Discretionary Clauses in Disability Insurance Policies Ruled Illegal in California

The California Department of Insurance and a federal district court have both recently held that the use of so called “discretionary clauses” in disability insurance policies, including those issued to plans governed by ERISA, violates California law and that the state law in this regard is not preempted by ERISA. A discretionary clause in an insurance contract is one that confers discretionary authority on the insurer, when making a benefit determination, to interpret the terms and conditions of the policy and to determine the eligibility of an insured for benefits under the policy. This type of policy provision is designed to limit a court’s review of the decisions of the insurer, as the claims review fiduciary, to an abuse of discretion standard under the holding of the U.S. Supreme Court in Firestone Tire and Rubber Co. v. Bruch, 489 U.S. 101 (1989).

In the Firestone decision, the Supreme Court held that a denial of benefits challenged under ERISA is to be reviewed under a de novo standard, which provides no deference to the administrative claim decision, unless the benefit plan gives the administrator or fiduciary discretionary authority to determine eligibility for benefits or to construe the terms of the plan. In that circumstance, the Court further held that an arbitrary and capricious standard of review is to be applied, subject to a conflict of interest analysis. While this standard of review has been variously described as “arbitrary and capricious” or “abuse of discretion,” the ability of defendants in ERISA benefit claims cases to have the court apply a standard of review that provides deference to the fiduciary’s administrative decision on the claim has been a significant advantage in litigating such cases. The Ninth Circuit Court of Appeals has recently stated that a benefit claim decision “grounded on any reasonable basis” is not arbitrary or capricious and that an administrator’s factual finding that a claimant is not totally disabled must be found to be “clearly erroneous” before it can be reversed.

In late 2003, the attorney for the plaintiff in Rowe v. Planetout Partners and Unum Life Insurance Company, an ERISA long term disability case, requested that the California Department of Insurance (“DOI”) issue an opinion as to whether discretionary clauses in disability insurance policies were “appropriate under California law.” The DOI has the authority to regulate the business of insurance in California, including the authority to review for approval the form of disability insurance policies intended to be sold in California. Once the form of a policy has been approved by the DOI, there is no time limit on the ability of the insurer to market that policy form in California.

Following its receipt of the request for a letter opinion on discretionary clauses, the DOI convened a meeting with the representatives of twenty two insurance companies to discuss disability insurance policies. The American Council of Life Insurers also submitted arguments onthe issue of discretionary clauses.

On February 26, 2004, the DOI issued a letter opinion holding that discretionary clauses in disability insurance policies violate California law and deprive insureds of protections to which they are entitled. In its opinion, the DOI defined “discretionary clauses” as any contract provisions or language that purport to confer on the insurer discretionary authority to determine eligibility for benefits or to interpret the terms or provisions of the contract. The DOI found that discretionary clauses render an insurance contract “fraudulent or unsound insurance” within the meaning of the California Insurance Code and that a discretionary clause makes the insurer’s promise to pay benefits under the conditions stated in the policy contingent on the unfettered discretion of the insurer, thereby nullifying the promise to pay and rendering the contract potentially illusory. The DOI further found that a discretionary clause causes the insurance contract to be ambiguous and likely to mislead the insured in violation of California law. The DOI also stated that, in the case of group, employer-sponsored disability contracts that are governed by ERISA, the presence of a discretionary clause and the application of the “arbitrary and capricious” standard of review deprives California insureds of the benefits for which they had bargained.

On February 27, 2004, the DOI issued a Notice to Withdraw Approval addressed to all disability insurers doing business in California. The Notice had the effect of conditionally withdrawing the DOI’s prior approval of eight disability insurance policy forms issued by five insurers because the policies contained discretionary clauses. The Notice also included an Order for Information directing all insurers licensed to offer disability insurance in California to submit to the DOI a list of insurance policy forms currently offered to California insureds providing disability or health coverage and containing discretionary clauses. The list is to identify the policy forms previously approved by the DOI as well as those offered for use in California without approval. Finally, the Notice clarified that the DOI’s definition of discretionary clauses includes “sole discretion clauses, allocation of authority provisions, interpretation of plan provisions and other similar terms.”

On March 24, 2004, the DOI sent a letter to the judge in the Rowe case to respond to questions that had arisen concerning the DOI’s letter opinion on discretionary clauses and the Notice to Withdraw Approval. In the letter, the DOI stated that it had regularly begun disapproving discretionary clauses in disability insurance policies in 1996 and that there might be “isolated instances” where policies containing discretionary clauses “escaped detection by traditional regulatory means.” The DOI letter further stated that its Notice to Withdraw Approval, if it remained in effect, would be effective “prospectively and not retroactively” and that the Notice would preclude insurers from further sales of the particular policies listed in the Notice but that it would not affect policies that had been already sold, including the policy at issue in Rowe.

In late March 2004, several insurance companies whose policies had been listed in the DOI’s Notice to Withdraw Approval filed a request for a hearing pursuant to the California Insurance Code to determine whether the withdrawal set forth in the Notice should be annulled, modified or confirmed. Briefs have been filed and the proceedings in the hearing on the DOI’s Notice are still underway.

On June 18, 2004, a federal district court in the case of Rosten v. Sutter Health Long-Term Disability Plan found the opinion of the California DOI to be persuasive in its interpretation of the California Insurance Code due to its thoroughness and what the court described as the validity of its reasoning. The judge went on to rule orally from the bench that the discretionary clause in the policy at issue in the case violated California law and that the DOI’s statutory authority to regulate discretionary clauses in insurance contracts is not preempted by ERISA because it is a law that regulates insurance within the meaning of ERISA’s savings clause. The court held that the standard of review in the case would be de novo even though the particular policy had been issued to the employer prior to the DOI’s letter opinion and the Notice to Withdraw Approval.

On July 1, 2004, another federal judge, in the same district as the Rosten case, issued a contrary written ruling in the ironically named case of Firestone v. Acuson Corporation Long Term Disability Plan, 326 F.Supp.2d 1040 (N.D. Cal. 2004). In the Acuson decision, the court rejected the plaintiff’s argument that the denial of disability benefits had to be reviewed under a de novo standard on the basis of the DOI’s letter opinion. The insurance company that had issued the policy in Acuson was not among the companies listed in the DOI’s Notice to Withdraw Approval. The court noted that once the California DOI has approved a policy that is otherwise validly issued, it is a binding contract and governs the obligation of the parties until the DOI revokes its approval. The court stated that it had no power to invalidate a portion of an insurance policy or to unilaterally reform the terms and conditions of the policy, and that the plaintiff’s only potential remedy was to file a writ of mandamus to compel the DOI to withdraw its approval of the policy. The court then granted the defendant’s motion for partial summary judgment, finding that the decision to terminate the plaintiff’s disability benefits would be reviewed only for an abuse of discretion.

Plan sponsors of insured disability plans and insurers operating in California should keep a close eye on these issues in the courts and in the proceedings before the DOI. Future issues of the Benefits Report will update you on any significant developments as to discretionary clauses in disability insurance contracts.