NAII's view of proposed penalties for unfair claims handling practices.

The 2001 legislative sessions are now well under way in the US. Insurers are closely watching the perennial crop of bills that seek to expand private rights of action against insurance companies. In particular, the National Association of Independent Insurers (NAII) monitors and lobbies against those bills that allow individuals who have been damaged in some way by an insurer's policyholder to directly sue that insurer, with whom they do not have a contract – the so-called ‘third party bad faith' legislation.

In at least a dozen states, legislation is pending that would either create a private cause of action for third parties or increase the penalties regulators can levy on insurers for unfair claims handling practices. Many of these bills will die quietly in committee without consequence. However, a Georgia bad faith bill has passed both houses of the Legislature.

Clearly, third parties that suffer damages should be made whole, but this greatly differs from saying that insurers should pay more than the maximum amount under their contract with the insured. Allowing third parties to directly sue the insurer with whom they had no contractual relationship creates coverage that was never intended and exposures never envisioned.

What happens to the reinsurance industry when state legislatures or court decisions create additional avenues for third parties to sue insurers? It increases litigation, the size of court awards, claims settlement costs and marginal or fraudulent claims – ultimately resulting in higher costs for reinsurers, primary insurers and consumers. At its worst, bad faith litigation can threaten the solvency of primary insurers, spawning bankruptcies with far-reaching consequences for the global reinsurance market.

Litigation versus regulation
Third party bad faith laws turn the regulation of insurer claim practices over to the courts. This leads to haphazard, highly volatile, and inconsistent ‘regulatory' decisions being handed down by judges and juries. NAII believes it is better public policy for insurers to be regulated by state insurance commissioners. Every state has rules and regulations that establish a clear set of claims practice standards, and state regulators have the authority to impose significant penalties on insurers which violate these provisions.

California's experience offers a textbook example of why NAII lobbies vigorously against bad faith laws as poor public policy for consumers as well as insurers. A 1979 California Supreme Court decision, Royal Globe v Superior Court, allowed claimants not only to sue the party responsible for the damages but also the party's insurance company. The court decision opened the floodgates to third-party bad faith suits until 1988, when Royal Globe was overturned by the California Supreme Court.

NAII, as part of coalition of insurers and other groups, scored a major victory in California last year by preventing the reinstatement of third-party bad faith legislation. By a resounding 70% to 30% margin, California voters in two ballot initiatives, Propositions 30 and 31, rejected bad faith laws already enacted by the Legislature. The coalition, Consumers Against Fraud and Higher Insurance Costs, had clearly communicated its message: the higher insurance premiums Californians paid under the Royal Globe decision lined trial lawyers' pockets and clogged the courts with more frivolous suits without any added benefit to the consumer. In fact, such suits endanger all other consumers by increasing overall insurance costs and threatening the very promise to pay through potential insolvency.

The defeat of Propositions 30 and 31 in California also undoubtedly deflected the filing and passage of bad faith bills last year in other states.

Excess of policy limits
Third party lawsuits provide an opportunity for claimants to receive awards, including punitive damages, well in excess of policy limits. This greatly increases the potential value of their claims, as they can demand compensation for actual damages and also pursue additional damages from the insurers such as punitive damages.

Reinsurers underwrite ‘extra contractual obligations' (ECO) or ‘excess of policy limits' (XPL) claims as part of their contractual agreement with primary insurers. For instance, if a third party claimant is awarded $5m for alleged bad faith in a liability suit, and the standard policy limit was $1m, the reinsurer may be obligated to reimburse the primary insurer for the difference.

To try to control these potential loss costs, reinsurer agreements typically require primary insurers to notify their reinsurers when wrongful death suits or claims in excess of a certain amount are filed. It is essential for reinsurers, through their primary insurers, to monitor how these claims are handled. One large punitive award can have a great impact on reinsurers, while multiple lawsuits or a class action lawsuit can have a devastating effect.

As part its efforts to educate the voting public, Consumers Against Fraud and Higher Insurance Costs commissioned a study of the impact of third-party bad faith on the California market. The study, by William G. Hamm, PhD, found that because claimants have the potential to recover much larger total awards, bad faith laws increase the incentive to pursue weak or marginal claims that they might otherwise abandon or settle. Insurers are also more likely to pay a settlement in a weak case to defray high legal costs in the event they are sued for unfair claims settlement practices.

Because insurers face a greater financial exposure under third party bad faith, they are also more likely to settle borderline claims rather than risk the potential legal costs they would face in court.

During the Royal Globe era, claims costs rose more rapidly in California than in other states, according to Hamm's study. For instance, in 1978, the bodily injury pure premium for California was $50, or 156% of the 49-state average. By 1988 – the year Royal Globe was overturned – that premium had increased to $184, or 222% of the 49-state average.

The study also found that Props 30 and 31 would raise auto liability insurance premiums by as much as 14.5%. That amounts to an additional $1.4bn in additional auto liability insurance premiums and another $200m in liability insurance premiums annually. Breaking it down further, the study showed that the average family in California would pay an additional $60 to $188 for auto liability insurance coverage per year.

The threat of bad faith lawsuits by third party claimants makes it more difficult for insurers to aggressively pursue suspected fraud cases. This provides the incentive for organised fraud rings to expand their activities, further driving up the cost of insurance.

Public policy initiatives
As of early March, states considering third party bad faith legislation or bills to expand administrative penalties for unfair claims practices included Arizona, Indiana, Iowa, Georgia, Maine, Massachusetts, Mississippi, New Jersey, New York, Oklahoma, Oregon, Utah and Virginia.

Georgia House Bill 478, which the Legislature has already enacted, would increase the present cap on first party claims for alleged insurer bad faith from 25% of the claim in question to 50%. The bill also creates a private cause of action for third parties in cases of property damage, primarily for auto damage claims.

NAII had lobbied vigorously against HB 478, as well as educated Georgia legislators and consumers that existing legal remedies are sufficient to discourage insurers from engaging in unfair claims settlement practices and penalising those that do.

All states have laws that allow parties to file a complaint with their department of insurance or insurance regulator if they believe an insurer has not attempted to settle a claim in good faith.

Hamm's study shows that regulation is an effective remedy. In California, for every 100,000 auto policies in force, only 38 complaints regarding unfair claims settlement practices were filed with the Department of Insurance (DOI) in 1998. Also in that year, the DOI determined that only one out of eight complaints was justified – slightly more than four justified complaints per 100,000 auto policies.

Permitting third parties a private right of action affects the entire insurance industry, including reinsurers. From a cost perspective, reinsurers are likely to feel the hit most directly and severely when a suit is filed that results in an ECO or XPL exposure to the reinsurer. Losses can reach the limits of coverage in the reinsurance contract. Accompanying these losses are the addition of defence costs, admittedly shared, but still borne to some degree by the reinsurer.

To try to mitigate these losses, reinsurers may wish to scrutinise and underwrite more closely a company's claims handling practices, as well as the jurisdictions in which the company writes.

As if severity of potential ECO and XPL losses were not enough, primary insurers' tendency to settle more claims under third party systems to avoid legal action also affects reinsurers' bottom lines. Losses to reinsurers will inevitably increase as part of loss-sharing agreements with the primary carrier.

NAII continues to fight third party bad faith bills in the states to keep regulatory control over claims practices where it belongs – with the state regulator. By quashing or limiting the impact of bad faith bills, NAII assists reinsurers in pricing for ECO and XPL coverage based on stable experience. In turn, this assures a stable insurance market by avoiding excessive losses and ultimately benefiting the consumer through lower prices.