United States: California Fair Claims Settlement Practices Regulations Upheld Following A Near-Decade Long Legal Challenge To Their Enforceability

Following nearly a decade of uncertainty as to their enforceability, the California Court of Appeal upheld key components of the California Fair Claims Settlement Practices Regulations on September 20, 2018 and affirmed that the California Insurance Commissioner has the authority to penalize insurers for engaging in improper claim settlement practices based upon even a single act of misconduct.

1. History of the Unfair Insurance Practices Act & Fair Claims Settlement Practices Regulations

In 1959, the California Legislature enacted the Unfair Insurance Practices Act ("UIPA"), Cal. Ins. Code § 790, et seq., in order to regulate trade practices in the business of insurance by defining and prohibiting unfair or deceptive acts or practices. In 1971, the Legislature enacted § 790.10 authorizing the Commissioner to promulgate regulations as are necessary to administer the UIPA.

The following year, in 1972, the Legislature enacted § 790.03(h), which prohibits 16 enumerated "unfair claims settlement practices" by insurers, "if knowingly committed or performed with such frequency as to indicate a general business practice."

In 1979, the California Supreme Court decided Royal Globe Ins. Co. v. Superior Court (1979) 23 Cal.3d 880, in which it resolved several disputes concerning the operation of the UIPA. First, the Court held that § 790.03(h) was not limited to a basis for imposing administrative penalties, but rather a third party claimant could bring a civil action against an insurer to impose liability against it based upon its commission of the unfair practices contained in such statute. Second, the Court held that the claimant could establish that an insurer had engaged in a business practice prescribed by § 790.03(h) through a "single violation knowingly committed." Finally, the Court held that the third party claimant could not sue both the insured and the insurer in the same action, but rather had to wait to sue the insurer until the liability of the insured had been "first determined."

Nine year later, in Moradi-Shalal v. Fireman's Fund Ins. Cos. (1988) 46 Cal.3d 287, the California Supreme Court reversed Royal Globe's holding that § 790.03 created a private right of action against an insurer that commits one the acts prescribed in § 790.03(h). Hence, in the wake of Moradi-Shalal, only the Commissioner could sue an insurer for violating the UIPA and the available relief was limited to a cease and desist order. Further, Moradi-Shalal indicated that Royal Globe's holding that a single act of misconduct could constitute a violation of § 790.03 was unfounded.

Accordingly, the following year, in 1989, the Legislature enacted Cal. Ins. Code § 790.035, which (i) authorizes the imposition of additional financial penalties for violations of § 790.03, and (ii) grants the Commissioner "the discretion to establish what constitutes an act" for purposes of imposing these new penalties.

In 1992, the Commissioner promulgated the Fair Claims Settlement Practice Regulations (the "Regulations"), 10 Cal. Code. Regs. §§ 2695.1-2695.14, which became effective in January 1993.

The Regulations prescribe how insurers must process insurance claims and authorize the Commissioner to penalize an insurer for engaging in prohibited claim settlement practices. Notably, the Regulations authorize the Commissioner to penalize an insurer based upon a single act, if the act was "knowingly committed," and defines the "knowingly committed" component so as to include not only those acts performed with actual knowledge, but also those acts "performed with . . . implied or constructive knowledge, including, but not limited to, that which is implied by operation of law."

2. The Cloud of Doubt as to the Enforceability of the Regulations

In 2012, a California Administrative Law Judge (an "ALJ") issued a pre-trial order in In re Globe Life & Accident Ins. Co. holding, among other things, that the Regulations unlawfully eliminated the general business practice test from the statute. The California Department of Insurance (the "CDI") did not appeal such order and ultimately dismissed the case on August 29, 2016. Even so, the issuance of such pre-trial order cast doubt over the future enforceability of the Regulations, which doubt was not resolved until the Court of Appeals issued its decision in PacifiCare Life and Health Ins. Co. v. Jones on September 20, 2018.

3. The Commissioner's Imposition of a $173.6 Million Penalty Upon PacifiCare

The dispute underlying PacifiCare began in 2007, when the CDI initiated a market conduct examination of PacifiCare's claims-handling practices following its 2005 acquisition by UnitedHealth Group. The Commissioner initiated the examination based upon his belief that, despite assurances from UnitedHealth that its acquisition of PacifiCare would not result in the deterioration of PacifiCare's claims handling practices, post-closing cost-cutting measures resulted in "failures at every level of claims handling."

