Fraudulent Application Can Haunt the Broker

December 2004

Insurance brokers have, for years, operated under the misconception that an insurer's exclusive remedy for a false application is rescission. They were wrong. The California Court of Appeal has made clear that if the broker knew that the statements were false when the application was submitted, it can be found liable to the insurer for damages resulting from its actions in submitting a fraudulent application.

by Barry Zalma
Barry Zalma Inc.

In Century Surety Co. v Crosby Insurance Inc., 2004 DJDAR 13917, November 17, 2004, the California Court of Appeal allowed an insurer to seek damages from the insurance broker who submitted to it a fraudulent and false application for insurance. In that case, Crosby Insurance submitted to Century Surety an insurance application for Baroco West Inc. The application represented that Baroco was a "drywall" contractor with no prior losses in the 2 years before the application. Century issued a policy in reliance on the facts represented in the application.

After the policy was issued a construction defect action was filed against Baroco as the "general" contractor. Century assumed the defense of Baroco but later withdrew after discovering Baroco's insurance application contained false information. The false information gave Century the right to rescind the contract of insurance and eliminate all obligations under the policy to Baroco. Century was not satisfied with rescission alone. It had been damaged, and demanded damages from the broker who deceived it and whose deception caused it to issue a policy.

Century, in addition, sued Crosby for losses caused by Crosby's alleged fraud, negligence, and negligent misrepresentation. The application submitted by Crosby incorrectly classified Baroco as a drywall subcontractor. The application was also supported by a forged letter from Crosby's office falsely stating that Baroco had no losses for 2 years.

The California Court of Appeal concluded that "generally" only insureds are responsible for a misrepresentation or material concealment in an application made out by an insurance broker. However, the court also found it was unreasonable if the law allowed an insurer no remedy against a broker who actively took part in the fraudulent application. [California Civil Code Section 3523: "For every wrong there is a remedy."] To prevent an insurer from suing a broker—who only represents the insured and not the insurer—for its fraud or complicity in the fraud of the insured would violate the ancient maxim stated in Civil Code Section 3523.

Defrauded Insurer Can Recover from Broker Fraud

The California Court of Appeal also relied on decisions of courts in other jurisdictions that imposed liability on an insurance broker in an insurer's action to recover for losses incurred as a result of the broker's fraud.¹ In addition, commentators noted:

• [S]ince a broker that is not the insurer's agent owes no fiduciary duty to the insurer, the broker is not liable for an alleged failure to reveal known facts. However, a broker will be held liable in tort to an insurer that issued a policy based on fraudulent material misinformation or the withholding of facts, where the broker knew, or reasonably should have known, that disclosure of the truth would have resulted in the insurer rejecting the application. [43 Am Jur 2d (Supp 2004) Insurance, § 158 (fns. omitted)] (Emphasis added.)

Finding these authorities persuasive, the court concluded that California case law does not provide any basis for exempting an insurance broker from the consequences of its own fraud.

No Exclusive Remedy of Rescission for a Broker's Fraud

The broker argued that the exclusive remedy available to Century is that of rescission of the policy under provisions of the California Insurance Code. California courts have made clear that the right of rescission established in the Insurance Code is not an insurer's exclusive remedy against an insured.²

Public Policy Supports Honesty in Applications

California courts have not ruled on the duty an insurance broker owes to an insurer under circumstances similar to those of the Century case. The California Supreme Court has set forth the factors for determining when a party to a transaction owes a duty to a third party. In Biakanja v Irving, 49 Cal 2d 647 (1958), the intended beneficiary under an invalid will sued the notary public whose negligence had caused the will to be refused admittance to probate. The trial court entered judgment in favor of the plaintiff beneficiary, and the notary public appealed. The California Supreme Court held that to sue for negligence, a plaintiff need not prove privity of contract with the defendant.

