Insurers rely on the information their insureds provide to evaluate risk and determine whether to issue insurance and at what price. This basic premise is reflected in California Insurance Code section 332 which states: “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.”
Misstatements or concealment of material facts in an application for insurance, even if unintentional, may render the policy void. (LA Sound USA, Inc. v. St. Paul Fire & Marine Ins. Co. (2007) 156 Cal.App.4th 1259, 1266-1267.) California Insurance Code section 359 provides a remedy to an insurer that has relied upon false or misleading information: “If a representation is false in a material point . . . the injured party is entitled to rescind the contract . . . .” Rescission “renders the policy totally unenforceable from the outset so that there was never any coverage and no benefits are payable.” (Imperial Cas. & Indem. Co. v. Sogomonian (1988) 198 Cal.App.3d 169, 182.)
However, “rescission is not the sole remedy for an insurer who has been subjected to misrepresentations and concealment of material facts by an applicant.” (Resure, Inc. v. Sup. Ct. (1996) 42 Cal.App.4th 156, 161.) An insurance company may also seek relief through other means, such as a claim for reformation or for damages for wrongful misrepresentation, or as a defense to coverage on the ground of misrepresentations in the application. (Id. at pp. 161-62.) In fact, the California Insurance Code section 650 makes clear that an insurer must exercise its right to rescind and to file a suit for rescission prior to “commencement of an action on the contract” by the insured. (Id. at p. 166.) If the insured files suit to enforce the policy first, the insurer may not file a separate rescission action, but must assert its rights in a cross-complaint or as a defense to the insured’s suit. (Ibid.)
It is important to understand that not all false statements can form the basis for relief. The false statement must be about something “material.” Materiality is determined “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.” (Cal. Ins. Code § 334.) “The materiality of a representation is a question of law.” (Merced County Mut. Fire Ins. Co. v. State of California (1991) 233 Cal.App.3d 765, 772, citation omitted.)
In May, the California Court of Appeal and the Ninth Circuit each gave us further guidance on the issue of rescission of an insurance policy and the prescribed steps to effectuate rescission and obtain enforcement of the rescission.
The California Court of Appeal in Southern. Ins. Co. v. Workers’ Comp. Appeals Bd. (May 10, 2017) 11 Cal.App.5th 96, reminded us that all insurance policies – including workers’ compensation policies — may be rescinded and they may be rescinded even after a claim is made on the policy. Indeed, that is often the first time a misrepresentation comes to light. To rescind a policy, an insurer must give notice of rescission and return or offer to return the benefits received (e.g., the premium). (Cal. Civ. Code § 1691.)
The Southern Insurance Court explained that “effecting” rescission by itself is not enough if an insurer wants to avoid loss payment; it must “enforce” the rescission – by getting a court to agree rescission is proper. This may be done by raising rescission as a defense to an action under the policy or by the insurer filing suit under California Civil Code section 1692 to enforce the rescission. Further, for workers’ compensation policies, if the issue arises after a claim is filed and rescission is asserted as a defense to the Applicant’s claim, the WCAB, not a civil court, is the place the rescission issue must be enforced. If, however, a workers’ compensation insurer wants simply to establish that the policy is void and there is no claim yet at issue, the insurer may – and probably must – seek that relief in civil court.
Importantly, in any rescission case, the burden of proof is on the insurer to establish that a material, “false representation” was made in the application for insurance. (Cal. Ins. Code § 359; Thompson v. Occidental Life Ins. Co. (1973) 9 Cal.3d 904, 919.) How is that burden met?
A number of cases hold that the sole fact an insurer asks specific questions on the application renders the answers “material” as a matter of law. (See, e.g., Cohen v. Penn Mut. Life Ins. Co. (1957) 48 Cal.2d 720, 726; Thompson, supra, 9 Cal.3d at p. 916.) While the Thompson Court applied an objective test for materiality, other courts have considered it a “subjective test,” requiring the insurer to demonstrate the “materiality” of the false information by putting on evidence of the importance of the information that was concealed or misrepresented in the application and the effect the true facts would have had on the insurer’s underwriting determination. (See, e.g., Imperial Cas. & Indem. Co., supra, 198 Cal.App.3d at pp. 181-182.)
Thus, an insurer may be unable to rely entirely on the “falseness” of the facts provided by the insured. More evidence, such as the specific testimony of an underwriter that the insurer would not have issued or renewed the policy if the insured had provided truthful information on the application for insurance, will assist an insurer in meeting its burden of establishing materiality.
As the Ninth Circuit in Star Ins. Co. v. Sunwest Metals, Inc. (9th Cir. May 18, 2017) No. 15-56562, 2017 WL 2198969, at *1 , most recently reminded us, the courts are reluctant to grant rescission if the insurer ignores “red flags” during the underwriting process that should have triggered more investigation into the answers provided by the insured in its application. A failure to investigate may be found to constitute a waiver of the right to rescind by the insurer.
Although the Sunwest Metals decision is unpublished, it well summarizes the California law relating to the duty to investigate. As the Sunwest Metals Court put it:
[The insurer] may not blindly ignore evidence of misrepresentation, collect premiums, and then opportunistically rescind once a claim is filed. Under California law, “[t]he right to information of material facts may be waived … by neglect to make inquiries as to such facts, where they are distinctly implied in other facts of which information is communicated.” Cal. Ins. Code § 336. Where an insurer has “before it information that plainly indicate[s] that the insured’s statements [are] not true,” it has a “duty of further inquiry” to determine the “pertinent facts.” Rutherford v. Prudential Ins. Co. of Am., 234 Cal.App.2d 719, 733–34, 44 Cal.Rptr. 697 (1965). This includes a duty to investigate “information which if pursued with reasonable diligence” would reveal misrepresentations. DuBeck v. Cal. Physicians’ Serv., 234 Cal.App.4th 1254, 1267, 184 Cal.Rptr.3d 743 (2015) (internal quotation marks omitted).
(Sunwest Metals, 2017 WL 2198969 at * 1.)
Although the Sunwest Metals Court agreed that the insured’s application contained material misrepresentations, it found that Star had evidence from the insured’s website and Star’s own site inspections that suggested the information was false and Star had failed to adequately investigate. Significantly, the Court observed that, although Star had asked questions on its application, it did not take steps to obtain adequate and responsive answers. In short, Star did not treat the answers as material to its underwriting. Thus, the Court determined that Star waived the right to rescind because of its failure to investigate.
As the recent California decisions on rescission demonstrate, an insurer may itself rescind a policy in response to a claim after discovery of fraud or concealment of material facts in the application for insurance. That rescission may not be effective, however, if the insurer cannot convince a court that it would not have issued the policy had the insured answered the application questions honestly and accurately. Insurers must remember that the burden of proof rests on them in any rescission case and the sufficiency of the evidence of materiality will be critical to enforcing a rescission. While the questions on the application may be considered evidence of materiality, further evidence should bolster any rescission case. Thus, any decision to pursue rescission should turn on the sufficiency of the underwriting evidence, including the ability of the underwriter to testify that the policy would not have been issued if the application had been answered truthfully, to demonstrate the materiality of the information requested on the application. Finally, any decision to pursue rescission should take into account the existence of any “red flags” in the underwriting file that would tend to demonstrate a failure to investigate and thus a waiver of the right to rescind.
Susan Field is a partner in the Firm’s Los Angeles office. Her full bio and contact information can be found at: http://www.musickpeeler.com/professional/Susan_Field/.