The Basics of Underwriting
The Business of Fidelity Insurance
Claims professionals (especially outside claim consultants) sometimes forget that fidelity insurers are in the business of assuming risks. The entire insurance industry is built around the concept of risk and risk sharing, where the insurer accepts a portion of an insured’s financial risk in exchange for an agreed upon amount of money, which is the premium paid by the insured in exchange for the purchased coverage. The risk can be characterized as an uncontrollable potential loss of something of value for which the insurer may be responsible to pay on behalf of its insured. As a practical matter, insurers make a profit by utilizing three statistical concepts: first, pooling risks, which is the insurer’s acceptance of a large number of policyholders that have a low risk of incurring similar losses; second, the law of large numbers, where insurers recognize that some of those policyholders will ultimately sustain a loss, but those policyholders will be in the minority; and time value of money, where an insurer collects premiums now and pays claims later, in some cases, many years in the future.
The Art and Science of Assuming Risk
Underwriting is the foundation of the insurance business, and, in effect, underwriters serve a gate-keeping function to develop an insurer’s risk strategy to ensure that the risk is acceptable to the business and that the risk is properly matched by the right premium amount. In other words, the purpose of underwriting is to spread the risk of loss among a large pool of insureds in a way that is equitable for the insureds while still being profitable for the insurer. If this critical balance is lost, the insurer and, at times, the market as a whole could face a significant financial impact.
In its most basic form, underwriting is the process of examining applications, evaluating the potential insured’s business, accepting or rejecting the risk, and classifying those risks that are acceptable to the insurer in order to charge the appropriate premium. Not surprisingly, every insurer has its own underwriting guidelines to determine what qualifies as an insurable risk and the appropriate terms, conditions, and pricing for accepting the risk.
The actual process of underwriting requires steps to evaluate risks and make rational, reasonable decisions based on, among other things, coverage terms, conditions, exclusions, retentions, and pricing acceptability. Underwriting is a complex process that involves data, statistics, and guidelines provided by actuaries. Within this framework, an underwriter needs to blend human judgment and data-driven analytics with the goal of finding the appropriate balance between costs and benefits—the “sweet spot” from which the insurer can profitably underwrite the risk.
Insurance companies learned long ago that if they did not underwrite, they would be inundated with bad risks. To stay profitable, insurance companies need to be selective about the risks that they assume; otherwise, they may be required to pay more in claims and operating expenses than they receive in premium dollars. If insurers are unable to make up this shortfall with earned investment profits, they may find themselves going out of business. It only takes a few relatively extra-bad risks to destroy an insurer’s profitability and surplus.
Over time, underwriting appetites change based on supply and demand. The main supply dynamics consist of other companies exiting and entering the market or adapting their own appetites. The main demand dynamics include changing coverage needs, evolving exposure traits, and new business models. There is no “one size fits all” formula for success, and underwriting operating models vary significantly based on industry, region, business type, and products. These factors and analyses may comprise confidential business information and strategies.
The underwriting process can vary depending upon the insurer’s risk appetite, the complexity of the risk, its underwriting capacity, reinsurance arrangements, and the type and size of the insured’s business. By way of example, a smaller sized enterprise’s coverage needs may be relatively standard so simplicity, speed, and automation are critical factors in efficiently placing coverage. Midmarket companies, including those with premiums of $50,000 to $300,000, occupy a unique and sometimes confusing position between large and small accounts. Thus, while risks presented by midmarket companies may require more analysis and structuring than smaller companies, they likely will not demand the level of review and work as a large account. Along these lines, midmarket accounts are often bundled to meet industry-specific needs, but without the same level of customization as large accounts. Large corporate accounts have more specific coverage needs and successful underwriting for these companies requires rigorous risk selection and creative, yet prudent, coverage design.
The Underwriter’s Role and Goals
The function of the underwriter is to utilize the insurer’s models and standards and other proprietary business information to evaluate potential insureds, assess their risks, formulate a coverage strategy tailored for the insured, and determine a premium that reflects the likelihood of a claim and enables the insurer to earn a profit. In doing so, underwriters must possess the professionalism, skill, education, and training to, among other things:
- understand the risks involved and the available and practical methods of dealing with these risks;
- be able to gather and understand the various resources used to evaluate each application and determine whether the applicant meets company underwriting standards;
- be able to evaluate past losses, judgments, and settlements in terms of the likelihood of reoccurrence in order to determine relative future risk; and
- be familiar with current trends in court judgments and laws in order to properly evaluate high-risk applicants.
