CALIFORNIA COURT RULINGS REJECT USE OF INSURANCE REGULATIONS TO DETERMINE UNFAIR TRADE PRACTICES

Introduction

Three years ago, in the FORC Quarterly Journal of Insurance Law and Regulation, I reviewed one of the most significant California decisions issued by an Administrative Law Judge (ALJ). That decision prohibited the California Insurance Commissioner’s use of the Fair Claims Settlement Practices Regulations (the “Regulations”) to support claims settlement violations and large penalties. [1] This decision is just one of several recent decisions holding that use of the Regulations by the California Department of Insurance (CDI) in reviewing insurance trade practices is invalid as the Regulations exceed the scope of the governing statutes.

The CDI’s response is that the Regulations (as well as other regulations which address trade practices) are within the Commissioner’s broad regulatory power to specify and clarify the nature and scope of the unfair practices and acts identified in the relevant statute.

The Unfair Trade Practices Act (UTPA) [2] delineates various acts which are deemed by the legislature to be unlawful and grants authority to the Commissioner to determine additional unlawful [3] acts under a specified procedure in the statute. [4] The Commissioner bases his authority for the issuance of the Regulations under his power to “administer” unfair practices, which he and various consumer groups allege is broadly conferred by the legislature. [5] Notwithstanding the Commissioner’s claims, the industry has successfully argued that the Regulations are unlawful as they go “beyond the scope” of the governing statute. [6]

GENERAL REGULATORY BACKGROUND

In 1988, California Proposition 103 was passed by the electorate. Among other things, Proposition 103 mandated prior approval of most property and casualty premium rates, participation by consumer groups in rate decisions and, perhaps most importantly, changed the position of Insurance Commissioner from an appointed to an elected office.[7]

With respect to prior approval of insurance rates, judicial decisions subsequently upheld the Commissioner’s “broad authority” to implement the new rating law based on the expertise of the CDI and the complexity involved in analyzing rates. [8]

Under the groundswell of this newfound authority, other legislation and regulations were quickly adopted to expand the Commissioner’s authority to establish a program to investigate consumer complaints, respond to inquiries and bring enforcement actions. For example, in 1992, the Commissioner promulgated regulations to implement the Fair Claims Settlement Practices Act of 1972. Notwithstanding the fact the Insurance Code identified 16 unfair claims settlement practices, the Commissioner’s regulations boldly asserted that they were intended to delineate minimum standards for the settlement of claims and defined additional unfair practices not included in the governing statute.

The CDI has used various regulations as the basis for its market conduct examinations. These examinations determine whether unfair practices have occurred and, if so, insurers can be disciplined and subjected to substantial penalties. Following the 2008 recession, penalties asserted by the CDI became more severe (which some viewed as an attempt to address declining state revenues). Insurers routinely paid the penalties rather than incur additional expenses in attempting to challenge the CDI.

Background of The Unfair TRADE Practices Act

In 1959, the California legislature enacted article 6.5, sections 790-790.15 of the California Insurance Code (CIC), to regulate trade practices in the business of insurance. The initial law followed the NAIC Model Law which regulated trade practices by defining or providing for the determination of all unfair practices and by prohibiting the trade practices so defined. [9]

In 1972, the legislature included claims settlement practices to the 1959 list of unfair practices. Unlike the other listed practices in which a violation could be based on one act or practice, a claims settlement violation required a finding of a general business practice based on the frequency of the act. [10] In addition, the legislature provided an “Order to Show Cause” (OSC) hearing procedure before an Administrative Law Judge. [11] The legislature also authorized a separate type of hearing under Insurance Code section 790.06 for the Commissioner to identify additional unfair acts not defined in the statute.[12]

Specific Cases involving the regulations

Three recent cases have tested the Commissioner’s authority to promulgate and use the Regulations as violations to support penalties. [13] By way of background, in 2010, three market conduct examinations culminated in OSC actions against three insurers who refused to pay the large penalty settlements proposed by the CDI. Two other cases were brought by trade associations challenging newly adopted regulations. At the center of each of these actions was whether the Regulations exceeded the scope of the statutorily defined unfair acts or practices and/or the Commissioner’s authority to promulgate such Regulations. [14]

One of the Superior Court cases resulted in an appellate determination that the trade practices regulations in that case were invalid. That case is now before the California Supreme Court upon the Commissioner’s request for review.

