Insurance and the Law of Unintended Consequences
April 2005
Insurance, like all parts of modern society,
is subject to the deprivations of the law of unintended consequences. The "law"
is defined as the understanding that "actions of people—and especially of government—always
have effects that are unanticipated or 'unintended.'"1
by Barry
Zalma
Barry Zalma Inc.
Insurance is controlled by the courts, through appellate decisions, and by
governmental agencies, through statute and regulation. Compliance with the appellate
decisions, statutes, and regulations—different in the various states—is exceedingly
difficult and expensive.
In the United States alone, people pay insurers more than $700 billion in
premiums, and insurers pay out in claims and expenses as much or more than they
take in. Profit margins are small because competition is fierce, and a year’s
profits can be lost to a single firestorm, hurricane, or flood.
Insurance as a Necessity
Neither the courts nor the governmental agencies seem to be aware that in
a modern, capitalistic society, insurance is a necessity. No person would take
the risk of starting a business, buying a home, or driving a car without insurance.
The risk of losing everything would be too great. By using insurance to spread
the risk, taking the risk to start a business, buy a home, or drive a car becomes
possible.
Insurance has existed since a group of Sumerian farmers, more than 5,000
years ago, scratched an agreement on a clay tablet that if one of their number
lost his crop to storms, the others would pay part of their earnings to the
one damaged. Over the eons, insurance has become more sophisticated, but the
deal is essentially the same. An insurer, whether an individual or a corporate
entity, takes contributions (premiums) from many and holds the money to pay
those few who lose their property from some calamity, like fire. The agreement,
a written contract to pay indemnity to another in case a certain problem, calamity,
or damage occurs by accident, is called insurance.
In a modern industrial society, almost everyone is involved in or with the
business of insurance. They insure against the risk of becoming ill, losing
a car in an accident, losing business due to fire, becoming disabled, losing
their life, losing a home due to flood or earthquake, or being sued for accidentally
causing injury to another. They are insurers, insureds, or people dependent
on one another.
Simplified Wording Causes Ambiguity
Insurance contracts can be simple or exceedingly complex, depending on the
risks taken on by the insurer. Regardless, insurance is neither more nor less
than a contract whose terms are agreed to by the parties to the contract. Over
the last few centuries, almost every word and phrase used in insurance contracts
have been interpreted and applied by one court or another. Ambiguity in contract
language became certain. However, the average person saw the insurance contract
as incomprehensible and impossible to understand.
Ostensibly to protect the public, insurance regulators decided to require
that insurers write their policies in "easy to read" language. Because they
were required to do so by law, the insurers changed the words in their contracts
into language that people with a fourth grade education could understand. Precise
language interpreted by hundreds of years of court decisions was disposed of
and replaced with imprecise, easy to read language.
The law of unintended consequences came into play, and instead of protecting
the consumer, the imprecise language resulted in thousands of lawsuits determined
to impose penalties on insurers for attempting to enforce ambiguous "easy to
read" language. The multiple lawsuits cost insurers and their insureds millions
of dollars to get court opinions that interpret the language and reword their
"easy to read" policies to comply with the court decisions. For more than 30
years, the unintended consequence of a law designed to avoid litigation has
done exactly the opposite.
The attempts by the regulators and courts to control insurers and protect
consumers were made with the best of intentions. The judges and regulators found
it necessary to protect the innocent against what they perceived to be the rich
and powerful insurer.
Bad Faith Causes Bad Behavior
In the 1960s, the California Supreme Court created a tort new to U.S. jurisprudence:
bad faith. A tort is a civil wrong from which one person can receive damages
from another for multiple injuries. The tort of bad faith was created because
an insurer failed to treat an insured fairly, and the court felt that the traditional
contract damages were insufficient to properly compensate the insured. The court
allowed the insured to receive, in addition to the contract damages that the
insured was entitled to receive under the contract had the insurer treated the
insured fairly, damages for emotional distress and punitive damages to punish
the insurer for its wrongful acts. Insureds, lawyers for insureds, regulators,
and courts across the United States cheered the action of the California Supreme
Court, and most of the states adopted the tort created by the California Supreme
Court.
After the creation of the tort of bad faith, if an insurer and insured disagreed
on the application of the policy to the factual situation, damages were no longer
limited to contract damages as in other commercial relationships. If the court
found that the insurer was wrong, it could be required to pay the contract amount and damages for emotional distress, pain,
suffering, punishment damages, attorney fees, and any other damages the insured
and the court could conceive.
It was hoped that the tort of bad faith would have a salutary effect on the
insurance industry and force insurers to treat their insureds fairly. However,
claims for $40 wrongfully denied resulted in $5 million verdicts. Juries, unaware
of the reason for and operation of insurance, decided that insurers that did
not pay claims were evil and that they wrote contracts so they never had to
pay. They punished insurers severely even when the insurer’s conduct was correct
and proper under the terms of its contract. The massive judgments were publicized,
and many insurers decided fighting its insureds in court was too expensive regardless
of how correct its position was on the contract.
Most of the massive verdicts were reversed or reduced on appeal. The bad
actors raised their premiums and lost little business. Other insurers, faced
with the massive verdicts, allowed fear to control reason, and paid claims that
were improper or fraudulent. The extra cost was passed on to all insurance consumers,
not to the insurers who acted improperly. They, in fact, profited since they
continued their wrongful acts and paid the few insureds that sued while honest
insurers paid frauds and claims they did not owe.
The law of unintended consequences struck again and resulted in punishing
the honest and correct insurers, honoring the insurers who acted in bad faith
with profit, and allowed many frauds to succeed.
© Barry Zalma 2005
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