Two significant rulings issued days apart upheld the authority of state departments of insurance to prohibit life and disability insurers from including discretionary clauses in their policies that would have the effect of triggering an arbitrary and capricious standard of review under the ERISA law. At issue was the adoption by several states of a model law promulgated by the National Association of Insurance Commissioners prohibiting discretionary clauses in health and disability insurers.

American Council of Life Insurers v. Watters, 2008 U.S.Dist.LEXIS 15185 (W.D.Mich. 2/29/2008), and Standard Ins.Co. v. Morrison, No. CV-06-47-H-DWM (D.Mont. Feb. 27).

The key issue decided by the court was whether the broad scope of ERISA preemption negated the effect of the bans in cases governed by the ERISA law. In the Michigan case, the plaintiff claimed two types of preemption – ordinary or complete preemption – which preempts any law that directly interferes with Congress’ intent in enacting ERISA and the Supreme Court’s ruling in Firestone Tire & Rubber Co. v. Bruch, 489 U.S. 101 (1989), which permits plans to contain such language. The Michigan court summarily rejected that contention, finding that Firestone does not compel discretionary clauses. Indeed, it found the opposite was the default rule. The court also determined that the prohibition does not interfere with Congress’ intent in enacting ERISA.

The more significant question addressed by both courts was whether the prohibition of discretionary clauses are directly preempted by 29 U.S.C. section 1144, a statute that preempts all laws that relate to employee benefit plans governed by ERISA, which are not otherwise saved from preemption by 29 U.S.C. section 1144(b), which exempts from preemption laws that regulate insurance. Both the Michigan and Montana courts found the savings clause applicable, basing their analyses on Rush Prudential HMO Inc. v. Moran, 536 U.S. 355 (2002), and Kentucky Ass’n of Health Plans Inc. v. Miller, 538 U.S. 329 (2003).

In Rush Prudential, the Supreme Court ruled that an Illinois law governing health maintenance organizations which providing for binding independent review of medical claim determinations fell within the savings clause. The HMO argued that the law impermissibly deprived it of its deferential standard of review and further claimed the state law supplanted ERISA’s enforcement mechanism. The Supreme Court rejected both arguments, finding:

”[I]n determining whether state procedural requirements deprive plan administrators of any right to a uniform standard of review, it is worth recalling that ERISA itself provides nothing about the standard. It simply requires plans to afford a beneficiary some mechanism for internal review of a benefit denial, 29 U.S.C. § 1133(2), and provides a right to a subsequent judicial forum for a claim to recover benefits, § 1132(a)(1)(B). Whatever the standards for reviewing benefit denials may be, they cannot conflict with anything in the text of the statute, which we have read to require a uniform judicial regime of categories of relief and standards of primary conduct, not a uniformly lenient regime of reviewing benefit determinations.” 536 U.S. at 384-85 (citing Pilot Life Ins. Co. v. Dedeaux, 481 U.S. 41, 56 (1987)).

The Supreme Court added that not ”only is there no ERISA provision directly providing a lenient standard for judicial review of benefit denials, but there is no requirement necessarily entailing such an effect even indirectly.” Consequently, the holding of Rush Prudential makes it clear the ERISA law affords no entitlement to a deferential standard of review. The Michigan court further noted:

”Statutes requiring de novo review do ‘not implicate ERISA’s enforcement scheme at all, and [are] no different from the types of substantive state regulation of insurance contracts we have in the past permitted to survive preemption, such as mandated-benefit statutes and statutes prohibiting the denial of claims solely on the ground of untimeliness.’ (Citing UNUM Life Ins. Co. of Am. v. Ward, 526 U.S. 358 (1999); Metro. Life Ins. Co. v. Massachusetts, 471 U.S. 724 (1985)).”

Continuing the analysis, the Michigan court further pointed out that like Rush Prudential, the law prohibiting discretionary clauses would be saved because the state regulatory law neither creates a new cause of action nor provides a new form of relief since the law still retains the remedies which are limited by 29 U.S.C. section 1132(a): ”Under the Rules, a participant or beneficiary of an insured ERISA plan who challenges a claim denial is limited to bringing an action under ERISA’s civil enforcement provisions.” The Montana court applied the identical analysis and added that while it may be true the motive of Montana’s insurance commissioner may have been to affect the standard of review applicable in ERISA suits, the court pointed out: ”The other side of the coin of this proposition shows that Standard wants the same thing: a deferential standard of review because this protects its interests; i.e, it lessens the chance that a plan administrator’s determination – that an insured should not be compensated for the costs of a realized risk – will be reversed.”

Both courts focused their analysis, though, on the most recent pronouncement from the Supreme Court, Kentucky Ass’n v. Miller, which applied a two part analysis to the ERISA savings clause.

”First, the state law must be specifically directed toward entities engaged in insurance. See Pilot Life, supra, at 50; UNUM, supra, at 368; Rush Prudential, supra, at 366. Second, as explained above, the state law must substantially affect the risk pooling arrangement between the insurer and the insured.” 538 U.S. at 342.

