Against insurance rescission.

• Author: Barnes, Brian

NOTE CONTENTS INTRODUCTION I. RESCISSION: A SUPERCOMPENSATORY REMEDY OBSERVED A. What Is an Innocent Misrepresentation? B. Rescission as a Supercompensatory Remedy C. Rescission in Action: A Case Study D. Rescission as an Incentive To Engage in Bad-Faith Underwriting II. RESCISSION'S SHAKY FOOTING IN CONTRACT LAW A. Restoring the Parties' Ex Ante Positions B. Protecting the Insurer's Freedom of Contract III. INSURERS' DEFENSES AND THE INEVITABLE INEFFICIENCY OF RESCISSION'S BINARY CHOICE A. Defining Rescission's Limits 1. Construction of Warranties as Representations 2. Heightened Risk of Loss Requirements 3. Categorical Statutory Bars to Insurer Recovery 4. Imputation of Knowledge of the Insured's Misstatement B. Rescission's Limits Are Inefficient IV. "ACTUARIALLY FAIR REFORMATION" AS AN ALTERNATIVE TO RESCISSION A. The Alternative Remedy Explained B. The Merits of a Middle Way 1. Efficiency 2. Doctrinal Coherence C. Actuarially Fair Reformation as a Workable Judicial Standard CONCLUSION INTRODUCTION

Equity abhors a forfeiture, (1) yet in most states the law approves a forfeiture when someone makes an innocent misrepresentation on his insurance application. In such cases courts usually rescind the in "rance contract at the option of the insurer. Thus, an insured can answer the questions on his application in good faith, faithfully pay his premiums, and act in reliance on the validity of the insurance contract only to discover after suffering a loss that he is not insured after all. This is a harsh result.

Rescission's severity is as obvious to insurance scholars as it is to anyone else, (2) so it is surprising that no one has undertaken a comprehensive critique of the traditional remedy. The dearth of scholarship on this subject is all the more surprising given that misrepresentations are "the most litigated issue in life insurance" (3) and are extremely important to other types of insurance as well. (4) This Note aims to fill this gap by criticizing the use of rescission as the remedy for innocent misrepresentations and proposing an alternative remedy called "actuarially fair reformation." I argue that rescission is inefficient, incompatible with general principles of contract and restitution, and responsible for the messy state of much of the relevant doctrine. Actuarially fair reformation, which would grant the insured the amount of coverage that an insurance company could have sold him had he told the truth, has the potential to cure these ills.

After discussing the basics of insurance law's use of rescission in innocent misrepresentation cases, Part I shows how insurers systematically profit from rescission. In short, rescission allows insurers to refuse benefits to people who make innocent misrepresentations and suffer losses even while retaining the premiums of similarly situated people who never file claims. Rescission's tendency to overcompensate insurers is evident from concerns that some insurers engage in post-claim underwriting, a deliberate failure to discourage misrepresentations that rescission makes profitable.

Part II discusses the two conceptual justifications for rescission that courts most often offer in innocent misrepresentation cases. I argue that because rescission systematically overcompensates insurers, it does not return either party to its ex ante position. The insurer's right to decide with whom it will contract similarly fails as a justification for rescission. Since the traditional remedy requires that the insurer return some--but not all--of what it receives from the insured, this remedy fails to unwind fully their contractual relationship. Part III argues that rescission is responsible for much of the doctrinal confusion surrounding misrepresentations by insurance applicants. Courts are reluctant to deploy such a harsh remedy against sympathetic policyholders, and the result is a body of case law that is difficult to reconcile with the legal rules it purports to apply.

Finally, in Part IV, this Note advocates a new remedy: actuarially fair reformation. Using this remedy, a court would award the misrepresenting insured the amount of coverage that his premiums could have bought had he accurately completed his application. Thus, rather than malting the binary choice between a total loss for the insured and strict enforcement of the insurance contract as written, a court could award the insured a recovery tailored to the degree to which his misrepresentation was material. Lest this remedy give insurance applicants an incentive to lie, courts would need to distinguish good-faith misrepresentations from fraudulent ones and refuse to reform the contracts of people who intentionally deceive insurance companies. While this asks somewhat more from courts than the approach that most states take today, I argue that courts can distinguish good- and bad-faith misrepresentations with enough accuracy to justify replacing rescission.

