The Hidden Conflict: The Secret Insurers Don’t Tell Insureds

Article written by Michael Childress.
Presented as a speech at Rutgers Law’s Fragmented Risk Conference March 1, 2013.

I. Introduction

The insurance industry operated for centuries under certain fundamental principles. An insured, looking to minimize its own risk, looks to purchase an insurance policy.  The insurer issues the policy and remains profitable by spreading risks over as large a population as possible.  In the event of a loss, the insurer and insured give effect to the policy terms.

In recent years, however, insurers have employed a cornucopia of cost saving tactics that have turned this elementary understanding of the insurance process on its head.  Brokers work to benefit the insurance industry while insurers analyze risk only after issuing policies and shift that risk back onto the insureds.  The supposed camaraderie and commonality of interest touted by insurers gives way to an increasingly adversarial process that treats the insured as a foe.

Following a loss, insurers lowball and coerce vulnerable insureds into signing releases and waivers.  Insurers cry wolf following a natural disaster and claim that bankruptcy is inevitable if they are compelled to pay claims on a large scale.

Highlighted by recent natural catastrophes such as Superstorm Sandy and the series of Christchurch, New Zealand earthquakes, the insurance industry is in desperate need of reform.  Governments across the world have attempted to step in and provide relief for the insureds, and individual states in the U.S. have promulgated statutes aimed at disincentivizing such insurer conduct.  These answers have been met with varying success.

II. Disaster Background

Natural disasters are occurring with increased frequency.  900 natural catastrophes caused $160 billion in overall loss worldwide in 2012,[1] and 2011 saw 820 catastrophes cause $400 billion in overall loss.  Compared to the 30 year average, which included 650 events and $115 billion in overall loss, natural disasters have also become more destructive.[2] Eight of the ten costliest natural catastrophes since 1950 occurred in 2004 or later and none occurred prior to 1992.[3] Violent hurricanes continue to hit the United States, New Zealand has suffered a series of earthquakes, and Australia has experienced  bushfires spanning five states,[4] a “major flood crisis” in Queensland,[5] and a cyclone.[6]

And yet the insurance industry is thriving.  Insurance premiums represented 8.1% of the United States’ GDP in 2011.[7] The first three quarters of 2012[8] saw U.S. property and casualty insurers enjoy a dramatic post tax net income increase, rising 221.7 percent to $27 billion.[9] Over the same period insurers’ underwriting losses tumbled 81% to $6.7 billion, while premiums grew 4.2 percent.[10] Australian insurers earned $21.21 billion and averaged a net loss ratio of 65.66% in the first three quarters of 2012.[11] Between July 2011 and June 2012, Australian homeowner insurers received $66 million in premiums and paid only $29 million in claims.[12] New Zealand insurers had loss ratios of 55.65% and 62.30% for material damage and business interruption policies and domestic buildings and contents policies, respectively.[13] The parent company of Vero Insurance, one of the biggest property insurers in Australia and New Zealand, saw its stock outperform the ASX 200[14] index “despite five years of disaster recoveries.”[15]

III. Insurance Background

The concept of insurance is not new or novel.  In ancient times, farmers of China sent their crops to market on boats. Inevitably, on occasion a boat sank along the way. The farmers began spreading their crops among numerous boats, so that if one boat sank, any one family would only lose a small portion of their crops, thus avoiding financial devastation. The loss was spread among many families, and was therefore manageable for each one.[16]

Actual insurance contracts originated in the 13th century with ship owners who wanted to protect themselves against the possibility of catastrophic losses. As before, ships were inevitably lost at sea from time to time. The owners were aware of this, but they could not foresee which ships would be lost at what time. Wealthy individuals agreed to receive a certain amount of money from each ship owner in exchange for a promise to pay for the loss of a ship when it occurred. Insurance is, in actuality, a social vehicle for spreading the risk of financial loss among a large group of people, thus making a loss manageable for any one person of that group.[17]

