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Insurer Seeks Rescission Due to Misrepresentation in an Application for Insurance – Court Rules that an Insurer is Required to not only Ask Questions but also to Investigate Answers

December 21, 2017

Background

Virtually all property policies provide an insurer with the right to rescind coverage when there’s evidence that the insured intentionally concealed or misrepresented material facts in their application for insurance. For a misrepresentation to be deemed material, it must have been an untrue fact that would have, if the truth was known, caused the insurer to reject the application. In other words, an insurer is entitled to truthful responses so that it can determine whether the applicant meets its underwriting criteria.

Under that backdrop, the U. S. Court of Appeals in California recently determined the extent to which an insurer is required to investigate whether an insured’s answers in an application for insurance are true, and how a waiver might occur by a failure to investigate.

Star Insurance Company v. Sunwest Metals, Inc.,

WL 3741305, U.S. Dist. Ct., C.D. Calif. So. Div. (May 18, 2017)

Sunwest Metals operated a recycling facility that processed various commodities including metals, plastics, paper, and glass. Beginning in August 2011, Sunwest was insured for two consecutive year-long policies for fire coverage under Star Insurance Company’s “Scrap Dealers Program.” Notably, in order to be eligible for the Scrap Dealers Program, no more than fifteen percent of a prospective insured’s revenue may come from paper and plastics processing. Thus, the program was designed primarily for metal scrap and glass recyclers; and paper and plastic recyclers were eligible for the program only when the paper and plastic recycling were incidental exposures.

In April 2013, Sunwest suffered a catastrophic fire and filed a claim under its policy. It is important to note however, that prior to the fire, Star Insurance apparently became aware that Sunwest recycled some degree of paper and plastics because that information was allegedly reviewed on Sunwest Metals’ website by a Star Insurance underwriter. In 2011, after the underwriter reviewed the website, she sought confirmation from the insured’s broker that paper and plastic recycling were only incidental parts of the company’s total revenue.

In 2012, when the policyholder applied for the policy to be renewed, the underwriter again asked for confirmation from the insured’s broker that Sunwest Metal’s operations consisted of 80% aluminum and 20% iron and steel. The broker confirmed those figures and attempted to reconcile conflicting information that a previous site inspection had revealed by stating that “Each day the amount [of metal versus paper] varies. The day the inspector came in may have had slightly different numbers. The application [for insurance reflects] an average of the entire policy year.” The truth, however, was that paper processing comprised the vast majority—nearly 66 percent—of Sunwest’s revenue.

Therefore, after Sunwest filed its fire loss claim, Star Insurance filed suit seeking rescission of the policy and denial of coverage based on misrepresentations in the application for insurance, and arguing that it was entitled to rely on the producer’s confirmations that paper and plastic recycling were only miniscule percentages of Sunwest metals’ annual revenue. Sunwest responded by filing an action for breach of contract and bad faith.

After a five-day bench trial, the district court determined that Star Insurance had waived its right to rescind by failing to investigate evidence of misrepresentation and granted judgment in favor of Sunwest in the amount of approximately $978,000. Thereafter, Star Insurance appealed.

An Insurer Cannot Ignore Information that “Distinctly Implies” a Misrepresentation

The Appellate court began its review by noting that neither Star Insurance nor Sunwest Metals dispute that the statements made in the insurance application process regarding the volume of Sunwest Metals’ paper and plastic recycling business were false. In that regard, Sunwest Metals argues that there are genuine issues of material fact as to the rescission claims because Star Insurance had notice that the representations were inaccurate and thus; (2) Star Insurance waived the alleged misrepresentations by failing to conduct a reasonable inquiry; (3) Star Insurance unduly delayed giving notice of rescission, prejudicing Sunwest Metals; and (4) that the alleged misrepresentations were not subjectively material to Star Insurance.

The appellate court responded by stating that Star will be considered to have waived its right to rescind the policy if it ignored information that “distinctly implied” misrepresentation of true facts regarding Sunwest’s operations. Thus, as a general rule, an insurer may “rely upon [the insured] … for such information as it desires” in determining whether to provide coverage. But it may not blindly ignore evidence of misrepresentation, collect premiums, and then opportunistically rescind once a claim is filed, i.e.,

[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. In other words, 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. This includes a duty to investigate information which if pursued with reasonable diligence would reveal misrepresentations.

In that regard, the appellate court noted numerous pieces of evidence spanning nearly two years that “distinctly implied” the falsity of information in Sunwest’s insurance applications and subsequent communications with Star. For example, (i) Sunwest’s website advertised paper and plastic recycling as a main part of its business; (ii) a September 2011 site inspection of Sunwest revealed that Sunwest “fill[ed] large dumpster bins” with, [among other things], paper products; and (iii) two other site inspections—one in January 2012 and one in 2008, the report of which Star received in February 2012—noted substantial paper processing. Thus, as the court explained:

[T]he duty of inquiry requires an insurer to not only ask questions, but also to investigate answers. Here, Star made inquiries, but then ignored the inadequacy of the answers it received. Having turned a blind eye for nearly two years, Star waived its right to rescind when Sunwest filed a claim.

Accordingly, the appellate court held that Star was clearly aware that the information in the application for insurance was inconsistent with these facts, as indicated by its repeated inquiries into Sunwest’s operations. Therefore, the appellate held that the district court did not err in finding that Star Insurance had prior information that “distinctly implied” material misrepresentations, and that it failed to satisfy its duty to investigate such evidence. The appellate court, however, found no evidence of bad faith concerning the coverage decision reached by Star Insurance in this case.

Conclusion

It should be noted that Star Insurance Company wisely filed a declaratory judgment action rather than simply rescinding the policy and denying coverage. That approach likely mitigated the allegations of bad faith and supported the court’s ruling in favor of the insurer on that count.

That said, not all states require an insurer to conduct an independent verification of the information provided by an insured in an application of insurance. Nor, do all states require a showing of intent to misrepresent material facts in order to establish a basis for rescission. So, it’s important for an insurer to review the law concerning these issues in the relevant state before considering a rescission action.

This article was originally published in the Legal Column section of the December 2017 issue of SIU Today, the magazine of the International Association of Special Investigation Units.