An Economic Analysis of the First Manifest Doctrine

• Publication year: 2021

76 Nebraska L. Rev. 819. An Economic Analysis of the First Manifest Doctrine

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David G. Newkirk*

An Economic Analysis of the First Manifest Doctrine: Paul Revere Life Insurance Co. v. Haas, 644 A.2d 1098 (N.J. 1994)

TABLE OF CONTENTS

I. Introduction 820
II. The Haas Decision 821
A. The Roots of Incontestability 825
B. An Economic Analysis of the Rule in Haas 827
1. C(F) (Cost of Fraud) x F(F)
(Frequency of Fraud). 829
2. ED(F) (Insurer's Ability to Detect
Fraud at an Early Date) 830
3. C(A) (Evidentiary Cost of Absence of
Insured and/or Passage of Time) 832
4. A(A) (Relatively Lower Ability of
Beneficiary to Successfully Present Evidence
of True State of Affairs to Court) 833
5. C(F) (Cost of Insurer Overreaching) 835
6. C(LS) (Cost of Loss of Security
Felt by Insured). . 836
7. TC(L) (Transactional Cost of Litigation) 837
C. Incentives from the Insured's Perspective 837
D. A Comparative Analysis: First Manifest and
Fraudulent Misstatement 838
E. Summary 839
III. The First Manifest Doctrine in Other
Jurisdictions 839
IV. Conclusion 851

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I. INTRODUCTION

It is unchanging black letter law that a contract of insurance is a transfer of risk. This system, which funds the transfer of risk, operates through an application of the law of large numbers. The transferred risk, or "peril," will produce a loss to some individuals in a large group. While each individual cannot predict if he will suffer the peril, it can be stated statistically that the peril will strike some individuals in the group. The insurer collects premiums from the group and pools them to cover these losses and the operating costs of the insurer. The risk-neutral individual, who does not know whether or not the risk will materialize, pays a small amount for protection against the small chance that it will materialize. These individuals fund the operation of a system that achieves a social good in an effective and efficient manner.(fn1)

The perfect operation of the system can be thwarted by free riders in two ways. First, when individuals who have chosen not to participate in the group attempt to transfer risk for a loss that already has occurred, the prevalence of the risk is altered in the group. In an insurance context, this can occur when a proposed insured conceals a condition and then claims benefits for that condition. The risk-neutral individuals who "play by the rules" end up participating in a system with an artificially high concentration of the risk and facing higher than necessary payments to fund the losses of free riders, who do not participate in the cost of the system, but reap the benefit of the system.(fn2) Second, the system also is defeated to the extent that legitimate losses are not indemnified.

Historically, courts and legislatures have focused on the second concern more than the first. Through "incontestability" clauses, the insurer's ability to challenge the validity of the contract has been legislatively limited in time or scope. As insurance fraud has become more prevalent, however, these clauses have been increasingly used by opportunists as a safe harbor for fraud. Judicial doctrines have attempted to find solutions that balance the desire to protect innocent insureds with the desire to avoid encouraging insurance fraud.

One of those doctrines is the so-called "first manifest" doctrine. This doctrine uses policy language to avoid incontestability facilitated fraud by allowing coverage, but limits the risks transferred to those

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intended by the contract. The doctrine allows the insurer to deny a specific claim for a concealed condition while allowing the insured to keep coverage under the policy in effect for any condition that was unknown to the applicant.

This Article discusses a recent leading case in the area, Paul Revere Life Insurance Co. v. Haas.(fn3)Haas represents an example of a state supreme court making new law to achieve policy objectives. Analysis of Haas and similar cases in other jurisdictions suggests that the relevant policy factors behind both incontestability and exceptions to incontestability can be described in equation form. A review of historical trends suggests that those variables leading to legislative recognition of incontestability have been supplanted by other factors. In contrast, those variables leading to judicial exceptions to incontestability, including insurance fraud, have become more prominent. This perspective suggests that recent first manifest cases represent a judicial balancing of an equation thrown out of balance by rising insurance fraud. Finally, the economic perspective suggests that the doctrine is a more efficient way to achieve multiple policy goals than the legislative alternative available in some states.

