Primer: Rescission of Insurance

An insurance policy is nothing more than a contract. It is a special type of contract because – by law – it contains an implied covenant of good faith and fair dealing. What that means is that neither party to the contract must do nothing to prevent the other from obtaining the benefits of the contract.

When a prospective insured violates the covenant of good faith and fair dealing by misrepresenting or concealing a material fact that deceives an insurer to take on a risk that would not have been taken had the truth been known the law allows the insurer – upon a presentation of sufficient admissible evidence – to rescind the policy and treat it as if it never came into existence.

Developing the evidence is not easy. It requires the effort of an insurance professional to collect the evidence – whether documentary or by oral testimony – to convince a judge or jury that the insurer acted properly, that the insured deceived the insurer and that the court should order that the policy was void ab initio (from its inception).

What an Insurer Must Prove to Rescind a Policy of Insurance

In many states, following ancient British precedent that predated the formation of the United States, an insurer that discovers a factual basis establishing that an insured obtained a policy by deceiving the insurer about the risk applied for by the insured the insurer may declare the policy void from its inception and treat it as if it never existed. In simple language, if the insurer discovers, either before or after a loss, that the policy was acquired as a result of a misrepresentation or concealment of a material fact, it may rescind the policy. In most states the ancient Marine Rule (first stated in 1766 in the British House of Lords in a case called Carrter v. Boehn) is followed and rescission is available regardless of whether the insured fraudulently or innocently misrepresented or concealed a material fact.

It is axiomatic in the United States that an insurance company is entitled to determine for itself what risks it will accept, and therefore to know all facts relative to the risk the insured seeks to transfer to the insurer. It has the unquestioned right to select those whom it will insure and to rely upon him who would be insured for such information as it desires as a basis for its determination to the end that a wise discrimination may be exercised in selecting its risks. To effectively rescind a policy of insurance in a state that applies the Marine Rule the insurer must be able to prove by a preponderance of the evidence that it entered into the contract of insurance because it was deceived about a fact material to its decision to insure or not insure.

To prove it is entitled to rescind the investigation conducted by the insurer must establish:

•That the insured submitted an application for insurance seeking an offer of insurance from the insurer.

•That the insurer reasonably relied upon the facts represented by the application when it made its decision to offer to insure.

•That the application contained one or more misrepresentations of material fact or that the insured concealed one or more material facts.

•That but for the misrepresentation the insurer would not have issued the policy on the same terms and conditions as it did had it known the true facts.

•That but for the concealment of material facts the insurer would not have issued the policy on the same terms and conditions as it did had it known the true facts.

•That it established materiality by contact with the underwriter who made the decision to insure who is willing and able to testify that had he or she known the true facts he or she would not have agreed to insure on the same terms and conditions.

•That the insured was advised, in writing, that the policy was rescinded and that the insurer either returned the premium or offered to return the premium.

In states like Louisiana that do not apply the Marine Rule the facts established must, in addition to the seven elements above, prove that the insured intended to deceive the insurer.

In all states the evidence needed to establish a ground, or multiple grounds, for rescission investigation needed can be obtained by the adjuster or SIU investigator interviewing, at least, the following:

•The insured(s);

•The insurance broker;

•The insurance agent;

•The underwriter who made the decision to insure; and

•Independent witnesses.

In addition, the investigation must be supported and enhanced by retaining competent, local, insurance coverage counsel to conduct an examination under oath of the insured(s) and collect relevant documents from the insured(s), the insurance agent or broker and the underwriter.

Once the investigation is completed then, and only then, should an experienced insurance coverage counsel – either the lawyer who took the examinations under oath or a separate independent coverage counsel – working in the location where the policy was issued to be performed who will opine upon the viability of the evidence, whether the evidence establishes facts sufficient to show that facts material to the decision to insure were misrepresented or concealed and whether the misrepresentation or concealment were presented to the insurer with an intent to deceive. With that information counsel should provide advice to the insurer whether state law allows for rescission based upon the facts determined by investigation and the law of the jurisdiction.

