Imagine the following: You are a new risk management professional at your company tasked with procuring insurance. You answer each question on the application in good faith and faithfully pay the premiums. Eventually, the company suffers a loss. You tender the claim and discover that the insurer seeks to rescind the policy for misrepresentations made on the application. The court agrees with the insurer, and finds that you are not insured after all.
As the insured in H.J. Heinz Co. v. Starr Surplus Lines Ins. Co., 2017 WL 108006 (3rd Cir. Jan. 11, 2017) (H.J. Heinz) learned, this is the harsh reality of rescission.
What is Rescission?
Rescission of an insurance contract for misrepresentations made on an application for insurance allows the insurer to declare that the policy was never in effect, the result being that coverage for a claim, when tendered by an insured to an insurer, is not covered. International Risk Management Institute, Inc., Glossary, Rescission.
Thus, as the U.S. Court of Appeals for the Third Circuit affirmed in H.J. Heinz, when the insurer discovers a misrepresentation after the policyholder suffers a loss, rescission permits the insurer to void the contract that would otherwise provide coverage for the insured’s loss.
Background: Heinz’s Application for Insurance
H.J. Heinz Company (Heinz) makes and sells food products worldwide. In May 2014, Heinz submitted insurance applications for contaminated product insurance to Starr Surplus Lines Insurance Co. (Starr). Starr’s application asked the following questions:
- Has the Applicant, its premises, products, or processes been the subject of recommendations or complaints made by any regulatory body, or internal or third-party audit over the past 12 months, or have any fines or penalties been assessed against the Applicant by any food or similar regulatory body over the last three years?
- In the last 10 years, has the Applicant experienced a withdrawal, recall, or stock recovery of any products, or has the Applicant been responsible for the costs incurred by a third party in recalling or withdrawing any products, whether insured or insurable under an accidental and malicious contamination policy?
Heinz’s new global insurance director was responsible for filling out and certifying the answers on the application—and he alleged that he did so in good faith. He responded to the first question in the negative, and attached a spreadsheet detailing the company’s loss history from 1998 to 2013 in response to the second question. The spreadsheet disclosed only one loss over 10 years that was greater than the $5 million self-insured retention (SIR) that Heinz requested.
Two Starr underwriters determined that the requested $5 million SIR was appropriate. The policy became effective on July 1, 2014.
Heinz’s Claim and Lawsuit
Two weeks after the effective date of the policy, China’s food control agency informed Heinz that baby food Heinz manufactured in China was contaminated with lead. Heinz recalled the product. Heinz tendered the claim to Starr. During its investigation, Starr found an undisclosed loss by Heinz exceeding $10 million after discovery of excessive levels of nitrite in baby food also manufactured in China that pre-dated the policy.
When Starr informed Heinz that it was reserving its right to limit or withhold coverage under the policy, Heinz filed suit against Starr for breach of contract and bad faith, and sought a declaration that Starr must indemnify Heinz for the loss. In its answer, Starr countersued for rescission, alleging that Heinz failed to disclose previous contamination incidents on its insurance application, thereby rendering the policy null.
The parties agreed to litigate Starr’s counterclaim for rescission first. Heinz claimed the incorrect information communicated was an inadvertent error made by its new global insurance director. A Pennsylvania federal jury, acting in an advisory capacity, found that Heinz made material misrepresentations and omissions, but agreed that those errors were inadvertent. The jury also found that Starr waived its rescission claim.
The district court, however, found that it was not bound by the advisory jury’s finding of waiver, and held that there was insufficient evidence that the insurer had knowledge of Heinz’s misrepresentations when it issued the policy. The district court entered judgment in Starr’s favor after concluding that Heinz’s material misrepresentations were sufficient to void the contract.
Heinz appealed, asserting that the district court erred because (1) Pennsylvania law, not New York law, applies to Starr’s counterclaim; (2) it applied the incorrect burden of proof; and (3) Starr waived its right to rescind.
Affirmation of Rescission for Material Misrepresentation
On appeal, the Third Circuit affirmed that a policy can be rescinded based on a material—albeit inadvertent—misrepresentation on an application for insurance.
The court first upheld the application of New York law after finding that the policy’s service-of-suit endorsement governed jurisdiction and did not supersede the unambiguous choice-of-law provision. The court also determined that the choice-of-law provision provided that the “validity” of the policy would be governed by New York law.
Next, the court held that it did not need to determine if New York law required rescission to be proved by a preponderance of the evidence, rather than the more demanding clear and convincing evidence standard, because the court found that Starr’s evidence met the clear and convincing evidence standard.
The Court found as follows:
The materiality of Heinz’s misrepresentation is self-evident. For the 10-year period identified in the application, Heinz disclosed only one loss in excess of a $5 million [self-insured retention]. In reality, however, Heinz experienced three losses exceeding a $5 million SIR, totaling more than $20 million. . . . Heinz’s misrepresentations were of such magnitude that they deprived Starr of “its freedom of choice in determining whether to accept or reject the risk.”
H.J. Heinz, 2017 WL 108006, at *128.
The panel also found compelling Starr’s evidence that it would not have issued the same policy if the correct information had been disclosed on the application.
Argument to Waive Rescission Claim Rejected
Lastly, the appellate court rejected Heinz’s argument that Starr issued the policy despite sufficient knowledge of the misrepresentations and thus waived its rescission claim. As evidence, Heinz referred to emails indicating that one of Starr’s underwriters read an article about one Heinz loss and also was aware of another loss because it was disclosed in a prior application for a different kind of insurance policy. The district court found that “[t]hese items, without more, would not trigger a reasonably prudent insurer to follow-up further.” H.J. Heinz Co. v. Starr Surplus Lines Ins. Co., 2016 WL 374307, at *7 (W.D. Pa. Feb. 1, 2016). The appellate court held that that the district court made no error, legal or factual, and also rejected Heinz’s argument that Starr failed to promptly assert rescission after a reasonable period of investigation. The five-month gap between when investigators knew of the previous losses to when Starr asserted rescission was “wholly unobjectionable.” H.J. Heinz, 2017 WL 108006, at *130.
The Heinz decision is an important reminder to policyholders of the harsh reality of rescission. Applications for insurance matter, and misrepresentations made on them—even unintentional ones—are not tolerated. Policyholders should give the same care and attention to applications for insurance as they do in other important aspects of their business.