The California Court of Appeal, for the first time since 1988, has agreed that when an insured misrepresents or conceals, in an application for insurance, facts subjectively material to the underwriter who agreed to the risk, the insurer may effectively rescind the policy.
On March 8, 2005 the California Court of Appeal, Second Appellate District, Division Five affirmed and enforced California's Marine Rule, enforced the rescission of an insurance policy because of misrepresentation or concealment of material fact, and defeated an argument that statutory language in a policy of insurance changed the law of rescission. In James E. Mitchell, Individually and as Trustee of the Mitchell Family Trust v. United National Ins. Co., 127 Cal. App. 4th 457, 25 Cal. Rptr. 3d 627, 2005 Daily Journal D.A.R., 05 Cal. Daily Op. Serv. 2009, 5 Cal. Daily Op. Serv. 2099, the Court of Appeal summarized its holding as follows:
[A]n insurer may, under [California] Insurance Code sections 331 and 359, rescind a fire insurance policy based on an insured's negligent or unintentional misrepresentation of a material fact in an insurance application, notwithstanding the willful misrepresentation clause included in the required standard form fire insurance policy (Insurance Code sections 2070 and 2071). [Emphasis added.]
Mitchell individually was the named insured under an insurance policy issued by United National that provided coverage for a commercial building owned by the Mitchell Family Trust in Los Angeles. During the policy period, the building was destroyed by arson. The arsonist, an acquaintance of Mitchell's, perished in the fire. In the ensuing investigation,1 United National discovered several purported misrepresentations in Mitchell's application for insurance, rescinded the policy, and offered to return Mitchell's premium.
United National moved for summary judgment on two alternative grounds:
Material misrepresentations in the application for insurance gave United National the right, under Insurance Code sections 331 and 359, to rescind the policy; and
The policy's dishonest act exclusion barred coverage because Mitchell's representative, to whom Mitchell had entrusted the property, intentionally set fire to the property.
The trial court granted summary judgment on both grounds.
Mitchell purchased the building in February 2000 in the name of his trust. On April 11, 2000, Mitchell's brokers submitted an application for insurance to Debra Messina of Excess & Surplus Lines Insurance Brokers, Inc., an authorized underwriter for United National. The application made certain material representations upon which the underwriter, Messina, relied in deciding to insure Mitchell:
the property to be insured consisted of a 3,420 square foot commercial building;
the building was to be used by Mitchell as a "video production studio and offices";
the business to be conducted in the building had $20,000 in payroll and generated $300,000 in receipts;
there was no existing insurance on the building;
the building had no uncorrected fire code violations;
the building had a burglar alarm; and
Records & Records & Filmworks, Inc. (later changed to James E. Mitchell) was the purchaser of the building.
In fact, the evidence collected by the insurer established that:
the building was less than 2,000 square feet;
the business conducted in the building had no officers or employees, was used only to film a music video for two days in May or June of 2000, and was leased to a tenant who operated a garment business;
the business in the building generated approximately $6,500 in receipts from February 2000 to the time of the fire;
the building was insured by the California FAIR Plan, an insurer of "last resort";
the building was subject to a City of Los Angeles abatement order stating that the building could not be occupied without a clearance or repaired without a permit and contained such deficiencies as being open to unauthorized entry, littered with combustible debris, excessive dry weeds or vegetation, broken windows, damaged or missing doors, damaged exterior wall covering, damaged interior wall and ceiling covering, and deteriorated flooring (and no permit had been obtained for corrective work on these deficiencies);
the building had no burglar alarm; and
the building was owned by the Mitchell Family Trust.
In addition, it was established by United National's thorough investigation and the examination under oath of Mr. Mitchell that in July 2000, he rented the property to a tenant who operated a garment manufacturing business. In August 2000, a city inspector cited the tenant for failure to obtain a certificate of occupancy, and Mitchell was forced to release the tenant from the lease and return most of the rent payments. The property was vacant on November 22, 2000, the date of the fire.