The Legal Bases for Rescission of Insurance

Rescission is an equitable remedy based in the ancient Ecclesiastical courts of Medieval England where all the judges were clergy whose stated purpose was to do fairness. The Ecclesiastical courts did not deal with damages nor were they allowed to enter money judgments. Rather, they resolved disputes between people fairly. They would enforce a contract by ordering the parties to perform as promised. They would allow for rescission that would void a contract from its inception if the contract was entered into by fraud or mistake.

The Supreme Court of Texas has explained that rescission is merely a shorthand name for “the composite remedy of rescission and restitution.” Cruz v. Andrews Restoration, Inc., 364 S.W.3d 817, 825 (Tex.2012) (citing Restatement (Third) Of Restitution and Unjust Enrichment § 54 cmt. a (2011)).  Rescission is not a one-way street. It requires a mutual restoration and accounting, in which each party restores property received from the other.

The risk that an insurance policy might be rescinded as the result of misrepresentation or concealment clearly operates as a brake on any temptation by the insured to misrepresent or conceal facts from an insurer in order to obtain coverage at a lower premium or on terms that would not be offered if the true facts were disclosed. The law of rescission is a major enforcement tool in maintaining the integrity and commercial dynamics of the insurance marketplace.

If there is a breach of warranty, a material concealment, or a material misrepresentation, rescission is a remedy available for selection by the insurer or the insured. It can be the most effective remedy depending on the law of the state where the policy was issued or is to be performed. In states that apply the Marine Rule, rescission is available for even an innocent misrepresentation or concealment of material fact. In states that do not honor the Marine Rule the grounds for rescission are more stringent. When an insurer believes it has been deceived by an insured into issuing an insurance policy advice from local coverage counsel is needed before a decision can be made to rescind a policy.

The rescission remedy is often used as an effective tool against a fraudulent claim. Since property and casualty insurers in the US are the victims of between $80 billion and $300 billion in fraud annually any defense to a fraudulent claim is important to an insurer’s anti-fraud efforts.

Experience has shown that people who are intent on perpetrating the crime of insurance fraud know crime better than they know the law of insurance. Where they may not be caught setting a fire or faking an invoice they will often err when acquiring the policy.

A mutual mistake of material fact, a unilateral mistake of material fact, the breach of warranty, a material concealment, or a material misrepresentation can all be grounds for rescission. To do otherwise would be to make a gift to the person who deceived the insurer.

There is a split of authority as to whether materiality is a question of law or a question of fact. Courts that have held that materiality is one of law have reasoned that the fact that the insurer has demanded answers to specific questions in an application for insurance is in itself usually sufficient to establish materiality as a matter of law. [Cohen v. Penn Mut. Life Ins. Co. (1957) 48 Cal.2d 720, 726; West Coast Life Ins. Co. v. Ward (2005) 132 Cal.App.4th 181, 187.] Courts holding that the question of materiality is one of fact have reasoned: “An incorrect answer on an insurance application does not give rise to the defense of fraud [and rescission] where the true facts, if known, would not have made the contract less desirable to the insurer.” [Ransom v. Penn Mut. Life Ins. Co. (1954) 43 Cal.2d 420]

Most courts recognize it is unfair to make an insurer abide by a contract that was not obtained fairly. The ancient maxim that “No one may profit from his wrong” is applied. In modern practice, the trial judge sits as both a court of law and a court of equity, changing hats and methodology as the case requires. Whether a contract should be rescinded is a decision made only by the court sitting as a court of equity. Its direction is to make a ruling that is fair to all parties. When the court grants rescission it always requires that the insured receive a return of the premium it paid so that both parties are in the same position they were in when the contract, now rescinded, was made.

Rescission is an equitable process that allows a court to conclude that it would be unfair to the parties to allow a contract to continue. It places the parties back in the position they were in before the contract date.

Insurers should use the remedy with care. If an insurer elects rescission without enough evidence it can bring the wrath of the courts down on the insurer and may be the basis for allegations of extra-contractual torts. If sufficient evidence exists, most courts will grant judgment in favor of the insurer and rescission will deprive the insured of all rights under the policy.