Following the completion of the examination, the CDI commenced an enforcement proceeding in order to impose penalties on PacifiCare for its allegedly unlawful claims-handling practices.

In 2013, following 230 days of evidentiary hearings taking place over three years, the ALJ issued a proposed decision finding that PacifiCare had committed 92 violations of § 790.03 and imposing a penalty of approximately $11.5 million.

On June 9, 2014, however, the Commissioner rejected the ALJ's proposed decision and instead issued his own decision finding that PacifiCare had committed 908,547 violations of § 790.03 (spanning some 20 categories, ranging from the failure to timely pay claims to the failure to provide notice of the right to seek an independent medical review), and imposing an aggregate penalty of $173.6 million. Not only was the decision remarkable for the unprecedented amount of the penalty, but it was the very first enforcement action brought under the UIPA since its enactment in 1959 that had been litigated to a decision or even a proposed decision.

4. The Superior Court's Injunction Against Enforcement of the Regulations

On July 10, 2014, PacifiCare filed a petition for writ of mandate and complaint for declaratory and injunctive relief, seeking review of the Commissioner's Decision by the Orange County Superior Court. PacifiCare characterized 98% of the claims handling violations found by the Commissioner to be "routine claims-processing mistakes" that did not rise to the level of unfair insurance practices. Accordingly, PacifiCare asserted that the Commissioner's Decision was based on arbitrary and fundamentally flawed interpretations of §§ 790.03(h) and 790.035.

PacifiCare sought a determination that three of the Regulations underlying the Commissioner's Decision, on their face, were inconsistent with the statutory language within UIPA and thereby facially invalid – namely, (i) § 2695.1(a), which states that, for purposes of defining an unfair claims settlement practice, a violation occurs when the practice is either "knowingly committed on a single occasion," or "performed with such frequency as to indicate a general business practice[;]" (ii) § 2695.2(l), which defines the word "knowingly" to include implied and constructive knowledge; and (iii) § 2695.2(y), which defines the word "willful" for the purpose of a penalty enhancement without requiring specific intent to cause harm or violate the law (collectively, the "Challenged Regulations").

Given the breadth and complexity of the issues, the Superior Court bifurcated the case. In the first phase, the Superior Court addressed the validity of the Challenged Regulations. At the conclusion thereof, the Superior Court sustained PacifiCare's facial challenge to the legality of the Challenged Regulations and enjoined the Commissioner from continuing to enforce them.

In the second phase, the Superior Court determined that its first phase invalidation of the Challenged Regulations negated $91 million of the penalties, and that the remaining $82 million in penalties were invalid on other grounds. The second phase ruling is the subject of a second appeal that has yet to be briefed.

5. The Court of Appeal's Decision

On appeal, the Court of Appeal was faced with having to determine whether the Legislature intended to authorize the Commissioner to: (a) regulate only established patterns of unfair claims settlement practices; or (b) authorize enforcement activities based on single acts of misconduct.

Specifically, the Court held that the first Challenged Regulation (§ 2695.1) was not inconsistent with § 790.03(h), because the California Supreme Court had previously held in Royal Globe that § 790.03(h) applies to "a single violation knowingly committed" and that ruling remains good law today. Accordingly, the Court of Appeal "reject[ed] PacifiCare's contention that an 'unfair claims settlement practice' must refer to an insurer's pattern of conduct, rather than to any individual act."

The Court of Appeal held that the second Challenged Regulation (§ 2695.2(l)), which defines the word "knowingly" to include implied and constructive knowledge, was not inconsistent with § 790.03(h), because the Commissioner's definition was entitled to deference, comports with traditional principles establishing corporate knowledge, tracks the Labor Commissioner's similar definition for the purpose of implementing regulatory penalties under the workers' compensation law, and appropriately creates incentives for insurers to make all proper inquiries and to exercise diligence in the claims settlement process. Accordingly, the Court rejected PacifiCare's contention that inclusion of implied or constructive knowledge within the meaning of "knowingly committed" writes out any scienter element from the statute and allows an insurer to be penalized for inadvertent acts.

Finally, the Court of Appeal held that the third Challenged Regulation (§ 2695.2(y)), which defines the word "willful" for the purpose of a fine enhancement without requiring specific intent to cause harm or violate the law, does not blur the distinction between willful and nonwillful violations and thereby create an inconsistency between the two-tier penalty scheme in § 790.035.

6. Conclusion

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