II. THE HAAS DECISION

Paul Revere Life Insurance Co. v. Haas dealt with several themes that will be common in first manifest cases:

historical policy concerns, which led to the incontestability clause, namely a belief that insurers used unequal power to overreach as against innocent insureds;

modern policy concerns recognizing the ease and prevalence of fraud;

the effect of any election between alternate clauses allowed by the relevant incontestability statute; and

the interaction between incontestability clauses and contract provisions dealing with preexisting conditions.

In Haas, the insurer sought a declaration that a policy issued to an insured was void or in the alternative that the policy provided no coverage for a condition concealed on the application. A trial court granted the insured's motion for summary judgment, holding that the insured's policy was incontestable. The insurer appealed.(fn4)

In this procedural posture, the appeals court therefore viewed all disputed facts in a light most favorable to the insurer. Under this standard, the court assumed that Haas knew he had suffered from a

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four-year history of retinitis pigmentosa, a degenerative condition that can lead to blindness. He neither disclosed this fact nor revealed treatment received for the condition when he applied for disability coverage with the insurer. Two years and nine months after issuance of the policy, Haas claimed that he had become totally disabled from retinitis pigmentosa and therefore was entitled to be paid under the policy.(fn5)The policy issued to Haas had statutorily mandated incontestability language, which stated as follows:

10.2 INCONTESTABLE

a. After Your Policy has been in force for two years, excluding any time You are disabled, We cannot contest the statements in the application. b. No claim for loss incurred or disability beginning after two years from the Date of Issue will be reduced or denied because a disease or physical condition existed before the Date of Issue unless it is excluded by name or specific description.(fn6)

This version of the incontestability clause was one of two alternate versions required by section 17B:26-5 of the New Jersey statutes. The second alternative would have provided that

[a]fter 2 years from the date of issue of this policy no misstatements, except fraudulent misstatements, made by the applicant in the application for such policy shall be used to void the policy or to deny a claim for loss incurred or disability (as defined in the policy) commencing after the expiration of such 2-year period.(fn7)

The appeals court found that the election to use the first version of the clause was fatal to the attempt to void the policy, even if Haas acted with fraudulent intent. "We would contravene the clear meaning of the policy, and indeed the statute, were we to graft the 'except fraudulent misrepresentations' phrase upon the clause pertinent here."(fn8)

The policy, however, also contained language that required the disability to be caused by a sickness that "first manifests itself after the Date of Issue and while Your Policy is in force."(fn9) The policy also indicated that it would not pay benefits for "a Pre-existing Condition if it was not disclosed on Your application."(fn10) This led to an argument that even if the policy was valid, the condition was not covered. Under this argument, the incontestability clause did not bar diseases that had not only existed, but had manifested in illness known to the insured. Alternately, the exclusion for preexisting conditions could be

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viewed as meaning that the disease was "excluded by . . . specific description."(fn11)

The appeals court rejected these arguments on several grounds. First, the court held that the insurer's position would frustrate the "reasonable expectations of the average member of the public who buys it."(fn12) Second, the court viewed the contract as a contract of adhesion and resolved any ambiguity as to whether the condition was excluded by specific description against the insurer.(fn13) Third, the court felt that the proposed rule "frustrates the underlying purpose of the incontestability clause," namely to limit litigation and to allow the insured a sense of security after the contestability period.(fn14)

The New Jersey Supreme Court reversed the appeals court decision and overruled prior New Jersey law in doing so.(fn15) Although the court evaluated the case based on contract language, it recognized that policy concerns were involved as well. "Ultimately . . . it involves a policy choice concerning the effect of an insured's concealment of a disability in an application for insurance on a subsequent claim for the concealed disability."(fn16)

The court initially discussed the historical policy justification for the clause. Unlike the historical conclusion that insurance fraud was only a "minuscule"(fn17) problem, however, the court also noted that "[i]nsurance fraud is a problem of massive proportions that currently results in substantial and unnecessary costs to the general public in the form...