Further, because underwriting is not an exact science, underwriters need to have a long-term view of risk and be able to manage the expectations of agents and insureds, a task that may be challenging.
Evidence of best underwriting practices should be reflected by the documents, information, and analysis contained in the underwriting file and demonstrate, among other things, the underwriter’s understanding of the risk, the insured’s intent with respect to the purchase of insurance (i.e., coverage goals) and how the premium and the scope of coverage offered reflect the insured’s goals and the risk assumed. A well-kept underwriting file should also explain why the risk was accepted or rejected, and that the underwriter accurately conveyed the intended scope of coverage to the agent or broker through clear documentation and unambiguous responses to the insured’s relevant questions. An underwriter’s notes or comments in the underwriting file may also reflect the intended meaning of critical policy language and the parties’ intent.
An underwriting file that is complete, accurately reflects the underwriting process, and contains relevant and up-to-date information and documents relating to the insured and its risk is essential to a successful placement. It can also be an asset to the insurer in responding to coverage issues, questions, claims, and disputes that may arise later.
The Underwriting Process—Seek Knowledge and Clarity
The Submission and Application
It is vital for insureds to present clear and complete information and responses to questions when submitting an application for insurance to ensure that its risks are accurately presented for evaluation. Along the same lines, it is vital for an insured to submit all information in writing to the underwriter as part of its application. If necessary, underwriters will utilize supplemental inquiries to obtain additional information to evaluate certain risks (e.g., social engineering fraud or client coverage supplemental applications).
An applicant’s incomplete, vague, or incorrect responses to the underwriting questions could result in one or more of the following to occur: (1) limiting the scope of coverage by modifying policy language to specifically include or exclude a specific coverage grant; (2) putting a sublimit to the coverage; (3) charging an additional premium to grant coverage; (4) the issuance of the binder with subjectivities; and/or (5) rejection of the risk/declining to offer terms.
A Duty to Inquire
For purposes of clarity, the insurer should always seek a complete application and clear responses to any supplemental inquiries from an applicant. Generally, while an insured may not conceal material information relevant to the risk, it has no duty to volunteer information. The underwriter should challenge vague or non-responsive answers or omitted responses in an application or proposal. The insured’s responses or lack of a response may trigger the insurer’s duty to make further inquiry in order to avoid issues involving waiver or estoppel.
The insurer’s duty to inquire was at issue in First Financial Insurance Co. v. Tillery. In this case, Tillery, the insured, sued to recover for breach of contract and bad faith after the insurer refused to honor the insured’s claims for fire damage to his mobile home. During its investigation, the insurer discovered what it considered to be material “omissions and concealments about prior losses” made by the insured on his application for insurance, and, as a result, the insurer voided the policy and refunded the insurance premiums. The jury disagreed with the insurer and awarded Tillery compensatory and bad faith damages. On appeal, the insurer asserted that the trial court erred in submitting the matter to the jury because “the facts concealed were material and they increased the loss.” The Alabama Supreme Court disagreed and affirmed the jury’s verdict, reasoning:
There was evidence that [the insurer] had previously paid one of [the insured’s] losses and that this loss was one of those not disclosed on [the insured’s] application. This evidence, if believed by the trier of fact, was sufficient to show that [the insurer] should have been on notice that further inquiry was necessary. In short, the jury could have found that, with a minimum of inquiry, [the insurer] could have checked its records and found that [the insured’s] application misrepresented the actual facts.
As illustrated by the decision in Tillery, information contained in the underwriting file may be introduced and considered by a court and jury for purposes of charging the insurer with constructive or inquiry notice of information affecting the nature of the insured risk. Having said that, misrepresentations, omissions, concealments and incorrect statements by insureds may have sever repercussions, including rescission.