According to Mitchell, before the property was damaged by the fire, he met Carl Robinson, who represented himself as a business consultant with a prospective buyer for the property, and gave Robinson the keys to the property for the purpose of showing it to the prospective buyer. On November 22, 2000, while Mitchell was in Chicago, Robinson set fire to the building and was killed in the ensuing blaze.
In his first amended complaint, Mitchell admitted that the application for insurance submitted to United National "contained inaccuracies" that caused United National to rescind the policy, but claimed that those inaccuracies were not material and were solely the fault of his brokers.
Ms. Messina, the underwriter, stated in an undisputed declaration, that the size and condition of the building, as well as its proposed use as an owner-occupied business, were important factors in rating the risk to be insured against and in deciding whether or not to issue an insurance policy. She further declared that had she known that there were uncorrected fire code violations, the building was substantially smaller than had been represented in the insurance application, and that the property was not to be used as studios and offices for Mitchell's own music video company, she either would have underwritten the policy differently or declined to underwrite it altogether. Further, she did not know of the existence of prior insurance coverage under the California FAIR Plan—an important underwriting consideration because such coverage indicated past problems in acquiring insurance
The trial court granted summary judgment in United National's favor, finding "as a matter of law on the undisputed facts that the information sought by United's underwriter and denied to it by plaintiff's false answers and omissions was material to United's decision to provide insurance coverage. The uncontradicted evidence of United's underwriter confirms the importance that United attached to the information. Under these circumstances, the materiality of plaintiff's concealment is established as a matter of law." The trial court further concluded, "in addition, coverage is excluded because the loss was the consequence of the dishonest act (arson) of plaintiff's authorized representative to whom he entrusted the property for the purpose of showing it to a potential buyer (Robinson)."
Insurance Code Sections 331 and 359
United National based its right to rescind the policy on Insurance Code sections 331 and 359. Insurance Code section 331 states: "Concealment, whether intentional or unintentional, entitles the injured party to rescind insurance." Insurance Code section 359 similarly provides: "If a representation is false in a material point, whether affirmative or promissory, the injured party is entitled to rescind the contract from the time the representation becomes false."
The court, recognizing the history of the rescission statutes are part of a larger statutory framework that imposes "heavy burdens of disclosure" "upon both parties to a contract of insurance and any material misrepresentation or the failure, whether intentional or unintentional, to provide requested information permits rescission of the policy by the injured party." (Imperial Casualty & Indemnity Co. v. Sogomonian, 198 Cal. App. 3d 169, 179-180 (1988) (Imperial).)2 The statutory scheme created by the California Insurance Code is a codification of what has become known as the "Marine Rule" first enunciated by Lord Mansfield in the House of Lords in Britain in 1766 in Carter v. Boehm, S.C. 1 Bl.593, 3 Burr 1906, 11 May 1766, that held in language almost identical to that in the California Insurance Code:
The governing principle is applicable to all contracts and dealings. Good faith forbids either party by concealing what he privately knows, to draw the other into a bargain, from his ignorance of that fact, and his believing the contrary.
But either party may be innocently silent, as to grounds open to both, to exercise their judgment upon. …
This definition of concealment, restrained to the efficient motives and precise subject of any contract, will generally hold to make it void, in favour of the party misled by his ignorance of the thing concealed.
There are many matters, as to which the insured may be innocently silent—he need not mention what the under-writer knows …. An under-writer can not insist that the policy is void, because the insured did not tell him what he actually knew; what way soever he came to the knowledge.
The insured need not mention what the under-writer ought to know; what he takes upon himself the knowledge of; or what he waves being informed of.
The under-writer needs not be told what lessens the risk agreed and understood to be run by the express terms of the policy. He needs not to be told general topics of speculation: as for instance—The under-writer is bound to know every cause which may occasion natural perils; as, the difficulty of the voyage—the kind of seasons—the probability of lightning, the hurricanes, earthquakes, etc. He is bound to know every cause which may occasion political perils; from the ruptures of States from war, and the various operations of it. He is bound to know the probability of safety, from the continuance of return of peace; from the imbecility of the enemy, through the weakness of their counsels, or their want of strength, etc.