Although the plaintiffs in both the Montana and Michigan actions argued that Kentucky Ass’n overruled Rush Prudential, both courts disagreed and found the later decision merely expanded upon earlier rulings and afforded more power to the states to regulate insurance. The Michigan court deemed the first prong of the Kentucky Ass’n test to be straightforward and to compel a conclusion that ”when insurers are regulated with respect to their insurance practices, the state law survives ERISA.” Rush Prudential, 536 U.S. at 366. It was clear to the court that the Supreme Court has repeatedly directed that state laws mandating insurance contract terms are saved from preemption. Hence, both the Michigan and Montana courts easily concluded the prohibition of discretion clauses ”are directed toward entities engaged in insurance.”

With respect to the second prong, the Michigan court pointed out that the test merely requires ”only that the state law substantially affect the risk pooling arrangement between the insurer and the insured; it does not require that the state law actually spread risk.” The Michigan court added:

”In this case, the Rules constitute legitimate ‘conditions on the right to engage in the business of insurance.’ Id. at 338. Just as in UNUM, the Rules will result in insurers paying over more money in claims and incurring more of the risk they have assumed. See Metro. Life, 471 U.S. at 473. The Rules ‘substantially affect the risk pooling arrangement between the insurer and insured’ because they ‘alter the scope of permissible bargains between insurers and insureds’ by prescribing a term to which they may not agree. Kentucky Ass’n, 538 U.S. at 338-39 & n.3. This is manifest in the purpose of the Rules, which is to prohibit discretionary clauses because they ‘unreasonably reduce the risk purported to be assumed in the general coverage of the policy.’ Mich. Admin. Code r. 500.2202(a). Thus, the Court finds the Rules also meet the second prong of Kentucky Ass’n and, therefore, the Rules constitute ‘law[s] … which regulate insurance’ under section 1144(b)(2)(A) of ERISA.”

Likewise, the Montana court determined, by reference to yet another earlier savings clause ruling from the Supreme Court, Unum Life Ins.Co. v. Ward, 526 U.S. 358 (1999) (holding that a rule permitting late notice of claim falls within the savings clause), the disapproval of savings clauses ”dictates to the insurance company the conditions under which it must pay for the risk which it has assumed.” The court criticized Standard for looking only at the Supreme Court’s language and disregarding the reasoning of the Kentucky Ass’n ruling, characterizing Standard Insurance Company’s argument as ”shrewd legerdemain,” but ”faulty legal reasoning.” The court added the insurer’s reasoning was contrary to the McCarron-Ferguson Act, 15 U.S.C. § 1011 et seq., which left to the states the authority to regulate insurance; and that the insurer’s argument would mean it would be left to the insurance industry to regulate itself. The court then pointed out:

”The reasoning in Kentucky Ass’n compels the conclusion that the concept of ‘risk pooling’ as used in the second prong of the articulated test is qualitatively different than Standard suggests. Standard argues that ‘risk’ only means, literally, the type of risk insured against, e.g., the risk of physical injury or property loss. It then argues, the ‘pooling’ of this risk refers narrowly to the insurance-industry practice of risk classification. Yet the [state law provisions at issue in each of the Supreme Court’s saving clause cases] … each affected the substantive terms of the insurance policies under scrutiny in these cases, and not simply the risk insured against. Standard’s interpretation ignores the reasoning of these cases that are the building blocks for the Kentucky Ass’n test.”

Thus, both courts found that the discretionary clause prohibition addresses the substantive terms of insurance forms in much the same manner as in every other Supreme Court ruling that upheld state regulation; and that the regulation is not preempted by the ERISA law.

Like the States of Michigan and Montana, Illinois has also adopted a regulation that prohibits discretionary clauses in health and disability insurance policies, 50 Ill.Admin.Code § 2001.3 (effective July 1, 2005). Other states that have adopted some form of the regulation are catalogued in an article authored by Professor John Langbein, ”Trust Law as Regulatory Law: The Unum/Provident Scandal and Judicial Review of Benefit Denials Under ERISA,” 101 Nw.U.L.Rev. 1315, 1340-41 (2007), where the author commented:

”The Unum/Provident scandal has provoked a concerted movement among state insurance commissioners to forbid terms in insurance policies that alter the standard of judicial review. The rationale for these interventions, in the words of the California provision, is that policy terms attempting to govern the standard of review deprive the insured of ‘the protections of California insurance law, including the covenant of good faith and fair dealing.’ The influential National Association of Insurance Commissioners is encouraging the states to take this position. The Hawaii Commissioner ruled in 2004 that ‘[a] ”discretionary clause” granting to a plan administrator discretionary authority so as to deprive the insured of a de novo appeal is an unfair or deceptive act or practice in the business of insurance and may not be used in health insurance contracts or plans in Hawaii.’ At that time such clauses were ‘prohibited by statute in Maine and Minnesota, and by Insurance Commissions in California, Illinois, Indiana, Montana, Nevada, New Jersey, Oregon, Texas, and Utah.’ In 2005, the Illinois regulations were further amended to forbid health or disability insurance contracts from ‘containing a provision purporting to reserve discretion to the [insurer] to interpret the terms of the contract, or to provide standards of interpretation or review that are inconsistent with the laws of the State.’ ”

Although the Illinois regulation has yet to receive a court test, the pair of rulings issued by the district courts in Montana and Michigan will no doubt prove influential and will hasten the demise of discretionary clauses, and thus, the arbitrary and capricious standard of review, in benefit claims involving health and disability insurance.

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This article was initially published in the Chicago Daily Law Bulletin.

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