Other Potentially Significant Documents in the Underwriting File
Many potentially significant documents in the underwriting file should be reviewed in any claim or coverage action. In addition to the application for insurance, the underwriting file typically contains other documents, including the following: (1) the agent’s supplemental application form (basically an application submitted by the agent in conjunction with the application of the insured); (2) the “rating sheet,” which describes the risk, values, and the premium to be charged; (3) premium payment records; (4) cancellation/non-renewal notices; (5) financial statements; (6) credit reports; (7) “Dun & Bradstreet” reports on an insured business that provide information about the operations of the business, its history, ownership, sales volume, and credit rating; (8) binders providing temporary coverage; and (9) loss-control reports and other reports on the insured’s operations. These documents are not only important to the underwriting process, but may provide useful information in the event of a claim, as discussed below.
Underwriting for Non-Traditional Coverages—Social Engineering Fraud
A fidelity bond or commercial crime policy protects organizations against certain financial losses related to acts of fraud and dishonesty, including theft. More recently, new non-traditional fidelity insuring agreements such as social engineering fraud are evolving to meet insureds’ demands and are becoming more common. At the same time, the underwriting process and the information required to correctly evaluate such risks are also evolving.
As part of this analysis, underwriters often investigate whether the prospective insured’s policies and procedures are in place to prevent a loss associated with social engineering fraud and whether such procedures are regularly followed. For example, it is important for an underwriter to know and understand whether an applicant (1) educates employees about social engineering fraud by training them to recognize warning signs that an email may be fraudulent; (2) implements a two-step process to verify fund-transfer requests received via email; (3) requires multiple designated people to authorize all fund transfers made in response to email requests; (4) sets limits on how many fund transfer requests may be made via email each day; (5) enforces a dollar limit on fund transfers; (6) makes payments using the Automated Clearing House (ACH), a computer system set up by the Federal Reserve Bank to process electronic transactions in batches (that takes a few business days to complete) using wire transfers, which are immediate; and (7) requires that all instances of social engineering fraud be reported to the FBI. All of these considerations are vital for an underwriter to properly evaluate and, if appropriate, write coverage for social engineering fraud.
Using the Underwriting File in Pre-Suit Claims and Litigation
Fidelity insurers often possess various and extensive categories of information in their underwriting file, including a future insured’s business classification, history and corporate structure, types of employees, financial status, loss histories, and relevant controls along with an assessment of the insured risk. The discoverability of information in an underwriting file may depend on the nature of the request (whether it is an informal request pre-suit or a formal request after the commencement of litigation), the opposing party’s allegations, the defenses asserted by the insurer, whether a bad faith claim is at issue, and the nature of the specific documents requested.
Pre-Suit Claims
Claims under fidelity bonds and commercial crime policies are, by their nature, extremely document intensive. A well-developed underwriting file compiled during the application process in a diligent and organized manner can be a valuable tool to the claims professional. In the context of a pre-suit claim, a review and analysis of the relevant underwriting file with input from the underwriter can be very instructive and provide the claims professional with, among other things, insight concerning the insured and its operations, prior claims history, and unique aspects of the insured and the risk at issue. With the underwriter’s assistance, claim professionals and/or insurer attorneys will be in a better position to ensure that the relevant documents are collected and reviewed and potential key witnesses are identified. The underwriter can also provide insight on the risks reviewed and the parties’ intent as to coverage and so place the claims professional in a better position to make an informed assessment of the claim and of all possible defenses.
Litigation
An area of frequent dispute in coverage litigation involves whether an insured or other party may seek through the discovery process the entire contents of an insurer’s underwriting file. This type of discovery dispute often arises when a party, usually the insured, argues that the policy wording is ambiguous and that the underwriting file will assist with the interpretation of the contested policy provision. Whether a court will permit such a request will often turn on whether the party seeking the discovery can demonstrate that contents of the underwriting file are relevant to address how the policy at issue was intended to cover the assessed risk and/or how the insurer might have interpreted the policy.
