Speech - Reflections on Insurance Regulation
Reflections on Insurance Regulationby J. Clark Kelso Annual General
Counsel Seminar Speech Delivered on July 26, 2001, Las Vegas, Nevada |
Good afternoon. I missed your annual meeting last year, largely owing to the busy schedule of someone who had just been picked out of the blue to lead the Department of Insurance. I=m grateful for the opportunity to address you this year and to offer some Reflections on Insurance Regulation.
I want to make it clear that my remarks today are my own personal views. Although I am serving as the Governor=s designee as Chair of the California Earthquake Authority, I am not speaking today in that capacity. Today, I speak only as an ex-Interim Insurance Commissioner.
I want to talk about three things: The implications of Gramm-Leach-Bliley upon insurance regulation; the health of the regulatory function in California and the relationship between public and private regulation of the insurance market; and the possibility of bad faith liability and punitive damage reform.
Gramm-Leach
Let=s turn now to Gramm-Leach and the convergence of the insurance and financial services industries, a convergence that will take place in an Internet-connected society.
I don=t think it is possible to overstate the impact of this ongoing change upon the industry and upon consumers and upon the regulatory environment. We are right at the beginning of what management scholars would describe as a second-order, revolutionary organizational change. There is extraordinary uncertainty during major change events like this.
Now I=m on the outside of the industry, so I can only imagine what must be going on inside of the industry, but my sense is that the next ten years are going to be a little bit rocky.
We=re already seeing the opening rounds of the battle. The big financial service companies are already entering the insurance business. It=s not a quick process, of course, because you have to go through lengthy licensing procedures, and you have to get licensed in each state. And there is the business development side of the insurance business which, in an industry that is so service oriented and so directly tied in to individual consumers, is going to slow down the financial service companies a bit. Banks no longer have individual agents sprinkled around the country with substantial personal, customer-oriented, local and community ties. That is one of the great advantages which the insurance industry has through its agent network.
And we=re also seeing insurance companies now offering the full set of financial and investment services that previously were the stuff of only banks and investment houses. At my last meeting with my insurance agent, we spent as much time talking about investment opportunities as about my insurance coverage.
At some point in the not too distant future, we=ll begin to see the convergence in earnest. On the regulatory side, there will ultimately be a battle between state Insurance Commissioners and federal banking and securities regulators. The Afunctional regulation@ model which is contained in Gramm-Leach may look good on paper, but when living and breathing regulators bump up against each other, we=ll see whether the theory works in practice. The National Association of Insurance Commissioners is working hard to promote uniformity of regulation and cooperation with federal regulators. But my own intuition is that the federal regulators have the upper hand. The Insurance Commissioners are a fragmented group, and there are too many of them to be effective in a battle with one or two determined federal regulators.
On the business side, the convergence will start in earnest when big investment houses start gobbling up insurance companies and big insurance companies start gobbling up banks. Think about the merger mania we have seen and are still seeing in the telecommunications industry and you=ll get a reasonable image of what we have to look forward to when the shakeout of financial services and insurance companies begins. We=ll see who is left standing at the end.
From my perspective as a consumer, I hope that at the end of the convergence, we will still have the personal service and professionalism that I believe is one of the great hallmarks of the insurance relationship. As a lawyer, I can attach some fancy legal labels to the difference. Banks and investment houses make it perfectly clear that they do not stand in a fiduciary relationship to their consumers. With my bank, I have only a debtor-creditor relationship. And my investment adviser always reminds me that I am not entitled to rely on much of anything that he says, although he=s a very friendly and very knowledgeable fellow.
With insurers, the situation is very different, as you all know. There is a relationship of trust and confidence that is critically important to the consumer=s peace of mind. I hope we don=t inadvertently lose that relationship because I believe it has great value to the millions of consumers who place their trust, their assets and their future in your hands.
Now I suspect that some in the insurance industry are hoping that courts will adopt the same type of functional regulatory approach that we see in Gramm-Leach. If so, then when your insurance company sells you an investment product, the insurance company will get the same legal limitations on liability that apply to investment companies. And that may indeed be the direction that the courts go.
But I wouldn=t count on that, and I would start preparing for the legal battle that is to come. I suspect there will be some courts that will look at combined insurance/financial services products as sharing some elements of the fiduciary or quasi-fiduciary relationship that now characterizes the insurance industry. And this possibility presents some real dangers to companies that try to behave as both insurers and investment advisers. When insurance and financial services combine, does the debtor-creditor relationship predominate or does the quasi-fiduciary relationship predominate? Will the relationship be governed by the law of contracts or the law of torts? The courts are going to have some very big and very tough decisions to make on this issue.
I have one other thought about the convergence, and that is its implications for privacy. The sharing of personal information among corporate affiliates and even beyond corporate affiliates is a very serious problem. In the United States, we have taken a very piecemeal approach to privacy issues. Our federal constitution does not even mention privacy expressly, and we have no overarching federal statute that regulates informational privacy. Unfortunately, it appears we are headed towards further fragmentation in the implementation of Gramm-Leach=s approach to privacy which establishes only modest protections at the federal level and leaves it up to the states to develop more rigorous requirements.
