Regulatory Underpinnings

In 1993, the CDI initiated regulatory micromanagement for claims handling in the state. The first version of what was then called the "Unfair Claims Settlement Practices Regulations" was issued to comply with the direction of the California Supreme Court, made as part of the ruling in a case known as Moradi Shalal, 46 Cal. 3d 287 (1988). The Supreme Court concluded that enforcement was the obligation of the CDI.

The CDI issued the first version of the Regulations in 1993 and modified them in 1996, 1997, 2004, 2007, and 2009. The 1997 changes renamed the Regulations the "California Fair Claims Settlement Practices Regulations," which remains. The Regulations imposed on all insurance personnel a detailed laundry list of actions the CDI considered wrongful or in violation of the Fair Claims Practices Act.

All insurance claims personnel are thus required to read and understand the Regulations or attend an annual training program no later than September 1 of each year. Insurers must also ascertain that every employee involved in the claims process is trained or has submitted a sworn statement that he or she has read and understands the Regulations. The Regulations require that the insurance claims managing executive attest, under oath, that each employee has been trained with regard to and/or understands the Regulations. Failure to comply can lead to administrative penalties being imposed upon the insurer or the prosecution of the officer for perjury.

CDI has employed the Regulations to assess serious penalties on insurers who have breached any of the regulations in multiple millions of dollars since 1993. Until last year, no one challenged the right of the CDI to punish insurers for violations.

In late 2012, California Administrative Law Judge Stephen J. Smith issued a 51-page ruling finding the CDI's Fair Claims Practices Regulations (FCPR) might not be brought as unfair claims acts. The ruling affects how the CDI has imposed, and will impose in the future, penalties against insurers for claims since the inception of the FCPR in 1992.

The Nature of Violation

Only two cases have gone to adjudication challenging the procedure and fines because most insurers opted to settle. The first case involved an auto insurer, whom the CDI charged with 450 violations. In both exams, the violations were considered to be more technical than substantive. The technical violations were failures, such as 30-day letter sent out a day or two late. A non-technical violation might relate to an insurer underpaying the settlement on a claim.

According to the insurance regulatory attorney, while every insurer is required to undergo a claims examination once every 3 years, the fines demanded by the department in these two cases were much higher than normal. The motion relied on California Government Code § 11506 to challenge the FCPR as improper to seek monetary penalties and a cease and desist order. A four-hour legal argument on the Motion occurred on May 25, 2012, before Judge Smith. The court's extensive ruling contained 150 separate findings, encompassing the following:

None of the standards prescribed in the FCPR appear anywhere in California Insurance Code § 790.03 (pursuant to which statute the CDI adopted the FCPR); these are additional standards added exclusively by regulatory action of the CDI.

Administrative Law Judge Smith's ruling was an indictment of the FCPR because for the past 20 years the CDI has required insurers to follow the FCPR under threat of an order to show cause for proceeding and large fines. The ruling may also result in changes to market conduct examinations if they are to serve as the basis for an OSC proceeding.

The decision will affect all lines of insurance regulated by the DOI. The ruling concluded the CDI incorrectly alleged the companies violated the regulation, instead of correctly alleging a violation of the statute. The CDI incorrectly used the regulations to create new acts. As a result, he said the regulations are invalid. The court said:

"What these regulations mean is that they are best practices, in effect, guidelines insurers can follow, such that they create a safe harbor for insurers and any type of action that would be brought by the department or in any potential litigation. Insurers can feel more comfortable about their claims operations, and they need to be focusing more on the 16 statutes than the [regulations], because [they] are so specific on how companies must do their claims, which is not what the intent of the 16 statutory acts are," according to counsel.

Counsel, Robert W. Hogeboom was quoted in the blog of his law firm, Barger & Wolen, as follows:

According to the article, the five Torchmark companies stood accused of nearly 700 unfair or deceptive acts but Judge Stephen Smith ruled in their favor, finding that the Department of Insurance had misused the fair claims regulations to expand the state's insurance laws. Experts believe the ruling will embolden other insurers to challenge the agency.

"Notwithstanding that the judge says this is particular to the Torchmark case, what he said throughout [the ruling] resonates with the industry, and it should resonate to the department," Hogeboom said.

My Assessment

Companies will probably continue what they've been doing, but they will feel more comfortable that they're not going to be penalized when they have a disagreement with the department. The CDI will probably have to determine if it wants to go to the legislature to create more statutes to give them more power to fine insurers. Since 1993, I opined that the Insurance Code, contrary to the statement in the Regulations, does not hold that a single act is a violation of Insurance Code Section 790.03(h). Rather, the Code requires that the wrongful acts be committed with such frequency as to indicate a general business practice.

The Regulations, by changing the meaning of the California Insurance Code for the purposes of enforcement, was designed to force insurers to be more careful than the Legislature mandated. Under the Regulations, therefore, a single violation is enough to require punishment of the insurer or the licensee by the CDI.

Whether an insurer is willing to challenge enforcement of this requirement that is more stringent than the Insurance Code requirement is yet to be seen. None has done so yet. Finally, the administrative law decision in the Torchmark cases challenged the requirement and the administrative law judge ruled in favor of the insurer.

The ruling could, however, be a trap for the unwary since it does not allow insurers to ignore the Regulations or the training requirements. It will simply prevent the CDI from assessing improper and unjustified fines. Since the Regulations set up a minimum standard for claims handling failure to fulfill the Regulations because there is little fear of major fines will be a double-edged sword because that failure can be presented as evidence that the insurer acted in bad faith and will subject the insurer to a punitive damage verdict much greater than the improper fines.