* * *
The reason of the rule which obliges parties to disclose, is to prevent fraud, and to encourage good faith. It is adapted to such facts as vary the nature of the contract; which one privately knows, and the other is ignorant of, and has no reason to suspect. (Emphasis added.)
As the Court of Appeal noted:
Insurance Code section 332, for example, requires each party to an insurance contract to disclose, "in good faith, all facts within his knowledge which are or which he believes to be material to the contract. …" The disclosure obligations imposed by these statutes are directed specifically at the formation of the insurance contract. Insurance Code section 334 states: "Materiality is to be determined not by the event, but solely by the probable and reasonable influence of the facts upon the party to whom the communication is due, in forming his estimate of the disadvantages of the proposed contract, or in making his inquiries." (Ins. Code, § 334, italics added.) Insurance Code section 356 provides: "The completion of the contract of insurance is the time to which a representation must be presumed to refer."
The Court of Appeal recognized that the reason for the right to rescind is in support of the parties' freedom to contract.
[An insurance company] has the unquestioned right to select those whom it will insure and to rely upon him who would be insured for such information as it desires as a basis for its determination to the end that a wise discrimination may be exercised in selecting its risks. (Robinson v. Occidental Life Ins. Co. (1955) 131 Cal. App. 2d 581, 586.) (Emphasis added.)
Citing to the history of rescission in California, the Court of Appeal recognized that it was applying a long line of California decisions, including Telford v. New York Life Ins. Co., 9 Cal. 2d 103, 105 (1937); Dinkins v. American National Ins. Co., 92 Cal. App. 3d 222, 232 (1979); Thompson v. Occidental Life Ins. Co., 9 Cal. 3d 904, 915-916 (1973); Williamson & Vollmer Engineering, Inc. v. Sequoia Ins. Co., 64 Cal. App. 3d 261, 273 (1976), and Imperial, supra, 198 Cal. App. 3d at p. 182, Croskey, et al., Cal. Practice Guide: Insurance Litigation, ¶ 5:169, p. 5-32.4 (The Rutter Group, 2004).
Insurance Code Sections 2070 and 2071
Insurance Code Section 2070 requires particular language in all fire insurance policies issued in California and Section 2071 is the language required. The standard form policy contains the following provision concerning an insured's concealment or misrepresentation of a material fact:
Concealment, fraud: This entire policy shall be void if, whether before or after a loss, the insured has willfully concealed or misrepresented any material fact or circumstance concerning this insurance or the subject thereof, or the interest of the insured therein, or in case of any fraud or false swearing by the insured relating thereto.
To void a policy based on the insured's violation of the standard form policy's fraud and concealment provision, "the false statement must have been knowingly and willfully made with the intent (express or implied) of deceiving the insurer. The materiality of the statement will be determined by the objective standard of its effect upon a reasonable insurer." (Cummings v. Fire Ins. Exchange, 202 Cal. App. 3d 1407, 1414-1415, fn.7 (1988), original italics [voiding fire insurance policy based on insured's fraudulent claim for policy benefits].)
The court recognized that an insurer's right to void a fire insurance policy under Insurance Code Section 2071 is more limited than the right to rescind accorded by Insurance Code sections 331 and 359 because the insurer must prove an intentional or willful act by the insured or the insured's agents while rescission can be affirmed when there is merely an innocent misrepresentation of a material fact. The statutes, however, are not mutually exclusive. An insurer faced with misrepresentations in an application for insurance may choose to rescind, void, or both.
The Court of Appeal concluded that there is no authority to support Mitchell's argument that the fraud and concealment provision in Insurance Code Section 2071, and not Insurance Code sections 331 or 359, governs the right to rescind a fire insurance policy based on misrepresentations in the insurance application. Different statutes within the same code should be interpreted to be consistent. The court, applying the rules of statutory interpretation found that the since standard form policy does not "provide for the consequences of a non-willful misrepresentation or concealment should not be read to prevent the application of other Insurance Code provisions that do."