The United States is very much out of step with the rest of the world on privacy protection, and we need to join other countries in respecting informational privacy. It is a global economy, after all, and whatever deals are struck in the context of Gramm-Leach-Bliley should take account of international developments.
The basis for privacy protection in most of the rest of the world is the Organization for Economic Cooperation and Development=s (OECD) Fair Information Practices (FIPs) which were developed in the 1960's and >70's to address technology implications at that time. The Fair Information Practices were codified in the OECD guidelines in 1980, and these privacy guidelines are recognized as a solid foundation from which to build everything from privacy legislation to self-regulated privacy standards for the privacy sector.
Fair Information practices place restrictions on the collection, use and disclosure of personal information, and can be summarized as follows:
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limiting the collection and use of personal information for the purposes intended;
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ensuring data accuracy;
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establishing security safeguards;
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being open about the practices and policies regarding personal data;
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allowing individuals access to their personal data and the ability to have it corrected; and,
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identifying persons to be accountable for adhering to these principles.
I recently received from my insurance company a privacy notice, and I have to say that it disappointed me to see such a complex and confusing document that made it very difficult for me even to know I had the right to opt-out. As it happens, I prefer to have my personal information shared because I think it facilitates transactions that I may be interested in. But I know there are many other consumers who would want to opt-out, and burying that option in the midst of mind-numbing legal prose does not speak well for the industry.
I would commend to your attention the OECD Fair Information Practices guidelines. Those guidelines are an excellent way of establishing the most ethically responsible use of personal data.
Public and Private Regulation of the Insurance Industry
My second topic is the general health of insurance regulation in California and the relationship between public and private regulation of the insurance industry. Within a few weeks of my becoming Insurance Commissioner last year, I met with consumer groups and industry representatives to give people a chance to take my measure. In those meetings, I indicated my belief that the Insurance Commissioner was primarily a market regulator responsible for ensuring the existence of a healthy insurance market in California.
Now I know that many of the industry representatives were somewhat heartened by this phrase B Amarket regulator@ B and many of the consumer representatives were disappointed that I was not intending to assume the position of a strong consumer advocate.
Today I=d like to expand a little on the notion of what a Amarket regulator@ should be doing. The health of the insurance market is determined not only by examining the financial solvency of insurers, but also by ensuring that consumers have access to new and fair products at reasonable prices, that insurance fraud is fought at every turn, and that insurers fully perform their legal obligations under the law and under their contracts. A fully engaged market regulator needs to be concerned about all of these elements.
Presently, the Department of Insurance does a good job of tracking financial solvency and combating fraud, although there is always more work to be done there and resources limit what the Department can accomplish.
In terms of product design and prices, the Department and the industry have witnessed some major failures in certain high-profile lines such as auto and earthquake. Failures at least from the perspective of consumers and, at times, the Legislature. For example, the Department has been challenged to implement the provisions of Proposition 103, and, more recently, to try to sell the Low Cost Auto program. The California Earthquake Authority is engaged in a process of self-examination and there are criticisms about the cost and coverage of the Authority=s limited earthquake policy and its sustainability over the long haul. My own sense is that the Authority is fundamentally sound, but we certainly will be having discussions for improving its stability over the next several months.
In each of these examples, the fact that the people through the initiative process or the Legislature through ordinary legislative processes have thought it was necessary to redefine products, coverage and prices suggests to me that the industry and the Department have failed. The industry and the Department have either failed to perceive inadequacies in the market, have misjudged the pressures for reform, or both. I generally don=t believe that product design and pricing are matters that should be dealt with through legislative which is subject to awkward compromises and is too rigid to respond to changing conditions. But if the Commissioner and the industry fail to sense the needs of the market, and fail to make a convincing case for existing market conditions, we can expect more oversight from legislators and voters. Ultimately, it is the responsibility of a strong Insurance Commissioner to provide the necessary leadership in this area.
The Department=s weakest suit right now is in the area of ensuring that insurers fully perform their legal and contractual obligations consistent with unfair insurance practices requirements. The Department has obviously faced some major setbacks and complications over the last year. First, the Quackenbush scandal essentially compromised the integrity of the Department=s market conduct review process. While I was serving last summer, there was clearly an unhealthy level of distrust between the industry and the Department. That lost trust will take time to be restored, but it is absolutely essential to a healthy insurance market for there to be that level of trust and confidence. The Department needs to convince consumers, the Legislature and the industry that it can fairly and fully enforce unfair practices regulations. Second, the legislation requiring that certain aspects of market conduct reports be made public has introduced new uncertainties into the process, and those have further complicated the Department=s efforts this year.
But even as these matters recede into history and the Department resumes a more consistent enforcement pattern, I think more can be done by the Department to ensure that insurers live up to their legal and contractual obligations. As you all know, the Insurance Code prevents the Department from adjudicating claims and this has, at times, limited the Department=s efforts to protect and help consumers get what their contracts entitle them to. Now frankly, I think the Department=s hotline accomplishes a lot more consumer protection than most people are aware of, and the hotline=s stories need to get greater attention.
