Is the Tide Turning Against Discretionary Clauses in Insurance Contracts?

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March 02, 2010

A recent decision by the Ninth U.S. Circuit Court of Appeals may make it harder for insurance companies in some states to defend claims denials. Standard Insurance Company v. Morrison, a case decided by the court on October 27, 2009, established its place in claims denial case history by addressing the standard of review in Employee Retirement Income Security Act (ERISA) cases.

Standard of Review History

When a participant brings a lawsuit to challenge a plan administrator’s denial of benefits under an ERISA plan, the first issue considered is what standard of review the court will use in reviewing the denial. Plan administrators much prefer the “arbitrary and capricious” standard of review, which allows a court to overturn a claim denial only when the plan administrator’s denial of the claim is found to have been unreasonable or unsupported by evidence. The alternative is the much less deferential “de novo” review, in which a court can effectively make its own determination of the claim.

It was unclear which standard would apply in claims denial cases until the U.S. Supreme Court issued its decision in Firestone v. Bruch in 1989. This landmark case held that a plan administrator’s decision will receive deference under the arbitrary and capricious standard of review when the plan document itself specifies that the plan administrator has full discretion to determine benefit claims. Without such language, the denial would be subject to the more stringent de novo review. As a result, in the 1990s, ERISA benefit plans were overwhelmingly drafted to include “Firestone language” giving the administrator discretion, and therefore, many plan administrators enjoyed the deferential review of the courts.

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Some argue that giving plan administrators the advantage of the arbitrary and capricious standard of review is a positive development. They assert that it reduces the amount of administrative and financial costs spent on defending claims, which remain available to the plan. Others, however, argue that the deferential standard of review gives plans an unfair advantage. In particular, critics claim that insurers have an inherent conflict of interest in denying claims (which would be paid from their revenues), and their decisions should be subject to more scrutiny in the courts. These critics no doubt feel that Montana’s Commissioner of Insurance, John Morrison, has somewhat leveled the playing field by using a state statute to invalidate discretionary clauses in insurance contracts.

The Morrison Case

The particular Montana statute used by Morrison to invalidate discretionary clauses states that the commissioner of insurance must disapprove any insurance policy form that contains any “inconsistent, ambiguous, or misleading clauses or exceptions and conditions which deceptively affect the risk purported to be assumed in the general coverage of the contract.” Morrison determined that discretionary clauses in insurance contracts were invalid under this statute and denied approval to proposed disability insurance forms submitted by Standard Insurance Company.

Standard appealed Morrison’s invalidation of the discretionary clauses in the federal court system, arguing that Morrison’s actions were preempted by ERISA. Even though the insurance contracts were issued only to employee benefit plans, Morrison argued that his actions were saved from preemption by ERISA Section 514(b), which provides that state laws regulating insurance are not preempted by ERISA. The Ninth Circuit agreed with Morrison, thus sanctioning the ability of states to ban discretionary clauses in insurance contracts.

Backlash Against Discretionary Clauses

The written decision in the Morrison case reports that at least a dozen states have taken steps to limit or bar the use of discretionary clauses in insurance contracts. The National Association of Insurance Commissioners also came out in opposition to discretionary clauses, and earlier in 2009, the Sixth Circuit let Michigan’s prohibition of discretionary clauses stand. With the tide turning in this direction, there will likely be more frequent and more complicated litigation over ERISA claims. Plan sponsors would be wise to bolster their claims review processes and prepare to defend claim denials under a de novo standard of review.

Please contact the Benefits Law Group if you would like assistance with compliance with Section 162(m) or any other benefits issue.

Reprinted with permission from Benefits and Compensation Law Alert Copyright 2009 M. Lee Smith Publishers LLC.

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