Avoiding ERISA under disability insurance contracts.

• Author: Winkles, D. Frank

As its name implies, the Employee Retirement Income Security Act of 1974 (ERISA) (1) was enacted for the primary purpose of protecting employees' rights under pension plans established by their employers. Like many laws, ERISA contains "add-on" provisions that extend its reach beyond its stated purpose. The most important of these is ERISA's inclusion of "employee welfare benefit plans," which extends its coverage beyond pension plans to any employer-sponsored plan that provides life, health, disability, or other insurance coverage to employees. Such benefits are usually provided through group insurance policies paid in whole or part by the employer.

In order to subject the provision of covered benefits to a single uniform regulatory scheme, ERISA preempts or supersedes any state laws that "relate to any employee benefit plan" covered by the act. (2) The courts have consistently ruled that ERISA preemption applies not only to state laws governing the formation and operation of such plans but also to state laws regulating the conduct of insurance companies in handling claims for benefits under policies provided through such plans, as well as state common law remedies applicable to improper claim handling, to the extent they apply to policies provided under ERISA plans. Pilot Life Insurance Co. v. Dedeaux, 481 U.S. 41 (1987). Preemption of state claim handling law applies notwithstanding ERISA's saving clause, (3) which exempts from preemption any state laws "regulat[ing] insurance." (4) Consequently, ERISA has had a major unintended impact on state laws regulating insurance claim practices, and on the remedies available to an employee whose insurer has denied a claim under a policy provided by his or her employer.

Insurance companies were quick to note that the remedies available to an employee for wrongful denial of ERISA plan benefits are far more restrictive and limited than are the remedies available under state law to insureds whose insurers have wrongfully denied their claims for policy benefits. There is no right to a jury trial under ERISA, because the ERISA action to recover plan benefits is equitable rather than legal. (5) In addition, there is no right to recover punitive or other extracontractual damages. (6) A successful plaintiff does not even have a right to recover attorneys' fees, although fees may be awarded in the court's discretion. (7) A court considering an award of fees under ERISA must consider a complex formula that includes 1) the bad faith or culpability of the defendant, 2) the defendant's ability to pay, 3) the deterrent effect of a fee award, 4) the benefit conferred on members of the plan other than plaintiff, and 5) the relative merits of the parties' positions. (8) In sharp contrast, in a state law action by an insured against the insurer for bad faith or other improper claim handling, the right to jury trial is inviolate, punitive and consequential damages are recoverable in appropriate cases, and in many states a successful plaintiff has an absolute right to recover attorneys' fees.

The potential savings for insurance companies by converting state law claims into ERISA claims are enormous. One company has estimated that for every state law claim handling case it can convert into an ERISA benefits case, it saves $600,000 in settlement costs. (9) Insurance companies have therefore adopted a practice of removing state law claim handling cases from state to federal court and arguing that the state law claims are preempted by ERISA. As a result, there has evolved a two-tier remedial scheme for improper claims handling. An insured who purchases an individual policy has the benefit of state statutory and common law claims for relief that generally include the right to recover consequential and/or punitive damages, a right to jury trial on those claims, and a right to recover attorneys' fees if successful. On the other hand, an insured whose otherwise identical policy was obtained through an employee benefit plan covered by ERISA is limited to an action to recover contract benefits, is denied a jury trial, and must rely on the court's discretion for recovery of attorneys' fees. Needless to say, this has the effect of affording insurance companies the opportunity to obtain bargain-basement settlements in ERISA cases. One court has commented on this anomalous situation as follows: "Enacted to safeguard the interests of employees and their beneficiaries, ERISA has evolved into a shield of immunity that protects ... insurers ... from potential liability for the consequences of their wrongful denial of ... benefits." (10)

The interpretation of the preemption clause in Pilot Life and its progeny is by no means a necessary reading of the statutory language. It is difficult to understand why state laws regulating insurance claim handling, and state common law remedies for breach of the duty of good faith and fair dealing available to insureds against their insurers, should be regarded as laws relating to employee benefit plans under ERISA. Such laws do not actually relate to the plans as such, in their formation, administration, financing, or any other aspect; they relate to the rights of insureds against their insurance companies. If an employee benefit plan promises insurance coverage to employees, and that promise is fulfilled by the purchase of an insurance policy, the duties of the employer have been satisfied; the duties of the insurance company to the insured employees are governed not by the plan but by state common and statutory law. State laws governing insurers' performance of their contracts should not be construed as relating to ERISA plans. For a forceful criticism of the preemption cases from this standpoint, see Korobkin, "The Failed Jurisprudence of Managed Care, and How to Fix It: Reinterpreting ERISA Preemption." (11)

The arguments on which insurance companies have relied to convert state law claims into ERISA cases are too many and various to be covered within the scope of this article. There are, of course, a great many cases that are legitimately within ERISA's scope. For the claimants in such cases, the only hope of obtaining an adequate system of remedies is statutory amendment that would give insureds whose policies are purchased by their employers the same remedies that are available to the holders of individual policies. There are, however, a great many cases in which insurance companies have attempted improperly to bring truly individual policies under the ERISA umbrella. This article will examine some of the situations in which policies with which an employer is connected in some way remain outside the scope of ERISA.

Employee-Paid and Owner-Benefit Policies

The fact that an insurance policy is obtained through an employer does not, in itself, mean that it is a part of an employee benefit plan. To be covered by ERISA, the policy must be provided by the employer to employees, and its provision must be pursuant to an actual employee benefit plan. To the extent that an employer simply makes arrangements with an insurance company to offer insurance to its employees (even at favorable group rates) which the employees are free to accept or reject, and for which they pay their own premiums, such coverage is not subject to ERISA. The Department of Labor has issued a "safe harbor" regulation clarifying the point. Group insurance offered to employees is not part of an employee welfare benefit plan if it satisfies all of the following conditions: 1) no contributions are made by the employer (or by an employee organization); 2) participation is completely voluntary; 3) the employer's sole function is to permit the insurer to publicize the program and to make payroll deductions for premium...