Christopher A. Wieber Employee Benefits Law Blog on Lawyers.com

A recent decision by the Sixth Circuit Court of Appeals should help to level the playing field between employee-claimants and the insurance companies that insure and administer their employer-sponsored benefit plans.  In American Council of Life Insurers v. Ross, the Court upheld Michigan regulations which bar insurance companies from issuing, delivering, or advertising insurance contracts or policies that contain so-called “discretionary clauses.”  The Court found that the state could ban these clauses from insurance policies as part of its ordinary authority over state insurance regulation.  It rejected the argument articulated by plaintiffs, a number of insurance industry groups, that the federal Employee Retirement Income Security Act, commonly referred to as ERISA, “preempted.” State law and deprived the State of the power to regulate in this area. 

Insurers frequently insert discretionary clauses – which state, in effect, that the insurer (or claim administrator) will have discretionary authority when interpreting plan terms and making benefit determinations – into employer-sponsored medical plans, long-term disability plans, and life insurance plans.  In disputes involving the denial or termination of benefits under ERISA-governed plans, courts have interpreted “discretionary clauses” in such a way as to place employees and plan participants at a substantial disadvantage.

What is wrong with discretionary clauses?

Our clients who seek benefits under employer-sponsored insurance plans are frequently stunned to learn of the far-reaching consequences of these discretionary clauses.  Rather than entering the courtroom on an equal footing, claimants face the forbidding hurdle of having to show not just that the plan’s denial of benefits was wrong, but that it was “arbitrary and capricious.”  This standard is the one that typically applies when an administrative agency, such as Social Security or a Zoning Board, renders a determination.  Application of the arbitrary and capricious standard means that instead of proving disability or the medical necessity of treatment by a preponderance of the evidence (that is, “more likely than not”) – as would be typical in an ordinary insurance dispute – a claimant must instead prove that the insurance company’s decision was “arbitrary and capricious” (that is, “without reason, unsupported by substantial evidence or erroneous as a matter of law”).  As interpreted by some courts, this standard of review has been practically insurmountable.  Claim denials have been upheld as long as there was “more than a scintilla” of evidence to support the insurance company’s decision.

The discretionary clause has also trumped other rules that favor the insured person.  Before the advent of discretionary clauses, courts commonly recognized that insurance companies have much more control over the drafting of their policies than the consumers or businesses who buy coverage.  They therefore used a rule called contra proferentum (literally, “against the one putting forth” the contract) to interpret ambiguous policy provisions:  the ambiguous provision would be read against the drafting insurance company and in favor of coverage.  However, the contra proferentum rule is typically discarded when a discretionary clause is present.  Instead, courts have deferred to an insurance company’s interpretation of its own unclear or ambiguous policy provision so long as the interpretation is within the range of possible reasonable interpretations, even if there is a more obvious interpretation or the claimant’s reading of the provision is more reasonable. 

Without a thorough understanding of ERISA and the significance of “discretionary clauses,” claimants may believe they are fully capable of presenting their own internal appeals to plan administrators when benefits are denied.  They assume a lawyer can be hired later, when “going to court.”  Nothing in the plan documents or insurance policies advises them that the internal appeal determination by the insurer can be given the hard-to-challenge status of an administrative agency decision and that proceeding without counsel at this early stage is potentially perilous and likely to determine the outcome of any subsequent lawsuit.  Claimants are often financially strapped by the benefit denials, and are further deterred from seeking counsel because courts will award attorney’s fees solely for legal services rendered in litigation, not for those rendered during the internal appeal process. 

Why should discretionary clauses be banned?

Critics of discretionary clauses have argued that they are inherently misleading because consumers are not made aware of their effect, and that they tend to undermine insurance consumers’ legitimate expectations.  There have been too many examples of unfair denials of legitimate claims (often upheld under the “arbitrary and capricious” standard because claimants did not know how to construct a case or present evidence on their appeals) for regulators to ignore the issue.

The Michigan Commissioner of the Office of Financial and Insurance Services (“OFIS”), who adopted the regulations at issue in Ross, was taking the same approach as regulators and legislators in a number of other states.  California led the way.   New York’s Insurance Department issued Circular Letter 8 in March, 2006, imposing restrictions similar to those in Michigan.  The Department banned “discretionary clauses” in health and disability policies because they “encourage misrepresentation or are unjust, unfair, inequitable, misleading, deceptive or contrary to law…”  Under pressure from the insurance industry, however, the regulations were withdrawn several months later, effective June 29, 2006.   

Insurers and their advocates have argued that discretionary clauses are not a problem because courts can and occasionally do rule in favor of claimants under the arbitrary-and-capricious standard triggered by such clauses.  This argument fails to address the central rationale for such regulations. The question is not whether claimants are capable of overcoming discretionary clauses in exceptional cases, but whether it is fair for insurers, through use of technical terms that most claimants and policyholders will not understand, to transform what was intended to be an inexpensive, even-handed process of internal claim appeals into a quasi-judicial process in which the lay claimant’s technical errors, such as gaps in evidence or expert witness support, can have disastrous consequences. 

State “no discretion” regulations are a reasoned attempt to address a problem of unfair and deceptive practices, an endeavor well within the traditional scope of state insurance regulation.  To our knowledge, the Sixth Circuit’s decision in Ross, issued on March 18, 2009, is the first by a federal appeals court to uphold the validity of such state-enacted “no-discretion” regulations.  Its decision is very good news indeed.