The purpose of insurance is to restore the insured to their original financial position. Over the years, its basic premise remains unchanged: to spread risk, thus making loss, when it occurs, manageable.[18] Moreover, the purpose of the Unfair Claims Settlement Practices Model Act (1972) is to set forth standards for the investigation and disposition of claims. This Act requires insurance companies to promptly investigate claims and settle claims in good faith by effectuating prompt, fair and equitable settlement of claims submitted in which liability has become reasonably clear.[19]

IV. Tactics Employed by Insurers to Deny or Minimize Claims: Hidden Conflicts

A. Broker Underwriting Interference

Insureds often have no contact with the entity actually providing insurance, but instead exclusively meet with insurance brokers or agents.  As such, the broker and not the insurer explains what the policy includes and excludes and deals with the insured in the event of a loss.  These brokers furthermore act under the guise of being a friend to the insured; the insured is lead to believe that the broker acts in the insured’s best interest, finds the best coverage, and stands up to the insurer.  Unbeknownst to the insured, however, the insurer spares no effort or expense in turning a broker into its own surrogate.[20]

Conflicts of interest manifest themselves in a variety of circumstances and at various times throughout the insurance process.  A common representation to an insured comes as the broker promises to scour the globe searching for the most comprehensive coverage at the most reasonable price.  What the insured does not know, however, is that insurers send more attractive brokers – those that minimize claims and costs – on lavish vacations in return for the broker’s client list and loyalty.[21] Faced with such added perks, brokers often only refer the insured to one or two choice insurers.

Insurers also achieve broker loyalty by basing the broker’s compensation on the insurer’s loss ratio.  In essence, insurers base brokers’ compensation not only on the number of clients provided but also on the amount the insurer pays out in claims; the more the insurer pays the insured, the less the insurer pays the broker.  Such payment schemes naturally result in a strong incentive for brokers to act in their own self interest and keep claims and payments down and premiums up.

When a loss occurs, the brokers or agents are the first line of defense against claims.  Notice of a claim must be given to the broker.  The brokers will, at that point, give an opinion of coverage or worthiness of the claim.  Fear of increased premiums, cancellation or inability to find cover, is often suggested.  The value of loss is minimized prior to and without any investigation of the visible damage let alone evaluation of any hidden damage.  Policyholders are encouraged to walk away.

This is all the more true after a wide spread disaster.  Many disasters include some type of water damage.  Water damage is often a covered and uncovered peril depending on the source.  This creates uncertainty and doubt about coverage which is seized on to create doubt about whether to proceed with a claim at all.

B. Post Loss Underwriting

In an ideal world, premiums and coverage are based on risk factors.  Before issuing an insurance policy, an underwriter or agent examines the property’s potential for loss and issues a policy with premiums based on the potential for loss.  However, through a process known as post-loss underwriting, insurers insure a building without first examining its risk factors.[22] The insurer quietly collects premiums and permits the insured to operate under the assumption that the property is sufficiently insured.  In the insured’s mind, any property defect would have been raised by the insurer or broker and attended to in the policy.  However, in such a situation it is only after a loss occurs that the insurer finally gets around to analyzing the risk, at which point the insurer knows precisely what it has to exclude.  The insurer can point to a perceived construction defect as the sole cause of the damage and deny the insured’s claim, despite the defect having existed well before the insurer issued the policy.  The insured could have taken appropriate action had it known at the outset that its property suffered from a construction defect, yet post loss underwriting’s tendency to lull the insured into a false sense of confidence often prevents the insured from becoming so informed.[23]

C. Claims Handling Practices: Shifting Risk Back onto the Insured

An insurer has but two basic obligations.  First, the insurer must provide services, the least of which encompasses conducting a reasonable investigation following a loss.  Second, the insurer must pay claims pursuant to the policy.  And yet, with increasing frequency insurers are conducting superficial investigations or forcing the insured to bear the cost of the investigation, whether directly (by demanding the insured pay the costs) or indirectly (through “broad information requests propounded upon the insured as part of a ‘claims’ investigation”[24]).