a) Western General

In 2010, following a 2005/6 market conduct examination on its automobile claims settlements, the CDI issued an OSC action against Western General Insurance Company alleging 387 violations of the Regulations. It also alleged violations of other statutes. [15]

The CDI based its case on the broader list of unfair acts and practices defined in the Regulations rather than the 16 acts specifically identified in the underlying statute. Accordingly, Western General filed a Motion to Strike each of the allegations brought under the Regulations. The company argued that the Regulations established new unfair acts, practices and penalties which could only be enforceable if enacted by the legislature via an amendment of the underlying statute or by the Commissioner through a section 790.06 process. The ALJ agreed and concluded that the CDI, by alleging violations not contained in the underlying statute, exceeded the scope of its authority when promulgating the Regulations. [16]

The ALJ emphasized that the CDI, in promulgating the Regulations, trespassed on the legislature’s authority to identify new or additional unfair practices. The court also concluded that promulgation of the Regulations circumvented the procedure set forth in section 790.06.

The ALJ dismissed the action with leave to amend and further ordered the CDI, when repleading the OSC action, to rely only on those facts which supported a violation of one of the 16 statutorily-defined unfair acts. [17] The CDI did not amend the OSC to conform to the judge’s ruling. The ALJ then ordered the parties to a settlement conference which resolved the case.

b) Torchmark

On August 11, 2011, the CDI issued an OSC against five Torchmark life and health insurers seeking penalties of up to $10,000 for each of 697 alleged unfair claims settlement acts and practices. 540 of the violations were alleged as direct violations of the Regulations. The bulk of the remaining 157 violations were based on other statutes, which violations the CDI alleged were subject to the penalties imposed under section 790.035. All of the allegations were considered technical violations. [18]

In response to the OSC, Torchmark filed a Demurrer and Motion to Strike alleging: (i) the reliance on the Regulations was improper as the Regulations exceeded the scope of the statutory violations specified in sections 790.03(h)(1)-(16); (ii) the pleading of statutes other than section 790.03 statutes was improper as only a violation of section 790.03 can support a penalty under section 790.035; (iii) the test for a violation of section 790.03 requires a finding that the act was both knowingly committed and performed with frequency; and (iv) the allegations were not plead in sufficient detail to prepare a defense.

On August 15, 2012, ALJ Stephen Smith agreed with Torchmark’s position and issued a 51-page decision. Judge Smith’s decision thoroughly analyzed the interaction between the Regulations and the statutorily defined unfair acts and concluded that any new unfair acts may only be included by legislative amendment of section 790.03 or pursuant to a proceeding by the Commissioner under section 790.06. ALJ Smith dismissed with prejudice and without leave to amend each of the 540 allegations which were based on the Regulations, ruling that the Regulations both exceeded the scope of the statute and in so doing created new unfair practices in derogation of the process required by section 790.06. The remaining 157 allegations, including 121 relying on alleged violations of other statutes, were dismissed with leave to amend. [19]

The CDI took no action on the 2012 ruling for 2 years. In 2014, the Commissioner issued a ruling in an unrelated administrative case, an OSC against PacifiCare Life and Health Insurance Company, [20] and declared such ruling precedential. [21] Almost immediately after the PacifiCare decision was issued, the CDI broke its silence in the Torchmark case and asserted that Judge Smith’s ruling had been nullified by the PacifiCare precedential decision, which the CDI claimed “validated” the Regulations.

Without seeking reconsideration of Judge Smith’s ruling or otherwise seeking action from the court, the CDI issued an “Amended” OSC against Torchmark, which was essentially a reissuance of the original OSC (including the 540 allegations dismissed with prejudice and without leave to amend). A new ALJ was assigned to the case and Torchmark submitted a new Motion to Strike arguing that the CDI lacked the authority simply to ignore Judge Smith’s order and reissue the OSC. Torchmark also asserted a laches argument based on the CDI’s unjustified 2-year delay in filing an amended OSC.

In January 2016, ALJ Mary-Margaret Anderson granted Torchmark’s Motion to Strike. Judge Anderson noted that the CDI had no authority to unilaterally decide that an order was no longer valid. She further held that the PacifiCareprecedential decision did not apply. Judge Anderson granted the CDI leave to amend its OSC to conform to Judge Smith’s rulings.