The grounds for a rescission use key terms such as concealment and misrepresentation. The California Insurance Code (applying the Marine Rule) defines the terms as follows:

Neglect to communicate that which a party knows, and ought to communicate is concealment. [California Insurance Code § 330.]

A representation is false when the facts fail to correspond with its assertions or stipulation. [California Insurance Code § 358.]

The effect of a concealment or a false representation on a policy of insurance is that it entitles the other party to rescind. [California Insurance Code § 331 and § 359.]

In LA Sound USA Inc. v. St. Paul Fire & Marine Insurance Co., 156 Cal. App.4th 1259 (2007), an insurer rescinded a directors and officers liability policy because of material misrepresentations in the application. The insured argued that the insurer could not rescind because it had not provided written notice of rescission or offer to restore the premiums paid. The court rejected this argument, noting that the insurer had filed an answer to the insured’s complaint in which the insurer alleged the affirmative defense of misrepresentation and filed a cross-complaint seeking rescission. The court held that the pleadings satisfied the carrier’s responsibility to provide notice and to offer restoration

.

In Nebraska:

Nebraska’s law of Rescission is clear. This equitable remedy dissolves and renders a written agreement a nullity. Haumont v. Security State Bank, 374 N.W. 2d 2, 7 (Neb. 1985). Rescission requires “a judicial effort to place the contractual parties in, as nearly as possible, substantially the same condition which existed when the contract was entered.” Kracl v. Loseke, 461 N.W. 2d 67, 76 (Neb. 1990). In ordering Rescission, a court must require all parties to return whatever they gained under the rescinded document. Gnuse v. Garrett, 261 N.W. 143, 144 (Neb. 1935). Lincoln Benefit Life Co. v. Edwards, 243 F.3d 457, 243 F.3d 457 (8th Cir. 03/15/2001).

In New Jersey:

Under New Jersey law, an insurer may rescind a policy when the insured makes a false statement in the insurance application that materially affects the acceptance of the insurance risk. (Concerning professional liability insurance) See also Gallagher v. New England Mutual Life Ins. Co. of Boston, 19 N.J. 14, 20 (1955). “In general, a representation by the insured, whether contained in the policy itself or in the application for insurance, will support the forfeiture of the insured’s rights under the policy if it is untruthful, material to the particular risk assumed by the insurer, and actually and reasonable relied upon by the insurer in the issuance of the policy.” Allstate Ins. Co. v. Meloni, 98 N.J. Super. 154, 158-59 (App. Div. 1967). See Merchants Indem. Corp. of New York v. Eggleston, 68 N.J. Super. 235, 244 (App. Div. 1961), affirmed, 37 N.J. 114 (1962). In applying the doctrine of equitable fraud to an insured’s answers to questions posed in insurance applications, when the question is subjective—as here where it asks whether the law firm is aware of any circumstances which may result in a claim being made against the firm—equitable fraud is present only if the answer was knowingly false. Ledley v. William Penn Life Ins. Co., supra, 138 N.J. at 635-37; Liebling v. Garden State Indem., supra, 337 N.J. Super. at 454. First American Title Insurance Company v. Lawson, No. A-0992-01T5 (N.J. Super. App. Div. 06/04/2002).

The court can grant either rescission of the insurance contract or an affirmative defense to an insured’s claim without requiring proof of any additional facts in support of the requested remedy or defense. Depending on the facts, the rescission is based on either a misrepresentation or a mistake of fact.

A contract may be rescinded on the basis of a material mutual mistake even if it is clear that everyone acted in complete good faith.

In N.Y. Life Ins. Co. v. Johnson, 923 F.2d 279 (3d Cir. 1991), the court stated:

While a Court might sympathize with a beneficiary who does not receive the proceeds of a policy obtained by the insured’s fraud, there are strong reasons of public policy supporting the rule which we believe prevails in Pennsylvania. If the only consequence of a fraudulent misrepresentation in a life insurance application is to reduce the amount paid under the policy, there is every incentive for applicants to lie. If the lie is undetected during the two-year contestability period, the insured will have obtained excessive coverage for which he had not paid. If the lie is detected during the two-year period, the insured will still obtain what he could have had if he had told the truth. In essence, the applicant has everything to gain and nothing to lose by lying. The victims will be the honest applicants who tell the truth and whose premiums will rise over the long run to pay for the excessive insurance proceeds paid out as a result of undetected misrepresentations in fraudulent applications. Id. at page 6. (Emphasis added.)