1. Running and Gunning

Following a publicized calamity such as a hurricane or earthquake, insurance companies are eager to acquire some positive media coverage.  After all, video of newly-homeless hurricane victims whose insurer refuses to pay a claim can hardly be good for business.  Insurers attempt to avoid this negative PR by engaging in a practice known as “running and gunning,” under which an unqualified adjuster slaps a Band-Aid on the damage and is never seen again.

Large scale natural disasters cause insurers to suffer somewhat understandable headaches.  Hundreds if not thousands of insureds become effectively homeless overnight and the insurer needs to send claims adjusters en masse to examine the affected properties.  The demand for qualified adjusters quickly eclipses the supply, and in their haste insurers send anyone into the field that can simultaneously walk and chew gum.  These individuals come from all walks of life and lack any formal training, yet are entrusted to assess intricate damage done to properties.  Furthermore, these adjusters’ salaries are commensurate with the number of properties examined and not the quality of work, making a methodical investigation all the less likely.

It is in this context that “adjusters” visit properties in the aftermath of a hurricane, conduct a quick and dirty investigation, and give a token check to the insured on the spot.  Video of an insured receiving a $5,000 check five days after a hurricane surely creates great publicity for the insurer, but the cameramen eventually leave and fail to record the adjuster never returning to the property.  Instead, the insurer’s claims department simply pays – or refuses to pay – the insured based on photos taken by the unqualified adjuster.

Such practices seem to fly in the face of various state Unfair Claims Practices Acts, which prohibit an insurance company from failing to adopt reasonable standards for the prompt investigation of claims and from refusing to pay a claim without first conducting a reasonable investigation.[25] These Acts have regrettably produced little effect on running and gunning, which continues unabated after every natural disaster.

2. Reinterpreting the terms after the fact

Most individuals purchasing property insurance are not experts and acquire insurance under the assumption that they will be covered if a flood or hurricane damages their property.  Insurers add to this belief by erecting barriers to the insured’s ability to examine the policy prior to issuance[26] and by including policy language subject to incredible interpretation.  As such, although an insured does not expect its insurer to contest a claim arising from water damage, the insurer can point to a provision distinguishing among various types of water damage, reinterpret the provision any way it so chooses, and deny the claim.

3. Limiting risk through underpayment and releases

One of the most effective tactics employed by insurers is also among the simplest: underpay the insured.  Following a natural disaster the insured’s property is often severely damaged or destroyed.  As a result, the insured is vulnerable and desperate to receive some payment in order to afford temporary housing or prevent its business from going under.  The insurer, acutely aware of the insured’s precarious situation, quickly offers a meager payment that will only cover a fraction of the cost to repair or replace the property.  The insured, already exposed and facing a lengthy court battle, reluctantly accepts this lowball offer.

Many insurers are not content to stop after receiving such a bargain.  Instead, the insurer will often make this payment contingent on the insured signing a document that categorizes the payment as the full and final settlement and releases all future claims the insured might have under the policy.  The insurer accomplishes this feat without providing separate consideration for this gratuitous release and despite the fact that the policy does not require a release in exchange for a claim payment.  In essence, then, the insured releases its rights without receiving consideration in order to obtain performance to which it is already entitled.  The insured’s need for immediate funds to house his family or keep her business afloat thus results in the insured receiving pennies on the dollar and being unable to properly repair its property.

Underpayment occurs with alarming frequency.  In 2007, the ten largest insurers in the United States paid out in benefits only about half the money they received in premiums.[27] Underpayments are also becoming more prevalent, as payouts from property and casualty insurers decreased from 67 cents for every premium dollar in 1987 to 53 cents per dollar in 2006.[28]

D. Using the law and the system to the fullest extent possible and thereby punishing the claimholder

Many insurance companies came to view claims procedures from the 1970s and 80s as undisciplined and overly reliant on an individual adjuster’s discretion.  Believing that these practices resulted in consistent overpayment of claims, insurers renewed their focus on the bottom line, standardized practices and removed any semblance of discretion.  This had the immediate effect of creating a new breed of adjustors who deny claims as a matter of right and, despite lacking a law license, interpret policies to exclude coverage.

