California Insurance Commissioner’s Authority to Regulate Insurers’ Homeowners RC Estimates

On January 23, 2017, the California Supreme Court ruled that the insurance Commissioner of that state was given the power by the legislature to specify what factors must be covered by replacement cost estimate tools used by insurers in connection with homeowners insurance. The decision is entitled Association of California Insurance Companies v. Dave Jones, As Commissioner. It is reported at 2017 Cal. LEXIS 217.

The regulation, issued by the Commissioner in 2011, was intended to combat the persistent problem in California of underinsurance. That problem cropped up starting at least in 1991 with the Oakland Hills fire and continuing into 2003 with the Southern California wildfires of that year. It came to the attention of California legislators in the course of public hearings conducted by them. The problem was not arrested by several steps taken by the legislature between 1992 and 2005 to reduce the instances where policyholders believed the amount of their homeowners’ insurance would enable them to rebuild their dwellings, and it turned out to be too little to do so. So, when large wildfires struck Southern California in 2007 and 2008, state officials realized the underinsurance problem persisted.

This routine shortfall – and its cause – was confirmed by a market conduct investigation conducted by the California Insurance Department in 2008, after brushfires in that year. The investigation disclosed that for a majority of the policies examined the coverage amounts actually duplicated what was indicated by the insurers’ own replacement cost calculators, thus focusing the department’s attention upon the accuracy of those calculators.

Based upon the evidence thus uncovered, the commissioner found that even the most careful replacement cost estimate would be misleading if it failed to consider all of the tasks necessary to repair or rebuild the subject home, including the cost of replacing the foundation, debris removal, demolition expenses and overhead and profit as well as engineering reports and architectural plans.

The findings also suggested the statutory authority for a regulation attempting to prevent insurers from misleading applicants and policyholders at the inception or renewal of coverage: The 1959 Unfair Insurance Practices Act (the “Act”). The Act regulates trade practices in the business of insurance by prohibiting those defined or determined by the commissioner to be unfair or deceptive.

Fitting comfortably within the rationale of the Unfair Insurance Practices Act, the regulation does not require an insurer to set or recommend a policy limit or to provide an estimate of the cost to rebuild or replace a home. But if the insurer chooses to advise applicants or policyholders of the replacement costs of their home, the regulation specifies what building and construction elements must be considered and communicated by the insurers. Any departure from this requirement would turn any communication of a deficient estimate into a deceptive act or practice outlawed by the Act. The regulation also requires that estimating methods be updated to reflect changes in the costs of rebuilding, including the changes in the cost of labor, building materials and supplies, and naturally that it take into account structures’ geographic location.

Shortly before the replacement cost regulation became effective, the Association of California Insurance Companies and the Personal Insurance Federation of California sued the Commissioner challenging the regulation’s validity on three grounds: They contended (1) the Commissioner lacked the authority under the act to define a new unfair or deceptive insurance practice; (2) that the regulation improperly restricted the underwriting of insurance, when the Commissioner lacked authority to regulate that aspect of the business, and (3) that the regulation violated the insurer’s right of free speech under the state and federal constitutions.

The Supreme Court rejected the first ground for invalidating the regulation, reversing the judgment of the trial court and Court of Appeal. But, because the lower courts had ruled that the Commissioner lacked authority, they had not considered the second and third grounds for invalidating the regulation. Therefore, the Supreme Court reversed the Court of Appeal’s judgment and remanded the case to the lower courts for considering the remaining challenges to the regulation.

In the process of doing so, however, the Supreme Court considered the trial court’s reasoning that a replacement cost estimate, which after all is an estimate, is always inaccurate to some degree and therefore cannot be deemed “misleading.” The Supreme Court observed that “the defect sought to be remedied by the Regulation is not the possibility that actual costs, for unforeseeable reasons, may not align with estimated costs. Rather, the Regulation seeks to reduce the possibility that an estimate would be misleading by ensuring that the estimate include all that is reasonably knowable about actual costs at the time the insurance contract is executed.”

In considering the Commissioner’s authority to issue the regulation, the Supreme Court pointed out that the purpose of the Act is to regulate insurance industry practices by defining practices constituting unfair or deceptive acts or practices, and prohibiting them. A specific portion of the Act outlawed business practices not defined specifically by the statute but which nonetheless should be ferreted out and declared to be unfair or deceptive. The Supreme Court rejected the objection of the challenging parties, who argued that by listing specific practices in the Act as unfair or misleading, the legislature impliedly found that others were not later to be found unfair or misleading. In so doing the Supreme Court said that in fact the Act specifically empowered the Commissioner to identify additional pernicious practices to prohibit, and that he or she had rulemaking authority as well. When the legislature used “open-ended” language in listing such practices, it implicates policy choices of the sort and an administrative agency is empowered to make and a court may thereby find that the legislature actually delegated the task of interpreting or elaborating on the statutory text to the administrative agency.

The court then turned to the question of whether or not the regulation was consistent with the Act, since, to be valid, a regulation must be consistent, and not conflict, with the statute it is designated to enforce, and the regulation must be reasonably necessary to effectuate the purpose of the statute. The court’s analysis of these questions, the parties agreed, depends in part on whether the regulation is best understood as quasi-legislative or interpretive. Although the court agreed that the characterization of the regulation as quasi-legislative or interpretive has an effect on the reviewing court’s analysis, some rules defy easy categorization.

Where, as here, an agency has been granted both the power to adjudicate and to promulgate rules, a court will generally defer to the agency’s choice of how to proceed in order to serve the statute passed. “A key part of the expertise of an agency brings to bear on its administrative function is its assessment of the trade-offs inherent in deciding whether to enforce a statutory mandate by way of an adjudication against the regulated entity or through a generalized rule.”

The Supreme Court found no need to decide whether the regulation’s interpretation of a misleading statement is best characterized as quasi-legislative or interpretive, since it found that even if the regulation were considered to be purely interpretive the court would conclude that the Commissioner had reasonably and properly interpreted statutory mandate.

Finally, because the Association plaintiffs leveled only a facial challenge to the regulation, its burden was to show, at the least, that a non-compliant replacement cost estimating tool would not be misleading in the vast majority of cases. The associations did not carry their burden in this regard and the court therefore rejected the facial challenge to the regulation.

What remains of the challenges to the regulation, and its fate, rest with the issues not addressed yet by the lower courts, and which the Supreme Court refrained from deciding. The rest of the story remains to be told.