In 2009, several courts considered whether state laws that bar discretionary clauses in plan provisions governing the administration of benefit claims were preempted by the Employee Retirement Income Security Act of 1974 (“ERISA”) and, if so, whether they were saved from preemption by virtue of ERISA’s savings clause. This article examines these decisions, and considers the impact they may have on plan sponsors and plan fiduciaries.
Two decades ago, the U.S. Supreme Court, in Firestone Tire & Rubber Co. v. Bruch, 489 U.S. 101 (1989), held that reviewing courts should apply a de novo standard of review to plan fiduciaries’ decisions unless the benefit plan provides the fiduciary with discretionary authority to determine eligibility for benefits or construe the terms of the plan — a “discretionary clause” — in which case the decision should be reviewed for an abuse of discretion, i.e., under an arbitrary and capricious standard of review.
Since Firestone, discretionary clauses have become commonplace in ERISA plans. The frequency in which such clauses are used has, however, generated debate on whether or not they are, in fact, beneficial. On the one hand, many state insurance regulators argue that a ban on discretionary clauses eliminates unfairness and misleading policy language, and also minimizes the conflicts of interest that exist when the claims adjudicator also pays the benefit. In fact, in 2002, the National Association of Insurance Commissioners (“NAIC”) adopted the “Prohibition on the Use of Discretionary Clauses Model Act” (the “Act”). The Act broadly disapproves of any proposed insurance form containing a discretionary clause, typically defined as any clause that: (i) provides an insurer with sole discretionary authority to determine eligibility for benefits under, or interpret the terms and provisions of, an insurance policy; and (ii) purports to give the insurer’s determination or interpretation binding effect as to the policy holder. The prohibition has been applied to life, disability, health, and long-term care policies purchased as part of a benefits plan established and maintained under ERISA. It appears that the Act was purposefully designed to reach insured ERISA plans. In an effort to curb the use of such clauses, many states have implemented the Act’s provisions in one form or another, and several insurance commissioners have unilaterally refused to approve discretionary clauses. Supporters of the use of discretionary clauses, however, contend that such clauses keep costs manageable, and that the failure to control litigation costs will discourage employers from offering employee benefit programs in the first place.
The debate over the use of discretionary clauses has, unsurprisingly, led to litigation. Plan sponsors and fiduciaries have challenged several state laws on the grounds that they are preempted by ERISA. The starting point for any ERISA preemption analysis is Section 514 of ERISA, 29 U.S.C. § 1144, which states that ERISA expressly preempts all state laws “insofar as they may now or hereafter relate to any employee benefit plan.” 29 U.S.C. § 1144(a). The only exception, known as the “savings clause,” is for laws that “regulate insurance, banking, and securities.” 29 U.S.C. § 1144(b)(2)(A).
There generally is no dispute that the state laws barring the use of discretionary clauses relate to an ERISA plan. The issue before the courts has been whether these state laws regulate insurance within the meaning of Section 514(b)(2)(A), which is determined by reference to the test set forth in Kentucky Ass’n of Health Plans v. Miller, 538 U.S. 329, 342 (2003). In Miller, the Supreme Court held that a law regulates insurance if it: (i) is “specifically directed toward entities engaged in insurance,” and (ii) “substantially affect[s] the risk pooling arrangement between the insurer and the insured.”