1. RESCISSION: A SUPERCOMPENSATORY REMEDY OBSERVED

   Rescission of the insurance contract is the normal remedy for misrepresentations on an insurance application. Where an insured makes a misrepresentation without the intent to deceive, however, rescission's consequences often seem unduly harsh: the policyholder acts in reliance on the existence of insurance coverage and faithfully pays his premiums only to discover after suffering a loss that he is uninsured. The insured's comparative fault in this scenario might justify a remedy designed to return the insurer to the position it occupied prior to the misrepresentation, but rescission is not so limited. Instead, the remedy allows insurers to profit from customers who make misrepresentations but never file claims. Ongoing concerns exist about whether insurers are doing enough to prevent misrepresentations. These concerns strongly suggest that rescission overcompensates insurance companies. But before making the case against rescission in greater detail, it is first necessary to define the scope of misrepresentation cases with which this Note is concerned.

   1. What Is an Innocent Misrepresentation?

      An insurance applicant makes a misrepresentation when his application asserts "something as a fact which is untrue and affects the risk undertaken by the insurer." (5) As I use the term here, a misrepresentation can be an affirmative assertion of an untrue fact or a more passive failure to provide a complete answer to an insurer's questions. (6) In either case, misrepresentations are defined by their consequences; a misrepresentation is any communication by an insurance applicant that induces the insurer to assess inaccurately the risk of loss. (7)

      Misrepresentations matter because they disrupt the underwriting process. Underwriters use the information in insurance applications to assess the risk of loss and assign premiums that reflect this risk. More specifically, the underwriter's task is to set premiums at levels such that the payments of those who do not suffer losses will produce at least enough revenue to cover the losses of those who do. (8) Since it must rely on the truth of statements in the application when assessing the risk of loss, misrepresentations "impair[] an insurance company's ability to price premiums responsibly and fairly based on the actual risk the applicant represents to the insurer." (9)

      It follows that undiscovered or unremedied misrepresentations cause the insurer to underestimate the risk of loss and shift some of the cost of insurance from the applicant to the insurance company. For the insurance company's policies to remain actuarially sound, it must pass this cost on to other members of the risk pool in the form of higher premiums. As such, an insurance policy underwritten on the basis of misrepresentations is "an instrument of injustice to the [insurer] and all its policy holders." (10) Because they threaten both the viability and the fairness of any insurance scheme, misrepresentations are a special concern in insurance law.

      An insured's misrepresentations may be fraudulent or innocent. Fraudulent misrepresentations are deliberately false and designed to mislead the insurer into issuing a policy that it either would not have issued or would have issued at a higher premium. (11) Such misrepresentations are an attempt to defraud the insurance company and its policyholders. In contrast, an insured commits innocent misrepresentation when he makes a misstatement as a result of "ignorance, mistake, or negligence." (12) As in other areas of private law, the difference between fraudulent and innocent misrepresentation in the insurance context turns on the good faith of the misrepresenting party. (13)

      Though the specific facts of innocent misrepresentation cases vary, most fit into one of two scenarios: either the insured represents a fact about which he is mistaken or he is responsible for a miscommunication with the insurer. Thus, the insured's good-faith misrepresentations may be based on an incorrect assumption, (14) an undiscovered fact, (15) or a forgotten detail. (16) In other cases the applicant misinterprets one of the insurer's questions, (17) fails to mention a fact that he wrongly assumes the insurance company already knows, (18) or does not read the application with care. (19) While the degree of the insured's culpability varies in these scenarios, the common theme is that the insurance contract is predicated on a misstatement, despite the applicant's good-faith attempt to answer the insurer's questions truthfully.

      Whatever the cause or extent of an innocent misrepresentation, black-letter insurance law provides a single remedy: rescission of the insurance contract at the option of the insurer. (20) This remedy permits the insurer to "either opt to void the contract based upon [its] defect, or choose, instead, to waive that defect and ratify the contract despite it." (21) Thus, when the insurer discovers an innocent misrepresentation after the policyholder suffers an...