Such is the theory. The reality can be different, as we will see momentarily.

Recipe for Bad Faith

Is this relevant to risk management? Yes. One huge risk that insurers manage is the peril of bad faith. If contingent income schemes tempt adjusters to cut corners in order to boost financial results, bad faith exposures increase. Furthermore, such pay plans may invite scrutiny from state insurance commissions, any of whom can initiate market conduct surveys.

Any adjuster pay plan that heightens that risk becomes a corporate liability, meriting re-examination on risk management grounds. Most insurance companies have a risk manager or someone, perhaps without that title, who fulfills this role. A well managed insurance company or TPA risk management program must assess the risk of bad faith or market conduct woes due to adjuster compensation plans, no matter how well-meaning. Pay schemes that increase bad faith and market conduct risks may flunk on risk management grounds.

The job of the claim department is to pay claims. Adjusters should pay claims frugally and prudently. They should pay only meritorious claims. They should fight bogus claims. Their job is to pay claims consistent with the insurance contract language. Period.

The adjuster's job is not to turn a profit for the company, to advance a company's A.M. Best rating, or to max out on the incentive compensation plan. Once these factors seep into the adjuster's consciousness at the file-handling level, mischief creeps in. Dysfunctional incentives drive suspect claim practices.

Hmmm, low-ball those settlement offers to save something off the reserve. Overstate early reserves in order to game them and look heroic to the bosses later. Ignore a policyholder's demand to settle a potential excess claim within policy limits because you think that you can save something by rolling the dice at trial. Drag out payments to defense law firms to minimize payouts and maximize company cash flow. Delay issuing claim payments in order to boost the financials that will go to the board of directors or to shareholders.

Before you call me na?ve or a Neanderthal, we all understand and value the role of profit. Insurance companies are financial, not philanthropic, institutions. Usually, they are for-profit enterprises. This is legitimate. So is having a good A.M. Best rating or hitting the jackpot on incentive compensation.

These cannot be the claim department's preoccupation, however.

Nevertheless, if you are a bad faith attorney, it is a wonderful way to guarantee full employment. Contingent pay schemes keep bad faith attorneys busy. I recently attended a Mealey's continuing education seminar in Philadelphia on Top 10 Insurance Coverage Issues. The speakers included an attorney from Anderson Kill, which specializes in representing policyholders in insurance coverage disputes. After his speech, I buttonholed him and asked about insurer compensation schemes that tie adjuster pay, or a portion of it, to attaining lowered claim payments or similar financial yardsticks.

His eyes lit up and he said that it was a dream come true in bad faith litigation. “Attorneys love to learn about such compensation plans in discovery and expose them to juries,” he said, weaving a tale that financial incentives encourage sharp practices.

Alternative Approaches

Okay Quinley, if you don't use financial yardsticks such as these, how are you going to motivate adjusters? Are we back to touchy-feely stuff like “Does a good job,” and, “Has a good attitude?”

If incentive income were not tied to financial goals, companies could link contingent compensation to criteria such as:

oadjuster productivity (caseload size, turnover, efficiency)

ocustomer satisfaction, measured by client surveys or anecdotal feedback (complimentary or complaint letters)

oprofessional development (continuing education courses, seminar attendance)

oqualitative assessments (thoroughness of investigation, analysis of coverage and damages, negotiating skill, etc.).

Unfortunately, these seem soft and fuzzy to financial people and are not pegged to hard numbers. They also take longer to evaluate than does punching data into a calculator or spreadsheet. Insurance management and shareholders want hard numbers. It is easier to measure loss payments this year versus next, rather than grappling with squishier concepts such as client satisfaction.

The latter takes more work. A customer survey must be hammered out on which everyone agrees. Decide how many clients to sample. Which clients to sample? Are they surveyed once or on an ongoing basis? Who tabulates the results? Sounds like a lot of work. Hey, why don't we just go back to measuring claim payments or loss ratio, as that is a lot easier?

It is a lot less work but, perhaps, a lot more dangerous in the long run. Savvy claim handling will help insurers turn profits, retain pristine A.M. Best ratings, and produce sweet payouts in incentive compensation. Those are byproducts, however, of good faith claim practices. They cannot be the North Star or the guiding principles. The pernicious effect of twisted financial incentives can create dysfunctional behavior by claim people who now see their jobs, not as acting in good faith toward insureds and claimants, but as, somehow, transforming claim departments into profit centers.

Recently, I taught an AIC 36 class, Liability Claim Practices. I noted to the class that there are more than 300 textbook pages discussing the adjuster's roles and duties in various types of liability claims. Interestingly, nothing in the text says that the adjuster's role is to turn a profit, burnish a financial rating, or improve the employer's financial results.

Claim people rarely run insurance companies. Top management usually comprises financial types with quantitative bents or production people who “go by the numbers.” They have understandable biases toward hitting the numbers when it comes to claim operations. This may trickle down to adjuster-level goals such as, “Reduce claim payments by 10 percent in 2004.”

Case Study

Bad faith risks from adjuster comp schemes tied to financial outcomes are not purely theoretical. A recent claim suppression plan got some carriers in trouble. A federal jury hit three insurance companies, including Travelers, with a total of $12 million in punitive damages and $60,000 in compensatory damages in January 2004, after they denied an $8,000 workers' compensation claim for carpal tunnel syndrome.

In Torres v. Travelers Insurance Company, No. 01-5056 (D.S.D.), attorneys for former nursing home cook Alice Torres discovered an incentive program at Travelers Insurance Co. Under this plan, the carrier allegedly offered adjusters up to 100 percent of their salaries in bonuses for reducing the overall payout of insurance claims from one year to the next. Travelers denied the existence of any such program, as did its co-defendants, Constitution State Services and Insurance Co. of the State of Pennsylvania.

The insurers insisted that the underlying claim was bogus, and that the carpal tunnel syndrome was not work-related. Still, Travelers was hit with $8.5 million of the punitive damages. Despite that, the focus of the litigation shifted from the underlying claim's legitimacy to the propriety of the insurers' adjuster compensation plans. Doubtlessly, when they launch such plans, insurers' top financial management teams applaud themselves for their result-oriented thinking in linking adjuster pay to the corporation's financial goals.

Right on. About time we held those claim people accountable for financial results.

Right on, indeed. Right on … into the bad faith cesspool.

Kevin Quinley is senior vice president of Medmarc Insurance Group in Chantilly, Va. Reach him at [email protected] or www.kevinquinley.com.