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Paul Zimmerman

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Statutes, Regulation, and Bureaucratic Decrees

Insurance is a heavily-regulated business.  Insurance consumers pay for the product before they receive the benefits of paid claims.  They give money to consumers and receive a promise that, in the event of a loss, the company will indemnify.  As a result, insurers end up holding a lot of money that doesn’t really belong to them.  It’s going to be needed to pay claims.  The majority of insurance regulation is intended to ensure that insurers make good on their promises rather than just stealing the money and not using it to pay claims.  It is similar to banking – another heavily-regulated industry.  Laws are passed to ensure that consumers receive the benefits that they pay for in advance. 

            There are four levels of law in California. 

  • The State Constitution.
  • Statutes – the California Codes. 
  • Regulation – the California Code of Regulations.
  • Underground regulations – rules that a state agency just makes up and enforces.  Underground regulations are sometimes called “desk drawer laws”. 

The Constitution.  The Constitution is a single document which embodies the “supreme” law of the state.   If a lower level of law conflicts with the Constitution, that lower level law will be held to be invalid.  Only the courts have the ability to invalidate a law as being unconstitutional. 

Only the voters have the power to change the Constitution.  This can occur either by voting in favor of a change proposed by the Legislature or by voting to approve a change offered through a ballot initiative proposed by petitions signed by enough voters to have it placed on a statewide ballot. 

The Constitution contains both broad principles, such as freedom of speech, and relatively precise laws, such as the manner in which the state regulates the practice of chiropractic medicine.  Whether it is a broad principle or a precise legal scheme, it relative fixed, in that it can only be changed with the approval of the voters. 

Statutes.  A statute is a law enacted by the State Legislature.  As a general rule, the Legislature is empowered to enact any statutes it wants to, so long as the statute does not violate the Constitution.  Once the Legislature enacts a statute, that law is legally valid and enforceable unless and until it is invalidated by a court.  Even if a statute appears to be clearly unconstitutional, the government can enforce it until it is invalidated by court action.  The Legislature can, within the limits of the Constitution, enact statutes on nearly any subject. 

The principle laws governing the insurance industry are statutes, most of which are found in the Insurance Code.

Regulation.  Many statutes are not sufficiently detailed to provide clear guidance to the public on precisely what they require.  For example, a statute may say something like “an insurer shall annually report financial data to the Commissioner, which shall be adequate to demonstrate that the insurer is solvent.”   The general thrust of this statute is clear, but by itself it does not give an insurer the level of detail to prepare and file a report that satisfies the statute. 

On what date is the report due?  Precisely what information must be reported?  What financial standards must be met for the insurer to be considered to be solvent?  None of these questions are answered by the statute.  Without further specifics, each insurer would just prepare its own report with the information it believes is necessary to demonstrate solvency.  Some insurers would probably provide too much information, others not enough, and others would provide information that isn’t really relevant.  None, however, would be able to be sure that the report it filed would be accepted by the Insurance Commissioner as satisfying the statute. 

In cases like this the law allows government agencies to adopt regulations.  The California Government Code specifies how a regulation must be adopted in a set of statutes called the Administrative Procedure Act, commonly known as the “APA”.  The APA defines “regulation” as a rule that is adopted by an agency to “implement, interpret or make specific” the statutes that the agency administers (Gov. Code § 11342.600).  A regulation is a law just as a statute is.  If an insurer violates a regulation it can get into trouble every bit as serious as if it violates a statute.   A regulation, in simple terms, is a law enacted by a state government bureaucracy. 

Limits on Regulations.  However, unlike the power of the Legislature to pass laws on almost any subject it wants to address, the power of an agency to enact a regulation is limited.  A regulation can only be adopted legally if it implements a statute enacted by the Legislature.  The hypothetical financial reporting statute discussed above would justify a regulation by the Department of Insurance defining what information must be reported, when it must be reported, and what it takes for the report to be “adequate to demonstrate that the insurer is solvent.”  This statute would not, however, allow the Department of Insurance to adopt a regulation that requires reporting on insurer claims activity or underwriting activity.  The statute only requires reporting of “financial data”.  This statute would justify a regulation specifying how, when, and what financial data must be reported, but it would not support a regulation to require reporting of data that are not “financial data.” 

Specifically, the APA says that a regulation “to be effective, shall be within the scope of [the] authority conferred” by the statute that it implements (Gov. Code 11342.1).  The APA further limits an agency’s power to adopt regulations by requiring that “no regulation adopted is valid or effective unless [it is] consistent and not in conflict with the statute [it implements] and [is] reasonably necessary to effectuate the purpose of the statute.”   If the Department of Insurance, using our hypothetical financial reporting statute, tried to adopt a regulation to require reporting of underwriting practices, that regulation could be invalidated because it is not consistent with the financial reporting statute and because reporting of underwriting is not “reasonably necessary” to satisfy the purpose of a statute that only requires financial reporting.   

