insurance contracts. To the extent that companies retroactively took money from policyholders' accounts or manipulated charges against policies they become vulnerable to allegations of financial mismanagement. A recent Internal Revenue Service tax ruling has raised serious concerns about the tax liabilities associated with so called "split dollar" life insurance sales programs and policies. These are relatively complicated financial transactions in which an employer pays part of an employee's life insurance premium. Under "split dollar," the employer's share of the premium is secured by a collateral assignment against the cash value of the policy, such that money is returned to the employer if the employee dies. On January 26, 1996, the IRS issued a ruling that concluded that an employee's equity under a "split dollar" plan has been taxable year to year as it built up at least since 1969. Reliable insurance periodicals have reported that for years insurance companies and sales agents have sold employers and employees on split dollar by representing that equity build up in such policies is non-taxable or not discussing tax implications at all. There are many millions of dollars at stake, and the industry may challenge the ruling. This is an area that bears close watching. The last area peculiar to life insurance is the phenomenon of demutualization of life insurance companies. Mutual companies are not structured like, and do not operate under the same restrictions and regulation, as do stock insurance companies. The details and significance of these differences are complex, but one problem that bears watching is the rights of policyholders in mutual companies to share in the financial performance of the company, especially if a mutual company is being converted to a stock company for strategic financial reasons. The notion that policyholders "own" a mutual company is a fiction; the reality is that most mutual companies are run by the company's executives answering to a hand-picked friendly board of directors; annual policyholder meetings frequently are attended only by policyholders who are also company employees. Mergers between insurance companies have been a natural byproduct of the financial stresses and strains in the industry, and one of the financial aspects of a stock corporation that is beneficial is that capital can be raised by the sale of stock without the commission burden attendant on selling life insurance policies themselves. The problem is that when a mutual company converts to a stock company the surplus of the company is to be distributed to the then existing policyholders, usually in the form of cash, stock in the new company, product enhancement, or a combination of these. To the extent that the surplus of a mutual company is wasted or diverted prior to changeover or improperly converted to executive salary, bonuses and the like, or hidden to be transferred to the new company, legal liability can attach. C. Some Relevant Law. Frazier v. Metropolitan Life Ins. Co. (1985) 169 Cal.App.3d 90 regarding damages and statute of limitations issues Loehr v. Great Republic Ins. Co. (1990) 226 Cal. App.3d 727 and Kurtz, Richards, etc. v. Insurance Communicators Marketing Corp. (1993) 12 Cal.App.4th 1249 regarding agents and brokers' status and insurer responsibility. Clement v. Smith (1993) 16 Cal.App.4th 39 regarding agent misrepresentation, but see Hadland v. NN Investors Life Ins. Co. (1994) 24 Cal.App.4th 1578. Dearth v. Great Republic Life Ins. Co. (1992) 9 Cal.App.4th 1256 regarding ERISA implications. Colonial Life and Accident Ins. Co. v. Superior Court (1982) 31 Cal.3d 785 for scope of discovery, pattern and practice evidence. III. DISABILITY INSURANCE A. Relevant Background. Disability insurance companies may also be life insurance companies, or subsidiaries or divisions of life insurance companies, and the financial and economic changes and trends that adversely affected life insurance companies likewise affected disability insurance operations. In addition, however, problems peculiar to disability lines manifested themselves in ways different from life insurance. In particular, market competition in disability products was driven primarily by a combination of lowered pricing, expanded benefits, liberalized disability definitions and increasingly generous amounts of benefits. Some of the typical ways that disability companies expanded benefit availability during the 1970s and 1980s were as follows:
B. Problem Areas. While disability insurers are reluctant to admit it in a disability claims bad faith case, the fact is that the marketing and underwriting practices in the disability lines described above placed the disability companies in a vulnerable position and financially unable to weather the economic down turn and the consequent pressures on the financial bottom line. The problem responses by disability companies to these pressures included an overall industry consolidation characterized by bankruptcies and mergers, elimination of liberal policy definitions and benefits, aggressive underwriting, and substantial cost or expense reduction (which is a euphemism for wholesale aggressive claim denial). Somewhat unique to the disability field, although becoming increasingly common in managed care health insurance as well, blocks of disability business were sold between companies, and in some cases policies sold by one company would be administered, including claims administration, by another company. By 1994, 81% of the long term disability insurance market was controlled by just six companies--UNUM (37%), FORTIS BENEFITS (13%), PAUL REVERE (10%), STANDARD OF OREGON (8%), CIGNA (Connecticut General) (7%), and GUARDIAN LIFE (6%). The remaining 19% of the market was shared by numerous other companies, prominent among them are PROVIDENT LIFE AND ACCIDENT, MASSACHUSETTS MUTUAL and CONNECTICUT MUTUAL, the latter two companies having recently merged their disability business into MASS MUTUAL. A recurrent problem that occurs as a side effect of these changes and reductions is the timing and nature of notices of reduction of benefits, their enforceability and the issues of when an insured has become disabled and when benefits have vested. Another big problem in the disability area is that so much, an estimated 60% to 65%, of disability insurance is group disability insurance and unless the group is composed of employees of public entities it is likely that causes of action based on claim denial, fraud and bad faith are preempted by ERISA. C. Some Relevant Law. Erreca v. Western States Life Ins. Co. (1942) 19 Cal.2d 388, Egan v. Mutual of Omaha, (1979) 24 Cal.3d 809, and Moore v. American United Life Ins. Co. (1984) 150 Cal.App.3d 610, regarding the nature of total disability, policyholder rights and damages. See Kanne v. Connecticut General Life Ins. Co. 867 F.2d 489, 492 (9th Cir. 1988) for discussion of ERISA applicability and preemption. Basically, if any of the following questions can be answered "yes" based on the facts of a particular case, it is likely that a court will hold that a plan or policy falls within the scope of ERISA.
