5. Traditional Regulation via Legal Doctrines of Misrepresentation and Warranty

As part of a libertarian impulse, the law has long facilitated separation and the economic benefits it often entails by permitting the insurer to investigate the risk characteristics of a potential insured even where this investigation probes generally private information about the insured. Moreover, subject to recent restraints on use of cheap observables such as race or gender, the law has not intervened in insurer’s selection of characteristics used to determine expected loss, even where this selection - often done in concert - causes substantial loss to identifiable social groups.

Pre-contractual investigations of all potential insureds can, in many instances, be quite costly. The doctrines of warranty and representation represent potentially cheaper vehicles to create symmetric information and thereby reduce adverse selection. Under both doctrines, the insured is given an opportunity prior to contract formation to make statements that, if true, demonstrate a lower risk and thereby lower premiums in the event a contract is formed. The insured accepts some penalty in the event that some subset of otherwise insurable events come to pass and the statements made prior to contract formation turn out to have been false to some pre-specified extent as determined by some post-event investigation.

The economic concept behind both warranty and representation is to restructure the ‘game’ being played by the insured and insurer into one where the insured’s dominant strategy is to reveal truthfully all private information about his risk and therefore to render the information symmetrical. The success of this concept becomes more likely as (a) the amount of the potential penalty increases, (b) the scope of the subset of events triggering the potential penalty increases, (c) the degree of falsity required to trigger the penalty decreases; and (d) the likelihood that falsity will be detected increases. The joint benefit to both insurer and insured increases as the expected cost of this post-event 5700 Insurance Regulation 845 determination decreases. Measurements of this expected cost should reflect both the cost of the investigation itself and the risk cost imposed on the insured as the result of a determination that is either incorrect or that occurs absent truly asymmetric belief structures.

The traditional doctrine of warranty is a structure that results in strong inducements to tell the truth but creates substantial costs. Under a polar version of the traditional doctrine, the penalty (defeasance of an otherwise existing insurance obligation) is exacted whenever any claim for insurance benefits arises and any statement made by the insured is shown to have been false to any degree. Thus, with warranty, a claim for insurance is defeated by the making of even minimally false statements even when the complete truth would not have lowered the premium for a policy providing indemnity only for the event that actually occurred. Because warranty bars claims even when the insured cannot be shown to have known that the statement was false, the doctrine protects the insurer (and, in a competitive market, insureds) from statements that the insured in fact knew to be false in conditions where the insurer cannot prove that knowledge. The downsides of the warranty mechanism include the frequent investigations into the truthfulness of pre-contractual statements and the undesirable transfer of risk to the insured in situations where belief structures were indeed symmetric but the insured was careless in his pre-contractual statements.

The doctrine of representation represents another method of controlling adverse selection. Although many variants of the doctrine exist, it may generally be idealized as a rule under which the insured is penalized (defeasance of an otherwise existing insurance obligation) whenever the insured knowingly made a false statement, a claim for insurance benefits arise, and the premium for a policy providing indemnity for the event that in fact occurred would have been materially higher had the insured been truthful. Since fewer events trigger an inquiry into the truthfulness of pre-contractual statements and since exaction of the penalty depends on the insured’s being shown to have knowingly lied, the expected penalty for false statements is less than that under traditional warranty. The incentive to be truthful and the correlative reduction in adverse selection may be tempered as well. On the other hand, representation rather than warranty lowers expected investigation costs and substantially reduces the chance of imposing a penalty on the insured in situations where beliefs were truly symmetric.

During the early nineteenth century, many American and English courts saw considerable virtue in a legal regime where warranties were unfettered in their ability to control adverse selection (Horwitz, 1992). In recent years, however, legal authorities, apparently believing representation either to be a superior vehicle for controlling adverse selection or in an effort at protecting insureds from the costs of warranty, have generally imposed a preference for 846 Insurance Regulation 5700 representation, at least in situations where the legal status of pre-contractual statements has been ambiguous. Some legislatures have thus enacted statutes that deem statements to be representations absent clear statements to the contrary. Others have enacted ‘contribute to cause’ statutes that permit penalization of the insured only where the premium for a policy providing indemnity for the event that in fact occurred would have been materially higher had the insured been truthful. Few jurisdictions have considered a contribute to cause standard coupled with a significant penalty (beyond mere defeasance of otherwise existing contractual obligations) for discovery of a material falsehood, although such a mechanism with low policing costs and high penalties would fit well with economic theory regarding control of illegal behavior (Polinsky and Shavell, 1979).

Also reducing the efficacy of the pre-contractual statement mechanism, though arguably decreasing its undesirable side effects, has been the doctrine of incontestability. Incontestability, which acts as a kind of statute of limitations against insurer defenses of misrepresentation of breach of warranty, generally addresses situations where there is a high risk of an erroneous determination that a pre-contractual statement was false: the insured is dead and thus unable to testify regarding knowledge of falsity or falsity itself against a life insurer seeking to avoid an indemnity obligation. Thus, at least for the subset of risk factors that the insurer could reasonably have determined by an investigation either before the contract or during some period of time (1 or 2 years) after formation of the contract, the law refuses to let post-event investigations result in a penalty to the insured (Simpson v. Phoenix Mutual Life Insurance Company, 1969).

