Monday, November 1, 2010
There is widespread acceptance of the idea that tort law and insurance are intimately related. The growth of liability insurance permitted the expansion of tort liability through the twentieth century, and the expansion of tort law in turn spurred the further development of liability insurance. The compensation objective of tort would not be served without the presence of insurance. First-party insurance obviates the need for tort in some circumstances and, through the collateral source rule, effectively funds contingent fees in other circumstances. And so on.
All of these ideas are based on the assumption that insurance works—that companies assess risks, insureds purchase policies against those risks, and the companies pay claims that are within coverage. Unfortunately, the facts about insurance are increasingly at odds with this assumption. Most companies pay out most claims most of the time, of course. But more and more, insurance companies deny valid claims in whole or part and force policyholders and tort victims to litigation to obtain the benefits to which they are entitled.
The economics of insurance creates this potential for opportunism. Every dollar a company does not pay out in claims is a dollar it keeps in profit. Outright denials, reduction of the amounts paid, and using litigation to diminish and deter claims potentially provides a greater benefit to a company than it loses in disappointed customers and a negative reputational effect.
Insurance companies have always been subject to these temptations. Since the early 1990s, however, the strategy has become more systematic and institutionalized across auto, homeowners, and disability insurance and extended even to commercial lines. Three factors led to the change.
First, there were a series of external shocks that put insurance companies under financial pressure. An extended soft underwriting market forced companies to continually cut premiums to attract customers. Medical costs, a principal part of the payouts of auto insurance companies, rose dramatically. Mother Nature intervened and made things worse as hurricanes, earthquakes, and wildfires imposed losses for which companies had inadequately reserved.
Second, attitudes changed. As elsewhere in American finance, a mania for growth and profits took hold. Many companies shifted from mutual to stock ownership to tap the capital markets as a source of growth. Allstate, newly demutualized, embarked on an extreme strategy of reducing underwriting standards and expanding its base of agents to increase its market share, and as it spun off from its lifelong association with Sears, shareholder value became primary. GEICO began spending half a billion dollars annually on advertising to attract customers, triggering a price war fought with premium and advertising dollars.
Third, a change agent entered the picture. Allstate and other companies hired the mega-consulting firm McKinsey & Company to redesign their claim strategies. At Allstate, McKinsey defined claims as a “zero-sum game,” with the policyholder and the company competing for the same dollars. Its goal was “to redefine the game . . . to . . . radically alter our whole approach to the business of claims.” Computer systems would be put in place to set the amounts policyholders would be offered, claimants would be deterred from hiring lawyers, adjusters would be rewarded for underpaying claims, and settlements would be offered on a take-it-or-litigate basis.
As a consequence, the claims department has become a profit center rather than solely the place that honors the company’s promise to pay what it owes, no more but no less. The results have been dramatic: For the property/casualty industry as a whole, the pure loss ratio—the amount paid in claims—has declined sharply; the industry pays out about a nickel less for every premium dollar compared to ten years ago and a dime less compared to twenty years ago.
The new reality of the insurance industry poses a number of challenges for the tort system. Most obviously, tort law’s compensation goal is undermined if compensation through insurance is less readily available. Beyond that, other perverse effects are possible.
For example, there may be both more litigation and less litigation.
If insurance companies are less willing to pay under liability policies at the full value of claims and more willing to contest claims through litigation, fewer claims will be settled and more brought to court. If they are less willing to honor first-party claims, insureds who are the victims of torts and might otherwise be satisfied with the benefits of their own insurance coverage may sue their injurer. And there will be more litigation about the claims practices themselves, under the rubric of bad faith.
At the same time, there may be less litigation, and less litigation in ways that challenges some of our conventional ideas about tort. One type of claim singled out by insurers and their management consultants is the minor auto accident producing soft tissue injuries, the so-called MIST case (Minor Impact, Soft Tissue). Companies over-invest in the defense of individual MIST claims in order to deter future claims, in part by changing the economics of law practice to make unprofitable the pursuit of such claims on a contingent fee. The argument is often made that the tort system tends to overcompensate small injuries and undercompensate large injuries. As MIST claims are singled out, at least half of the argument is undercut; victims of such accidents are often undercompensated.
These challenges may require some rethinking by tort scholars. Even more important is the threat posed to insurance as an institution. Insurance is the great protector of the standard of living of the American middle class. Illness, injury, and death will occur, and insurance can ease the financial burden of loss, but only when it works.
--Jay Feinman, Distinguished Professor of Law, Rutgers-Camden