But I think we are seeing a more aggressive model of dispute resolution being developed at the Department of Managed Health Care. It also has a hotline for consumers, and its hotline takes a somewhat more proactive role in resolving disputes, serving essentially as a mediator even when counsel become involved.
The Department of Insurance has tried this type of more active dispute-resolution on a pilot project basis, and I think the Department should consider going to the Legislature with a more comprehensive, permanent proposal.
And here is where I think we need to be creative in forging a more cooperative and productive relationship between public enforcement and private enforcement actions. One of the objections to having the Department more involved in dispute-resolution is that it can deprive the insured of his or her right to a jury trial. This objection cannot simply be ignored. Private suits and the citizen jury have important roles to play in ensuring compliance with contractual and legal obligations. So if we expand the Department=s dispute-resolution capacity, we need to design the system in such a way that it supports instead of supplants the filing of appropriate private claims. In this way, private enforcement actions can themselves support the Department=s own mission and can effectively supplement the Department=s own enforcement resources.
Bad Faith Liability and Punitive Damage Reform
This brings me to my last topic, possible reform of the law pertaining to bad faith liability and punitive damages. Dr. Kari Kelso and I have recently co-authored two studies of jury verdicts in California over the last decade. Our first study focused on jury verdicts in bad faith actions, and our second study examined punitive damage verdicts during the 1990s.
The results were, I think, quite remarkable. We discovered that juries awarded punitive damages in about 42% of the pro-plaintiff insurance bad faith jury verdicts. And punitive damages accounted for an astounding 77% of all damages awarded in bad faith actions. We also learned that, compared to all other causes of action, the median ratio of punitive to compensatory damages in cases where punitive damages were awarded was highest in bad faith actions. In other words, juries were, in bad faith actions, much more frequently awarding very high punitive damages compared to compensatory damages than with other causes of action. With these sort of numbers, it is fair to say that the possibility of recovering punitive damages is a substantial factor in encouraging private enforcement.
But we also know that punitive damages are wildly variable in their assessment, and this uncertainty creates problems for the industry and I think credibility problems for the jury system itself. As you know many punitive verdicts (and probably most very large verdicts) end up being reduced on appeal, but that is simply a sign of a broken system at the trial court level. And in light of the United States Supreme Court=s decision in Cooper Industries v. Leatherman Tool Group, where the court held that federal appellate courts should review the amount of punitive damages under a de novo standard, we are likely to see even more reversals on appeal. Instead of relying on appellate judges to correct the mistakes, we should fix the system at the trial court level.
I am working on a balanced proposal to reform the bad faith liability system, including punitive damage reform. I haven=t put all of the pieces together yet, but I thought I would share a few ideas with you today to get a dialogue started. First, it is worth considering adopting a treble damage cap for punitive damages in bad faith cases. Justice Janice Rogers Brown suggested a general treble damage cap for punitive damages in her concurring opinion in Lane v. Hughes Aircraft, and I think it is an especially good idea in bad faith cases to bring some greater stability to bad faith jury verdicts.
Second, with punitive damages being awarded in almost half of the bad faith jury verdicts in any event, it is time to consider simply adopting a treble damage remedy in bad faith actions. Perhaps we should simply dispense with punitive damages entirely, or limit them to truly extraordinary cases, and simply award treble damages as a matter of course. A treble damages remedy, such as we have in antitrust, is deliberately designed to promote private enforcement as an adjunct to public enforcement, and so a treble damages remedy fits into my notion of cooperative public and private enforcement of contractual and legal obligations.
Third, to handle the problem of very small compensatory damages resulting in still very small treble damages, we should consider adopting a minimum recovery for small cases, such as $50,000 or $75,000, or we should provide for a recovery of attorneys fees in small cases.
Fourth, if we can replace punitive damages with treble damages, it may be possible to create a special treble damage recovery in third party bad faith situations. I=m not thinking here of a second lawsuit along the lines of Royal Globe. I=m thinking here of some way at the end of a third party liability action for the court to determine whether to impose treble damages for bad faith settlement practices. This would help to fill a significant gap in the enforcement of the unfair insurance practices requirements since as things stand now, we have no private enforcement and virtually no public enforcement directed at third party bad faith actions.
As I think you can see, this proposal gives something to all of the stakeholders while also requiring all of the stakeholders to give something up. The industry gets protection from the variability of punitive awards, but in return must live with a treble damage remedy, either a minimum award or attorneys fees in small cases, and the creation of a treble damage remedy in the third party bad faith context. Consumers lose the possibility of ultra-large punitive awards (a possibility that, in light of appellate review is largely illusory in any event) but in return are guaranteed awards sufficient to pay compensatory damages plus attorneys fees in an amount great enough to attract counsel.
I=m not sure whether the pieces all fit together nicely, and I=m confident that this type of complex proposal would face all sorts of political obstacles. But this is worth thinking about because, among other things, it forces us to consider how we can better coordinate public and private enforcement, and both types of enforcement are absolutely critical to developing a truly healthy insurance marketplace.
I=d like to thank you again for inviting me to speak today, and I=m looking forward to participating in the remainder of today=s events.