Thursday, June 1, 2017

No. 220: Connecticut Violates the Constitutional Rights of Insurance Policyholders

Connecticut recently enacted a law that authorizes a Connecticut-domiciled insurance company to divide itself into two or more insurance companies. In this post I explain the reasons for my opinion that the law violates the constitutional rights of insurance policyholders.

An insurance contract creates a creditor-debtor relationship between the parties. The policyholder is the creditor and the insurance company is the debtor. Consider this loan contract analogy:
Sue borrows money by entering into a loan contract with a bank. The bank is the creditor and Sue is the debtor. Sue and her friend Jim later enter into a separate contract under which Jim agrees to take over Sue's obligations. Imagine the reaction of the bank's loan officer when she receives this letter from Sue:
"Effective immediately, my obligations to you have been taken over by Jim. You have no recourse to me in the event of Jim's failure to meet his obligations to you."
The problem is that a debtor cannot be relieved of his, her, or its obligations to a creditor without the consent of the creditor. In the case of an insurance policy, the insurance company (the debtor) cannot be relieved of its obligations to the policyholder (the creditor) without the consent of the policyholder.

If the policyholder consents, the transaction would be a "novation," in which another debtor is substituted for the original debtor. Stated differently, another insurance company is substituted for the original insurance company. Stated still differently, the obligations under an insurance policy contract are transferred from the original insurance company to another insurance company.

The two major types of consent to a novation are affirmative (positive) consent and implied (negative) consent. Affirmative consent occurs when the creditor signs a form granting permission to complete the novation. Implied consent occurs when the creditor does nothing and is deemed to have consented to the novation.

The Penn Mutual Case
In 1963 Mr. X bought a noncancellable and guaranteed renewable disability insurance policy from Penn Mutual Life Insurance Company. In the 1970s Penn Mutual stopped issuing new disability policies, but continued to administer its previously issued disability policies.

In 1986 Penn Mutual sent Mr. X a letter informing him that his disability policy had been transferred to Benefit Trust Life Insurance Company. In response to Mr. X's inquiry, a Penn Mutual official said that Benefit Trust had taken total control of the disability policies and the obligations under them, and that Penn Mutual had no further obligations under the policies. In response to my subsequent inquiry, a Penn Mutual senior officer said policyholders would have no recourse to Penn Mutual in the event of Benefit Trust's insolvency. None of the three Penn Mutual letters said anything about the need for Mr. X's consent to the transfer.

The Advisory Committee
The Penn Mutual case and other similar cases prompted me to write many articles in The Insurance Forum about policy transfers. I also volunteered to serve on an advisory committee appointed by a working group of the National Association of Insurance Commissioners (NAIC) when the regulators sought to deal with the firestorm my articles had created. I was one of nine members of the advisory committee; the other eight represented insurance companies.

All nine members of the advisory committee agreed an insurance company must obtain the consent of the policyholders in a policy transfer. Eight industry members agreed that implied consent was adequate. I disagreed, insisting that affirmative consent was essential.

The chairman of the advisory committee asked the industry members to draft a model bill or model regulation based on implied consent. The advisory committee then submitted its model to the working group. I drafted a model based on affirmative consent and submitted my model to the working group as a minority report of the advisory committee.

The Constitutional Question
When the advisory committee submitted its model based on implied consent to the chairman of the working group, he was concerned about whether such a model would survive a challenge under the U.S. Constitution. He asked the chairman of the advisory committee to obtain a legal opinion. The chairman of the advisory committee asked an attorney member of the advisory committee to write a legal opinion. Here is the final sentence of the legal opinion:
For the reasons set forth above, we are of the opinion that the implied consent provision of the proposed Model Act would withstand a challenge based upon the United States Constitution.
I asked an attorney who specializes in constitutional law to review the legal opinion that the advisory committee had obtained. He wrote a memorandum that included these two sentences:
Having carefully reviewed the [advisory committee's opinion] letter and the authorities it discusses, I do not believe that the analysis set forth in the letter is persuasive. For the reasons discussed below, it is far from clear that an implied consent provision would pass muster under either the Due Process or Contract Clauses of the Constitution.
The working group and the NAIC decided to rely on the advisory committee's legal opinion. The NAIC model, therefore, is based on implied consent. In an article in the August 1992 issue of The Insurance Forum, I showed the full text of each of the two opinion letters.