The CDI followed with a Second Amended OSC, now containing only 35 allegations. A Motion to Strike was again filed on Torchmark’s behalf noting the CDI's continued failure to comply with Judge Smith’s rulings. ALJ Anderson granted Torchmark’s Motion to Strike and dismissed the proceeding with prejudice, thereby ending the case. The decision was then sent to the Commissioner as a proposed decision on May 18, 2016. The Commissioner has 100 days to accept or reject the decision. If he rejects the decision, Torchmark will likely use the three ALJ decisions in its favor as the basis for a Writ of Mandate to Superior Court.

c) PacifiCare

While the Western General and Torchmark cases were engaged in procedural Motion to Strike issues based on the validity of the Regulations, the PacifiCarecase proceeded by a hearing on the merits. It became a bitter case as a former Commissioner, in approving the merger of PacifiCare into United Healthcare, was assured that PacifiCare would timely pay claims and adhere to prescribed standards. [22]

The evidentiary hearing commenced in December 2009 and concluded on July 27, 2013, comprising more than 230 days of hearing and over 60 witnesses. The ALJ assessed a penalty of $11,518,350. In November 2013, Commissioner Dave Jones rejected the ALJ’s decision and in a 220 page decision issued on June 9, 2014 increased the penalty to $173,603,750. [23] The length of the hearing, the costs involved and, of course, the enormous penalty were concerns to the industry.

PacifiCare filed a petition for Writ of Mandate and Complaint for Declaratory Relief. Because of the size and complexity, the case was divided into three phases. [24]The first phase was PacifiCare’s Motion for Judgment on the Pleadings which challenged a number of statutory interpretations provided in the Regulations. On August 1, 2015, Superior Court Judge Kim Dunning issued her Order on Phase 1 focusing on the language in the Regulations which provided the basis for a violation. Her rulings followed a number of Judge Smith’s previous rulings.

Judge Dunning ruled that:

i) The test for a violation under Insurance Code section 790.03(h) as rewritten by the CDI in Regulation section 2695.1 was unlawful as it expanded, altered and amended Code section 790.03(h). Regulation section 2695.1(a) was invalid as Insurance Code section 790.03(h) did not recognize a “Single Act” theory. Judge Dunning further declared that the definition of “knowingly” in Regulation section 2695.2(l) was invalid, along with the definition of “willful” in Regulation section 2695.2(y).

ii) The rejection of the three definitions called into question the ongoing viability of the Insurance Commissioner’s decision. Further, she noted that any precedential decision based on the void Regulations was in excess of the Insurance Commissioner’s jurisdiction and could not stand in any case.

Based on the rulings, PacifiCare argued that the entire decision should be reversed because the penalty was premised on the invalid Regulations which were the basis for the Commissioner’s $173 million penalty. The case is ongoing as the judge requested that the parties engage in settlement discussions. [25]

CASES ADDRESSING OTHER REGULATIONS

While the Insurance Commissioner’s authority to promulgate claims settlement regulations was being challenged, other cases similarly questioned the Commissioner’s authority to adopt regulations pertaining to post claims underwriting and the standards for estimating the replacement value for total losses on homeowners insurance.

1. ACHLIC v. Poizner

In 2010, the Association of California Life and Health Insurance Companies (ACHLIC) filed a Writ of Mandate alleging that the CDI abused its discretion in adopting regulations relating to post claims underwriting. The regulations at issue involved the CDI’s June 5, 2009 rulemaking proceeding involving preexisting conditions. [26] ACHLIC asserted that the regulations conflicted with the Insurance Code and existing case law. The key issue in the writ was whether the CDI had authority, either express or implied, to promulgate the challenged regulations.

ACHLIC contended that the CDI exceeded its authority in promulgating Regulation section 2274.74, “Standard for Avoiding Prohibited Postclaims Underwriting.” The CDI contended that Insurance Code sections 790.10 and 12921 authorized the CDI to adopt the Regulations. The court disagreed and rejected the CDI’s argument that Insurance Code section 790.10 authorized the CDI to adopt such broad regulations for the following reasons:

i) Insurance Code section 790.10 expressly authorized the Commissioner to, “from time to time as conditions warrant, after notice and public hearing, promulgate reasonable rules and regulations, and amendments and additions thereto, as are necessary to administer this article.” The court held that post claims underwriting, however, is governed by a separate article outside the reach of Insurance Code section 790.10.

ii) Insurance Code section 790.03 defined “unfair methods of competition and unfair and deceptive acts or practices in the business of insurance” to include nine categories of actions, none of which included post claims underwriting and rescission based thereon.

iii) Nothing in the language or structure of Insurance Code section 790.03 indicated that the list of actions was anything but exclusive. The statute did not contain language commonly found in other statutes setting forth a list of included or excluded items, such as “including, but not limited to.”