Laws reducing the penalty for false statements likewise potentially weaken the use of post-event investigations as an underwriting tools for controlling adverse selection. These laws reduce, however, the costs associated with erroneous determinations of falsity and determinations of falsity in the face of symmetric beliefs. Legislative distrust of the market’s determination of optimal methods of adverse selection control may explain statutes limiting the penalty for false declarations of age on a life insurance policy to a reduction in the indemnity equal to the difference between the face amount of the policy and the amount of insurance that could have been purchased for the same premium had the insured been truthful about age. Similar judicial distrust of the market may explain occasional rulings limiting the penalty for false representations to a reduction in indemnity equal to that which the insured would have been entitled to had it told the truth in the application process.

(1) Any statement of fact made by a policyholder in an application for an insurance policy is a representation by the policyholder.

  (2) Subject to the rules governing defense obligations, an insurer may deny a claim or rescind the applicable insurance policy on the basis of an incorrect representation made by a policyholder in an application for an insurance policy (hereinafter referred to as a misrepresentation) only if the following requirements are met:

  (a) The misrepresentation was material as defined in § 8; and

  (b) The insurer reasonably relied on the misrepresentation in issuing or renewing the policy as specified in § 9.

  (3) When the policy is rescinded under subsection (2), the insurer must return all of the premiums paid for the policy.

Comment:

a. The functions of the misrepresentation defense. The functions of misrepresentation doctrine generally are to encourage contracting parties to provide accurate information during the contracting process, to protect those who are misled to their detriment, and to penalize those who mislead. The misrepresentation defense is especially important in the context of insurance contracts. The efficient functioning of insurance markets requires that insurers receive accurate information regarding potentially insured risks so that, among other reasons, insurers can price their policies accurately. The possibility of a claim denial or policy rescission can create incentives for the applicants to provide accurate information during the policy application and renewal process, so long as the contours of the misrepresentation rules match insurance applicants’ understanding of what is expected of them. In addition, as a matter of fairness, policyholders who make intentional or reckless misrepresentations on their insurance applications should not be permitted to shift losses to insurance companies that have relied in good faith on the policyholders’ answers. Such losses ultimately are shifted to other policyholders who have behaved in good faith in the application and renewal processes.

b. Encouraging insurers’ best practices in information gathering. Policyholders are not the only parties to insurance contracts with access to relevant information. Insurers sometimes have the ability to obtain certain types of information regarding an insurance applicant’s risk characteristics from sources other than the applicant. Such sources may be as reliable as, or even more reliable than, the information available to the applicant. Misrepresentation doctrine also should encourage insurers to make use of alternative sources of information that are available to them. The reasonableness aspect of the reliance requirement stated in § 9 encourages insurers to make use of that access to information without imposing excessive burdens on insurers. In addition, § 9 states an “inquiry notice” approach that has been adopted by a number of jurisdictions: once an insurer has been put “on notice” that there may be a factual error in the policyholder’s representations, the insurer has a duty to make a reasonable investigation. See § 9, Comment d.

c. Misrepresentation as a defense and as a basis for rescission. When the requirements of § 7 are met, the insurer may invoke misrepresentation as a valid defense to coverage for a particular claim and as a basis on which to rescind the policy. The burden of proof with respect to each element of misrepresentation lies with the insurer.

d. Relationship to cancellation and rescission. Misrepresentation by a policyholder can provide a basis for either rescinding or cancelling a policy. Rescission voids the policy ab initio or “from the beginning.” Therefore, if a policy is rescinded, it is as if the policy had never been written; the policy does not provide coverage for any claims; and the premiums are returned. If all of the elements of this Section are met, and the rescission remedy is available to the insurer, the policy is said to be voidable or rescindable at the election of the insurer. By contrast, when an insurance policy is cancelled, it is no longer in force going forward from the date of cancellation. Cancellation prematurely terminates the policy period but otherwise preserves the possibility of coverage of claims arising before the cancellation.

e. Statutory modification. Statutes in some jurisdictions govern the procedure for the cancellation, rescission, and nonrenewal of certain types of insurance. Automobile liability insurance is the most prominent example. With respect to auto liability coverage, the limitations on rescission and cancellation are linked to state laws requiring motor-vehicle owners to carry liability coverage. Such compulsory insurance laws are designed to protect third-party victims in the event of an accident. That same concern underlies the limitation on insurers’ rescission and cancellation rights. When applicable, those statutes supersede the rule followed in this and the ensuing Sections regarding misrepresentation and concealment.

f. Warranty law. This Section does not endorse the use of warranties as distinct from representations in the application or renewal process for liability insurance. Warranties are reported to have been first used in the 17th century and to have come to prominence in the 18th century, primarily in the area of marine insurance. Policyholders were asked to make warranties (a category of promises) regarding particular facts about the risk being insured. If a warranty proved to be false, the policy was voidable without regard to whether there was reasonable detrimental reliance on the part of the insurer. This strict rule was justified in the marine-insurance context on the grounds that the parties to the contract were of roughly equal sophistication and that evidence necessary to prove the significance of the misrepresentation was often difficult to gather (if the ship had gone down at sea, for example). Warranties are said to remain strictly enforced with respect to marine insurance, for which the most important coverage is a form of property insurance. When policyholders are relatively unsophisticated (as in the case of consumer policyholders), the strict application of warranty provisions is unduly harsh and unfair to insureds, as the law has increasingly recognized. This Section does not follow the few remaining courts that treat warranties as a separate category, outside the special context of commercial marine-insurance policies. Rather, this Section treats all statements of past or present fact made in connection with the process of applying for or renewing any liability insurance policy as representations. Promissory warranties, which are descriptions of future facts or promises with respect to future actions, are subject to the requirements of this Section as well.

