Understanding D&O Severability Provisions
THE UNDESIRABLE CONSEQUENCE of rescission actions has caused many directors to seek ways to eliminate or limit the risk of rescission.
During the soft insurance market, corporate executives demanded, and insurers routinely included, severability provisions in D&O applications and policies. Severability provisions effectively separate the good from the bad insureds as each insured is treated separately.
Generally, there are two types of severability clauses: (i) severability of conduct provisions; and (ii) severability of application provisions.
A severability of conduct provision precludes the imputation of one insureds wrongful conduct to all innocent insureds with respect to the operation of a policy exclusion. For example, with respect to a policys personal profit exclusion, if one insured actually intended to obtain an illegal personal profit, but the other individual insureds did not participate and were unaware of his conduct, his conduct with respect to the operation of a policy exclusion will not be imputed to the remaining insureds.
In comparison, a severability of application provision assures that if the insured companys financial condition has been misrepresented to the insurer, only those directors or officers who were aware of the misrepresentation would loose their coverage.
Severability does not eliminate the risk of rescission.
Conceptually, a severability of application provision eliminates the risk of rescission for innocent insureds for misrepresentations made in the application process. These provisions, however, are relatively untested in the courts and there are several issues concerning their effectiveness.
First, a severability of application provision does not preclude an insurer from attempting to rescind a policy. While a small number of cases have held that these severability provisions are effective, no court has held that such a provision eliminates an insurers right to rescind. Rather, these severability provisions merely require the insurer to prove that each insured was aware of the misrepresentation. In several cases, insurers have filed rescission actions against all insureds despite the severability provisions that were in place.
One viable argument which may negate a severability provision is that rescission treats the policy as a whole as if it never existed, thereby effectively eliminating the existence of the severability provision. This theory was relied upon by the court in Home Insurance Co. vs. Dunn in ruling that innocent insureds were not protected by a severability provision because the policy was void ab initio (as if it never existed). The court reasoned that [b]ecause the fraud was committed during the negotiation of the contract, no insurance policy existed Because no policy existed, the defendants may not now rely on the waiver [of exclusion] provisions.
Reproduced from National Underwriter Edition, September 16, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.
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