255 S.W.3d 786

Court of Appeals of Texas,

Austin.

Mike GEESLIN, Commissioner of Insurance, and Texas Department of Insurance, Appellants

v.

STATE FARM LLOYDS, Appellee.

No. 03–05–00067–CV.May 22, 2008.

OPINION

DIANE HENSON, Justice.

This appeal concerns the validity of a rate order issued by the commissioner of insurance. The rate order was based on now-expired article 5.26–1 of the insurance code, which provided the procedure by which Texas homeowners insurance providers were to file their initial homeowners insurance rates with the Texas Department of Insurance (“TDI” or the “department”) as required by Senate Bill 14 in 2003.1 Tex. Ins.Code Ann. art. 5.26–1 (West Supp.2004–2005). The rate order required State Farm Lloyds to reduce its filed homeowners insurance rates by twelve percent. State Farm Lloyds sought review in district court. Finding that article 5.26–1 was unconstitutional and that State Farm Lloyds’s due process rights had been violated, the district court vacated the rate order. Appellants now seek reversal of the district court’s judgment. We conclude that the portion of section 4 of article 5.26–1 setting out what insurers are required to prove on appeal to the commissioner (“the proof provision”) is unconstitutional on its face and as applied to State Farm Lloyds. Therefore, we affirm the judgment of the trial court in part as to its findings that the provision of former Article 5.26–1, section 4, which requires an insurer to prove that a rate *792 reduction would produce inadequate rates, is unconstitutional and that State Farm Lloyds’s due process rights were violated. Because we further hold that the unconstitutional proof provision is severable, we sever that provision, reverse the trial court’s judgment as to the constitutionality of the remainder of the statute, and remand to the department for further proceedings consistent with this opinion.

FACTUAL AND PROCEDURAL BACKGROUND

From 1991 through 2003, Texas insurance companies operated under a system of flexible rate setting, which allowed insurers to charge up to 30 percent more or less than a state-promulgated benchmark rate. House Research Organization, Bill Analysis, Tex. S.B. 14, 78th Leg., R.S. (2003). During that time period, in an effort to avoid regulation, insurance companies began shifting more and more of their business toward unregulated branches called Lloyd’s companies. Id. Originally unregulated because they generally covered specialty risks at lower-than-standard rates, Lloyd’s companies grew from about 20 percent of the market in 1991 to about 95 percent of the market in 2003. Id. Thus, by 2003, only five percent of the Texas homeowners insurance market was regulated. Id.; House Comm. Report, Tex. S.B. 14, 78th Leg., R.S. (2003). In this mostly unregulated market, Texas consumers were paying the highest premiums in the country, often for policies providing reduced coverage. Id.

To address these issues, the Texas Legislature passed Senate Bill 14, which amended the insurance code to establish a new system for regulating residential property insurance rates. Act of June 2, 2003, 78th Leg., R.S., ch. 206, 2003 Tex. Gen. Laws 907. Under the new system, insurers were required to file their rates with TDI, and TDI would then review and either approve or disapprove those rates.

The changes to the system of insurance regulation were implemented in three phases. Article 5.26–1, effective June 11, 2003, through September 1, 2004, established a one-time procedure for quickly bringing all Texas homeowners insurance providers under this new rate-regulation program. According to its terms, insurers were required to file their initial regulated rates with TDI within twenty days of the effective date of SB 14, June 11, 2003, and to implement the rates immediately. Tex. Ins.Code Ann. art. 5.26–1, § 2(a). Within forty days of the filing deadline, TDI was required to review and either approve or modify the initial rates. Id. art. 5.26–1, § 2(b).

After the initial filing, article 5.142, effective June 11, 2003, through December 1, 2004, provided temporary rate-regulation procedures. Id. art. 5.142 (West Supp.2004–2005). Under the terms of article 5.142, insurers were required to file their rates with TDI and await the commissioner’s approval before implementing these rates. Id. art. 5.142, § 5.

Finally, after December 1, 2004, article 5.13–2 allowed insurers to file rates and implement the rates immediately without prior approval. Id. art. 5.13–2, § 5 (West Supp.2005). Under this permanent file-and-use system, insurers can use proposed rates immediately, but TDI can review and either disapprove the rates before they go into effect or disapprove further use of the filed rates after they go into effect. Id. art. 5.13–2, §§ 5, 7.