Concluding, importantly, that insurers are entitled to exercise their right to freedom of contract and the right to make an informed decision whether or not to insure a given risk are strong policy considerations that support more liberal rescission rights for misrepresentations made at the inception of the insurance contract. As one authority has noted: "Despite the significant statutory prescription of fire insurance policy terms, contracts of this kind are treated as voluntary contracts rather than legislative enactments, since they derive their force and efficacy from the consent of the parties." (10 Couch On Insurance (3d ed. 1998) § 149:3, p. 149-10.)
Finding that both Insurance Code Sections 331 and 359 and the fraud and concealment provisions of the standard form policy prescribed by Insurance Code Section 2071 apply to misrepresentations made at any time the rescission provisions normally govern the parties' obligations during formation of the insurance contract, and allow an insurer to rescind a fire insurance policy based on an insured's negligent or unintentional concealment or misrepresentation of a material fact.
The standard fraud and concealment provision of the standard fire insurance policy on the other hand is exercised in connection with a claim for policy benefits. Importantly, the Court of Appeal refused to accept Mitchell's argument and concluded:
that the fraud and concealment provision in the standard policy … requiring the insurer to prove a misrepresentation was willful in order to void the policy does not affect the application of Insurance Code sections 331 and 359, allowing the insurer to rescind the policy in the event of a negligent or unintentional misrepresentation.
Misrepresentation of Material Facts
Mitchell's application for insurance contained misstatements of fact concerning the size and use of the building, the existence of building code violations, and the existence of insurance coverage for the property. The materiality of a misrepresentation is determined by its probable and reasonable effect upon the insurer. When deciding to rescind or not rescind an insurer should consider, according to the Court of Appeal:
The test for materiality is whether the information would have caused the underwriter to reject the application, charge a higher premium, or amend the policy terms, had the underwriter known the true facts. (Old Line Life Ins. Co. v. Superior Court, 229 Cal. App. 3d 1600, 1604 (1991))
The misrepresentation need not relate to the loss ultimately claimed by the insured. (Torbensen v. Family Life Ins. Co., 163 Cal. App. 2d 401, 405 (1958))
Whether the decision to enter into the contract, in estimating the degree or character of the risk, or in fixing the premium rate thereon (Holz Rubber Co., Inc. v. American Star Ins. Co., 14 Cal. 3d 45, 61 (1975))
"Materiality is determined by the probable and reasonable effect that truthful disclosure would have had upon the insurer in determining the advantages of the proposed contract. [Citations.] Essentially, we must decide whether the insurer was misled into accepting the risk or fixing the premium of insurance. [Citations.]"].) "This is a subjective test; the critical question is the effect truthful answers would have had on [the insurer], not on some 'average reasonable' insurer." (Imperial, supra, 198 Cal. App. 3d at p. 181, original italics; see also Cummings v. Fire Ins. Exchange, supra, 202 Cal. App. 3d at pp. 1414-1415, fn. 7; Coca Cola Bottling Co. v. Columbia Casualty Ins. Co., 11 Cal. App. 4th 1176, 1189, fn. 4 (1992).)
The Court of Appeal recognized, and agreed with Imperial, supra, 198 Cal. App. 3d at page 179, where the court suggested that the issue of materiality of a misrepresentation in an insurance application might be one of law. The Imperial Court stated:
The "fact that the insurer has demanded answers to specific questions in an application for insurance is in itself usually sufficient to establish materiality as a matter of law." … The court also stated when there is undisputed evidence that false information was given in an application for insurance and the insurer issued a policy in reliance upon this information, the materiality of a misrepresentation or concealment may be established as a matter of law. … The court went on to say that materiality was established by "the nature of the insurance coverage which defendant sought, the quality and quantity of the information which was not disclosed," in addition to the fact that the insurer "specifically requested the information on its application and therefore relied upon it in issuing the policy."
The application questions presented to Mitchell plainly impacted the decisions on whether to insure and the premium to charge. Mitchell admitted that questions concerning the ownership, size and condition of the building, the nature of the business to be conducted, and its payroll and receipts, and the existence of insurance under the FAIR Plan were factors impacting either the underwriting decision or the amount of the premium and coverage, and that his answers to these questions may have affected the decision to bind coverage and the amount of the premium.
