An insurer has a right to rescind an insurance policy based on a material misrepresentation in the insurance application by the insured. In general, to prove the right to rescind an insurance policy, the insurer must prove that there was a material misrepresentation of a fact or statement of the application that if known to be false by the insurer, the insurer would not have bound the insurance policy. Florida, Missouri, and North Carolina are examples of states whose misrepresentation in the application statutes follow this general rule of proof. 1

However, some state statutes, such as Tennessee, Louisiana, and District of Columbia, require an additional element of intentional misrepresentation.2 Proving intent of a person or entity is a more difficult standard of proof and may determine the success or failure of a claim or defense of the right to rescind by an insurer. The difficulty of the high standard of proof of intent was demonstrated in two recent fidelity cases where the insurers asserted the right to rescind the policy for material misrepresentation in the application.

Kurtz v. Liberty Mutual Ins. Co.

In Heide Kurtz v. Liberty Mutual Ins. Co., Case No. CV 11-7010 DMG (C.D. Cal. April 14, 2014), Namco Financial Exchange Corp (“NFE”) applied for a crime policy with Liberty Mutual and excess policies with Zurich American Ins. Co., Axis Ins. Co., and Twin City Fire Ins. Co. An application question for all insurers was:

“Are proceeds from 1031 transactions held in bank accounts segregated from those of your operating funds?”

NFE responded “no.” 3 Liberty Mutual declined to issue the crime policy to NFE because NFE’s response indicated that it lacked internal controls to reduce the theft risk of the client funds in NFE’s possession. In August of 2007, NFE forwarded a new application and answered Question Three in the affirmative. The crime policy and excess crime policies were issued.

After a $35 million fidelity claim was made on NFE’s misappropriation of its clients’ 1031 funds, the insurers rescinded the policies based on NFE’s representation of separate accounts in the application for insurance. The California federal court granted the insurers’ motion for summary judgment on their rights of rescission. The court applied California’s statute on rescission, which states that “[i]f a representation is false in a material point, whether affirmative or promissory, the injured party is entitled to rescind the contract from the time the representation becomes false.”

Cal. Ins. Code § 359.

The court reasoned that NFE provided a material, false statement in its affirmative response to the application question, because the uncontroverted facts were that NFE did not have a separate account for its clients’ 1031 funds. The insurers testified that if they had known that NFE did not have a separate account, they would not have issued the crime policies. The court applied a subjective standard to determine that the failure to separate client funds from business funds was a direct risk to the employee theft or dishonesty insurance. Furthermore, when NFE’s trustee argued that the insurers failed to prove intentional misrepresentation, the court held that California “uniformly hold[s] that an insured’s misrepresentation or material facts on an insurance application is sufficient to deny coverage even if negligent or unintentional.” Citing to Nieto v. Blue Shield of Cal. Life & Health Ins. Co., 181 Call. App. 4th 60, 75-77, 103 Cal. Rptr. 3d 906 (2010).

FDIC (Wheatland Bank) v. OneBeacon Midwest Ins. Co.

In The Federal Deposit Ins. Corp., as receiver for Wheatland Bank v. OneBeacon Midwest Ins. Co., 2014 WL 1292833 (N.D. Il. March 31, 2014), Wheatland Bank applied for a financial institution bond with OneBeacon and responded in the negative to two application questions:

• Question 64 – “Does any director/trustee or officer have any knowledge of any fact, circumstance or situation involving the Financial Institution, its subsidiaries, or any past or present director/trustee, officer or employee, which would reasonably be expected to give rise to a future liability or bond loss?”
• Question 65 – “Are there any claims or potential claims that have not been reported to the insurer involving the Financial Institution, any subsidiaries, or any Insured Person resulting from their activities as such?”

In Illinois,

“No misrepresentation or false warranty made by the insured or in his behalf in the negotiation for a policy of insurance, or breach of a condition of such policy shall defeat or avoid the policy or prevent its attaching unless such misrepresentation, false warranty or condition shall have been stated in the policy or endorsement or rider attached thereto, or in the written application therefor. No such misrepresentation or false warranty shall defeat or avoid the policy unless it shall have been made with actual intent to deceive or materially affects either the acceptance of the risk or the hazard assumed by the company.”