The U.S. Circuit Court of Appeals for the Sixth Circuit was the first circuit court to address the preemption issue. In American Council of Life Insurers v. Ross, 558 F.3d 600, 46 EB Cases 1385 (6th Cir. Mar. 18, 2009), several national trade associations (the “Industry”) representing health plans, health insurers and life insurers that conduct business in Michigan sought a declaratory judgment that Michigan’s ban on discretionary clauses did not apply to the administration and enforcement of ERISA plans. The Sixth Circuit concluded that a state law ban on discretionary clauses was saved from preemption. In so holding, the court rejected the Industry’s argument that the Michigan ban was not directed at regulating insurance because the regulation’s effects were felt primarily by plan fiduciaries, not insurers. Relying on Miller, the court reasoned that “regulations directed towards certain entities that also happen to disable other entities from engaging in the regulated behavior will not remove such regulations from the scope of ERISA’s savings clause.” Next, the court held that the Michigan ban substantially affected the risk-pooling arrangement between insureds and insurers because the ban: (i) directly dictated which policy terms were prohibited; and (ii) eliminated plan administrators’ “unfettered discretion” in making benefits determinations. The Sixth Circuit also rejected the Industry’s argument that the ban did not affect the risk-pooling arrangement between insureds and insurers because the ban only had an impact after the risk had been transferred (i.e., the state law had no impact until after the risk already was transferred to the insured), since the Supreme Court had not inquired into the timing of the substantial effect on the risk-pooling arrangement in prior decisions. Finally, the court concluded that the Michigan ban did not create any alternative remedies to ERISA and did not conflict with ERISA’s goal of establishing uniform standards for adjudicating benefits claims; there was no state law at issue that implicated ERISA’s civil enforcement scheme or any rule that authorized any relief in state court.
A few months later, in McClenahan v. Metro. Life Ins. Co., 621 F. Supp. 2d 1135, 46 EB Cases 2408 (D. Colo. May 7, 2009), a district court ruled that a Colorado statute that prohibited discretionary clauses was saved from preemption. Here too, the court relied on Miller and concluded that “enforcement of the Colorado statute would dictate ‘to the insurance company the conditions under which it must pay for the risk it has assumed.’” In so ruling, the court rejected MetLife’s argument that the statute conflicted with ERISA insofar as it would preclude application of the arbitrary and capricious standard of review in all Colorado ERISA cases. Relying on the Supreme Court’s decision in Rush Prudential HMO, Inc. v. Moran, 536 U.S. 355 (2002), the court concluded that ERISA itself provides nothing about the standard of review and thus the statute did not conflict with ERISA.
The Ninth Circuit, in Standard Insurance Co. v. Morrison, 584 F.3d 837, 47 EB Cases 2697 (9th Cir. Oct. 27, 2009), followed the reasoning of Ross and concluded that a Montana state law prohibiting any insurance contract from containing a discretionary clause was saved from preemption. In addition to rejecting many of the same arguments advanced by the Industry in Ross, the Ninth Circuit rejected Standard’s argument that the ban is not specifically directed at insurers because it was nothing more than an attempt to apply the common law rule that ambiguous contract terms are interpreted against their drafters. While finding that the ban achieves some of the same ends as the common law contra proferentem rule, the court observed that the commissioner did not require approval of most contracts and its requirement that insurance forms be approved is an expression of its special solicitude for insurance consumers. Because Montana insureds may no longer agree to a discretionary clause in exchange for a more affordable premium, the court concluded that the scope of permissible bargains between insurers and insureds had been narrowed. In other words, the ban on discretionary clauses “dictates to the insurance company the conditions under which it must pay for the risk it has assumed.”
On different facts, the Tenth Circuit reached a different conclusion in Hancock v. Metropolitan Life Insurance Co., 2009 WL 5103121 (10th Cir. Dec. 29, 2009). In Hancock, the court concluded that Utah’s rule, which authorized discretion-granting clauses as long as they disclose certain matters and conform to the rule’s font requirement, was preempted by ERISA. Because the rule related to the form, and not the substance, of ERISA plans and thus did not remove the option of insurer discretion from the scope of permissible insurance bargains in ERISA plans, it had no impact on risk-pooling and was therefore not within ERISA’s savings clause. On that basis, the Tenth Circuit found Utah’s rule distinguishable from the state bans on discretionary clauses in Ross and Standard Insurance.
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The courts’ willingness to enforce state bans of discretionary clauses will increase the incentive to move to self-funded plans for employers large enough to undertake this risk. Since ERISA § 514(b)(2)(B) exempts self-insured plans from insurance regulation, a self-funded format will permit larger plan sponsors to continue using discretionary clauses as a means to control the scope of the benefits to be provided. Smaller employers may, however, be forced into an unappetizing choice of paying higher premiums or terminating employee-benefit programs they can no longer afford.