IV. HEALTH INSURANCE A. Relevant Background. The trends in health insurance and health care in the 1980s and into the 1990s are characterized by a shift from fee-for-service medicine to managed care, from free and open patient choice to restricted access, from traditional indemnity plans to risk pooling (including capitation and systems formation), from physician mediated usage to corporate-pressured reduction in usage (including office visits, hospitalizations and specialist care and procedures). In addition, there has been a major wealth-shifting within the health system from physicians to managed care executives, staff and consultants. Along with the transfer of money in the system has been power to dictate organizational features; for instance, managed care has imposed on physicians "gag clauses" which prevent physicians from discussing with their patients treatment options, payment or claims policies, financial arrangements, and even criticism of claims handling and utilization review. There is no indication that these trends will reverse. At present there are over thirteen million Californians in health service plans (typically referred to as HMOs in reference to the Federal Health Maintenance Organization Act). It is estimated that 110 million Americans, or 20-25% of the population, are enrolled in managed care. An additional 14,000 a day are enrolled, and by the year 2,000 total managed care enrollment wil be 40% or more of the population. In a community like Sacramento, 90% of the population is either insured or in a health plan, and of those, almost half (45%) are enrolled in an HMO, only about one-quarter (24%) have traditional indemnity insurance, 9% are on Medicare, 6% on Medicaid, 6% are enrolled in preferred provider organizations (PPOs), and 2% are covered under the federal dependent CHAMPUS program. According to one poll, the United States has the highest dissatisfaction with its medical care at the present time, and the lowest confidence in government to address problems with it. HMOs, as a result of competition and aggressive cost containment (sometimes a euphemism for care denial) have held premium increases in the last two years to a range of zero to 3% while PPO premiums have increased 9% to 10%, and traditional private indemnity insurance premiums have increased 10% to 15%. During the same period the overall consumer price index has increased only 3% and medical inflation as a component, which was typically double digit, has been 4-1/2%. Health care insurance and other coverages are going through convulsive changes that are typical of new markets characterized by initial disorganization, and then dislocation and realignment, followed by maturation, and eventual stability. Health care is hardly stable as at present it is not untypical to find medical groups bought and sold as well as the patient populations that go along with them. There is also evidence that managed care's aggressive cost containment practices cannot go on indefinitely in the face of consumer dissatisfaction, regulatory and legislative scrutiny and legal liability. B. Problem Areas. Typical problems that arise and result in a need for legal intervention in the area of health care today include refusal to approve specialist care, refusal to approve hospitalization or an operation, refusal to approve skilled nursing facility admissions, refusal to approve acute rehabilitation. In addition, there are restrictions on care of pregnancy and delivery (for instance, placing a geographic limit of 30 miles on delivery coverage or limiting hospitalization associated with delivery to one day), unwarranted transfers of patients from hospitals to skilled nursing facilities, from skilled nursing facilities to convalescent facilities, and from convalescent care to home, refusal to pay for emergency room care out of town, unreasonably narrowing applicability of "medical necessity" to deny coverage, expanding definitions of "custodial care" to deny coverage, challenging physician and hospital charges as "not usual, customary and reasonable (UCR)," denying care as being "experimental" or "investigational." Health insurers and health plans have arbitrarily reduced and/or rendered benefits illusory, they have resolved ambiguities against insureds in determining coverages, and there have been numerous incidences of false advertising and fraud (for instance, enrolling Medicare recipients as insured and then not providing care that would have been provided under Medicare). Primary care physicians in this new world of medical care have been characterized as "gate keepers," but it is becoming increasingly clear both in theory and practice that physicians, like patients, have little or no autonomy, and must fight financial managers and utilization review people for the authorization to obtain and provide medical care and to get paid for it. C. Some Relevant Law. Cases that address many of the foregoing issues in managed care are as follows:
See also deVries, Health Insurance Bad Faith, CAOC FORUM, Vol. 25, No. 9, November 1995. V. CONCLUSION It has long been known that recurrent problems in the insurance industry are cyclical in nature. The insurance business is really four separate businesses operating in close coordination-marketing, underwriting, claims administration and investment; each operates under different principles and responds to different factors in the economic market place. Insurance, as a business, is characterized by an "insurance business cycle." High periods of profitability, largely from investment income, are accompanied by aggressive pricing and marketing and a loosening of or an abandonment of sound underwriting practices resulting in increasing "underwriting losses" (current claim related costs exceed premium income) which are offset by investment income. When underwriting losses grow to a point where they catch up with investment profits, or when investment profits substantially decrease, profit is affected and surplus or reserve accounts are impacted. Insurance-related decisions that are driven principally by short term economic considerations as part of a business model inherently conflict with the law applicable to the insured-insurer relationship, which for most of this century has been recognized as a special relationship predicated on trust in which the vulnerable insured has a special protected right to fair treatment. Essential to that special relationship and trust is the notion that the insurer will not place its financial interest above the rights of its insured. As discussed above, this tension between insurers' economic self-interest and the rights of insureds is dynamic in the 1990s, and the need for legal access and legal redress for insureds is greater than ever. |
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