The United States District Court for the Northern District of California in Lawyers Title Insurance Corp. v. United States Fidelity & Guaranty Co. provided some helpful guidance as to why insureds may seek the production of an insurer’s underwriting file:
To respond sensibly to plaintiff’s argument it is necessary to focus on what this suit is about: it is not about the manner in which [the insurer] has processed plaintiff’s claim, a claim which plaintiff did not present until after filing this declaratory relief litigation. Rather, the suit is about coverage, which means that it is primarily about what the words in a contract mean. It follows that documents generated by [the insurer] in response to the suit and subsequent “claim” are not likely to be of great evidentiary moment, if they are admissible at all. At its heart, plaintiff’s objective may be to learn what defendant, and defendant’s lawyers, secretly think the language in the contract means. Plaintiff may hope that it will find documents which suggest an interpretation of the relevant contract language that is arguably inconsistent with the position taken by [the insurer] at trial, thus creating some doubt in the mind of the trier of fact about what [the insurer’s] real view of the contract language is.
Unlike a request for the production of the insurer’s claim file, which often requires some allegation of bad faith, courts will frequently permit the production of the underwriting files in disputes regarding merely the interpretation of and/or application of certain policy wording.
Cases Addressing the Relevancy of the Insurer’s Underwriting File
The Federal Rule of Civil Procedure 26(b)(1) provides:
Unless otherwise limited by court order, the scope of discovery is as follows: Parties may obtain discovery regarding any nonprivileged matter that is relevant to any party’s claim or defense and proportional to the needs of the case, considering the importance of the issues at stake in the action, the amount in controversy, the parties’ relative access to relevant information, the parties’ resources, the importance of the discovery in resolving the issues, and whether the burden or expense of the proposed discovery outweighs its likely benefit. Information within this scope of discovery need not be admissible in evidence to be discoverable.
Thus, although documents and information from the underwriting file may be inadmissible at trial, this disallowance is often insufficient to preclude their production at the discovery stage.
Opposing parties in litigation often seek information in an insurer’s underwriting file and, in response, the insurer typically will object to those requests on multiple grounds, including the basis of relevancy. Courts across the country have addressed the relevancy of the underwriting file during the course of litigation and what effect, if any, it may have in clarifying the parties’ intent at the time that coverage was placed. The majority of courts will require a sound showing of relevance before they will order disclosures of underwriting materials. However, in some jurisdictions, the issue of relevancy may not require that the party seeking the underwriting file claim that the policy is ambiguous.
In Tim Long Plumbing, Inc. v. Kinsale Insurance Co., the United States District Court for the Eastern District of Texas considered an insured’s motion to compel discovery of the insurer’s claim file, underwriting materials, and other information, and granted in part the insured’s motion to compel. In that case, the insured plumbing contractor submitted a claim when a leak caused water damage to a home, which was denied by the insurer. The court held the underwriting file was “relevant for a limited purpose” to address assessment of risks the policy was intended to cover and how the insurer interpreted “various policy terms,” reasoning:
The Court finds that Plaintiff has identified a specific reason as to why the underwriting file is relevant to the case. What Plaintiff has not done, however, is claim that the entire underwriting file is relevant. The Court therefore determines that, absent privilege, Defendant must only produce those portions that reference Defendant’s evaluation of what risks it expected to cover in the policy and how it interpreted the various policy terms.
In H.J. Heinz Co. v. Starr Surplus Lines Insurance Co., the dispute between the insurer and insured arose from costs associated with the recall of contaminated Heinz baby cereal that was sold in China. There, the insurer sought to rescind the policy and argued that the insured omitted material information from its application. In response, the insured requested discovery from the insurer’s underwriting files related to other product contamination policies sold by the insurer to policyholders with similar annual sales for the year 2014. The United States District Court for the Western District of Pennsylvania granted the insured’s request, ordering the insurer to produce (1) other policyholders’ applications; (2) the applicant’s loss history information; (3) information that the insurer obtained during the underwriting process about the applicant; (4) premiums charged; and (5) any analysis conducted by the insurer on whether to issue the policy or set the premiums. According to the court, the insured was “entitled [to] discovery that may reveal information that is relevant to combat [the insurer’s] position on rescission; the main mechanism to do so is through examining other comparable policies issued by Starr and associated risks.”