iv) The legislature could have easily included post claims underwriting within the definition of unfair methods of competition or unfair or deceptive acts or practices had it intended Insurance Code section 790.03 to cover this practice.

v) Finally, the decision held that the legislative intent articulated in Insurance Code section 790 supported the conclusion that the legislature reserved for itself, and only itself, the right to categorically define unfair methods of competition and unfair and deceptive acts or practices. Insurance Code section 790.06 outlined the procedures to be followed “whenever the commissioner shall have reason to believe that any person engaged in the business of insurance is engaging in this state in any method of competition or in any act or practice in the conduct of the business that is not defined in Section 790.03.” [27]

2. ACIC and PIFC v. Commissioner Jones

In 2011, Commissioner Dave Jones promulgated section 2695.183 of the California Code of Regulations to enhance the standards for estimating the replacement value for total losses on homeowners insurance. The Commissioner’s intent was to curb the problem of underinsurance on homes following wildfires which were becoming more prevalent in California.

The new regulation prohibited a broker-agent or insurer from “communicating” an estimate of replacement cost with an application or renewal of a homeowner’s total loss replacement policy without following the prescribed rules within the regulation. It required that the estimate must conform to specified requirements and standards. Included in the standards for the estimate were expenses reasonably incurred to rebuild the structure in its entirety, including the cost of labor and materials, overhead and profit, plus consideration of a list of 11 components and features of the insured structure, all of which must be annually verified. The regulation held that communication of the estimate to an applicant or insured which did not comply with the regulation constituted a “misleading statement” under Insurance Code section 790.03(b).

Two trade associations [28] opposed the regulation and filed a Writ of Mandate in Superior Court alleging that the Commissioner lacked authority to create a new unfair act. The Commissioner argued that he had broad authority under section 790.10 to adopt regulations to protect purchasers of homeowners insurance. In March 2013, the Superior Court held for the associations. [29] The Commissioner appealed. On April 8, 2015, the Court of Appeals, in a published decision entitled Association of California Insurance Companies v. Jones, found that the Commissioner lacked authority to adopt the regulations at issue. [30]

The Court of Appeal concluded that “the Commissioner did not have the authority to add content and format requirements for replacement cost estimates in homeowner insurance to the list of practices set forth in section 790.03 under the guise of deeming nonconforming estimates misleading under section 790.03, subdivision (b).” [31] The court ruled that, read together, the provisions of the Unfair Insurance Practices Act (UIPA) “demonstrate that the Legislature did not give the Commissioner power to define by regulation acts or conduct not otherwise deemed unfair or deceptive in the statute.”[32]

The Court of Appeal observed that the Commissioner’s position that he had the authority to adopt the regulation under Insurance Code 790.10 would make Insurance Code section 790.06 “superfluous.” [33] The court explained: “Put differently, under the Commissioner’s interpretation of its authority under the UIPA, he would never have to resort to the procedures in section 790.06 regarding practices not ‘defined’ in section 790.03 because the Commissioner could always argue that conduct not meeting standards in a regulation promulgated under the cover of the Commissioner’s power to administer under section 790.10 would be ‘misleading.’ This is precisely what the Commissioner has done here.” [34] The Commissioner could have used the procedures in section 790.06 to seek a determination that replacement cost estimates not including certain information are unfair and deceptive, but he failed to do so.

The Court of Appeal concluded “that the UIPA has not as of yet given the Commissioner authority to regulate the content and format of replacement cost estimates.” [35] The Commissioner then requested review by the California Supreme Court, which accepted the case for review.

The Commissioner, in his briefs to the Supreme Court, makes the following arguments:

i) Section 790.10 grants to the Commissioner broad authority to issue regulations to administer the UIPA. Section 790.10 does not limit the circumstances under which the Commissioner may issue regulations or mandate content of the regulations. Rather, it delegates quasi-legislative rulemaking authority to the Commissioner to issue substantive rules of general applicability.

ii) The Commissioner’s power to administer the UIPA includes the power to deem specific practices to be inherently misleading. The Commissioner’s broad authority includes the authority to issue regulations that “fill in the details and make specific the operation of a specific scheme.”

iii) The Court of Appeal’s reading of the act to limit the Commissioner’s rulemaking authority is inconsistent with legislative intent. [36]