g. Concealment. Some jurisdictions have adopted a separate doctrine of concealment that requires a showing by the insurer that the policyholder knowingly and intentionally concealed material information from the insurer. Concealment can be difficult for insurers to prove, and it is difficult to find cases decided on the basis of concealment doctrine, in large part because insurers have learned to ask questions about the risk factors that they regard as material. The requirements of the concealment defense are, and should be, particularly difficult for insurers to satisfy in the consumer-insurance context because consumer policyholders ordinarily do not know what information not specifically asked about by the insurer is material to the underwriting process.

h. Misrepresentation in the renewal process. The misrepresentation rules followed in this Section apply not only to an initial application for insurance but also to an application for a renewal of a policy. All the concerns regarding the need to encourage an honest and forthright exchange of information from policyholder to insurer apply to the renewal process as well. In setting premiums for renewal policies, insurers also need to have reliable information regarding the policyholders’ risk characteristics. Applying the misrepresentation doctrine to the renewal process helps strengthen the policyholder’s incentives to make honest disclosures and ensures that misrepresentations by policyholders at the renewal stage do not go uncorrected. Thus, if at the renewal stage an insurer provides the policyholder with information that the insurer intends to use to compute the renewal premium and asks the policyholder to confirm that the information is accurate, and if the policyholder so confirms, then that confirmation is a representation to which misrepresentation rules apply. A policy renewal does not ordinarily include an affirmation by the policyholder that statements in the original application remain true. If the insurer wants the policyholder to make such an affirmation, it must expressly make that request at the time of renewal and must, prior to the policyholder’s affirmation, provide the policyholder with a written copy of the statements from the original application with respect to which affirmation is sought.

i. Representations by a policyholder. Whether and when a person speaks on behalf of a policyholder or an insurer is determined by the law of agency. This is a fact-specific determination that should not be resolved simply on the basis of the job title of the person involved. See § 5, Comment b.

j. The problem of innocent misrepresentations. Many common-law courts and legislatures have articulated the doctrine of misrepresentation as one of, in effect, strict liability. Under the common-law or legislative rules in most states and the rule followed in this Section, the misrepresentation defense is available to the insurer whenever there is reasonable and detrimental reliance by the insurer on a material misrepresentation by the policyholder, even if the policyholder’s misrepresentation was entirely innocent and unintentional. Although there are strong fairness and efficiency objections to this strict-liability approach, the legislatures in most states have chosen that approach; and among the minority of states without controlling legislation, only about one third have adopted a common-law knowledge requirement. The fairness objection to the majority rule followed in this Section rests on the view that policyholders purchase liability insurance as protection from negligence, and they should therefore be protected from negligence in applying for insurance. The efficiency objection rests on the similarity between the risk of making an innocent misrepresentation and the risk of making some other mistake that leads to liability, both of which are the kinds of risks that risk-averse policyholders would prefer to shift to insurers and that insurers are able to bear. Because legislation sometimes addresses this issue, however, and because courts sometimes find alternative grounds for reaching the same result, in practice the unfairness that many observers contend results from the absence of a knowledge requirement does not arise as frequently as might be supposed.

A misrepresentation by an insured during the application for, or renewal of, an insurance policy is material only if, but for the misrepresentation, a reasonable insurer in this insurer’s position would not have issued the policy or would have issued the policy only under substantially different terms.

Comment:

a. The function of the materiality requirement. The misrepresentation defense encourages the sharing of truthful and relevant information. The materiality requirement addresses the objective relevance of that information and encourages efficient underwriting practices on the part of insurers. A material misrepresentation is one that so significantly understates the risk presented by the policyholder’s application or renewal that the misrepresentation would induce an objectively reasonable insurer in this insurer’s position either to (a) issue a policy when it would not otherwise have done so or (b) issue a policy on substantially different terms than it would otherwise have done. This definition of materiality is sometimes referred to as the “material to the risk” or “increased risk” test of materiality, in the sense that the falsity of the misrepresented fact would lead a reasonable insurer in this insurer’s position to bear a substantially greater risk than it believed it was insuring.

b. In this insurer’s position. This Section states a tailored objective understanding of materiality that considers the relevance of the misrepresented information from the perspective of a reasonable insurer in the position of the actual insurer. This tailored objective understanding may in some cases differ from that of an average or ordinary insurer. The question is not what an average or ordinary insurer would have done, but rather what a reasonable insurer in the position of this insurer would have done. Evaluating materiality from the perspective of an average or ordinary insurer could have the undesirable effect of inhibiting insurers from developing innovative underwriting categories or other underwriting practices that differ from the norm.

