Paper or Plastic? What An Insurer Knew or Should Have Known May Prevent Rescission

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Star Insurance Co. v. Sunwest Metals, Inc., 2015 WL 3741305 (C.D. Cal. June 15, 2015) is currently on appeal before the Ninth Circuit.  The Court will decide whether an insurer waived the right to rescind a policy for material misrepresentation in an application by failing to investigate further during underwriting.

The insured, Sunwest Metals, Inc. was an operator of a recycling collection center.  It applied for and obtained coverage under Star Insurance Co.’s special scrap dealer program, designed to insure metal recyclers.  Paper and plastic recycling were eligible for inclusion in the program only if they were “incidental exposures,” no more than 15% of the recycler’s annual revenue.  The rationale for limiting coverage for paper and plastic recycling was to limit exposure to fire risks.  Sunwest’s application for insurance indicated its annual revenue was derived 80% from aluminum, 20% from iron/steel, and “small amounts” from non-metals.

After suffering a fire at its facility, Sunwest sought coverage under the Star policy.  After investigation, Star discovered Sunwest’s paper and plastic recycling significantly exceeded the negligible amounts represented in the applications.  Star filed for declaratory relief seeking to rescind its two consecutive year-long policies based on material misrepresentation in the applications by Sunwest.

Following a five-day bench trial, the court held Star waived its right to rescind the policy.  The court found that Star waived its right to information under California Insurance Code section 336 by neglecting to inquire into material facts that would have been “distinctly implied” from other sources.  For example, during the application process, Star’s underwriters noticed that Sunwest’s web site showed paper and plastic were recycled at Sunwest’s facility, and Star’s broker was vague in answering inquiries about the paper and plastic recycling.  Star also asked for, and received, a loss control report describing Sunwest’s purchases and sales of aluminum, glass and paper, but the report did not specify the quantities of each.  The court found these “numerous red flags” imposed on Star a duty to investigate further, and that Star’s failure to do so amounted to waiver of its right to rescind the policies.

This ruling appears to conflict with long-standing California insurance law that allows an insurer to rescind based on a material misrepresentation or an omission in direct response to a question asked by the insurer on an application, without further investigation.  See, e.g., Mitchell v. United Nat. Ins. Co. (2005) 127 Cal.App.4th 457, 476-477.  If the insurer asks the question on the application, it should be entitled to reply upon the response without further investigation.  Simply asking the question should be proof of its materiality if it relates to the underwriting of the risk.  Otherwise, there may always be a question as to how far an insurer is required to inquire into potential misrepresentations in order to avoid waiver of its rescission rights.  Moreover, other courts have recognized that an applicant should act with the “utmost good faith” in providing information relevant to the risk to be insured.

The district court’s decision permits a court to engage in a subjective, post-hoc evaluation of the application process in a rescission case.  For example, during the application process, Star was found to have noticed a discrepancy between the application and the loss control report provided.  Star emailed Sunwest regarding the discrepancy, and received a response from Sunwest’s broker, that Star considered satisfactory.  The court found, however, Star should have found the response “not credible,” “challenged this explanation,” and “investigate[d] or confirm[ed] the representations.”

Under the standard the District Court applied, the right to rescind for material misrepresentation in an application may be considered a triable issue of fact, as opposed to an issue that may be decided as a matter of law by the trial court.  Did the insurer have a duty to make further inquiries based on other information provided during the application process?  If the insurer has a duty to investigate further, How far does that extend?  Under existing California law, an insurer is not required to take “all possible measures to reveal” a misrepresentation.  Lunardi v. Great-West Life Assurance Co. (1995) 37 Cal.App.4th 807, 826.  The district court’s decision in Star thus creates uncertainty as to how far the insurer must go to reveal a misrepresentation to avoid a waiver of the right to rescind the policy.

The finding of a waiver under Insurance Code section 336 in Star also appears to conflict with the concept of waiver under California law.  Waiver is the “intentional relinquishment of a known right after knowledge of the facts.”  Waller v. Truck Ins. Exchange, Inc. (1995) 11 Cal.4th 1, 31.  On appeal, Star has argued that it did not waive its right to rescind because it had no knowledge regarding the extent of Sunwest’s paper and plastic recycling operations and, even with additional inquiry, the information would not have been revealed.  Thus, the Ninth Circuit will decide whether to find a waiver in the absence of the insurer’s actual knowledge of the falsity of an insured’s representation.

The Ninth Circuit’s review of the Star case may be closely watched.  The result in Star could suggest the standard for seeking rescission for material misrepresentation or omission in an insurance application involves a duty of inquiry or investigation beyond simply accepting the completed application at face value.

Cheryl Orr is a partner with Musick, Peeler & Garrett in its Los Angeles office.  Her full bio and contact information can be found at: