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Arbitration Clauses in Insurance Contracts:The Urgent Need for Reform

The growing use of binding, pre-dispute arbitration clauses poses a huge threat to insurance consumers. It represents a major shift in the balance of power between insurers and consumers that must be addressed by state legislators and insurance regulators.

Background: How Arbitration Differs From Litigation

Arbitration is a form of alternative dispute resolution (ADR). Its original purpose was to provide a swift and informal means of adjudicating disputes between businesses. Its use has also been customary in fixing the amount of loss for purposes of property damage, uninsured motorist and no-fault automobile coverage.

Unfortunately, in recent years businesses have realized that binding, pre-dispute arbitration clauses can be used to gain an unfair advantage in fighting lawsuits by consumers and workers. It now appears that some insurance companies have begun using the clauses to immunize themselves from suits over bad faith claims settlement practices, consumer fraud, and denials of treatment in managed care.

The advantage a company may gain comes from five unique characteristics of arbitration:

High costs. While the court system is publicly subsidized, arbitration is not. In fact, the costs of litigating in a private court system are very steep. Typically, filing fees in arbitration cases range between $750 and $3,000. Arbitrators hourly fees, which must be deposited in advance, amount to thousands of dollars more. These costs raise an insurmountable barrier for most litigants, who usually are financially distressed because of the same incident that gave rise to their legal problem. The result is that claims that could have been asserted in court must be abandoned.

Arbitrator bias. Arbitrator bias results from two features of the system. First, the potential for receiving “repeat business” provides an incentive for arbitrators to favor companies that are frequent users of the system. Arbitrators who issue high awards or rule for plaintiffs in close cases can be and have been blackballed from future cases. Second, most arbitration panels include representatives of the industry being sued. Needless to say, people having such sympathy for defendants would never be included on a jury. As a result, arbitration awards tend to be a fraction of what juries award in comparable cases.

Unavailability of class actions. Class actions are extremely important in remedying nickel-and-dime cheating by businesses. It is not feasible for consumers to recover small-scale overcharges in individual proceedings. This means that pro-consumer laws such as the Real Estate Settlement Procedures Act, which bans kickbacks in mortgage transactions, are harder to use in combating frauds such as “packing” of credit life insurance policies by predatory lenders. Insulation from class actions gives unscrupulous insurers a license to steal in small increments.

Unavailability of discovery. Discovery is the procedure by which parties to a lawsuit obtain information from each other and from third parties. Discovery is especially important to consumer plaintiffs who need access to business records to prove their cases. While discovery is a right in court proceedings, in arbitration it is a privilege granted at the discretion of the arbitrator. Moreover, arbitrators have no authority to order non-parties to comply with subpoenas, often requiring the filing of a court case which arbitration is supposed to make unnecessary.

Finality. It is nearly impossible to appeal an arbitration ruling, even if an arbitrator ignores the law. Not only can this lead to unfairness in individual cases, but it also prevents the law from evolving in response to new problems.

How Arbitration Clauses Threaten the Protection of Insurance Consumers

There are three primary areas in which arbitration abuses arise in the insurance context.

Bad Faith Claims Settlement Practices

Lawsuits over “bad faith” or unfair claim settlement practices play an important role in protecting insurance consumers. Often an insurance company will “low-ball” claimants or unreasonably delay or deny claims. Some disreputable insurers do this on a regular basis. The “bad faith” lawsuit remedies such practices, by requiring the insurer to pay punitive damages and/or attorney s fees in addition to the amount of the claim. Raising the stakes in this manner is a crucial deterrent to insurer misconduct.

The case of Southern United Fire Insurance Company v. Pierce, 775 So.2d 194 (Ala. 2000) demonstrates how an insurance company may draft an arbitration clause to insulate itself from damages for bad faith refusals to pay claims. The clause they used required panels of three arbitrators, tripling the fees that the consumer must pay to have his case heard. The clause also prohibited the arbitrators from allowing discovery of “evidence relating in any way to a transaction other than the [consumer s] specific transaction.” This restriction makes it impossible to prove that the company engaged in a pattern of improper denials of claims, a crucial element of establishing a case for bad faith activity.

Managed Care

The second area in which arbitration threatens insurance consumers is managed care. As states have slowly begun to impose liability upon HMOs for arbitrary denials of treatment, and Congress seems poised to allow liability for ERISA health plans, insurers have begun imposing arbitration clauses upon patients. Unless Congress prohibits HMOs from requiring arbitration, Patients Bill of Rights legislation may be rendered toothless.

