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Claims Practices

When Agents or Applicants Lie to Insurers

Barry Zalma | March 1, 2007

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Some years ago my solution to a mid-life crisis was to buy a custom-made replica of the Studebaker Avanti, a fiberglass sports car powered by a 5-liter V-8. After I bought my dream car, I found it was almost impossible to insure because the manufacturer only made 400 a year.

My insurer canceled me because it could not calculate an appropriate premium. I went to my neighborhood direct writer who had no problem insuring the car. He filled out a lengthy application form and handed it to me to sign. Much to the agent's surprise, I actually read the application and found he had marked the form showing "no cancellations." I had told him of the cancellation and asked why he had put a false statement in the application.

"It's not important," he responded "you weren't canceled for cause."

The application only asked if I was canceled, so I insisted he correct the application. The insurance was issued. Had I allowed the application to go through as filled out, and then had a claim, I would have faced a situation where I might have had no coverage. Of course, if I could prove that the agent of the direct writer had the knowledge of the prior cancellation, I could have defeated a claim of rescission, but with difficulty. If I did, the agent would have found himself liable to the insurer for any claim it paid to me.

The Case for Rescission

In most states, a mutual mistake of material fact, a unilateral mistake of material fact, a breach of a warranty, a material concealment, or a material misrepresentation can all be grounds for rescission. When an insurer is deceived, regardless of the intent of the deceiver, the remedy of rescission is available to the insurer. Rescission is an equitable remedy that was created by ancient ecclesiastical courts in England. When an insurance policy is rescinded, it places the parties back in the position they were in before the contract date. The insured gets the premium back, and the insurer gets back the policy as if there was never a contract.

Insurers usually use the remedy with care. As one court put it after agreeing that a rescission was proper:

  • Our conclusion here should not result in an assumption by insurers that policy liability can, with impunity, be avoided or delayed by assertion of a claim for rescission. That is a tactic which is fraught with peril. Where no valid ground for rescission exists, the threat or attempt to seek such relief may itself constitute a breach of the covenant of good faith and fair dealing which is implied in the policy. (Emphasis added.)

Imperial Casualty & Indemnity Company v. Levon Sogomonian, 198 Cal. App. 3d 169 (1988).

A recent decision of the California Court of Appeal involved a commercial building that was destroyed by an arson fire. The insurance policy provided the insured with coverage for a commercial building in Los Angeles. During the policy period, the building was destroyed by arson. The insurer discovered several misrepresentations in the insured's application for insurance, obtained the advice of counsel, and rescinded the policy. The insured sued.

The trial court granted summary judgment because the application made material representations on which the insurer's underwriter relied in deciding to insure the building, which included matters that should have been learned by his agent and avoided. For example:

  • The property was not owned by the named insured but by a family trust.
  • The property was vacant.
  • The property had been previously insured by the FAIR Plan, an insurer of last resort, who had canceled the insurance.
  • The property had been condemned by the city.

The trial court granted summary judgment in the insurer's favor, and the court of appeal affirmed, finding that, as a matter of law on the undisputed facts, the information sought by the underwriter and denied to it by the insured's false answers and omissions was material to the insurer's decision to provide insurance coverage. [James E. Mitchell, Individually and as Trustee of the Mitchell Family Trust v. United National Insurance Company, 127 Cal. App. 4th 457, 25 Cal. Rptr. 3d 627 (2005).]

Avoid Even the Implication

To avoid litigation from the client of an insurance agent or broker when the clients' policy is rescinded, the insurance agent or broker must, when obtaining an application for insurance, explain to the proposed insured the importance of truthful and accurate responses to the questions. The agent or broker should never make subjective decisions on the importance of facts to a particular insurer.

The prudent agent or broker should ask the proposed insured about each and every question on the application for insurance. None should be skipped even if they seem to have no relevance to the particular insured.

The agent or broker should also insist that the insured read the application and affirm that all of the answers are correct before it is signed. If the insured refuses, or cannot read English, the agent or broker should read the application to the insured. The application process should be noted in the log, and the insured should be asked to sign the application.

Defense counsel, faced with grounds for rescission should always contact—if an agent is involved—the agent to determine if his records or memory establish that he knew (but did not disclose to the insurer) the facts that were misrepresented or concealed. If the facts were known to the agent, the remedy of rescission is not available to the insurer, and the claim should be paid. Claim must then be made to the agent for the amount paid. Insurers must consider the agent to be a source of indemnity for the costs of investigation and payment of claims on a policy that should never have been issued.

Claims Best Practices

The agent who learns of a material fact that is not reported to the insurer faces suit from either the insurer or the insured, or both. The prudent insurance agent will always report to the insurer and its underwriter all facts he or she learns from the potential insured. If the agent is not prudent, and hides material information from the insurer he or she represents, the agent should immediately give notice of a potential claim to his errors and omissions insurer.

The insurance adjuster, needing to complete a thorough investigation as required by fair claims practices statutes, must make a habit of asking each insured every question on the application for insurance. If there is a discrepancy between the statements made by the insured at the time of the investigation and those made by the application, the adjuster must not assume the investigation is complete. The adjuster must:

  • Go to the offices of the agent or broker and obtain a complete copy of the file and ask the agent or broker if he knew of the true facts as related by the insured.
  • Collect the contract between the agent or broker and the insurer to clarify their relationship.
  • Submit the findings of the investigation to competent coverage counsel for advice on whether the remedy of rescission or voidance is available to the insurer.

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