c. Distinguishing materiality from reliance. In some jurisdictions the materiality test is stated in a way that either expressly adopts or could be interpreted as adopting a subjective standard. In those states the materiality requirement asks, in effect, whether the particular insurer in the case would have issued the policy under the same terms had it known of the true facts. This is a subjective causation test that is indistinguishable from the subjective element of the detrimental-reliance requirement. In this Section, materiality is a purely objective inquiry. The materiality requirement requires the insurer to demonstrate that there is an objectively reasonable basis for the judgment embodied in its regular underwriting practices.

d. An objectively reasonable basis for the underwriting judgment. Perhaps the most common way to demonstrate that an insurer had an objectively reasonable basis for the judgment embodied in its underwriting practices is to demonstrate that a reasonable insurer—with “reasonable” understood here as ordinary or average—would regard the misrepresented information as very important. Because most misrepresentation cases concern misstatements that almost any insurer would regard as important, courts rarely confront situations in which an innovative insurer asks questions that most other insurers do not. In such an unusual case, the proper inquiry is not whether the information would be sufficiently important to an average or ordinary insurer. If that were the proper inquiry, the materiality element would make it impossible for insurers to insist upon honest answers to innovative questions. Rather, the proper inquiry is whether the information would be sufficiently important to a reasonable insurer in this insurer’s position.

It is important to emphasize that the materiality analysis focuses on a “reasonable insurer in this insurer’s position,” not on “this insurer.” The work that the reasonableness requirement is doing in this context is to require that there be some evidence supporting the actual insurer’s judgment that the information is important, so that there is a basis for the trier of fact to evaluate whether a reasonable insurer in this insurer’s position would agree with that judgment. This evidence can consist of an actuarial opinion, an empirical study, testimony regarding custom and practice, or any other evidence that a reasonable insurer would use to decide whether a category of information is sufficiently important for the purpose of deciding whether to insure an applicant and, if so, at what price.

e. Substantiality. For the materiality standard to be met, the insurer must demonstrate that, knowing the correct facts ex ante, a reasonable insurer in its position would have offered the policy, if at all, only with substantially different terms, such as a substantially higher premium. The misrepresentation defense is not available in circumstances in which a reasonable insurer in this insurer’s position would regard the misrepresentation in question as trivial or inconsequential. Courts have used a wide variety of verbal formulations to express the requirement encapsulated in this Section by the phrase “substantially different terms.” Although courts have not often used this precise expression, it best gives effect to the principal purpose of the materiality requirement by making clear that a fact having only an insubstantial effect on policy terms is not of sufficient objective relevance to the risk being insured.

  Illustrations:

  1. On an application for a standard homeowner’s insurance policy, the policyholder is asked whether in the past 10 years he has been a defendant in a civil lawsuit. The policyholder who has in fact been sued three times during that period nevertheless checks the “no” box on the application. The insurer issues the policy. Had the insurer known the truth with respect to this question, it would not have issued the policy. The insurer can demonstrate that other insurers also decline to issue homeowner’s insurance policies to applicants who have been sued three times in the past 10 years. Accordingly, the policyholder’s misrepresentation was material.

  2. On an application for a standard automobile-insurance policy, the policyholder is asked how far she commutes to work each day. The policyholder answers “two miles,” when the correct answer is “five miles.” The insurer issues the policy with a premium of $1000 for six months. Had the insurer known the truth with respect to this question, it would have charged $25 more for a policy. The policyholder’s misrepresentation was not material.

  3. An insurer conducts research that demonstrates to its reasonable satisfaction that people who frequently play a certain kind of online video game are more likely to suffer a substantial loss under their automobile-insurance policy. The insurer adds a question asking whether the applicant plays this kind of video game to its application for auto insurance. A policyholder who regularly plays the game more than 10 hours a week provides the false answer “no” to the question, “Have you played [this kind of video game] within the last 60 days?” Had the policyholder answered yes to this question, the insurer would not have issued the policy. The policyholder’s misrepresentation was material.

  4. An insurer adds a question regarding history of sexually transmitted disease to its application for homeowner’s insurance based on the belief of a senior executive that people with a history of sexually transmitted disease are likely to pose a higher liability risk. A policyholder who does have a history of sexually transmitted disease provides a false answer “no” to the question, “Have you ever been diagnosed with a sexually transmitted disease?” Had the policyholder answered yes to this question, the insurer would have charged the policyholder 50 percent more for the liability coverage. At trial in a case in which the insurer raises this false answer as the basis for a rescission, the insurer is unable to present any evidence supporting the senior executive’s belief that it considered before adopting the policy, nor is it able to present any evidence from its claims records supporting the association between sexually transmitted disease and liability risk. The policyholder’s misrepresentation was not material.

The reliance requirement of § 7(2)(b) is met only if:

  (1) But for the misrepresentation, the insurer would not have issued the policy or would have issued the policy only with substantially different terms; and

  (2) Such actions would have been reasonable under the circumstances.