In response, the Association of California Insurance Companies (ACIC) argued that the UIPA does not confer the type of broad quasi-legislative authority the Commissioner has claimed. The Commissioner’s overbroad assertion of his authority under the UIPA conflicts with the statutory text and structure in section 790. ACIC made the following arguments:

i) The legislature has set forth a very detailed and specific list of practices and prohibited acts that it has defined as unfair or deceptive under section 790.03. The legislature has not enacted any language empowering the Commissioner to make new law.

ii) The UIPA is a classic “self-executing statutory scheme” that does not require agency action to spell out what particular acts are prohibited. The acts that are prohibited are already spelled out in section 790.03.

iii) When the UIPA was adopted, the legislature provided a mechanism for the Commissioner to redress particular instances of novel or new practices that the Commissioner contends are unfair or deceptive and fall outside of section 790.03’s detailed list. That mechanism is section 790.06, which permits, on a case-by-case basis, an Order to Show Cause procedure before a Superior Court. This is a process that does not permit the Commissioner to exercise quasi-legislative authority.

iv) Sections 790.03(b) and 790.10 do not confer authority on the Commissioner to define new categories of unfair or deceptive insurance practices. The Commissioner’s argument that sections 790.10 and 790.03 confer authority on him, under 790.10, to allow the issuance of substantive rules of general applicability, is wholly inconsistent with the UIPA’s text and structure which reserved to the legislature the power to define unfair or deceptive practices while delegating to the Commissioner only the power to “determine” on a case-by-case basis and with a concurrence of a Superior Court Judge under section 790.06.

v) The only provision the legislature authorized the Commissioner to utilize to “fill up the gaps,” in terms of new instances of unfair practices, is the procedure in 790.06. The Commissioner has created through his regulation new requirements which by themselves would require an ongoing procedure under section 790.06. The Commissioner’s attempt -- to characterize the replacement cost regulation as nothing more than a requirement that an estimate be complete -- cannot withstand scrutiny.

vi) The replacement cost regulation goes much further than requiring complete estimates. It creates in quasi-legislative fashion new categories of misleading practices. The ultimate effect of the regulation is to dictate how insurers may communicate with insureds and potential insureds and to deem certain communications misleading.

vii) Section 790.06 provides a limited case-by-case mechanism to determine whether novel instances of unenumerated practices the Commissioner views as unfair or deceptive should be treated as such. ACIC concludes that the section 790.06 process is the sole gap-filling procedure or mechanism authorized by the legislature in the UIPA. [37]

There has been no ruling on the argument in the ACIC case.

LEGISLATURE HEARING ON ENFORCEMENT OF THE UNFAIR PRACTICES ACT

On April 27, 2016, in response to the legal skirmishes in the cases discussed above involving trade practices regulations, the Senate Committee on Insurance held a hearing concerning the enforceability of the Regulations and the ongoing cost for the hearings in these cases. The hearing was called to examine the history and the status of these cases and potential legislative solutions. [38]

In that regard, the Committee noted in its notice of hearing that:

Typically, the Legislature avoids involvement in ongoing litigation. However, the costs and scope of the litigation (with little end in sight), the drafting problems in UPA, and other factors, may persuade the Legislature to act sooner rather than later. To the extent that confusion about the UPA undermines the predictability and enforceability of the law, clarifying the UPA could provide clear rules for the regulator and the regulated. [39]

The Committee is looking at the possibility of legislation to clarify whether it wishes to reserve for itself the authority to adopt new unfair practices or to give the Commissioner the authority to do so via rulemaking. At the same time, the Committee recognizes that the California Supreme Court decision in ACIC v. Jones, which will be forthcoming likely by the end of this year, “may determine whether legislation is needed at all.” [40]

CONCLUSION

The trend of these cases reflects the CDI’s attempts to legislate via adoption of regulations rather than seeking new or amended legislation on important issues affecting the public interest. To date, the judiciary has held that section 790 is a special process in which all unfair trade practices are defined by the section 790.03 statute and, as such, new unfair practices may only be defined or determined by the legislature or by the Commissioner pursuant to the process authorized under section 790.06. The California Supreme Court decision should shed light on the Commissioner’s power to regulate unfair trade practices.

The Commissioner’s arguments in ACIC v. Jones seek to expand his authority to adopt regulations under section 790.10 with the effect being to deemphasize the section 790.06 process to determine new unfair acts. Depending on the supreme court’s upcoming decision, the legislature may become involved to clarify the authority between the legislature and the Commissioner in determining new unfair acts.