In Silgan Containers v. National Union Fire Insurance, the United States District Court for the Northern District of California permitted discovery into the insurer’s underwriting, finding that “[a]lthough the interpretation of an insurance policy is a legal question, an insured is entitled to explore what risks the insurer expects to cover in the policy.” In particular, the court ordered the insurer to produce its underwriting file “on the issue of the interpretation of the disputed insurance policy terms” because “[t]he underwriting file is relevant to determining the risks that [the insurer] expected to cover in the policy, how it interpreted the various policy terms, and whether the terms of the policy are ambiguous in the first instance.”
Cases Where Courts Rejected or Narrowed Requests to Discover an Insurer’s Underwriting File
Although courts sometimes permit discovery of an insurer’s underwriting file on the basis of relevancy when policy interpretation is at issue, other courts have denied discovery of underwriting materials when the insured has failed to identify an ambiguity in the policy. Stated differently, if the issue before the court does not truly concern an issue of policy interpretation or claims of bad faith, the underwriting file is likely irrelevant and not discoverable.
In Milinazzo v. State Farm Insurance Co., the plaintiff, as the assignee of the insureds, alleged that the insurer breached its insurance contract when it failed to defend, indemnify, or settle the underlying lawsuit. In discovery, the plaintiff sought the complete underwriting file from its inception to the present. The court rejected the plaintiff’s request, concluding that the insurer did not have to disclose its underwriting file because it was irrelevant to the plaintiff’s breach of contract claim and the determination of coverage under the policy. However, the court clarified that parties may discover underwriting files in bad faith claims or where a party has made a prima facie showing that material terms in the contract are ambiguous.
In Safeco Insurance Co. of America v. Weissman, the insured filed the action seeking a declaration that the insurer had a duty to defend and indemnify it pursuant to their contract of insurance with respect to an underlying state court action alleging defamation and tortious interference with business relations. During discovery, the insured sought the production of, among other items, the insurer’s underwriting file. The United States District Court for the Southern District of Florida rejected the insured’s attempt to obtain the insurer’s underwriting file, recognizing that the insurer’s “claim file and underwriting file are irrelevant to this dispute” and that “[a]n insurer’s decision to issue insurance is distinct from an insurer’s decision to deny a claim.”
A similar decision was reached in Westfield Insurance Co. v. Icon Legacy Custom Modular Homes, where the United States District Court for the Middle District of Pennsylvania denied an insured homebuilder’s request for discovery of the insurer’s underwriting file and documents relating to the insurer’s claims, investigations, and coverage decisions in cases involving construction-related work, where the insured failed to point to any ambiguity in the policy and the bad-faith claim had been dismissed.
In National Union Fire Insurance Co. of Pittsburgh, Pa. v. Mead Johnson & Co., the issues presented were whether “personal and advertising injury” coverage existed under the policy, whether any exclusions applied, and whether the insurer’s (as opposed to the insured’s) copy of a deductible endorsement was operative and binding on the parties. The United States District Court for the Southern District of Indiana found that the term “personal and advertising injury” under the policy was unambiguous and, in turn, rejected the insured’s attempt to discover the underwriting file, reasoning that “[t]he court therefore agrees with the Insurers that discovery of the underwriting files—except for that portion that relates to the Deductible Endorsement—is not relevant to the meaning of ‘personal and advertising injury,’ and would not lead to the discovery of admissible evidence.”
In the case of Retail Ventures, Inc. v. National Union Fire Insurance Co. of Pittsburgh, Pa., the United States District Court for the Eastern District of Ohio considered whether an insured was entitled to discover information regarding its fidelity insurer’s treatment of similar claims of other insureds. There, the insured sued the insurer seeking coverage under a computer fraud insurance policy for a computer hacking incident. The insured sought discovery not only of the claim file and underwriting file related to the insurance policy, but also of documents concerning claims made by other policyholders for coverage for computer fraud losses. The court sided with the insurer and denied the insured’s motion to compel, finding that the requests were overbroad and unduly burdensome and noted that it was not persuaded that information regarding claims of other policyholders was relevant to the plaintiff’s claim.
It is important to recognize that when disclosing an underwriting file during the midst of litigation, the insurer and insured can seek a voluntary protective order that designates certain documents as confidential and limits their use to the litigation only. Further, the parties may wish to file certain documents under seal with the court when appropriate and, by doing so, protect their confidentiality.