Comment:

a. The function of the detrimental-reliance requirement. Misrepresentation doctrine includes both subjective and objective aspects. The reliance element, especially in § 9(1), primarily addresses the subjective aspect: the impact of the misrepresentation on the particular insurer. This element requires an insurer to demonstrate that the misrepresentation caused it significant harm. If the insurer would have issued the policy on substantially the same terms even if it had received the correct information, then the insurer did not rely to its detriment on the misrepresentation. Thus, a misrepresentation by a policyholder will not render a policy voidable when the insurer has actual knowledge of the true facts or of the falsity of the policyholder’s representation. This reliance requirement is similar to the inducement requirement in the common law of contract, which is, in turn, similar to the causation doctrine in tort.

b. The contribute-to-the-loss approach. To demonstrate detrimental reliance it is sufficient that the insurer demonstrate that it would have charged a substantially higher premium had it received the correct information, even if that information had nothing to do with the risk that produced the loss in question. It is sometimes suggested that insurance law should limit the insurer’s misrepresentation defense to situations in which the misrepresentation by the policyholder actually materialized in (“contributed to”) the loss that occurred and for which the insured filed a claim. This is often referred to as the “contribute-to-the-loss” or “causal relation” approach. The proponents of this approach argue that requiring such a close causal connection between the policyholder’s misrepresentation and the actual loss suffered by the insurer protects insureds from arbitrary outcomes. The classic example comes from life insurance: when the insurance applicant falsely represents him- or herself to be a nonsmoker but then dies from a cause unrelated to smoking, the contribute-to-the-loss approach would not permit the insurer to deny coverage based on misrepresentation. The same principle could apply in the liability insurance context as well. (See Illustration 4 below.)

This Section does not follow the contribute-to-the-loss approach for four reasons. First, the contribute-to-the-loss rule does not address the primary concern to which the doctrine of misrepresentation is a response: the problem of high-risk policyholders intentionally and dishonestly understating their risks in order to obtain coverage at a price that is subsidized by honest members of the same risk pool. Such adverse selection is unfair and inefficient (as discussed in Comment a to § 7) and should be discouraged even if the policyholder’s misrepresentation did not give rise to the loss under the policy. The contribute-to-the-loss approach would penalize only those misrepresentations that happen to contribute to the particular loss for which the insured files a claim. By contrast, the standard followed in this Section appropriately penalizes all misrepresentations that meet the requirements of § 7. Second, the contribute-to-the-loss rule can be unreasonably difficult for an insurer to satisfy, because of the absence of proof of the precise connection between the misrepresentation in question and the cause of the loss for which a claim is being filed. The rule therefore results in unfair cross-subsidies, as relatively high-risk policyholders who have misrepresented their risks under circumstances in which the causal connection is present but impossible to prove are subsidized by relatively low-risk policyholders who have made no such misrepresentations. Third, no court has adopted the contribute-to-the-loss rule as part of the common law of liability insurance. Finally, if a court were willing to adopt a common-law innovation to address the unfairness of the strict-liability misrepresentation rule, the arbitrary outcomes that the contribute-to-the-loss approach is intended to avoid are better addressed by limiting the insurer’s misrepresentation defense to situations in which the policyholder acted intentionally or recklessly.

c. The role of agents in establishing reliance. Insurance organizations act through people. The law of agency determines which people act for an insurer and in which circumstances, as well as the circumstances under which an insurance broker is in fact an agent of the policyholder rather than the insurer. Agency law can also affect what constitutes detrimental reliance on the part of an insurer. Ordinarily, if an agent of an insurer knows that a misrepresented fact is untrue at the time of the application, there can be no detrimental reliance on the part of the insurer, as the agent’s knowledge is imputed to the insurer. Similarly, if the agent is aware of the misrepresentation and assures the policyholder that the insurer will not rely upon the false information in question in deciding whether to issue the policy or in determining the policy terms, and if it is reasonable under the circumstances for the policyholder to rely on those assurances, the insurer may be estopped from invoking the misrepresentation defense. See § 6 on estoppel. These rules have the beneficial effect of placing the burden on insurers to monitor their agents and adopt practices and procedures that ensure that agents will convey all relevant information to the insurer and not engage in behavior that detrimentally misleads policyholders. The difficulty with these rules, however, is that they also create the risk of collusion between policyholder and agent to defraud the insurer. To some extent, insurers can reduce this risk by taking precautions in selecting and monitoring their agents. In addition, however, courts can be made aware of this problem and take it into account when applying the misrepresentation rules.

  Illustrations:

  1. The insurer asks on the application for a standard homeowner’s insurance policy whether the applicant “serves on the board of any organization, whether for profit or not for profit, and, if so, whether the applicant is an insured under a Directors’ and Officers’ Liability Insurance Policy issued to the organization.” The policyholder, who is an active board member for two nonprofit organizations, nevertheless checks the “no” box in the space next to this question and submits the application. The insurer’s agent, who takes the application for the insurer, reasonably believes that this answer is correct. The insurer issues a standard homeowner’s policy for a preferred low-risk premium of $775/year. The policyholder subsequently is sued and tenders the suit to the insurer for a defense. At this point, the insurer investigates the policyholder’s activities, and learns that the policyholder had in fact been a member on the board and that the board did not have Directors’ and Officers’ Liability Insurance policies. Had the policyholder answered truthfully about her service on the nonprofit boards, the insurer would not have issued a homeowner’s policy to her. The insurer reasonably and detrimentally relied on the policyholder’s misrepresentation. Because there is no contribute-to-the-loss requirement, it does not matter whether the suit arose out of the insured’s activities as a board member.