Adjusters were not the only professionals to experience the ramifications of this profit-driven strategy, as it eventually came to affect the insurer’s attorneys.  Although insurers tend to express no reservations with litigating claims into oblivion, pursuant to this redeveloped strategy insurers now examine their attorneys’ billable hours with increased scrutiny.  The attorneys in turn are forced to find new ways to create revenue, and often end up taking unprincipled stands in court in order to prevent an early disposition of the case.  Every motion is contested, requests for production go unheeded, and interrogatories are met with objections or left unanswered.  As a result, settlements today are few and far between and previously routine coverage disputes now wind up in protracted litigation.

This increasingly adversarial process is further aggravated by an unexpected culprit: tort reform.  The reduction of available damages in tort in the 1980s caused an exodus of litigators away from the tort world and into to the contract world.  Little cordiality ever existed in tort litigation, so when these attorneys began litigating contract claims what little congeniality was left disappeared.

As a result, what used to be a levelheaded process has deteriorated to the point where insurers view their insureds with the utmost contempt.  Insureds can no longer expect a straightforward or fair clams adjusting process and instead must prepare to meet heavy resistance at every step.

Uniformly, adjusters and experts for insurance companies limit their investigations to visible damage.  This leads the insured to believe there is no further damage.  The results of hidden damage often manifest long after the claim is closed and the policyholder has no further remedy.  The fact is most policyholders never know the true value of their losses or what they are really owed.

E. Schemes of Arrangement

Perhaps the most facially persuasive argument insurers make in the wake of a catastrophe is that they simply cannot afford to pay all the claims.  The insurers point to the swath of devastation incurred, shrug their shoulders, and claim that paying every claim would render them bankrupt and subsequently cause thousands of insureds to lose coverage.  Insurers made these claims after Hurricane Katrina and the New Zealand earthquakes, and likely will make these claims following Superstorm Sandy.  Insurers have found general success in this regard, as governments effectively bail out insurers and reduce consumer protections[29] while insureds accept reduced payments.  Similarly, insurers use these catastrophes as grounds for raising premiums, which increased an average of 30% in New Zealand following the series of earthquakes.[30]

If these claims were accurate, they would indeed be compelling.  However, in reality insurers are “paying out lower claims, charging consumers higher premiums, reaping greater profits, and are more financially solid than at any other time in history.”[31] The stability of property and casualty insurers following a catastrophe is perhaps best demonstrated by U.S. insurers’ financial conditions post Hurricane Katrina.  A straightforward indicator of how much an insurer pays in claims is the pure loss ratio, which compares total losses incurred in claims plus adjustment expenses with total premiums earned.  If an insurance company pays $75 in claims for every $100 collected in premiums, for example, the loss ratio is 75%.  Accordingly, lower loss ratios represent higher earnings for insurers.  The following chart represents U.S. property and casualty insurers’ pure loss ratios from 2000 to 2006:

The pre-Katrina ratio average is 67%, yet the years including and following Katrina see the ratio dwindle to 61.5% and 53.3%.  Similarly, 2006 was the property and casualty insurance industry’s best year since 1988.[33] Property and casualty insurers had a $600 billion surplus in 2006-07, while Hurricane Katrina resulted in $28.6 billion in damages after taxes.[34] The net premiums written to surplus ratio provides further insight.  The insurance industry over time has varied in expressing what it considers a prudent ratio, with most experts comfortable with ratios under 1.5 to 1 (1.5) or 3 to 1 (3). Property and casualty insurers’ ratio was 0.8 in 2005 and 0.7 in 2006.[35] Simply stated, the insurance industry became more profitable following Katrina, and reports of financial calamity are grossly misleading.