The Attorney-Client Privilege And Work Product Doctrine
Because the contents of the fidelity insurer’s underwriting file may contain communications from counsel, it is important that the claim professional understand how the attorney-client privilege and/or work product doctrine might apply to the contents of that file. Having a basic understanding of these principles is important in ensuring that the privilege and/or protection, once established, is properly preserved.
Attorney-Client Privilege
Scope
Varying definitions have been given by courts and commentators to the attorney-client privilege; however, at its essence, it can be defined as protecting from disclosure communications between a client and a lawyer, in his capacity as counsel, which are made in confidence for the purpose of obtaining or rendering legal advice. The privilege is absolute unless waived. The burden of establishing the attorney-client privilege is on the party claiming the privilege. Therefore, where the insurer seeks to withhold underwriting documents from production, the fidelity insurer will bear the burden of proving the application of the attorney-client privilege to each and every document and/or communication that it seeks to withhold as privileged.
As noted above, for the attorney-client privilege to apply, the communications must have been made for a legal purpose. Courts addressing the privilege in the insurance context have generally drawn a distinction between attorneys acting in a business capacity, in which case the privilege does not attach, and attorneys acting in a legal capacity, in which case the privilege does attach.
Waiver
The attorney-client privilege can be waived, either by express or implied waiver. Express waiver occurs when the privileged communication is disclosed to third parties outside of the attorney-client relationship. In the insurance context, these third parties may include lower-level employees in the insurance company that do not have a “need to know” the contents of the communication to perform their jobs effectively or to make informed decisions on behalf of the company. Even though a claim professional may think that disclosure of attorney-client communications within the company is harmless, they should exercise caution that the individual to whom disclosure is made actually has a “need to know.”
In addition to express waiver, an insurer can impliedly waive the attorney-client privilege by putting the privileged communication “at issue” in the litigation. This typically occurs when the insurer asserts the advice of counsel as a defense to the insured’s claim. Most courts hold that asserting the advice of counsel defense precludes the use of the attorney-client privilege to shield that advice from discovery.
Work Product Protection
Scope
The work product doctrine provides for protection of documents and tangible things prepared in anticipation of litigation or for trial by or for a party or party’s representative. Unlike the attorney-client privilege, as to which an absolute protection applies, the work product doctrine is a qualified protection in that disclosure may be required if, depending on the nature of the work product, the requesting party shows a substantial or extraordinary need for the documents or things. In the insurance context, the insurer’s underwriting file will not, in most circumstances, present issues related to work product because as the underwriting documents will likely have been prepared in the “ordinary course of the insurer’s business” and not “in anticipation of litigation.”
Exceptions
The work product protection is a qualified protection that, even if established, may be overcome if the requesting party can show a substantial need for the materials to prepare its case and that it cannot, without undue hardship, obtain the substantial equivalent by other means. For example, in litigation involving bad-faith claims, the insured will typically argue that because the reasonableness of the insurer’s conduct is on trial, it has a substantial need for the documents in the insurer’s files—usually, the claim file, which otherwise may be protected as work product—to establish what the insurer knew and when it knew it. As noted above, the work product doctrine generally is not implicated in disputes concerning the discoverability of underwriting files.
Rescission and the Voidance of a Fidelity Bond—A Drastic Remedy, but Not Dead Yet
The rescission of an insurance policy, if used properly, unwinds the insurance transaction, and the parties are restored to their position prior to the contract; it is as if the insurance contract never existed. Although rescission is primarily an equitable device, its use and scope are authorized by many state statutes. In situations where the insured has made material misrepresentations or fraudulently applied for a policy, it shields the insurer from unwarranted claims and unjust liability.
Although some jurisdictions (e.g., Colorado, Connecticut, Iowa, Kansas, New Jersey, New Mexico, Pennsylvania, Rhode Island, and South Carolina) rely principally on common law to resolve issues concerning when an insurer may rescind a policy based upon information provided or not provided in an insurance application, most states have enacted statutes governing the insurer’s right to rescind contracts of insurance. Generally speaking, three types of state statutes exist regarding rescission: (1) states that allow rescission based on material misrepresentation; (2) states that limit rescission to a knowing or reckless misrepresentation; and (3) states that limit rescission to an intentional or fraudulent misrepresentation.
