Disputes over insurance coverage between carriers and insureds are not all that uncommon. Reasonable minds can differ on the meanings of policy terms, exclusions, even limits of coverage. What many folks don’t realize, however, is that it also is common when coverage disputes arise for a carrier to take a close look at why it issued the policy in the first place.
Insurance carriers use the application to gather information as part of the underwriting process. They seek information relevant to the proposed risk and use the information to set premium levels. Carriers are entitled to rely upon the answers given to questions on the application.
When a coverage dispute later arises, a carrier will perform a coverage investigation. This can occur before a lawsuit being filed, during litigation, or both. An insurer often will compare the information gathered during the coverage investigation to the information originally given by the insured on the application. If the carrier determines through its coverage investigation that the insured provided false information on the original application, bigger problems than an uncovered claim could be in store for the insured.
Misrepresentations on insurance applications subject the insured to the chance an insurance policy will be rescinded. Rescission allows an insurer to void the policy retroactively to the inception date, the idea being the insurer never would have issued the policy in the first place had it been provided with correct underwriting information. This would leave the insured without coverage after the policy has been issued.
Related: Read "Illegal Rescission is an Oxymoron."
Most jurisdictions permit an insurer to void the policy from its inception if it is issued in reliance on a material misrepresentation. Generally, a misrepresentation is a false statement as to a fact made to the insurer at or before the making of the insurance contract. A misrepresentation is generally considered material if knowledge by the insurer of the facts misrepresented would have led to a refusal by the insurer to agree to issue the insurance policy, or caused the policy to be issued with either lower coverage limits or a higher premium. If an insurance policy is rescinded, the insurer must return all premiums collected from the insured. Thus, for business reasons, a carrier may choose not to pursue rescission even if it believes it could.
Related: Read "Rescission is Right When Insured is Wrong."
Moreover, even if the insurer can make the above showing, the insurance carrier can waive a claim to void the insurance policy. Waiver can occur if an insurance company fails to act within a reasonable amount of time after learning of the misrepresentation, or if it acts in a manner which causes the insured to believe it has coverage, and the insured reasonably relies on those actions to its detriment.
It may surprise some people to learn that misrepresentations in the application are generally attributed to the insured, even if the insured does not sign the application. Therefore, an insured generally cannot defeat a rescission claim by the carrier simply by alleging it did not sign the insurance application. However, if a policy is rescinded where an application was not signed, the broker can likely expect an E&O claim to follow. To help demonstrate, let’s consider the following scenario.
Assault at Good Eats
Good Eats is a restaurant that uses Diligent Insurance Agency for general liability insurance. Diligent prepares and submits an unsigned application to a potential insurer, ABC Carrier. On behalf of Good Eats, Diligent truthfully answers "no" to questions on the application which ask whether bouncers or security personnel are used at the restaurant. ABC issues a general liability insurance policy for policy year 1.
Just before renewal, Good Eats institutes live music on Friday and Saturday nights to increase business. During these nights Good Eats hires Bouncer Bob to serve as a bouncer to ensure all entrants are over 21 years old. Pursuant to ABC’s underwriting guidelines, when an insured uses bouncers or any other security, a full assault and battery exclusion must be used. This exclusion removes from the scope of coverage any damage arising out of an assault or battery occurring at the insured’s establishment.
Related: Read Matthew Marrone's previous column, "Quick Action, Multiple Notices Needed to Assist Insureds with Claim Reports."
For policy year 2, Diligent believes the risk is identical to policy year 1. Thus, to make the renewal process easier for the insured, it makes a photocopy of the unsigned insurance application for year 1, enters in the current date and submits it to ABC without first presenting it to Good Eats. Thereafter, in connection with the renewal process, ABC sends an underwriter to inspect Good Eats, who notices the presence of live entertainment and security. It then issues a general liability insurance policy without the full assault and battery exclusion for policy year 2.
A few months later, Bouncer Bob is charged with assaulting Peter Patron, and Good Eats promptly notifies ABC of the event. Within weeks, ABC returns Good Eats’ premium and files an action to rescind the insurance policy for policy year 2 based upon the material misrepresentations regarding security in the insurance application. Around the same time, Patron files suit against Good Eats.
In defense of the rescission action, Good Eats asserts ABC waived the right to rescind the policy because it knew Good Eats had live entertainment and employed security before issuing the policy for policy year 2. Good Eats also files an E&O claim against Diligent seeking to recover the amount it might have to pay to Patron, along with all defense costs incurred. Good Eats claims if it had been asked the questions about security in the application for policy year 2, it would have answered the questions truthfully.
Whether or not ABC waived its right to rescind Good Eats’ policy would likely involve factual questions for a jury to decide. What this particular scenario highlights, however, is how messy a situation can become when a rescission action is involved. It may require an insured to defend two different actions, and will likely result in the insured looking to the broker for a remedy. Sometimes, particularly if it’s clear the broker made a mistake, the broker’s E&O carrier may even decide to "drop down" and directly defend the insured in any underlying action. Moreover, if a policy is ultimately rescinded, the insured may be left with a gap in coverage, further exposing both insured and broker to additional uninsured risks. Simply put, rescission poses more potential problems than a garden variety coverage dispute.
The most effective way to limit your exposure to E&O claims involving rescission of a policy is to make sure the insured has signed the application. It’s been written in this column before, and it bears repeating: a signed application can be your best friend when defending an E&O claim. If there are misrepresentations on a signed policy application, the insured will have a far more difficult time blaming you for them. It also helps if you instruct the insured in writing to review the application for accuracy and completeness. Maintain a copy of the application and any such correspondence in your underwriting file. Doing so can protect you from potential claims arising when a carrier rescinds a policy based upon a misrepresentation in the application.