Even under current law, HMOs can be liable for medical malpractice committed by the doctors they employ. The table below compares medical malpractice awards in Kaiser Permanente s arbitration program in California to jury verdicts. As the table clearly shows, by any measure, injured patients receive far less compensation from arbitrators than they do from courts.

Medical Malpractice Awards: Arbitration versus Litigation


Mean Award

Median Award

Kaiser Arbitration



Jury Verdict Research Database



Bureau of Justice Statistics Database (1992)



Bureau of Justice Statistics Database (1996)

Not available


Unfair and Deceptive Marketing

Misrepresentations and other deceptive practices have all too often been used in marketing insurance, and arbitration clauses are preventing consumer advocates from remedying them. One example is the sale of single premium credit life insurance policies as part of predatory lending transactions. Consider what happened to Lorraine King of Dolton, Illinois, who was solicited for a subprime mortgage refinancing. The lender added a credit life insurance policy at a cost of $10,555.61. The lender admitted receiving a six percent kickback from the life insurance company. The same life insurance company sells the credit life policy to borrowers in the prime market for $16.50 per month.

A Consumers Union study found that the loss ratios for credit life policies (the ratio of benefits paid out to premiums paid in) “are unconscionably low far below any reasonable measure of benefit in relation to the premium charged to consumers.”

Arbitration clauses are being used to insulate credit life insurers from judicial scrutiny of their practices. Credit life insurers began using the clauses in response to a spate of fraud lawsuits initiated by state attorney generals and individual consumers. Not surprisingly, an arbitration agreement was included in the loan documents signed by Mrs. King.

State Regulation of Arbitration

The Federal Arbitration Act (FAA) mandates that all arbitration clauses be enforced by the courts, and preempts state legislatures from banning them. The exception to this rule, however, is arbitration clauses in insurance contracts. The McCarran-Ferguson Act “reverse preempts” FAA and allows states to restrict the use of arbitration by insurance companies.

Some states ban the use of arbitration by insurers. In eleven states there is a statutory ban applying across the board to any insurance contract, although three of those states courts have not upheld the ban. In three states, there is no statutory ban but courts have refused to permit arbitration of bad faith lawsuits. Most states, however, have not enacted any restrictions on arbitration, and consumers are seriously threatened.

For years the business community has lobbied legislators to roll back consumers right to sue. Now, however, they can accomplish through the use of preprinted forms more than they ever hoped to accomplish through legislation: abolition of the right to trial by jury, de facto caps on damage awards, and elimination of class action lawsuits. Indeed, the head of one arbitration provider has told corporate counsel that using arbitration clauses lets them enact “do-it-yourself civil justice reform.”

This abuse of arbitration demands attention by insurance regulators. We propose that NAIC consider model state legislation and model regulations to protect consumers from unfair arbitration clauses.

Potential Solutions

We believe the best approach to this problem is to simply ban the imposition of binding, pre-dispute arbitration clauses altogether. This leaves open to consumers the option of choosing arbitration after a dispute has arisen. When arbitration is a post-dispute option, the parties are free to compare different ADR methods and providers with court litigation, and can choose the most efficient and cost-effective forum for an individual case. This competitive marketplace for dispute resolution options, sometimes called the “multi-door courthouse” approach, forces both the courts and ADR providers to resolve cases speedily and inexpensively.

The other approach is to regulate the imposition of binding, pre-dispute arbitration. The attached summary of state laws on arbitration demonstrates that there a number of options in this regard.

Some states have chosen to simply require that conspicuous notice be given to consumers of arbitration requirements. We feel that this is insufficient, given the realities of the insurance market. First, consumers do not understand the significance of the arbitration clause; certainly those consumers who fall prey to predatory practices such as single-premium credit life policies would be unlikely to understand it. Second, arbitration clauses are becoming so prevalent that it may be impossible to find a competing insurer who doesn t require them. Third, health insurers are usually chosen by one s employer, making notice requirements moot in the context. Finally, consumers who object to the clauses identify themselves as rights-conscious, and may be subject to informal blacklisting.

Any regulation of arbitration must be carefully tailored to address all five of the problems enumerated at the beginning of this paper cost, bias, class actions, discovery, and appeals and must extend in scope to the three main problem areas: fraudulent marketing, managed care, and bad faith.

Per Sharon Lybeck Hartman, Second Annual Report of the Office of the Independent Administrator. 12-31-2000. Approximately 5 percent of the cases in this pool are not medical malpractice cases.


FAA allows an arbitration clause to be voided on the basis of unconscionability, but few courts are willing to scrutinize the fairness of arbitration. FAA allows states to ban arbitration for transactions that do not substantially affect interstate commerce.