BUSINESSWEEK ONLINE : NOVEMBER 8, 1999 ISSUE
LEGAL AFFAIRS

State Farm: What's Happening to the Good Neighbor?
Judges and juries have found the insurer guilty of serious misconduct

One of Peggy Frey's most cherished possessions is her black 1988 Mustang 5.0 convertible. When the front of the car was demolished by a wayward pickup truck last year, the Tampa housewife expected State Farm Mutual Automobile Insurance Co. to restore it with genuine Ford parts. Instead, the massive insurer used cheap Taiwanese replacements which, to Frey's shock, barely fit together. When she slams the hood now, the headlights sometimes pop out.

The repair job is so shoddy that Frey believes the value of her Mustang has dropped by at least $2,000. That may not sound like a lot of money, but as many as 4.7 million other policyholders may have been treated the same way. That's why a Marion (Ill.) jury hit State Farm with a $456 million judgment on Oct. 4 for breaching its contract with customers by using generic replacement parts. A few days later, state court Judge John Speroni tacked on $730 million in punitive and other damages for misleading policyholders about the quality of replacement parts.

Stung by the decision, State Farm Chairman Edward B. Rust Jr. on Oct. 8 tried to assure employees that the court had made a big mistake. The jurors ''weren't allowed to hear the full story,'' Rust told a group of about 250 managers in an auditorium at Bloomington (Ill.) headquarters. ''Our company did not commit fraud.''

But no matter how hard Rust tries to portray the car-parts verdict as an anomaly, the truth is that State Farm is in a whole lot of legal trouble these days. Last year, the company's life insurance unit forked over $200 million to settle a class action charging that agents engaged in a variety of misleading sales practices. And in 1997, the company shelled out $100 million to settle claims brought by Los Angeles area homeowners charging that the company had secretly reduced their earthquake coverage before the 1994 Northridge quake.

State Farm has also been rocked by a string of blistering punitive damage decisions over the past year, some of which involve serious misconduct. In August, 1998, for example, a Utah state appeals court judge ruled that the company should pay $25 million in punitive damages for the ''systematic destruction of documents'' and ''systematic manipulation of individual claim files to conceal claim mishandling,'' among other things. Just after, an Idaho appeals court hit State Farm for $9.5 million in punitives for using ''a completely bogus'' outside bill-review company to cut down the cost of medical claims.

Add it all up, and State Farm has quietly gotten itself into more hot water than any insurer since Prudential Insurance Co., which in the early 1990s shelled out a fortune to settle charges that it had misled consumers about life insurance and real estate investments. While the legal judgments aren't an economic threat to State Farm, which has a policyholders' surplus of nearly $45 billion, they do raise questions about whether something has gone awry inside the nation's largest property insurer, which has worked hard to become one of America's most trusted companies. It not only insures one in every five cars in the country, but millions of homes and lives as well. ''State Farm has sold as its product 'peace of mind,' using an advertising slogan which promises consumers that they can count on it to act 'like a good neighbor,''' wrote Judge William B. Bohling in last year's $25 million Utah decision. ''But...State Farm's corporate policies involve betraying the trust that it invites policyholders to place in it.''

Such harsh words are surprising, considering the insurer's reputation for treating its customers well. After all, it's a mutual, so the policyholders literally own the company. As a result of this structure, State Farm has no shareholders and managers have no stock options. Hence there's no Wall Street pressure to boost the bottom line. State Farm even voluntarily refunded $1.5 billion in ''unspent premiums'' to its customers over the past two years because of lower-than-expected claims.

And even as the chiefs of publicly held insurers such as Allstate (ALL), American General (AGC), and Cigna (CI) rake in total compensation in excess of $5 million, Rust took home only about $1.5 million last year. ''The top dozen or so managers at State Farm are all leaving a million dollars a year on the table because they like working there,'' says Brian Sullivan, editor of Auto Insurance Report.

Headquartered in the Illinois flatlands, halfway between Chicago and St. Louis, State Farm has an unusually loyal corporate culture. While it's a huge company, with 79,000 employees and more than 16,000 agents, many say it feels more like a family business than a big conglomerate. Executives tend to spend their entire careers at the company, and many have parents and children who have also worked at State Farm. The leading example is Rust himself, who declined to be interviewed for this story. He took over the top job in 1985 from his father, Edward Sr., who in turn succeeded his father, Adlai Rust. Together, the Rust men have run State Farm for more than 35 years (page 142).

State Farm's long-term record, meanwhile, is a strong. Margins are getting thinner in the key auto business, and the company is prone to unpredictable catastrophe losses. But its annual premium writings have steadily risen to $37.3 billion in 1998. Renewal rates are close to the best in the industry. Last year, only 4% of its auto customers defected to other insurers--compared with an industrywide average of 7.5%.

This customer loyalty is the strongest sign that the company treats its policyholders fairly, says Kim Brunner, senior vice-president and general counsel. He blames the company's troubles in court largely on tort lawyers. While admitting that ''there's no question we make mistakes,'' he says it's easy for opposing attorneys to demonize the massive insurer before juries--especially when the plaintiffs have a sympathetic hard luck story. ''We're talking about circumstances where people are emotionally upset because they've had a loss,'' says Brunner. ''You are going to get cases... where we may come across in an unfavorable light before a judge or a jury.''