Mr. Johnson answered a life insurance application regarding smoking in the negative although he had smoked for thirteen years and was smoking ten cigarettes a day during the month he applied for the policy. If New York Life had known the true facts, it would have issued the policy—but at a substantially higher premium. Johnson died of causes unrelated to smoking.

Rescission not only deprives the insured of the indemnity he or she seeks, but it causes the insurance to disappear entirely as if it never existed.

In general, concealment involves the suppression or withholding of information. An intentional concealment of a material fact by an applicant for insurance provides the insurer with a valid defense to a claim or the basis for rescission of the insurance contract. In this case the applicant concealed the names of the treating physicians. In most states, not including California, if the applicant’s failure to reveal information is not an intentional concealment, such conduct does not constitute a sufficient basis for a defense by an insurer.

In W. Coast Life Ins. Co. v. Hoar, 558 F.3d 1151 (10th Cir. 2009), the Tenth Circuit allowed an insurer to rescind a policy because of the insured’s failure to advise the life insurer of his engagement in hazardous activities.

In Admiral Ins. Co. v. Debber, 295 Fed. Appx. 171 (9th Cir. 2008), rescission was affirmed because the insured misrepresented and concealed facts material to the decision of the insurer to insure, that it had two prior claims. The court concluded that “a material misrepresentation or concealment in an insurance application, whether intentional or unintentional, entitles the insurer to rescind the insurance policy ab initio.”

The California Court of Appeal reaffirmed the general rule with regard to concealment and misrepresentation and the rescission of insurance policies. In Imperial Cas. & Indem. Co. v. Sogomonian, 198 Cal. App. 3d 169, Cal. Rptr. 639 (Ct. App. 1988), a leading California case on materiality, the insured answered two questions on the application falsely. Mr. Sogomonian advised the insurer that he had never incurred a loss and that no insurer had ever canceled, non-renewed, or refused him insurance. The claims investigation established six prior losses, including a landslide that damaged the property downslope and a water damage claim from a leaking roof that was paid on the same day he signed his application. Investigation also established that two insurers had canceled insurance for Mr. Sogomonian, including the insurer immediately preceding the application, because of poor housekeeping. The Imperial Casualty & Indemnity Company underwriter testified that had she known the true facts she would not have insured Sogomonian against the risk of loss of his home and its contents. The court stated: “An insurance company is entitled to determine for itself what risks it will accept, and therefore to know all facts relative to the applicant’s physical condition. It has the unquestioned right to select those whom it will insure and to rely upon him who would be insured for such information as it desires as a basis for its determination to the end that a wise discrimination may be exercised in selecting its risks [citations]…”

When an insurer is seeking rescission, the trial court must balance the equities to determine whether the plaintiff is entitled to the relief he or she seeks. [Johnson v QFD, Inc, 292 Mich App 359, 370 n 3; 807 NW2d 719 (2011)]. Courts are not required to grant rescission in all cases. For example, rescission should not be granted in cases where the result thus obtained would be unjust or inequitable or where the circumstances of the challenged transaction make rescission infeasible. Moreover, when two equally innocent parties are affected, the court, in the exercise of its equitable powers, must determine which blameless party should assume the loss.

When an insurance company seeks rescission, the trial court’s next step is to determine whether the insurance company’s claim concerning the third-party is justified by the equities of the case.

In states like Louisiana, that by statute does not apply the Marine Rule, to void coverage due to a misrepresentation in the insurance application, the insurer must prove that:

• the insured made a false statement;

• the false statement was material; and

• it was made with intent to deceive. [Willis v. Safeway Ins. Co. of La., 968 So. 2d 346, 350 (La. App. 2007)]. [IA]