State Farm Lloyds filed with TDI on June 26, 2003, submitting its then-existing rates as its initial rates. On August 18, 2003, TDI notified State Farm Lloyds of its determination that the rates must be reduced by twelve percent, stating that the rates “are not reasonable for the risks to *793 which they apply.” State Farm Lloyds appealed.

Pursuant to the terms of article 5.26–1, a hearing on State Farm’s appeal was to be conducted before the commissioner. TDI noticed the case for hearing fifteen days from the date that State Farms Lloyds filed its appeal. In preparation for the hearing, State Farm Lloyds served discovery requests on TDI, including deposition notices, requests for documents, and interrogatories, seeking to determine how TDI had set the rate reduction for State Farm Lloyds. Although State Farm Lloyds’s discovery requests were served pursuant to the department’s rules of practice and procedure for contested cases, TDI refused to produce for deposition any of its employees with knowledge of relevant facts about TDI’s rate reduction, denied all of State Farm Lloyds’s requests for documents and interrogatories, and withheld the workpapers and exhibits of its testifying expert until after State Farm Lloyds prefiled its direct case, arguing that the case was a rate case, not a contested case, and, therefore, the contested case discovery rules did not apply. See 28 Tex. Admin. Code §§ 1.82–.84 (2003). After a pretrial hearing on August 25, 2003, TDI agreed to present one of its two designated testifying experts for a limited, one-and-a-half-hour deposition.

The commissioner heard the merits of the case on September 2 and 3, 2003. To prevail in its appeal under the terms of article 5.26–1, State Farm Lloyds was required to show by clear and convincing evidence that the rate reduction specified by TDI would produce inadequate rates. An inadequate rate was defined as a rate that is “insufficient to sustain projected losses and expenses” and “endangers the solvency of an insurer using the rate.” Tex. Ins.Code Ann. art. 5.142, § 2(b)(2); see also id. art. 5.26–1, § 1(b) ( “The definitions adopted under article 5.142 of this code apply to this article.”). Following the hearing, the commissioner issued a final order affirming the department’s rate reduction, stating in a single conclusion of law that the rates recommended by TDI would produce adequate base rates for State Farm Lloyds.

State Farm Lloyds sought judicial review in district court. The district court granted summary judgment in favor of State Farm Lloyds, declaring appellants’ actions void and unenforceable, vacating the commissioner’s rate order, and denying appellants’ request to remand the case for further administrative proceedings. According to the district court, article 5.26–1 was unconstitutional on its face and as applied, violating the due course of law provision of the Texas Constitution and the due process clause of the United States Constitution. Article 5.26–1 was also unconstitutional, the court found, because it violated the takings provisions of both the Texas Constitution and the United States Constitution. Further, the court found that appellants had denied State Farm Lloyds due process by failing to follow the applicable contested case provisions of the Administrative Procedure Act (“APA”) and TDI’s own contested case rules. See Tex. Gov’t Code Ann. §§ 2001.051–.178 (West 2000); 28 Tex. Admin. Code §§ 1.1–.90 (2003). The commissioner and TDI appealed to this Court.

ANALYSIS

Standard of Review

1 2 3 The material facts are not in dispute, and the propriety of summary judgment is a question of law. Westcott Commc’ns, Inc. v. Strayhorn, 104 S.W.3d 141, 145 (Tex.App.-Austin 2003, pet. denied). We review the district court’s summary judgment de novo. *794 Valence Operating Co. v. Dorsett, 164 S.W.3d 656, 661 (Tex.2005); Provident Life & Accident Ins. Co. v. Knott, 128 S.W.3d 211, 215 (Tex.2003). When the material facts are not in dispute, both parties move for summary judgment, and the district court grants one motion and denies the other, we review the summary judgment evidence presented by both sides, determine all questions presented, and render the judgment that the district court should have rendered. Texas Workers’ Comp. Comm’n v. Patient Advocates of Tex., 136 S.W.3d 643, 648 (Tex.2004); FM Props. Operating Co. v. City of Austin, 22 S.W.3d 868, 872 (Tex.2000).

Constitutionality of Article 5.26–1

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1. The provision of article 5.26–1 that sets out the proof requirement for rate reviews is unconstitutional on its face.