The Recent Connecticut Law
On February 16, 2017, a legislative committee held a public hearing on House Bill 7025 "authorizing domestic insurers to divide." In testimony at the hearing, the Connecticut Insurance Department (CID) endorsed the bill, saying in part:
Generally, this bill will authorize a Connecticut domestic insurer to divide into two or more resulting insurers. This type of corporate restructuring is the reverse of a merger: instead of combining two or more insurers into one, a division will divide the Connecticut domestic insurer into two or more resulting insurers... The domestic insurer is required to file the plan of division with the Insurance Commissioner and obtain approval of the plan. The Commissioner may hold a public hearing to consider the matter if it is deemed in the public interest.
At the same hearing, The Hartford Group also spoke in favor of the bill. A company official said in part:
Being able to segregate businesses would allow domestic insurers to pursue more focused management strategies tailored for individual lines of business. This bill also provides domestic insurers a practical way to segregate and sell businesses that are no longer part of their business strategy, something that Connecticut law doesn't currently provide.
A case in point: In 2012, The Hartford announced it was no longer writing certain life insurance business. Later that year, we transferred our individual life and retirement plans businesses to Prudential and Mass Mutual, respectively. However, The Hartford could not realize a full and final sale of these businesses. Instead, we used the only practical option available. We entered into reinsurance arrangements with those companies. As a result, we have ongoing obligations, administrative complexity and compliance risk associated with those businesses. The long term obligations under the reinsurance arrangements means that The Hartford will experience that complexity and risk for many years to come.
On April 5, 2017, the Connecticut House of Representatives approved the bill. On May 3, the Connecticut Senate approved the bill. On May 8, the bill became law as Public Act No. 17-2 after Connecticut Governor Dannel Malloy did not sign or veto the bill within five days. The law will take effect October 1. I am not aware of anyone testifying against the bill at the hearing, nor am I aware of any publicity about the bill.

Based on testimony at the hearing, I believe that Connecticut's division law is patterned after similar laws in Arizona, Pennsylvania, and Rhode Island. I plan to explore those laws and their origins.

The Debevoise Analysis
Debevoise & Plimpton is a law firm that represents insurance companies. On May 11, three days after the bill became law, Debevoise issued a "client update" on the new law. Debevoise said the new law
may prove to be a valuable tool for Connecticut domiciled insurance companies. It could be used to isolate a block of business for sale to a third party in a transactioon that without the statute could only be accomplished through reinsurance. It could also be used by a company to separate its active book of business from a troubled run-off block, potentially improving the capital position and credit rating of the active company.
General Observations
What Hartford failed to mention in its testimony is that the company could have asked the affected policyholders for their consent to novation of their contracts. Prudential and Mass Mutual would have taken over administration of all the contracts, and would have taken over Hartford's obligations under the contracts of policyholders who consented to the transfer of the obligations. With regard to the contracts of policyholders who did not consent to the transfer, Prudential and Mass Mutual would have continued to administer the contracts, but Hartford would have retained responsibility for the obligations under the contracts.

The "case in point" in Hartford's hearing testimony makes clear the objective of the "division law." The "reinsurance arrangements" were "assumption reinsurance agreements" under which Hartford transferred the policies to Prudential and Mass Mutual. Hartford would have been relieved of its obligations to each policyholder only with the consent of that policyholder, and would have had to retain the obligations to each policyholder who did not consent to the transfer. Because policyholder consent is not required for a "division" or for the sale of a company, Hartford is now able to place unwanted blocks of business in a second company and then sell the second company, thus transferring its obligations to all the affected policyholders without their consent.

Hartford is now permitted to write letters to their policyholders similar to Sue's letter to the bank in the loan contract analogy, and similar to Penn Mutual's 1986 letters to its disability insurance policyholders. In my opinion, the division law allows Connecticut-domiciled insurance companies to transfer their obligations without policyholder consent, and thereby to violate the constitutional rights of their policyholders.

Available Material
I am offering a complimentary 31-page PDF containing the full text of the division law (20 pages), the CID and Hartford testimony at the hearing (3 pages), the Debevoise client update (4 pages), and my article in the August 1992 issue of The Insurance Forum (4 pages). Email and ask for the June 2017 package relating to Connecticut's division law.