Typically, a misrepresentation is deemed material if it would affect the premium charged or exposure to the risks of providing the specified coverage. For a policy to be rescinded, false statements, concealment of facts, omissions, or misrepresentations must have been made in the application and must be material. Notably, almost every state requires that the insured’s misrepresentation be material to justify rescission of the policy. Though “materiality” varies among jurisdictions, it is commonly agreed that a material misrepresentation in an insurance application prevents recovery under the insurance policy. Certain categories of misrepresentations or nondisclosures, such as prior loss history and financial statements, may be considered material as a matter of law. To prove rescission, an underwriter can often establish that the misrepresentation is material to the insurer.
Cases Where Rescission Has Been Upheld
Applications for various types of insurance include questions and inquiries that all share a common purpose: to allow the insurer to determine whether the insured is aware of any matters that may result in a claim under the policy to be issued as well as the nature of the risk to be assumed.
In Scottsdale Indemnity Co. v. Sun Coast General Insurance Agency, the United States District Court for the Central District of California upheld rescission on the ground that the insured failed to disclose an escalating dispute with another insurer in its application:
First, the nature of the information withheld reflects materiality. Sun Coast applied for professional liability insurance to cover claims arising out of its business as an insurance agent; Scottsdale specifically asked whether any of the insurers Sun Coast contracted with had cancelled Sun Coast’s agency contract and whether Sun Coast was aware of any potential claims against it; and Sun Coast failed to disclose knowledge of both. . . . The materiality of a “potential claim” to a claims-based insurance policy is self-evident. Cancellation of an agency contract is also facially material to an insurer’s assessment of the risk associated with issuing the policy where, as here, the policy could cover claims arising out of the cancellation. This common-sense conclusion is supported by undisputed evidence that when Sun Coast disclosed information about another insurer’s cancellation of its agency contract, Scottsdale noted that information as a negative rating factor in the underwriting rating worksheet it executed in connection with the 2015–2016 Policy.
Likewise, in Berkley Regional Insurance Co. v. Greater Eastern Credit Union, the United States District Court for the Eastern District of Tennessee affirmed rescission of the fidelity bond, explaining:
In the context of a bank applying for insurance coverage, the bank is generally in the best position to make accurate representations about the financial conditions of the bank. The insurance company cannot do anything but attempt to ensure that the bank has made every effort to truthfully answer the questions on the insurance application. In this case, [the insurer] specifically inquired about what any director or officer may know about any potential claims. It also noted that it expected [the insured] to ensure that “every reasonable effort [was] made to obtain sufficient information to facilitate the proper and accurate completion of this application.” [The insured] was on notice of [the insurer’s] expectations. In this case, Allen had been embezzling from [the insured] since at least 2011, at least two years before the original bond was issued and at least five years prior to the renewal application. Allen stole a total of approximately $1.25 million dollars from [the insured] over a seven-year period. [The insured] was in the best position to discover this fraud at some point during this period.
Again, in Kurtz v. Liberty Mutual Insurance Co., the United States Court of Appeals for the Ninth Circuit affirmed the district court’s grant of summary judgment for the insurer on the issue of rescission, holding as follows:
The district court properly granted summary judgment for Insurers on Kurtz’s breach of contract and declaratory relief claims because Insurers established as a matter of law that NFE made a material misrepresentation on its insurance application . . . . Question 3 on the insurance application asked: “Are proceeds from 1031 transactions held in bank accounts segregated from those of your operating funds?” The district court properly concluded that Question 3 was not ambiguous because the question is not “capable of two or more constructions, both of which are reasonable,” in looking at the application as a whole, and “in the circumstances of the case.”