215 ILCS 5/154. Furthermore, “the Illinois Supreme Court has held, however, that the insurer must show an ‘actual intent to deceive’ if the insured has made its misrepresentations on ‘knowledge and belief.” Citing to Golden Rule Ins. Co. v. Schwartz, 786 N.E.2d 1010, 1016-17 (Ill. 2003).

Under Illinois’ intentional misrepresentation statute and common law, the issue before the court on OneBeacon’s motion for summary judgment on its right to rescind the policy was whether Wheatland Bank intended to deceive OneBeacon in response to questions on its knowledge and belief in the application.

The relevant facts to the two application questions involved Michael Sykes, an executive of Wheatland Bank, and an owner of Mezzanine Finance LLC (“MFL”). Sykes proposed that Wheatland Bank issue loans to two real estate development projects, the Pendolino and Village Walk projects. Regarding the Pendolino project, MFL made a second-lien loan to the Pendolino project on the same day that Wheatland Bank closed its loan to the Pendolino project. Sykes disclosed the MFL loan in the Pendolino project to one of the members of Wheatland’s Loan Committee five days before the Loan Committee ex post facto approved the loan. The events of the Pendolino loan occurred eight months prior to Sykes executing the application for the fidelity bond. Regarding the Village Walk project, MFL had issued a second-lien loan on the project prior to Sykes proposing that Wheatland issue a loan. The MFL loan to Village Walk was past its maturity date and MFL had issued a default letter imposing late fees and default interest prior to Sykes’ proposal to Wheatland. Wheatland closed on the Village Walk loan a month Sykes executed the application for the fidelity bond.

The court denied OneBeacon’s motion for summary judgment on its right to rescind because it determined that there were issues of fact to be weighed by the jury regarding Sykes intent to deceive OneBeacon at the time of the application. The court reasoned that regarding the Pendolino loan, Sykes could have reasonably believed that his disclosure of the MFL loan prior to the Committee’s ex post facto approval precluded any potential claim for fraud or dishonesty. Also, the court determined that the Village Walk loan occurred after the application and any intent to deceive by not updating his answer was weak in light of Sykes’ optimistic belief that the Village Walk loan was a good fit for Wheatland Bank. Once again applying a subjective standard, the court concluded that the reasonableness of Sykes’ belief regarding the loans was an issue for the jury to determine.

Conclusion

When the state statute requires proof of intentional misrepresentation, evidence of the false statement in the application is insufficient to support a rescission of the policy. In these intent states, an insurer must also prove that the insured intended to misrepresent or deceive the insurer in its response.

1″(1) Any statement or description made by or on behalf of an insured or annuitant in an application for an insurance policy or annuity contract, or in negotiations for a policy or contract, is a representation and is not a warranty. A misrepresentation, omission, concealment of fact, or incorrect statement may prevent recovery under the contract or policy only if any of the following apply:

(a) The misrepresentation, omission, concealment, or statement is fraudulent or is material either to the acceptance of the risk or to the hazard assumed by the insurer.

(b) If the true facts had been known to the insurer pursuant to a policy requirement or other requirement, the insurer in good faith would not have issued the policy or contract, would not have issued it at the same premium rate, would not have issued a policy or contract in as large an amount, or would not have provided coverage with respect to the hazard resulting in the loss.”

Fla. Stat. § 627.409 (2014). See also Georgia Statute § 58–3–10 (2013); Revised Statute Missouri §§ 376.580, 376.800 (2013).

2″No written or oral misrepresentation or warranty made in the negotiations of a contract or policy of insurance, or in the application for contract or policy of insurance, by the insured or in the insured’s behalf, shall be deemed material or defeat or void the policy or prevent its attaching, unless the misrepresentation or warranty is made with actual intent to deceive, or unless the matter represented increases the risk of loss.” Tennessee Code § 56–7–103. See also District of Columbia Code § 31–4314; Louisiana Revised Statute 22:860.

3NFE was a 1031 Exchange company, which held its client’s property sale proceeds until the client could find a replacement property to purchase or if no property was found to return the funds to the client. This process allowed the clients to defer capital gains tax under the Internal Revenue Code Section 1031.