Last week, I explained why insurance companies would prefer ambiguous policies over policies that provide explicit coverage for some damage, such as hurricane storm surge. This week, we explore why insurers would prefer ambiguity instead of simply excluding coverage altogether? Why not just say – “If your house is damaged by a hurricane that includes storm surge, we will pay nothing, even if 99% of the damage was caused by wind alone.”

The short answer: The insurer likes being in the position where it knows that it will never pay such claims, but where the consumers and the regulators tacitly expect payment of such claims. An explicit exclusion of coverage would signal that fact to the market and regulators, and thereby reduce the monetary value of the policy. From an economics perspective, “when information is asymmetric between the parties, the better-informed party may refrain from proposing a more complete contract because, in doing so, she may communicate private information to the other party and thereby compromise her share of the contracting surplus.”[1]

Now for the details of the argument:

A policy with ambiguous coverage is at least subjectively worth more to consumers than one which explicitly excludes valuable coverage, and the insurers hope that consumers will pay more for that ambiguity than they would pay for a policy with an explicit exclusion.[2] In essence, the insurers want consumers to think that they are getting value for money when the value is not really there.

In a similar case in the health insurance context, plaintiff’s attorney William Shernoff discovered internal documents in which an insurance company executive set the objective of moving consumers over to a new policy in which they could “reduce claims cost by 40%” while still “appear[ing] similar to [the] current plan."[3] In this case, the insurers quibbled over the meaning of “diagnostic laboratory procedures” and “prescription drugs."[4]

But what about competition in the insurance market? (Stop snickering.) Even if some insurers changed their policies to explicitly exclude some coverage, it is not clear that consumers would notice, much less migrate to other company’s policies. Empirical research suggests that consumers are not so responsive.[5] Rather, as Todd Rakoff explains,

for most consumer transactions, the close reading and comparison needed to make an intelligent choice among alternative forms seems grossly arduous. Moreover, many of the terms concern risks that in any individual transaction are unlikely to eventuate. It is notoriously difficult for most people, who lack legal advice and broad experience concerning the particular transaction type, to appraise these sorts of contingencies.[6]

For this reason, the terms of standard form contracts tend over time to get worse and worse for consumers.[7] So the consumer marketplace may not itself do much in policing insurance policies, especially given that all the companies essentially offer the same form.[8]

A more significant deterrent to adding an explicit exclusion is found in those states where the insurance commission must approve any policy before it is sold to the public.[9] In such a situation, where the insurance industry is essentially bargaining with the insurance commission, Judge Posner describes the value of ambiguity:

Deliberate ambiguity may be a necessary condition of making the contract; the parties may be unable to agree on certain points yet be content to take their chances on being able to resolve them, with or without judicial intervention, should the need arise. It is a form of compromise like ‘agreeing to disagree’.[10]

A commission may be unwilling to approve a policy with new explicit exclusions, but would tacitly approve policies that are silently ambiguous on the issue.[11] In addition to the insurance commission, mortgage bankers may also eventually object to insurance policies that are too narrowly crafted, since they ultimately bear much of the risks that the insurers refuse.

In addition to these factors that discourage companies from adding new explicit exclusions, there are also more general deterrents to changing their policies. Any change to a policy, even one that seems favorable to the insurer, reduces predictability and makes historical risk-pool data less useful, thus making prediction of claims under the new policy more difficult.[12] Moreover, insurers have a culture of cooperation from sharing standardized policies to pooling risk data, which discourages any one company from changing policy language.[13] In addition, some commentators suggest that ambiguities remain because insurers (or their regulators) do not want to make policies longer and more technical, and therefore less easy to read.[14] While true in some cases, these concerns would not seem to apply to a very predictable occurrence such as hurricane storm-surge, which could be addressed in a few words.

Altogether, there are compelling reasons why insurers choose to retain ambiguities in their policies. Can the courts possibly police this behavior? The common law offers a venerable duty of “good faith and fair dealing” which applies to all contracts. One of the earliest cases on point explains the duty:

The Lord Chief Justice identified the two most common varieties of a lapse in good faith: inducing a person to enter into a contract by making false representations or by withholding information which may be of relevance to that person in deciding whether to enter the bargain.)[15]

If the insurer intentionally withholds information that it does not intend to pay certain claims, which the consumer believes will be paid, then this would be a violation of the duty.

Proving that the insurer had such information and withheld it would require litigators to discover the insurer’s process of drafting the current language. The courts have not settled on a rule for when drafting history is discoverable, largely because such information is thought to be irrelevant in the traditional process of contract interpretation.[16]

The tort of bad-faith insurance litigation usually focuses on claims-handling procedures, rather than contract-drafting process. However, the foregoing argument suggests that punitive damages for bad-faith liability should also be applicable to the process of drafting the contracts itself.