Mitchell argued that Messina and United National should have verified the accuracy of his representations at the time the decision was made to insure him rather than wait until after a loss. The Court of Appeal disposed of the argument with ease citing to ancient authority that Ms. Messina had no obligation to verify the accuracy of the representations, citing to Robinson v. Occidental Life Ins. Co., supra, 131 Cal. App. 2d at 585, which held that in connection with an insurance application "[i]t was not incumbent upon [insurer] to investigate [insured's] statements made to the examiner. It was [insured's] duty to divulge fully all he knew.…"
The decision to affirm the rescission was reached because:
the evidence of materiality of the misrepresentations was uncontradicted;
the application was for significant insurance covering the peril of fire;
the information sought went directly to questions of insurability, risk, and premium;
the insured admitted that there were misrepresentations on the application, and
that the insurer considered the information important to its underwriting decisions.
With such overwhelming facts the Court of Appeal concluded, using a double negative, that a reasonable trier of fact could not find that the representations in this case were not material.
Since the court's conclusion on rescission resolved the entire case it declined to discuss the intentional act portion of the case.
Conclusion and Lessons
Every California insured, and every broker representing insureds, must treat applications for insurance seriously. Answers must be accurate at the time the application is submitted to the insurer for a decision to insure or not insure. Misrepresentations or concealment of material facts—whether intentional or innocent—can leave an insured with a legitimate claim, without coverage.
Although Mitchell was apparently not innocent in his misrepresentations—his representative burned the building intentionally and so incompetently that he died in the fire—admission that facts established as material were misrepresented on the application was sufficient to allow United National to rescind.
Insurers faced with an application that appears to contain false representations that would have been material to the decision to insure or not insure, must protect themselves and, before deciding to rescind, complete a thorough investigation that includes, at the very least, the items below.
Components of a Proper Claims Investigation
The recorded statement of the insured with a detailed review of all of the representations made in the application.
The examination under oath of the insured to obtain under-oath statements of the true facts and why different facts were made on the application.
The recorded statement of the retail broker to determine the source of the information on the application.
Obtaining a complete copy of the retail broker's file.
Obtaining a complete copy of the underwriting file.
The recorded statement or other interview of the underwriter to determine—without the use of leading questions—the effect true statements of fact from the insured would have had on the decision to insure or not insure.
The sworn declaration of the underwriter establishing the effect true statements of fact from the insured would have had on the decision to insure or not insure the risk.
Underwriting manuals or other documents created by the insurer before the risk was accepted that would have had a bearing on the decision to insure or not insure—such as an underwriting manual that limits the risks that an underwriter may accept.
Finally, advice of independent coverage counsel, as to the advisability of rescission.
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1 Although the opinion does not mention it, the investigation consisted of an examination under oath of Mitchell conducted by counsel for United National, Barry Zalma.
The relevant provisions of the Insurance Code, also cited by the court in Imperial, supra, 198 Cal. App. 3d at 180, n.8, are:
§ 330. Concealment defined. Neglect to communicate that which a party knows, and ought to communicate, is concealment.
§ 331. Effect of concealment. Concealment, whether intentional or unintentional, entitles the injured party to rescind insurance.
§ 332. Required disclosure. Each party to a contract of insurance shall communicate to the other, in good faith, all facts within his knowledge which are or which he believes to be material to the contract and as to which he makes no warranty, and which the other has not the means of ascertaining.
§ 334. Materiality. Materiality is to be determined not by the event, but solely by the probable and reasonable influence of the facts upon the party to whom the communication is due, in forming his estimate of the disadvantages of the proposed contract, or in making his inquiries.
§ 356. Time of reference. The completion of the contract of insurance is the time to which a representation must be presumed to refer.
§ 358. Falsity. A representation is false when the facts fail to correspond with its assertions or stipulations.
§ 359. Effect of material false representation. If a representation is false in a material point, whether affirmative or promissory, the injured party is entitled to rescind the contract from the time the representation becomes false.
§ 360. Materiality. The materiality of a representation is determined by the same rule as the materiality of a concealment.