Expert Commentary

Insurance and the Law of Unintended Consequences

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


Claims Practices
April 2005

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.


1From "Unintended Consequences," available at: http://www.econlib.org/library/Enc/UnintendedConsequences.html.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

Like This Article?

IRMI Update

Dive into thought-provoking industry commentary every other week, including links to free articles from industry experts. Discover practical risk management tips, insight on important case law and be the first to receive important news regarding IRMI products and events.

Learn More