  2. Same facts as Illustration 1, except that, had the insurer received the correct information, it would have issued the same policy with a premium of $800/year. Here the insurer has not shown detrimental reliance, because the terms of the policy that would have been issued absent the misrepresentation are not substantially different from the terms of the policy that was issued.

  3. Same facts as Illustration 1, with the following exceptions: The agent who reads the application is aware of the policyholder’s volunteer activities and notices the incorrect answer, but nevertheless, without disclosing this knowledge to the policyholder or the insurer, forwards the uncorrected application to the insurer, which later issues the policyholder a standard homeowner’s policy for a preferred low-risk premium. Because the agent knew the correct facts about the information that was misrepresented, the agent’s knowledge is imputed to the insurer, which therefore is deemed not to have relied on the misrepresentation.

  4. On an application for auto liability insurance the policyholder is asked who will be the primary driver of the car. The policyholder, knowing that his teenage daughter will be the primary driver, nevertheless answers that he will be the primary driver. The insurer issues a policy for a preferred low-risk premium of $750/year. If the policyholder had answered truthfully, the insurer would have issued the same policy, but only for a premium of $1500/year. An accident occurs while the policyholder (rather than his daughter) happens to be driving the car, and the accident gives rise to a lawsuit against the policyholder. The insurer is entitled to the misrepresentation defense even though the misrepresentation in question did not contribute to the loss that occurred. The impact of any state auto-insurance-policy cancellation statute is beyond the scope of this Illustration.

d. Inquiry notice and the objective-reasonableness element of the reliance requirement. Under this Section, the insurer must show not only that it relied on the misrepresentation, but also that this reliance was reasonable under the circumstances. This reasonableness requirement has a different objective than the reasonableness requirement of the materiality element of the misrepresentation defense. In the materiality element, the reasonableness requirement focuses on whether the insurer reasonably regarded the information as important. In the reliance element, the reasonableness requirement focuses on whether the insurer reasonably failed to discover or act upon the truth. Accordingly, under § 9(2), the insurer must show that an objectively reasonable insurer in this insurer’s position would not have discovered the misrepresentation in question before the claim arose. See § 8, Comment d, for further discussion of the reasonable insurer in this insurer’s position. This objective element of the reliance requirement provides an incentive for insurers to undertake a reasonable amount of investigation and analysis before issuing a policy and, in some cases, even after the policy is issued (for example, if there was insufficient time to complete a reasonable investigation before issuing the policy). Thus, for example, if there is something suspicious in an application that would cause an objectively reasonable insurer to undertake further investigation, the reasonable-reliance requirement would impose such a duty on the insurer. This objective requirement makes systematic what is sometimes referred to as the “inquiry notice” doctrine, which holds that, when a contracting party has been put “on notice” that there might be a factual error in the counterparty’s representations, the contracting party has a duty to make a reasonable investigation. What constitutes a reasonable investigation at the underwriting stage of a liability insurance transaction will depend on the circumstances of each case and may vary depending on the type of policy, the nature of the risks, and the type of insured.

  Illustration:

  5. On an application for auto liability insurance, the policyholder is asked whether she has received any speeding tickets in the past five years. The policyholder, knowing that she has had five speeding tickets during that time, nevertheless checks the “no” box. Had the insurer known the truth about the policyholder’s speeding tickets, it would not have issued the policy. The insurer accepts the policyholder’s “no” answer as true without checking her prior driving record, even though the insurer is aware that the policyholder’s previous auto policy, issued by a different insurer, had been cancelled on misrepresentation grounds. The insurer’s actual reliance on the policyholder’s misrepresentation was not reasonable, because the insurer failed to make the reasonably straightforward investigation that an objectively reasonable insurer would have made into the truthfulness of the policyholder’s answers on her application under the circumstances.

e. Evidence of reliance. In determining whether the insurer detrimentally relied on the policyholder’s misrepresentation, the court may consider the insurer’s past practices with respect to accepting or rejecting similar risks. Relevant evidence may include documents such as contemporaneous underwriting manuals, written guidelines, or the underwriting files of other similarly situated policyholders in the same general time period.

f. Requiring reliance even for fraudulent misrepresentations. Sections 9 and 11 of the Restatement Third, Torts: Liability for Economic Harm (Tentative Draft No. 2, 2014, approved in May 2014; official text expected in 2019), require justifiable reliance even in the case of fraud. Justifiable reliance is a somewhat less demanding requirement than reasonable reliance, requiring only freedom from recklessness. The rationale for a less demanding requirement seems to be that the protection afforded by the reasonable-reliance requirement is unnecessary when the misrepresenting party has committed fraud. Both standards promote what may be the most important objective of the reliance requirement: avoiding an incentive for insurers to include in insurance applications irrelevant or unimportant questions to which applicants can be expected to provide knowingly false information. This Section follows the reasonable-reliance requirement for two reasons. First, the difference between justifiable and reasonable reliance is unlikely to have much significance in the insurance context, so the additional burden associated with maintaining separate standards is unlikely to provide much benefit to the insurance pool. Second, and more importantly, there are externalities in the liability insurance context that are not present in the usual fraud context. In many if not most cases the main beneficiary of the fraud is not the policyholder, but rather a tort claimant who was harmed by the policyholder. Therefore, § 7 imposes a reliance requirement even for intentional misrepresentations. This does not require proof that the policyholder had knowledge of, or was willfully indifferent to, the fact that the misrepresentation in question was likely to be relied upon by the insurer. It is enough that the insurer reasonably relied on that material misrepresentation to its detriment.