A more contemporary example can be found in insurer Ansvar’s conduct following the series of earthquakes that hit Chirstchurch, New Zealand in 2010 and 2011.  Ansvar, which subsequently changed its name to ACS (NZ) Ltd, insured churches and historic buildings throughout Christchurch.[36] Following the earthquakes, Ansvar pursued a unique strategy of officially claiming solvency yet planted seeds of doubt by withdrawing from New Zealand,[37] cancelling all insurance policies, threatening higher premiums[38] and asking insureds to agree to a contingency plan in the event of insolvency [39] (in turn causing the New Zealand Reserve Bank to voice concerns over the fairness to insureds who take longer to settle claims[40]).  Ansvar’s CEO even went so far as to suggest that those who settle their claims early – before Ansvar becomes insolvent – would receive a larger settlement.[41] Feeling this pressure exerted by Ansvar,  many insureds scrambled to settle and opted to receive a discounted claim rather than “risk” getting nothing at all.[42] Ansvar, perhaps unsurprisingly, remains solvent to this day.

V. Solutions

A. Government Answers

1. New Zealand: Earthquake Commission

Well before the Canterbury earthquakes of 2010 and 2011, New Zealand enacted the Earthquake Commission Act 1993.[43] Following a natural disaster, the Act provides monetary relief for damage to residential buildings and personal property for individuals who already have insurance.[44] Although the Act has eased tension on some New Zealand insureds, others are left exasperated with the process[45] and the cost weighs heavily on the state.  The Earthquake Commission paid over $4.1 billion as of January 2013,[46] the state’s reinsurance premiums more than tripled in the earthquake’s aftermath, and the EQC has suggested that private insurers have attempted to shift costs onto the state.[47] Furthermore, the EQC’s efforts have not ameliorated the ills inherent in the property insurance industry, as fewer than 300 houses were estimated to have been replaced in 2012, insurance payouts moved at a “sluggish” pace,[48] and a 2012 survey reported that 80% of respondents experienced delay in rebuilding and many worried about “the death of elderly property owners exhausted by perceived dishonesty, dubious tactics and double-dealing on the part of both EQC and insurers.”[49]

2. Australia: Financial Ombudsman Service

The Financial Ombudsman Service was established in 2008 in order to resolve disputes between consumers and financial service providers such as insurers.  If an insured believes its insurer underpaid or wrongfully denied its claim, the insured can lodge a dispute with the FOS.  If the insurer and insured are unable to resolve the dispute directly, the FOS resolves the dispute through negotiation and conciliation;[50] if the parties still have not reached an agreement, FOS will issue a determination that reads like an informal court opinion.[51]

Home building and contents insurance disputes constituted slightly over 10% of all disputes in 2011-12. [52] A majority of the disputes in this arena arose from insurers denying claims, making lowball offers or delaying the handling of claims.[53] However, the FOS has received an influx of natural disaster related claims since 2010, which has in turn delayed the processing of non disaster related claims.[54] FOS resolved approximately 70% of the 1,772 accepted natural disaster disputes over an 18 month period from 2011 to 2012.[55]

B. Washington Insurance Fair Conduct Act: Five Years Later

Perhaps recognizing the difficulties insureds face in dealing with property insurers, state legislatures have promulgated statutes aimed at punishing and preventing improper insurer conduct.  In 2007 Washington passed perhaps the most comprehensive of these statutes,[56] despite the insurance industry spending millions of dollars to force a referendum.[57] The statute forbids insurers from engaging in “unfair methods of competition” or “unfair or deceptive acts,” and prohibits an insurer from “unreasonably deny[ing] a claim for coverage or payment of benefits to any first party claimant.”[58] An insurer that unreasonably denies a claim is liable for actual damages and attorneys’ fees and litigation costs, and may be further liable for treble damages.[59] This approach has been generally received as a more effective method to deter insurer misconduct.[60]

Has this been effective to balance the playing field?  Time will tell.

VI. Conclusion

Property insurers continue to exceed profit expectations despite natural disasters increasing in both number and destruction.  Although common sense dictates that property insurers should struggle in a disaster’s wake, insurers have avoided paying claims through developing techniques that are sometimes subtle, sometimes obvious, and always novel.  Having lived through a hurricane or earthquake, insureds are often ill-equipped to properly handle these tactics, and insurers – despite state efforts at curbing such behavior – walk away unscathed.