It's true State Farm has been hit by baseless suits. But with the third-largest corporate legal department in the country--726 lawyers strong--the company is hardly a helpless victim of the plaintiffs' bar. Moreover, its legal woes have come about largely because of damning internal documents and damaging testimony from internal whistleblowers.

If there's a common theme in State Farm's big court losses, it's that judges and juries think the company has taken cost-cutting too far. Sullivan blames this parsimony, in part, on its ''unique and powerful culture.'' Employees ''really do believe they shouldn't pay inappropriate claims with the policyholders' money. They're passionate about that--and sometimes that passion goes over the top,'' he says. Additionally, the inbred culture makes it ''hard for them to say, 'God, we made a mistake,''' says Sullivan.

In the auto case, the judge and jury were both troubled by internal memos that indicated that State Farm knew generic parts were inferior--but told customers the opposite. In one 1993 memorandum, for example, a State Farm executive wrote, ''Quality and fit of [generic] parts continue to present a problem. Example: Ranger Bronco II hoods--the locking plate has a cold weld and will not hold.... This is an obvious safety problem.''

State Farm argues that this document, and others like it, are evidence that the company aggressively weeds out shoddy parts. But Judge Speroni concluded that the company had ''misrepresented, concealed, [and] suppressed'' information about problems with generic parts. ''State Farm occupies a position of trust with policyholders.... State Farm violated this trust,'' he wrote. Brunner says he plans to appeal the verdict.

The company suffered an even worse tongue-lashing last year, when Utah judge Bohling decided it was guilty of document destruction, among other misdeeds. The case centered on Curtis Campbell, a policyholder involved in a 1981 accident in which one man died and another was seriously injured. When Campbell was sued for driving negligently, the insurer rejected an offer to settle his case for $50,000, the maximum value of his coverage. Instead, State Farm decided to roll the dice at trial--thereby exposing Campbell to personal liability if the judgment came in higher. When a jury tagged him for $253,000, Campbell sued State Farm for failing to accept the earlier settlement offer.

During the trial, four former State Farm employees testified that claims agents faced relentless pressure to cut costs, and that their pay raises were largely determined by their ability to meet pre-set payout targets, not on the scope of claims they might face in a given year. Additionally, they said the company routinely destroyed old training guides, procedure memos, claim-handling manuals, and other documents that could be used against it in litigation. One Utah manager told jurors State Farm had tried to destroy some of the documents related to the Campbell case.

Infuriated by this testimony, as well as several incriminating internal documents, Bohling came down hard. State Farm has constructed ''a nearly impenetrable wall of defense against punishment for its wrongdoing, one so effective that it is able to pressure its adjusters to deny consumers insurance benefits with impunity, knowing that...any victims who actually do reach trial will have great difficulty establishing the basis for punitive damages [because of] a body of evidence that has been systematically sanitized,'' he wrote. The company is appealing and says its performance review and document retention practices are entirely legal.

''COOKIE-CUTTER'' REPORTS. When will the bad news end for State Farm? Probably not any time soon. A new litigation battlefield is emerging over another one of its controversial cost-cutting practices: the use of outside ''utilization review'' companies to analyze medical bills.

In recent years, State Farm and many other insurers have hired these companies to help them resolve disputes over a policyholder's course of treatment. For a fee, the review company runs a computer analysis of how a person's bill compares to others with the same condition. Sometimes a doctor will weigh in for an extra charge. State Farm insists the utilization review companies are independent and objective, but critics charge that they almost always side with State Farm in order to win more business. Last year, an Idaho appeals court awarded a policyholder $9.6 million after determining that the review company State Farm hired in her case ''did not objectively review medical records, but rather prepared 'cookie-cutter' reports of stock phrases, assembled on a computer, supporting denial of claims.''

The decision was based largely on the testimony of James Mathis, a former State Farm supervisor in Washington State who unsuccessfully sued the company for wrongful termination after he was fired in 1994. He says that outside review companies compete aggressively for the massive insurer's business. ''If we didn't see consistent cost-cutting of 20% or more, we would stop using them,'' Mathis says. The company has labeled Mathis a disgruntled ex-employee and says that utilization review is a valuable claims-management tool widely used throughout the industry.

Since that decision, State Farm has been fighting to keep a lid on the utilization review litigation, settling several private lawsuits across the country without admitting guilt. The company is also fighting to prevent public interest groups from unsealing the documents filed in an Oregon utilization review case it settled last year. Many plaintiffs' lawyers are hoping these papers will provide ample grist for future litigation. In August, meanwhile, a class action was filed in Maryland seeking $100 million apiece from State Farm and two other insurers for misleading consumers about utilization review companies.

Notwithstanding the controversy, State Farm defends utilization review. Like the use of generic repair parts, the company says it is a practice that helps to keep costs lower, thereby allowing it to offer lower rates. Noting that insurance companies are frequently victimized by fraud, Brunner adds that it has no choice but to adopt aggressive management strategies. ''If you start routinely overpaying claims, then you are not serving the mass of your policyholder base,'' says Brunner. ''There's a balance here.''

But with so many court decisions going against State Farm, is the company starting to strike the wrong balance? Though many judges and juries obviously think so, policyholders aren't showing any signs of defection. Until that changes, State Farm may not dramatically change its ways.

By Mike France in New York, with Andrew Osterland in Chicago

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