INSURANCE CODE

TITLE 5. PROTECTION OF CONSUMER INTERESTS

SUBTITLE F. INSURANCE FRAUD AND IDENTITY THEFT

CHAPTER 705. MISREPRESENTATIONS BY POLICYHOLDERS

SUBCHAPTER A. GENERAL PROVISIONS

Sec. 705.001. DEFINITION. In this subchapter, "insurance policy" means a contract or policy of insurance.

Added by Acts 2003, 78th Leg., ch. 1274, Sec. 2, eff. April 1, 2005.

Sec. 705.002. APPLICABILITY OF SUBCHAPTER. Except as provided by Section 705.005, this subchapter applies to each insurance policy issued or contracted for in this state.

Added by Acts 2003, 78th Leg., ch. 1274, Sec. 2, eff. April 1, 2005.

Sec. 705.003. POLICY PROVISION: MISREPRESENTATION IN PROOF OF LOSS OR DEATH. (a) An insurance policy provision that states that a misrepresentation, including a false statement, made in a proof of loss or death makes the policy void or voidable:

(1) has no effect; and

(2) is not a defense in a suit brought on the policy.

(b) Subsection (a) does not apply if it is shown at trial that the misrepresentation:

(1) was fraudulently made;

(2) misrepresented a fact material to the question of the insurer's liability under the policy; and

(3) misled the insurer and caused the insurer to waive or lose a valid defense to the policy.

Added by Acts 2003, 78th Leg., ch. 1274, Sec. 2, eff. April 1, 2005.

Sec. 705.004. POLICY PROVISION: MISREPRESENTATION IN POLICY APPLICATION. (a) An insurance policy provision that states that false statements made in the application for the policy or in the policy make the policy void or voidable:

(1) has no effect; and

(2) is not a defense in a suit brought on the policy.

(b) Subsection (a) does not apply if it is shown at trial that the matter misrepresented:

(1) was material to the risk; or

(2) contributed to the contingency or event on which the policy became due and payable.

(c) It is a question of fact whether a misrepresentation made in the application for the policy or in the policy itself was material to the risk or contributed to the contingency or event on which the policy became due and payable.

Added by Acts 2003, 78th Leg., ch. 1274, Sec. 2, eff. April 1, 2005.

Sec. 705.005. NOTICE TO INSURED OF MISREPRESENTATIONS. (a) This section applies to any suit brought on an insurance policy issued or contracted for after June 29, 1903.

(b) A defendant may use as a defense a misrepresentation made in the application for or in obtaining an insurance policy only if the defendant shows at trial that before the 91st day after the date the defendant discovered the falsity of the representation, the defendant gave notice that the defendant refused to be bound by the policy:

(1) to the insured, if living; or

(2) to the owners or beneficiaries of the insurance policy, if the insured was deceased.

(c) This section does not:

(1) make available as a defense an immaterial misrepresentation; or

(2) affect the provisions of Section 705.004.

Added by Acts 2003, 78th Leg., ch. 1274, Sec. 2, eff. April 1, 2005.

SUBCHAPTER B. SPECIAL PROVISIONS RELATED TO LIFE, ACCIDENT, AND HEALTH INSURANCE POLICIES

Sec. 705.051. IMMATERIAL MISREPRESENTATION IN LIFE, ACCIDENT, OR HEALTH INSURANCE APPLICATION. A misrepresentation in an application for a life, accident, or health insurance policy does not defeat recovery under the policy unless the misrepresentation:

(1) is of a material fact; and

(2) affects the risks assumed.

Added by Acts 2003, 78th Leg., ch. 1274, Sec. 2, eff. April 1, 2005.

SUBCHAPTER C. SPECIAL PROVISIONS RELATED TO LIFE INSURANCE POLICIES

Sec. 705.101. DEFINITION. In this subchapter, "insurance policy" means a contract or policy of insurance.

Added by Acts 2003, 78th Leg., ch. 1274, Sec. 2, eff. April 1, 2005.

Sec. 705.102. APPLICABILITY OF SUBCHAPTER. This subchapter applies to any insurance policy issued or contracted for in this state.

Added by Acts 2003, 78th Leg., ch. 1274, Sec. 2, eff. April 1, 2005.

Sec. 705.103. DOCUMENTS TO ACCOMPANY POLICY. Except as otherwise provided by this code, a life insurance policy must be accompanied by a copy of:

(1) the policy application; and

(2) any questions and answers given in connection with the application.

Added by Acts 2003, 78th Leg., ch. 1274, Sec. 2, eff. April 1, 2005.