In Roberts v Ball, Hunt, Hart, Brown & Baerwitz, 57 Cal App 3d 104 (1976), the court extended the Biakanja rule to hold that a lawyer owed a duty of care to a third party when the lawyer provided a document, which contained a negligent misrepresentation, to a principal with the intent that the document be relied upon by the third party.

The factors set forth in Biakanja support finding a duty on the part of an insurance broker toward an insurer.

1. The transaction of applying for an insurance policy is intended to benefit the insurer as well as the insured and is designed to influence the insurer's conduct in issuing an insurance policy.

2. Harm from misrepresentations in an insurance application, such as the precise harm alleged to have occurred in the Century case (defense costs), is easily foreseeable.

3. Injury is certain in that the insurer incurred costs in defending an insurance claim on a policy that would not have been issued but for the misrepresentations in the application.

4. The misrepresentations in the application were material to the insurer's decision to issue the policy and thus were closely connected to the ensuing injury.

5. Under the circumstances alleged, the factor of moral blame supports a finding of duty.

6. Imposing liability on insurance brokers for misrepresentations in insurance applications would act as a deterrent in preventing future harm.

The court of appeal, concluded:

• policy reasons support imposing a duty on insurance brokers to exercise reasonable care in preparing insurance applications under the facts alleged in the cross-complaint. We emphasize that our holding should not be construed as treating an insurance broker as a guarantor of information in an insurance application or as imposing a duty on a broker to independently investigate information provided by the insured. However, when the broker knows of actual misstatements, the broker may be held liable for transmitting those misrepresentations in an insurance application knowing the insurer will reasonably rely on them. [Emphasis added.]

Insurers Should Investigate the Culpability of the Broker

A prudent insurer who discovers that grounds for rescission exists should not limit its investigation and remedy to the rescission alone. If it incurs damages to defend insureds or otherwise, and if its investigation reveals the broker submitted a fraudulent application with knowledge of the fraud, it should seek recovery from the broker.

The insurer should include the following in all investigations relating to a potential rescission.

1. Obtain a complete copy of the broker's file.
2. Interview the insured and determine if he or she advised the broker of the true facts and the statements of the broker regarding the facts stated in the application.
3. Interview the employees of the broker responsible for completing the application.
4. Obtain the advice of counsel concerning the right to rescind.
5. Obtain the advice of counsel as to the facts needed to prove fraud or intentional misrepresentation of material fact.
6. If there is sufficient evidence, file suit to recover damages.

A prudent insurer that finds grounds for rescission exist should always, before rescinding or filing suit, seek the advice of a competent insurance coverage counsel or an insurance coverage consultant in the jurisdiction where the insurance was issued. With appropriate advice, the insurer can avoid unnecessary litigation with its insured, safely rescind the policy, and recover its expenses from the broker who acted for the insured in transacting insurance with the insurer. This potential for recovery only works with independent brokers and will never work with an appointed agent whose knowledge is the knowledge of the insured.

¹Midland Ins. Co. v Markel Serv. Inc., 548 F2d 603, 607 (5th Cir 1977), [applying Texas law] holding that substantial evidence supported the jury's finding that an insurance broker misrepresented the facts to the insurer concerning the limits of the insured's primary liability coverage, that such misrepresentations were material, and that the insurer's reliance on the misrepresentations resulted directly in the loss to the insurer; Putnam Resources v Pateman, 958 F2d 448 (1st Cir 1992), [applying New York law] holding that an insurer was required to establish a claim of intentional misrepresentation against an insurance broker by clear and convincing evidence; Westfield Ins. v Yaste, Zent & Rye Agency, 806 NE2d 25 (Ind App 2004), holding that questions of material fact precluded summary judgment on an insurer's claim against a broker for actual fraud.

² See De Campos v State Comp. Fund, 122 Cal App 2d 519, 525-526 (1954); see also Williamson & Vollmer Engineering, Inc. v Sequoia Ins. Co., 64 Cal App 3d 261 (1976) (stating that the remedy of rescission for fraud under the Insurance Code is not in derogation of other remedies recognized under other provisions of law).

© Barry Zalma 2004

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