Appellants contend that, when considering the insurance code as a whole, article 5.26–1 can be construed to operate constitutionally and that the trial court therefore erred in finding that the provision is facially *795 unconstitutional. State Farm Lloyds had challenged the constitutionality of the statute on the basis that it allowed the commissioner to impose confiscatory rates.

12 13 Regulated companies are constitutionally protected from confiscatory rate orders. A government-set rate must allow a regulated company to not only recover its operating expenses, but also to realize reasonable returns on its investments sufficient to assure confidence in the continued financial integrity of the enterprise. Duquesne Light Co. v. Barasch, 488 U.S. 299, 307, 109 S.Ct. 609, 102 L.Ed.2d 646 (1989); Railroad Comm’n v. Houston Natural Gas Corp., 155 Tex. 502, 289 S.W.2d 559, 572 (1956). A rate that does not allow for a reasonable rate of return is confiscatory and unconstitutional. Jersey Cent. Power & Light Co. v. Federal Energy Regulatory Comm’n, 810 F.2d 1168, 1181 (D.C.Cir.1987).

Section 4 of article 5.26–1 provides that “the burden of proof is on the insurer to show, by clear and convincing evidence, that the rate reduction specified by the department would produce inadequate rates.” Tex. Ins.Code Ann. art. 5.26–1, § 4. A rate is inadequate if it is “insufficient to sustain projected losses and expenses to which the rate applies, and continued use of the rate endangers the solvency of an insurer using the rate,” or if the rate “has the effect of substantially lessening competition or creating a monopoly within any market.” Id. art. 5.142, § 2(b)(2).

14 15 Rather than allowing for a reasonable rate of return on investments, article 5.26–1 only safeguards an insurer from rates that could lead to insolvency. While other provisions of the insurance code comport with the constitutional prohibition on confiscatory rates, providing, for example, that rates must be “just,” “fair,” “reasonable,” “adequate,” “not confiscatory,” and “not excessive,” see id. arts. 1.02(b), 5.26–1, § 2 (West Supp.2004–2005 & Supp.2005), the commissioner is not required to apply constitutional standards when conducting an article 5.26–1 rate review. Article 5.26–1 instead requires the commissioner to approve potentially confiscatory rates, absent clear and convincing evidence that such rates would lead to insolvency. We note, however, that rates can be confiscatory without necessarily leading to insolvency. Thus, the proof provision set out in section 4 of article 5.26, by allowing for the imposition of confiscatory rates, fails to provide regulated companies with a constitutionally adequate review of government-set rates. We therefore hold that the proof provision is unconstitutional on its face.2 See Guaranty Nat’l Ins. Co. v. Gates, 916 F.2d 508, 512 (9th Cir.1990) (declaring a statute unconstitutional for its failure to provide a mechanism to guarantee a constitutionally required fair and reasonable return to a regulated insurer).

2. Article 5.26–1 was unconstitutional as applied to State Farm Lloyds.

16 Appellants next assert that even if section 4 of article 5.26–1 is unconstitutional on its face, the rate order is valid because the commissioner did not require *796 State Farm Lloyds to meet the unconstitutional proof requirement at the hearing. Citing evidence to the contrary, State Farm Lloyds argues that the unconstitutional proof provision was applied throughout the rate-reduction appeal and that the commissioner’s decision following the rate hearing was based on this unconstitutional proof provision.

The record establishes that, when TDI initially notified State Farm Lloyds of its rate reduction, it set out the following proof requirement: “The burden of proof is on the company to show, by clear and convincing evidence, that the rate reduction specified by the department would produce inadequate results.” In its notice of hearing, TDI reiterated this proof requirement and also included the language of article 5.142: “A rate is inadequate if the rate is insufficient to sustain projected losses and expenses to which the rate applies, and continued use of the rate: (A) endangers the solvency of an insurer using the rate; or (B) has the effect of substantially lessening competition or creating a monopoly within the market.” Likewise, TDI used the same language in its opening statement before the commissioner at the merits hearing. Further, in its final order, the commissioner referred to the “inadequate” proof provision, concluding in finding of fact 25 that “State Farm did not show by clear and convincing evidence that the rate reduction specified by the Department would produce inadequate results.” Thus, the evidence establishes that this unconstitutional standard—rather than some other constitutional standard—was applied by the commissioner in upholding TDI’s rate determination. We hold that article 5.26–1 was unconstitutional as applied to State Farm Lloyds.