In Scottsdale Indemnity Co. v. Martinez, Inc., the United States Court of Appeals for the Eleventh Circuit affirmed the district court’s grant of summary judgment for the insurer on the issue of rescission:
Finally, there is no genuine dispute of fact that Walters, who was the CEO/CFO of [the insured], knew the facts misrepresented, even assuming that she did not intend to deceive [the insurer]. With regard to Question 4, Walters knew that someone with withdrawal and deposit authority was performing reconciliation functions, namely, Walters. Regarding Question 3, as CFO, Walters handled all of [the insured’s] financial accounting, including supplying financial information to Bowen for purposes of preparing tax returns. It is also undisputed that Walters was embezzling funds from [the insured] for many years and that she altered [the insured’s] financial records to cover up her theft. Based on this evidence, and for the reasons explained above, the district court did not err in finding that no reasonable jury could conclude that Walters did not know of the facts misrepresented.
Cases Where Rescission Has Been Found to Be Improper
Alternatively, if rescinding a fidelity bond or commercial crime policy will leave third-party claimants seriously harmed and without a remedy, some courts may be more inclined to exercise their inherent equitable powers of discretion to deny rescission, whether it be “expressly or sub silentio.”
In National Credit Union Administration Board v. CUMIS Insurance Society, Inc., the United States District Court for the District of Minnesota found that rescission was improper because the manager of the credit union who embezzled more than $3 million filled out the renewal application, reasoning that the only reason the manager “did not disclose the existence of her theft was for her own benefit and to the detriment of the company,” such that the adverse interest exception applied to the manager’s misrepresentation on the insurance application.
Similarly, in Everest National Insurance Co. v. Tri-State Bancshares, Inc., the United States District Court for the Western District of Louisiana found no rescission where the bank executive knowingly embezzled nearly $2 million even though the executive lied on the bond application, reasoning that the lies only benefited the executive and not the bank:
The Court has no hesitation in concluding that Scott’s embezzlement was not a fact that he would have disclosed on the 2011 Application or 2014 Renewal Application because to do so would have exposed his fraud and brought his scheme to a screeching halt. If his scheme was discovered, Scott would be facing criminal prosecution, the loss of his job, the prospect of having to repay all of the misappropriated funds, and the concomitant damage to his and his family’s reputation. Because Scott was acting in his own interest in lying on the 2011 Application and 2014 Renewal Application, and because his interests starkly diverged from the best interest of Tri-State, the Court finds that Scott’s knowledge of his own defalcations is not imputable to Tri-State. Accordingly, Scott’s misrepresentations will not bar Tri-State from recovering on the fidelity bond.
In Star Insurance Co. v. Sunwest Metals, Inc., the United States Court of Appeals for the Ninth Circuit rejected the insurer’s attempt to rescind the policy because the insurer failed to follow up on multiple pieces of evidence indicating that information in insured’s applications was false, reasoning that although the insured represented in its application that nearly all of its revenue came from metals processing when most of its income came from paper processing, the insurer made repeated inquiries, “but then ignored the inadequacy of answers it received” and “[h]aving turned a blind eye for nearly two years,” the insurer waived its right to rescind when the insured filed its claim.
A similar result was reached in Ocean’s 11 Bar & Grill, Inc. v. Indemnity Insurance Co., RRG., where the insured sought coverage under its general liability policy for injuries arising out of assault and battery and its insurer rescinded the policy based on several purported misrepresentations in the application, including the square footage of the premises. The insured argued the information that it supplied were not misrepresentations, but the result of ambiguity in the applications. The United States District Court for the Southern District of Florida ruled in favor of the insured, reasoning that the question regarding “square footage” and whether it encompassed only publicly accessible space was ambiguous.
Conclusion
Insurance underwriters play an invaluable role in evaluating each application of insurance to determine the risk classification to which an applicant should be assigned and to make a final underwriting decision. This process requires underwriters to review various risk factors with the goal of protecting the insurers by allowing them to offer insurance at premiums that are commensurate with the levels of risk. As a result of proper underwriting, insurers can be more confident that they will be able to fulfill their future financial obligations to policyholders under their policies. In the event that a claim arises or litigation commences concerning the meaning of critical policy language, an underwriter’s knowledge of the insured, its operations and the risk, all of which should be clearly and thoroughly documented and organized in the underwriting file, can be crucial to confirm the underwriting intent as to the interpretation of policy language and the grant of coverage.