NOTES:

 

1. George G. Triantis “The Efficiency Of Vague Contract Terms: A Response To The Schwartz-Scott Theory Of U.C.C. Article 2” 62 La. L. Rev. 1065, 1071 (2002). On this general concept that contract language can send signals to other parties see, Franklin Allen & Douglas Gale, “Measurement Distortion and Missing Contingencies in Optimal Contracts”, 2 Economic Theory 1 (1992) and Kathryn E. Spier, “Incomplete Contracts and Signaling”, 23 Rand. J. Econ. 432 (1992).

2. It may also be objectively more valuable if there is a real chance of collecting at least something on a claim under an ambiguous term. The chance of something is better than a guarantee of nothing.

3. William Shernoff, Payment Refused, NY: Richardson & Steirman, 1986 at 74.

4. Id.

5. See generally, Jeffrey E. Thomas, “An Interdisciplinary Critique Of The Reasonable Expectations Doctrine” 5 Conn. Ins. L.J. 295.

6. Todd D. Rakoff, (1996) “Contracts Of Adhesion: An Essay In Reconstruction”, 96 Harvard L. R. 1173 at 1226-27. (He continues: “Customers do shop some terms, but within a limited compass. That compass is defined largely by immediacy of impact (cash or credit), by ease of comparability (size of downpayment), and, to a certain extent, by the customs and practices of the trade (warranty terms in some industries at some times). As the last example indicates, businesses can and occasionally do undertake to combat otherwise-rational consumer apathy in order to "sell"' new form terms. This is an expensive proposition, however, because the firm must both underwrite the additional risks comprehended by the new term and bear the cost of stimulating shopping behavior. At times, special business needs will make the expense worthwhile. Ordinarily, it is preferable to compete in regard to terms that already engage the customers' attention - most notably price.)

7. Id. (“The predictable consequence is that over time more and more risks are shifted to the adhering party.”)

8. See Appleman on Insurance 2d at §2.2 (“Competition among insurers is a significant factor influencing uniformity, if not standardization, among the coverage terms employed by insurers. An unusual policy form or coverage provision … is likely to be imitated by other insurers.”)

9. See Gulf Ins. Co. v. Neel-Schaffer, Inc. 904 So.2d 1036 (Miss., 2004) (“We again emphasize that the Mississippi Code provides a specific statutory mechanism for the Commissioner to disapprove a policy form currently in effect.”)

10. Richard Posner. “The Law and Economics of Contract Interpretation” 83 Tex. L. Rev. 1581, 1583 (2005).

11. See also Michael Rappaport “The Ambiguity Rule and Insurance Law: Why Insurance Contracts Should Not Be Construed Against the Drafter” 30 Ga. L. Rev. 171 (1995) at n50 (“There are … many limits on the ability of insurers to redraft ambiguous language. Insurance contracts must be filed with state regulators in most states, and some states may prohibit the intended changes.”)

12. Continental Casualty Co. v. Pittsburgh Corning Corp., 917 F.2d 297, 299 (7th Cir. 1990)” "[I]nsurance companies are very reluctant to change terminology whose meaning has been fixed in litigation or approved by the state agencies that regulate insurance.") See also Appleman on Insurance 2d at §2.2. Nonetheless insurance companies’ did change policy language in order to better specify how concurrent causes would be treated. Stephen P. Groves, “There She Blows! Is it Wind or Water Damage? Experiences in Hugo and Andrew” in Property Insurance Issues in Catastrophe Losses, Pamela Levin, Ed. ABA (1996) at 66.

13. See Appleman on Insurance 2d at §2.2 (D) (describing the Insurance Services Office, which prepares the vast majority of standard form policies).

14. Rappaport supra note 11 at 208-209; Harnischfeger Corp. v. Harbor Ins. Co., 927 F.2d 974, 976 (7th Cir. 1991) (“Drafters cannot anticipate all possible interactions of fact and text, and if they could the attempt to cope with them in advance would leave behind a contract more like a federal procurement manual than like a traditional insurance policy. Insureds would not be made better off in the process. The resulting contract would be not only incomprehensible but also more expensive.”) The views are substantially echoed by James M. Fischer, “Why Are Insurance Contracts Subject to Special Rules of Interpretation?: Text Versus Context” 24 Ariz. St. L.J. 995, at 999.

15. Peter Eggers et al, Good Faith and Insurance Contracts 2d, London: LLP at 1 (2004) (emphasis added, citing Carter v Boehm (1766) 3 Burr 1905, 1910; 97 ER 1162, 1164.

16. See Barbara O'Donnell, Law and Practice of Insurance Coverage Litigation, LPINLIT § 1:15.