The APA is enforced in California by the Office of Administrative Law (OAL).  This obscure but powerful state agency reviews every regulation adopted by a state agency to confirm that it was adopted legally pursuant to APA.  If an agency does not follow the APA in adopting its regulation, then OAL has the authority to disapprove the regulation.  OAL also has the power to determine that an action taken by an agency without going through the APA is illegal. 

Example of a Valid Regulation.  The Insurance Code, which are the statutes enforced by the Department of Insurance, provides that no insurer may operate under any name that has not been approved by the Insurance Commissioner (Ins. Code § 881).  This statute, however, leaves many questions unanswered, such as how does an insurer apply for approval and what are the standards that make a name acceptable or unacceptable.  In order to clarify the statute, the Department of Insurance has adopted regulations answering these and similar questions.  These regulations are found in Title 10, California Code of Regulations sections 2278.50 – 2278.59.  These regulations define how an insurer applies for approval of a name, lists certain words – such as “federal”, “bank”, and “agency” – which cannot be used in the name of an insurance company, and establishes other standards – such as a requirement that the name of a life insurance company must contain the word “life”. 

Nobody has ever challenged the validity of this regulation.  It is clearly within the scope of the statute that it implements and nobody has suggested that it is not reasonably necessary to effectuate the purpose of the statute. 

A Thought on the Politics of Regulations.  It has become common in some political discussions to attack regulation as an abuse of government power.  It is important to understand that lawfully-adopted regulations are not, in and of themselves, evil or even burdensome.  The Department of Insurance regulation on insurer names, for example, does nothing except clarify a law that is otherwise ambiguous.  It tells insurers what names are legal, which are illegal, and how to go about getting the approval for names that is required by the Insurance Code.  This is a regulation that makes it easier for an insurer to operate.  While there may be questions about the specifics of the regulation – for example, some people may think that under some circumstances an insurer name should be able to include the word “bank” – on the whole this regulation helps clarify how an insurance company must operate.  It is not necessarily burdensome merely because it is a regulation. 

The regulations are not inherently burdensome.  State agencies can, and often do, adopt regulations which are thought to be excessive or burdensome, but it is the content of a regulation, not the mere fact that it is a regulation, which determines whether or not it is a benefit or a burden to the people it governs.  In short, a good regulation operates to make business operations clearly and reasonably uniform.  A bad regulation, like any bad law, can impose unnecessary costs and burdens, but it is unfair and inaccurate to say as a general principle, that regulations are bad. 

Example of an Invalid Regulation.  About 9 years ago the Department of Insurance adopted a regulation saying that certain provisions of life insurance policies, called “disability offset clauses”, were illegal and that the Department would not approve any life insurance policy containing one of these provisions.  The problem that the Department faced with this regulation was that there was no statute which addressed these provisions in any way.  In order to claim that these regulations were authorized by a statute, the Department relied upon a statute which prohibited misrepresentation of the terms of an insurance policy.  The Department argued that the disability offset clauses are illegal under various questionable court cases, and therefore that a policy which contained these clauses was misrepresenting what the policy could legally provide. 

The life insurance industry challenged these regulations in court.  The trial court rejected the regulations, determining that the regulations were not within the authority of the statute relating to misrepresentation.  Rather than appealing the trial court decision, the Department negotiated a settlement with the insurers.  As part of the settlement the Department repealed the challenged regulation.  

Underground Regulation.  The APA provides that any rule which satisfies the definition of regulation, but which was not formally adopted under the APA procedures is invalid (Gov. Code 11340.5).  A rule such as this is called an underground regulation.  An underground regulation may be as simple as a letter from a state agency or a formal program an agency attempts to force upon an entire regulated industry. 

The easiest rule of thumb is that any statement of a general rule which cannot be found either in the California Codes or in the California Code of Regulation is an underground regulation.  Under both the APA and decisions by the CA Supreme Court, an underground regulation is never valid.  Unlike a statute or a validly-adopted regulation, which is legally enforceable unless and until it is declared invalid by a court, an underground regulation is legally void. 

Prior to 1996 the law on underground regulations, state agencies were much less restrained by the underground regulation law than they are today.  In 1996 the California Supreme Court issued a decision in the landmark case of Tidewater v. Bradshaw, 14 Cal. 4th 557.  Although the statute had not changed, the Tidewater decision clarified that the statute was absolute.  In Tidewater the Supreme Court invalidated an order by the Industrial Welfare Commission as an illegal underground regulation.  This made it clear to state agencies that actions by state agencies, whether they were called orders, opinions, notices, or bulletins, still had to comply with the APA.  Agencies such as the Department of Insurance, which had routinely issued bulletins to impose rules, were put on notice by Tidewater that the only lawful way to establish regulatory rules was through rulemaking under the APA. 