3. Severability

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The provision we have held invalid is the proof provision for a rate-review hearing, which requires insurers to prove “that the rate reduction specified by the department would produce inadequate results.” See Tex. Ins.Code Ann. art. 5.26–1, § 4. Despite our removal of the “inadequate” proof provision, several provisions remain that provide guidance to the parties in setting rates and to the commissioner in conducting a rate-review hearing.

Under the insurance code, insurers begin by setting their own rates and filing these rates with TDI. Id. art. 5.26–1, § 2(a); art. 5.142, § 4(a); art. 5.13–2, § 5(a). Depending on which provision applies, the insurer may be allowed to immediately begin using those rates, see id. art. 5.13–2, § 5(a), or may be required to await TDI’s approval of those rates, see id. art. 5.142, § 4(a). In setting these rates, insurers are guided by statutory rating criteria. See id. art. 5.142, § 3. These statutory guidelines require the insurer to consider:

(1) past and prospective loss experience inside this state, and outside this state if the state data are not credible;

(2) the peculiar hazards and experiences of individual risks, past and prospective, inside and outside the state;

(3) the insurer’s historical premium, exposure, loss, and expense experience;

(4) catastrophe hazards within this state;

(5) operating expenses, excluding disallowed expenses;

(6) investment income;

(7) a reasonable margin for profit; and

(8) any other relevant factors inside and outside this state.

Id. These guidelines specifically direct the insurer to consider a reasonable margin for profit in setting its rates. Id. Furthermore, *799 the insurer is directed to base its rates on its own historical premium and loss data, as well as its own data for expenses and for profit and contingency factors. Id. § 3(e).

The insurer is further instructed that rates must not be “excessive, inadequate, unreasonable, or unfairly discriminatory for the risks to which they apply.” Id. § 3(d). Articles 5.142 and 1.02 provide the following definitions of “excessive,” “inadequate,” and “unfairly discriminatory”:

[A] rate is:

(1) excessive if the rate is likely to produce a long-term profit that is unreasonably high in relation to the insurance coverage provided;

(2) inadequate if the rate is insufficient to sustain projected losses and expenses to which the rate applies, and continued use of the rate:

(A) endangers the solvency of an insurer using the rate; or

(B) has the effect of substantially lessening competition or creating a monopoly within any market; or

(3) unfairly discriminatory if the rate:

(A) is not based on sound actuarial principles;

(B) does not bear a reasonable relationship to the expected loss and expense experience among risks; or

(C) is based in whole or in part on the race, creed, color, ethnicity, or national origin of the policyholder or insured.

Tex. Ins.Code Ann. arts. 1.02(c), 5.142(b).6 These definitions not only define an inadequate rate as one that “endangers the solvency of an insurer using the rate,” but they also set out additional rating criteria, including the parameters for a permissible level of long-term profit, which cannot be “unreasonably high in relation to the insurance coverage provided.”7 Id.

Reading the statute as a whole and considering article 5.26–1 in light of articles 5.142 and 1.02, the parties are provided with detailed guidance for setting a rate, and the commissioner is given detailed standards for approving or disapproving a filed rate. The unconstitutional “inadequate” proof provision can be severed without requiring “the court to write words into the statute, to leave gaping loopholes in the statute, or to foresee which of many different possible ways the legislature might respond to the constitutional objections.” See Randall v. Sorrell, 548 U.S. 230, 262, 126 S.Ct. 2479, 2500, 165 L.Ed.2d 482 (2006). Having severed this unconstitutional “inadequate” provision, we conclude that the remainder of the statute comports with constitutional standards for setting insurance rates, which require that *800 the insurer be permitted to earn a reasonable profit.

