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 ante,¹ and to 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 If a contract is rescinded, it is, to the law, nonexistent.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. But 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:

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 Arizona, rescission is grounded in statute that provides:

Misrepresentations, omissions, concealment of facts and incorrect statements shall not prevent a recovery under the policy unless:

1. Fraudulent.

2. Material either to the acceptance of the risk, or the hazard assumed by the insurer.

3. The insurer in good faith would either not have issued the policy, or would not have issued the policy in as large an amount, or would not have provided coverage with respect to the hazard resulting in the loss, if the true facts had been made known to the insurer as required either by the application for the policy or otherwise. ³

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.

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. [Emphasis added.] ⁴

Because of a perceived need to protect the innocent claimant rescission will not be allowed in some cases because of a statutory enactment similar to K.S.A. (Kansas Statutes Annotated) 1989 Supp. 40-3118(b). "Those courts have held that rescission has been abrogated and that the only remedy for an insurance company is cancellation in strict accordance with the terms of the statute."⁵

The Supreme Court of Idaho stated the universal, common law rule of rescission that both parties must be placed back in the place they were before the contract was attempted. It explained the need to return consideration as follows:

The party desiring to rescind a contract must, prior to rescinding, tender back to the other party any consideration or benefit received under the contract by the rescinding party. . . . ⁶

If it rescinds the policy, the insurer must return to the insured the entire premium it collected, or it will find the policy it believed was rescinded is still enforceable. In some states, actual return of premium is required while others find that an offer to return the premium is sufficient to effect the rescission. If rescission is properly effected, the putative insured can only collect as damages the premium paid.⁷

In Holtzclaw v. Bankers Mut. Ins. Co., 448 N.E 2d 55, 58 (Ind. App. 1983), 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.

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.

In some states, even if the false statements made in the application were not warranties, but were merely misrepresentations or concealment (whether innocent or intentional), grounds exist for rescission. Fraud need not be proved; this is called the Marine Rule. The "Marine Rule" is ancient law:

The reasons underlying the rule are expressed in the leading case of Carter v. Boehm, 3 Burr. 1905, 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, it has been relaxed, at least in the United States, in the case of fire and life policies because of the practice of insurers to make inspections or ask questions which may reasonably be supposed by the insured to produce whatever information the insurer wants. . . . We think the marine rule is exceptional only because in other types of insurance the applicant usually may honestly consider himself discharged from any duty of affirmative disclosure about matters concerning which he has not been interrogated. Where that is not the case, the rule of uberrimmae fides should still be enforced. ⁸

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.

The South Dakota Supreme Court was asked to resolve a dispute over the right to rescind a policy of insurance after the insurer learns that it was deceived by a false statement on an application for insurance. In De Smet Farm Mut. Ins. Co. of South Dakota v. Busskohl, 834 N.W.2d 826 (S.D. 2013), De Smet Farm Mutual Insurance Company of De Smet, South Dakota sued its insured claiming that it lawfully rescinded an insurance contract with David Busskohl and was entitled to recover monies paid before it learned of the misrepresentation that was the basis of the rescission.

It is settled law in South Dakota that a misrepresentation as to a material matter in an application for insurance, even absent a showing of an intent to deceive, renders the policy voidable, because an insurer is entitled to rely on the truthfulness of the answers given. Braaten...