Tidewater also made it clear that an underground regulation was void at its creation.  Unlike a statute or lawfully-adopted regulation, which are presumed valid until invalidated by the courts, under Tidewater an underground regulation never has the force of law.  By clarifying that an underground regulation is not made valid by calling it an order or a bulletin, and that an underground regulation is invalid from inception, the case forced state agencies to be much more careful about complying with the APA. 

Although all underground regulations are illegal, not all underground regulations are equally harmful.  Sometimes a state agency action may technically be an underground regulation, but in fact be beneficial.  Suppose a statute or regulation contains an ambiguity which was not noticed when it was adopted.  The agency may issue a bulletin saying “we see that this phrase is ambiguous and that it may mean either X or Y.  The Department interprets this phrase to mean X and not Y.”  If this bulletin does nothing more than clarify an ambiguity – that is, if the choice of X or Y is otherwise noncontroversial and doesn’t harm anybody – then the bulletin is beneficial.  One former director of the Office of Administrative Law summarizes this principle by saying that although all underground regulations are equally illegal, an underground regulation is only a problem when it hurts somebody.  

Example of an Underground Regulation.  In 2010 the CA Department of Insurance implemented a program which it called the “Iran Investment Initiative”.  The Department sent a letter to all insurers announcing that they had identified 50 different businesses “doing business with the Iranian oil and natural gas, nuclear, and defense sectors.”  The letter said that the 50 identified companies were “subject to financial risk” because of their relationships with Iran, and announced that henceforth the Department of Insurance would not recognize any insurer investments in these companies, or in companies owned by these companies, as admitted assets on the insurers’ financial statements.  

The “Iran Investment Initiative” was announced in a letter from the Department of Insurance.  The letter did not cite any statute or regulation which authorized the Department to take this action.  Since declaring otherwise legal investments to be nonadmitted assets had serious implications for the financial situation of insurers, the Iran Investment Initiative created serious concerns for insurers.  This was a classic case of an illegal underground regulation which caused potential serious harm to the regulated public. 

The insurance industry reacted accordingly.  They first used the APA procedure which allows OAL to determine that a state agency action is an illegal underground regulation.  OAL reviewed the Iran Investment Initiative and issued a determination that it was an illegal underground regulation.  Although an OAL determination is not directly enforceable – a state agency is not legally required to comply with an OAL determination – such a determination is recognized by the courts and when an underground regulation identified in an OAL determination is taken to court, it is almost always invalidated by the courts. 

The insurance industry subsequently challenged the Iran Investment Initiative in court.  In the face of this court challenge, which was supported by the OAL determination, the Department of Insurance backed down.  It settled the lawsuit by an agreement with the insurance industry that changed the program from a mandatory action to a voluntary program in which the Department requested insurers to voluntarily refrain from investments in the listed companies.  Most importantly, the Department eliminated its decree that investments in these companies would not be recognized as admitted assets.  Since the resulting program was voluntary, it no longer met the legal definition of a regulation and therefore it was no longer an illegal underground regulation.  It was merely a request which no longer purported to have actual force of law. 

The Practical Problem of Challenging Illegal Regulation.  A regulation which is adopted pursuant to the APA may still be illegal because it is not authorized by a statute or is not reasonably necessary to effectuate the purpose of the statute.  An underground regulation can be invalidated based upon the APA prohibition against underground regulation.  In either case an invalid rule can be challenged as an illegal violation of the APA. 

Although an illegal regulation, whether formally adopted or underground, can be invalidated by the courts, such a challenge still presents substantial practical problems to the regulated public.  The legal process for invalidating a regulation is expensive and time-consuming.  A court challenge will probably cost the person or business bringing the challenge at least $50,000 in attorney fees.  Furthermore, it requires the challenging party to be willing to sue its regulator.  A business always wants to remain on good terms with its regulator, and challenging the legality of its operations does not promote good relations. 

The legal issues, therefore, are not the only considerations in deciding whether or not to challenge an illegal regulation or an underground regulation.  The ultimate decision has both legal and practical implications.  A potential challenge must consider both the legal strength of the case and the practical benefits of overturning the illegal rule.  In many cases a business may decide that the rule in question, even if objectionable, is not so objectionable as to justify the expense associated with the challenge or the damage that the challenge will cause to the relationship with the regulator. 

The laws regulating the adoption of regulations are relatively clear.  The question of what to do when a regulator appears to have violated those laws unfortunately is not.     

This article is not offered as, and should not be relied on as, legal advice. You should consult an attorney for advice in specific situations.