Economic and Behavioral Distortions, and How Insurance and ERISA Law Cope With Them

One of the problems that insurers, and insurance law, have to confront is the distortion in behavior, economic and otherwise, that insurance can create. Insurance coverage law deals with this problem in a number of ways, such as by means of the known loss doctrine, which - although the specifics of its application vary from jurisdiction to jurisdiction - essentially holds that a person cannot insure against an expected, existing or highly probable loss. As such, it prevents an insured company or individual from insuring against something the company or the person intends to do and knows is likely to cause harm. One can think of the known loss doctrine in this context as protecting against people undertaking harmful activities that they would not otherwise have done if they did not think they could insure themselves against the consequences.

We can also understand the various treatments given by the courts of different states to the question of whether a punitive damages award against an insured is insurable as being part of the same thought process. . . .

If one believes that a company is more likely to engage in the type of extremely harmful conduct that can give rise to punitive damages if a punitive damages award is covered by insurance and thus not actually paid by the wrongdoer, then it makes sense to declare punitive damages uninsurable. This removes any distorting effect on the motives of the potential wrongdoer that flows from having insurance for the potential punitive damages award that could arise from the company’s conduct. If, on the other hand, one does not believe that being able to insure against a punitive damages award affects the likelihood of the insured company committing such egregious acts, then the risk of distorting an actor’s conduct is not one that warrants declaring punitive damages to be uninsurable (there may, however, still be other reasons for declaring punitive damages to be uninsurable, such as a simple desire to directly punish the wrongdoer).

Insurance companies likewise deal with these types of problems of distortion as best they can, often by writing terms into the policy that defeat coverage if the insured knew or should have known when it engaged in the conduct giving rise to the loss that harm was likely to occur. Such a provision makes sure that the insured’s knowledge that it is insured against any harm it causes does not become a distorting factor in the insured's thought process when it decides whether or not to engage in the conduct at issue.

Interestingly, the law of ERISA as it has continued to be developed by the courts confronts and must deal with the same type of questions. In cases involving claims for benefits governed by ERISA that were denied by an administrator, courts are often confronted with situations in which the administrator that denied the claim for benefits is also the party that would have had to pay the benefits if the claim for benefits had been allowed. Theoretically, in that situation, the administrator could benefit from denying the benefits, and, if so, the question arises as to whether the administrator's decision making was distorted by this fact. As a result, the courts have had to establish rules for when this situation constitutes a conflict of interest on the part of the administrator, and when - and how - it should affect a court’s review of the denial of the claim for benefits. Courts in different circuits have reached different conclusions on this issue.

What brings this issue to mind at this time is a post on the Insurance Coverage Blog this week about a distortion in the market for homeowners insurance in Massachusetts. As David Rossmiller notes in his post:

the Massachusetts Fair Plan, the state's involuntary "insurer of last resort," has become the most popular insurer in parts of the state like Cape Cod, because the premium increases it intends to impose are much lower than the market rate.

This is apparently driven by the fact that the reinsurers for the open market carriers are raising their rates, which are driving up the cost of homeowners insurance in areas potentially exposed to hurricane and similar risks.

The Insurance Journal article from which David dug out this interesting bit of information goes on to point out that:

The biggest increases are in store for coastal Cape Cod, where the Fair Plan has become the leading property insurer rather than the insurer of last resort as intended. For Cape homes, it has filed for an average 25 percent hike, although its actuaries maintain that experience supports as much as a 68 percent increase.
The Fair Plan is not the only property insurer grappling with hurricane models and reinsurance costs. These same forces are also driving private insurers to exit markets and raise rates, making the Fair Plan the most affordable and often only option for many Cape Cod and other coastal homeowners.

Can there possibly be a better example of an economic distortion caused by insurance and the structure of the industry than this? An entity, the FAIR plan, created to protect people who cannot get insurance on the open market is instead used to subvert free market pricing.

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