Sec. 705.104. MISREPRESENTATION IN APPLICATION FOR LIFE INSURANCE. A defense based on a misrepresentation in the application for, or in obtaining, a life insurance policy on the life of a person in or residing in this state is not valid or enforceable in a suit brought on the policy on or after the second anniversary of the date of issuance of the policy if premiums due on the policy during the two years have been paid to and received by the insurer, unless:

(1) the insurer has notified the insured of the insurer's intention to rescind the policy because of the misrepresentation; or

(2) it is shown at the trial that the misrepresentation was:

(A) material to the risk; and

(B) intentionally made.

Added by Acts 2003, 78th Leg., ch. 1274, Sec. 2, eff. April 1, 2005.

Sec. 705.105. APPLICABILITY OF OTHER LAW. Subchapter A does not apply to a life insurance policy:

(1) that contains a provision making the policy incontestable after two years or less; and

(2) on which premiums have been duly paid.

Added by Acts 2003, 78th Leg., ch. 1274, Sec. 2, eff. April 1, 2005.

Overview

In looking at whether a falsehood of some sort will be held to create disadvantages for the policyholder (such as rescission of  policy or as disallowing a claim), courts and legislatures tend to focus on three factors:

1) [culpability] The culpability of the insured in making the false statement

2) [materiality] The extent to which the ex ante risk created by the insured had the statement been true differed from the ex ante risk created by the insured given the truth

3) [causation] Whether the loss suffered by the insured was caused by the peril about which the insured made the false statement of whether it was due to some other peril

Culpability

With respect to culpability, I think it is useful to think of four categories. The question is where is the court going to draw the line between actionable misrepresentation and non-actionable. And then, will that line be independent of the other factors (materiality and causation) or will it depend on them.

a) non-negligent falsity. As it happens what the insured said was false but there was no way on earth the insured could know that. The insured says he did not have cancer in applying for life insurance after two test sfor cancer conducted by an eminent oncologist both came back negative. In fact, due to an error in the printing software used by the lab, the tests were actually positive.

b) negligent falsity: The insured did not know what they were saying was false; in fact the insured believed the statement to be true, but the insured should have known of the falsity by doing an adequate investigation. The insured represents on an automobile insurance policy that they drive 20 miles each day. In fact, they drive 35 miles each day. The insured was foolishly using the straightline distance between home and work rather than the distance actually traversed.

c) reckless falsity: The insured represents that he does not have high blood pressure. In fact, the insured had not had a blood pressure test in the past 5 years and the last time it was read, his blood pressure, along with almost everyone else in his family, was extremely high. The insured doesn't know the statement is false; maybe his blood pressure has gone down. Nonetheless, at best the insured knows that he has no idea whether his statement is true.

d) Intentional: The insured represents that he does not have high blood pressure. In fact, two tests conducted the day of the application show that his blood pressure is extremely high. The insured makes the representation knowing that if he says he has high blood pressure he will, at best, pay a higher rate for the life insurance.

Materiality

There are several concerns with materiality. One is "how" material must the departure be. An insured who applies to automobile insurance says they drive 39 miles to and from work each day. In fact, the distance is 41 miles. Unbeknownst to the insured, the insurer uses certain categories to measure driving risk, one of which happens to break at 40 miles. Thus, in this instance, the misstatement was material to the insurer, and perhaps slightly material to the true risk (danger doesn't suddenly jump at 40 miles; the insurer is just using that as a convenience). There's another matter. Suppose there are a number of ways of determining the risk level posed by an insured. One can't say that a particular algorithm is better than another (though there may be some that are terrible). If an insured's falsehood would change the risk result output by a particular insurer's algorithm (say by 10%) does it matter than other insurers don't even use that input or that, given everything else, the falsehood would not change the result of those other insurers' algorithm.

A second issue is whether the insurer can affect the degree of materiality required through contract law itself. This is basically the debate one sees in Vlastos and other places about the difference between a "warranty" and a "misstatement." A warranty is a bit of a bundle: in the Lord Mansfield view of things, it created strict liability (no culpability required) and set the materiality requirement at zero. The whole idea of a warranty was that the insurer didn't want some ill informed court making a decision about whether something really mattered or not. Or suppose the insurance contract doesn't use the language of warranty and misrepresentation. Suppose, for example, in the Vlastos case, the insurer had not demanded a warranty but had instead included a custom exclusion (via "endorsement") stating, "We do not provide coverage for any insured unless a janitor is occupying the third floor at the time of loss." Should that change the degree of culpability or materiality required?

Do you see, by the way, how there's a danger with permitting an insurer to request warranties. Suppose we were back in the Lord Mansfield era. Would you as an insurer confine your inquiries to things that were material? Might you not bait the insured into making mistatements by asking them lots of questions on irrelevancies and hoping that at least one of their responses was false.

Causation

One way of preventing insurer fishing expeditions for falsehoods is to require that the falsehood have related to a peril that actually caused the loss.  Thus, if a life insurer asks for precise measurements of height and would ordinarily seize upon the person saying they were 5'2 instead of 5'1.5 but the insured ends up being shot in a mass killing, the insurer wouldn't be able to deny coverage. So there'd be no point in insisting upon precision where it wasn't material to the risk. On the other hand, a requirement of causation means that falsity carries less of a risk. Thus, persons of low risk will end up subsidizing persons of high risk. Depending on the situation (and your values) this may be good or bad.