CHAPTER 5 RESCISSION OF INSURANCE POLICIES

• Jurisdiction: United States

Insurance contracts are based upon total good faith and trust between the parties who enter into a contract of insurance. If one of the parties breaches that trust, the law allows the parties to be returned to status quo ante¹ and act as if no policy ever existed. The law that allows the return to status quo ante is called the equitable remedy of rescission.

Rescission is a remedy that allows the parties to obtain a fair resolution to a legal problem rather than money damages. If a contract is rescinded, it is, to the law, nonexistent. Because rescission destroys rights people have under contracts, it requires that a preponderance of evidence convince the court that it would be unfair and unreasonable to allow anyone to enforce the terms of the contract.

Property and casualty insurers in the United States are the victims of more than $300 billion of insurance fraud annually. The rescission remedy, although fraught with danger if not elected carefully, can be an effective tool against a fraudulent claim. People who are intent on perpetrating the crime of insurance fraud know crime better than they know the law of insurance. The fraud perpetrator will seldom be caught setting a fire or faking an invoice because they prepared their crime carefully. The fraud perpetrator, however, having little knowledge of the law of insurance and the equitable remedy of rescission, will often err when acquiring the policy.

A mutual mistake of material fact, a unilateral mistake of material fact, a breach of warranty, a material concealment, and a material misrepresentation or fraud can all be grounds for rescission.

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 when a court is faced with a request to confirm rescission.

As an equitable remedy the party seeking rescission must deal fairly with the other party. 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.²

The California Insurance Code, a model applying the Marine rule first explained by Lord Mansfield in Carter v. Boehm, defines the terms and basis for rescission in California as follows:

§ 330 Neglect to communicate that which a party knows, and ought to communicate is concealment.

§ 358 A representation is false when the facts fail to correspond with its assertions or stipulation.

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

In Stipcich v. Metropolitan Life Ins. Co., 277 U.S. 311, 316 (1928), the Supreme Court observed that "[i]nsurance policies are traditionally contracts uberrimae fidei and a failure by the insured to disclose conditions affecting the risk, of which he is aware, makes the contract voidable at the insurer's option." Insurance companies seek a wealth of health history information from applicants because that information is extremely important to the underwriting decision.

In New York Life Ins. Co. v. Johnson, 923 F.2d 279 (3d Cir. 1991), the Third Circuit explained why an innocent beneficiary could receive no benefits if grounds for rescission exist. This ruling applies in the 9th Circuit and all California courts because it clearly explains the reason why fraud should not be rewarded:

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 has 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. ³

The California Court of Appeal reaffirmed the general rule stated in the California Insurance Code that the test to determine the materiality of facts misrepresented or concealed, when rescinding a policy of insurance, is subjective. It is determined by the effect the false information had on the particular underwriter who made the decision to insure.

The reasons underlying the rule are expressed in the leading case of Carter v. Boehm, 3 Burr. 1905, [reproduced supra in Chapter 1,] where Lord Mansfield (in 1774) explained that insurance is a contract upon speculation, and, since the special facts upon which the contingent chance is to be computed most commonly lie in the knowledge of the insured only, the underwriter proceeds upon confidence that he does not hold back any known fact affecting the risk, and is deceived if such a fact is concealed, even though its suppression should happen through mistake and without fraudulent intention. While this principle still persists in full vigor in marine insurance and has been adopted by the legislature of the state of California in its Insurance Code, is applied with more vigor in California than in most states. The marine rule is exceptional only because in other types of insurance, the applicant may honestly consider himself discharged from the duty of affirmatively disclosing any matters about which he has not been interrogated. Where that is not the case, the rule of uberrimae fides should still be enforced. ⁴

Insurance companies rely on the good faith and fair dealing of prospective insureds when making a decision to insure or not insure against a particular risk of loss. When the insured fails to act in good faith and gives false or misleading information to the insurer, so that it issues a policy it would normally refuse, the law of equity allows the insurer to void the policy from its inception as if the policy never existed. A court, concluding rescission is proper, will put the parties back to the position they were in before the policy was issued.

A misrepresentation is material if it naturally and reasonably influenced the judgment of the underwriter in making the contract at all, estimating the degree or character of the risk, or fixing the rate of premium. Misrepresentations to an insurance company which, if the truth were known, would affect the premium charged or exposure to the risks of providing coverage are material.

A false statement on an application for insurance made with the intent of obtaining insurance that the applicant knows is not available, and which would cause damage to the insurer if an accident were to occur, is the same as common law fraud.

In California, although its application of the equitable remedy of rescission appears to those in other states to be draconian, the result in Barrera v. State Farm Mut. Auto. Ins. Co., 71 Cal. 2d 659, 79 Cal. Rptr. 106, 456 P.2d 674 (1969), caused the California Supreme Court to refuse rescission under certain circumstances where an automobile liability insurer could not be rescinded when the insurer failed to investigate representations contained in the application and a third party was injured before the insurer decided to rescind. The duty to investigate the risk directly inures to the benefit of third persons injured by the insured. Such an injured party, who has obtained an unsatisfied judgment against the insured, may properly proceed against the insurer; the insurer cannot then successfully defend upon the ground of its own failure to reasonably investigate the application.

Insurers cannot afford to thoroughly investigate every application presented to them to determine if an insured lied, as required by the California Supreme Court in Barrera. To do so would increase the cost of insuring, especially in cases where circumstances changed.

If an insurer learns that it issued a policy based upon misrepresentations of material facts, it should immediately notify the putative insured that the policy is rescinded and return or offer to return the premium immediately. If there is an injured person, as there was in Barrera, consideration should be given whether to reserve rights, provide a defense, and demand repayment from the putative insured who obtained the coverage by fraud.

In the leading California case of Imperial Cas. and Indem. Co. v. Sogomonian, 198 Cal. App. 3d 169, 243 Cal. Rptr. 639 (Cal Ct. App. 1988)—which took up 15 years of the author's time—although the insurer could not prove that the insured intentionally burned down his house, it was able to prove that there were misrepresentations and concealment of material fact, which allowed the insurer to rescind the policy.

"In its motion for summary judgment Imperial produced evidence that the defendants, in responding to questions in the policy application, (1) specifically denied (for the immediately preceding three years) any loss history and any policy cancellations or renewal refusals, and (2) failed to include" material facts concerning prior losses and prior cancellation. The insurer produced evidence of multiple claims before the application, including one where the claim was paid on the date the insured, Sogomonian, was paid by a prior insurer who then refused to renew the policy it had issued to Sogomonian.

Imperial also offered the deposition testimony of one of its former underwriters who was responsible for making the decision to issue the subject policy. She testified that she relied on defendant's application,

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