In so holding, we note the consistency between our decision in this case and the solution crafted by the California Supreme Court when faced with a similarly imperfect statutory provision aimed at reducing skyrocketing car insurance rates in California. See Calfarm Ins. Co. v. Deukmejian, 48 Cal.3d 805, 258 Cal.Rptr. 161, 771 P.2d 1247 (1989). The statute passed by the California legislature, Proposition 103, contained a rate-adjustment mechanism that the insurers argued would preclude relief from confiscatory rates. See id. at 1250. Like the statute at issue here, Proposition 103 provided that “rates and premiums reduced ... may be only increased if the commissioner finds, after a hearing, that an insurer is substantially threatened with insolvency.” Id. at 1253. According to the California Supreme Court, such wording violates the constitutional standard of a fair and reasonable return. Id. The provision was therefore held to be invalid under the due process clause of the California Constitution and the United States Constitution. Id. at 1256.

Having determined that the statute’s “insolvency standard” was unconstitutional, the court then turned to the issue of severability. Id. Proposition 103 contained a severability clause much like the one in the Texas Insurance Code. As the court discussed in Calfarm, California case law provides three criteria for severability: the invalid provision must be grammatically, functionally, and volitionally separable. See Santa Barbara Sch. Dist. v. Superior Court, 13 Cal.3d 315, 118 Cal.Rptr. 637, 530 P.2d 605, 617–18 (1975). Applying these criteria to the provision in question, the court found the section containing the insolvency standard to be “clearly severable.” Calfarm, 258 Cal.Rptr. 161, 771 P.2d at 1256. The court determined that the provision was grammatically severable because it could be removed without affecting the wording of any other provision. Id. It was also functionally severable because its removal would merely eliminate an exception to the general rate-setting standard of the statute, which would otherwise operate unobjectionably. Id. Finally, the provision was volitionally severable because the remainder of the statute would likely have been adopted even if the invalidity of the insolvency standard had been foreseen; the voters “would presumably prefer rate setting and regulation under the balance of the initiative to the method of setting insurance rates which existed before the initiative was enacted.” Id.

As the Calfarm court explained, the invalidation and severance of the provision at issue “leaves untouched the general standard for rate adjustment,” which states that no “rate shall be approved or remain in effect which is excessive, inadequate, unfairly discriminatory or otherwise in violation of this chapter.” Id. Similarly, in the present case, the invalidation and severance of the provision requiring insurers to prove that the rate reduction specified by TDI would produce inadequate results has no effect on the general standard for rate review. As discussed above, the statute provides that “[a]n approved or modified rate ... must be just, reasonable, adequate, not excessive, and not unfairly discriminatory for the risks to which it applies.” Tex. Ins.Code Ann. art. 5.26–1, § 2(b). Further, given the crisis in the insurance market, the legislature would likely have adopted provisions for rate regulation with or without the sentence in question that sets out the proof requirement. See Calfarm, 258 Cal.Rptr. 161, 771 P.2d at 1256.

Because we have held that the proof provision is unconstitutional and must be *801 severed, we conclude that, under the remaining, valid provisions of article 5.26–1, an insurer must show by clear and convincing evidence that a rate filed under article 5.26–1 is “just, reasonable, adequate, not excessive, and not unfairly discriminatory for the risks to which it applies,” which means that the rate must allow for a “reasonable profit,” but not one that is “unreasonably high in relationship to the insurance coverage provided.” See Tex. Ins.Code Ann. art. 5.26–1, § 2(b), art. 5.142, §§ 2(b)(1–3), 3(d), art. 1.02(c)(1–3).

Due Process

In their next argument, appellants contend that, despite the expedited proceedings required by article 5.26–1, the proceedings under article 5.26–1 met all procedural due process requirements. In response, State Farm Lloyds argues that, because appellants refused to comply with the APA and TDI’s own rules, State Farm Lloyds’s due process rights were violated.

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We hold that State Farm Lloyds’s due process rights were violated by (1) the unconstitutional proof requirement, (2) appellants’ failure to apply the APA, and (3) appellants’ failure to fulfill certain requirements of due process.

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CONCLUSION

Because we conclude that the portion of section 4 of article 5.26–1 setting out the insurer’s proof requirement is unconstitutional on its face and as applied to State Farm Lloyds and that State Farm Lloyds was denied constitutionally adequate review of TDI’s rate order, we affirm the judgment of the trial court as to the insurer’s proof requirement and as to due process. We sever the unconstitutional provision requiring an insurer to prove that a rate reduction by TDI would produce inadequate rates, reverse the trial court’s judgment as to the constitutionality of the remainder of the statute, and remand to the department for further proceedings consistent with this opinion.