Case Briefs

The court acknowledged that material misrepresentations of fact made in connection with an application for insurance constitute a ground for rescission. However, the court recognized that an insurance carrier cannot successfully defend a claim upon the ground of its own failure to reasonably investigate the insured's application. The court noted that an insurer's duty to investigate derives “principally from the public policy underlying California's Financial Responsibility Law and the 'quasi-public' nature of the insurance business.” The court also noted that both of these public policy considerations mandate the conclusion that the failure of an insurer to reasonably investigate the insurability within a reasonable time after issuance of the policy “results in the loss of the carrier's right to rescind, as opposed to its right to cancel, the policy.” As the court further explained, if the carrier had not timely rescinded the policy “prior to an accident in which the insured negligently injures a third person, the policy necessarily remains in effect at least through the time of the accident; the insurer cannot thereafter rescind, but only cancel the policy.” The court premised its holding in significant part upon the “quasi-public” nature of an insurance contract. It stated: “The reasonable expectation of the public is that insurance companies provide them with insurance. This expectation would be frustrated if the courts allowed an insurance company to 'perpetually postpone the investigation of insurability and concurrently retain its right to rescind [the insurance policy] until the injured person secures a judgment against the insured and sues the carrier.' ” The court emphasized that a contrary rule would “ defeat the public's expectation for insurance companies” and allow an insurer to avoid investigating until there is an accident or injury, thereby “allowing the insurance company to collect premiums … without the risk associated with the policy in violation of its public obligations as an insurance company.” The court also noted that as a practical matter, a contrary rule would mislead an insured into believing that he or she was covered, when, in fact, he or she might not be, thereby discouraging the insured from obtaining insurance that actually does provide coverage. While the court's ruling was with respect to an automobile policy, the court's focus on the “quasi-public” nature of an insurance contract indicates that the ruling is not so limited and may, in fact, extend to any third-party insurance policy.

Can Failure to Include a Special Endorsement Justify Reformation of the Policy?

In Illinois Central Railroad Company v. Dupont, No. 02-30613 (5th Cir. 4/01/03), 2003 WL 1704649, the U.S. Court of Appeals for the Fifth Circuit affirmed a lower court's grant of summary judgment in favor of an insurer, holding that the failure to include a special endorsement in the policy, even if required by regulations, cannot give rise to a reformation of the policy deeming the endorsement to be a part of the policy.

Underwriters Insurance Company (“Underwriters”) issued a business automobile policy to Denmar Logging, Inc. (“Denmar”). Illinois Central Railroad Co. (“Railroad”) sued Denmar after an accident in which one of Denmar's contract drivers collided with a Railroad train. Underwriters intervened in the suit seeking a declaratory judgment that its policy did not cover the accident. Underwriters moved for summary judgment on the grounds that the policy only covered one truck owned by Denmar. The Railroad argued that by virtue of a regulation promulgated under the Motor Carrier Act of 1980, Denmar was required to have a special endorsement in its insurance policy. The endorsement, known as the MCS-90, provides that the insurer will pay within the policy limits any judgment recovered against the insured motor carrier for liability resulting from the carriers' negligence, whether or not the vehicle involved in the accident is specifically described in the policy. The Railroad argued that the endorsement should be deemed a part of the policy because of the regulation.

The district court granted summary judgment in favor of Underwriters, holding that Denmar was exempt from the regulation requiring the endorsement because Denmar was hauling an “agricultural commodity” not subject to regulation, and that even if the endorsement was required, the Railroad was not entitled to a reformation of the policy. The Fifth Circuit affirmed on the latter grounds without resolving whether the regulation even applied to Denmar.

The Fifth Circuit refused to reform the policy to deem the endorsement to be a part of the policy. The Fifth Circuit noted that even if the endorsement was required, the regulations are directed at the motor carrier, not its insurer. The Fifth Circuit did not interpret the regulations as imposing a duty on the insurer to make sure that the motor carrier secured the required insurance. The Fifth Circuit noted that the penalty for non-compliance with the regulation was a fine against the “person … who knowingly violates” the financial responsibility rules.

The Fifth Circuit also rejected the Railroad's argument that public policy required that the endorsement be deemed a part of the policy. The Fifth Circuit questioned the fairness of placing a duty on insurance companies to determine the insured's status as a motor carrier and whether it is otherwise subject to the Motor Carrier Act. Additionally, holding that the endorsement is automatically a part of the policy, whether or not the insured requested or paid for such an endorsement, would create a perverse incentive not to comply with the regulations.

Finally, the Fifth Circuit distinguished Prestige Cas. Co. v. Mich. Mut. Ins. Co., 99 F.3d 1340 (6th Cir.1996), cited by the Railroad. In Prestige, one of the insurers conceded that the MCS-90 endorsement was incorporated into the policy such that the court was not called upon to decide the issue.

Insurer Must Seek Rescission Before Third-Party Files Claim

In the case of USAA v. Pegos, 2003 (Cal. App. Lexis 445) (Cal. Ct. App.), March 25, 2003, the California Court of Appeal addressed the question of whether an insurance carrier can rescind an automobile liability insurance policy after the insured injures another person. The court held that the insurance carrier could not do so. As the court stated:

“Unless it has conducted a reasonable investigation as to the insurability of its insured, an insurance company may not rescind an automobile insurance policy based upon the material misrepresentations of its insured after the insured injures a third party … This requirement is to protect the public from injury by the insured's acts rather than to reward a dishonest insured.” (For in-depth information on rescission, see the article titled “Can the Innocent Survive Rescission?” beginning on page 1.

The court acknowledged that material misrepresentations of fact made in connection with an application for insurance constitute a ground for rescission. However, the court recognized that an insurance carrier cannot successfully defend a claim upon the ground of its own failure to reasonably investigate the insured's application. The court noted that an insurer's duty to investigate derives “principally from the public policy underlying California's Financial Responsibility Law and the 'quasi-public' nature of the insurance business.” The court also noted that both of these public policy considerations mandate the conclusion that the failure of an insurer to reasonably investigate the insurability within a reasonable time after issuance of the policy “results in the loss of the carrier's right to rescind, as opposed to its right to cancel, the policy.” As the court further explained, if the carrier had not timely rescinded the policy “prior to an accident in which the insured negligently injures a third person, the policy necessarily remains in effect at least through the time of the accident; the insurer cannot thereafter rescind, but only cancel the policy.” The court premised its holding in significant part upon the “quasi-public” nature of an insurance contract. It stated: “The reasonable expectation of the public is that insurance companies provide them with insurance. This expectation would be frustrated if the courts allowed an insurance company to 'perpetually postpone the investigation of insurability and concurrently retain its right to rescind [the insurance policy] until the injured person secures a judgment against the insured and sues the carrier.' ” The court emphasized that a contrary rule would “ defeat the public's expectation for insurance companies” and allow an insurer to avoid investigating until there is an accident or injury, thereby “allowing the insurance company to collect premiums … without the risk associated with the policy in violation of its public obligations as an insurance company.” The court also noted that as a practical matter, a contrary rule would mislead an insured into believing that he or she was covered, when, in fact, he or she might not be, thereby discouraging the insured from obtaining insurance that actually does provide coverage. While the court's ruling was with respect to an automobile policy, the court's focus on the “quasi-public” nature of an insurance contract indicates that the ruling is not so limited and may, in fact, extend to any third-party insurance policy.

Can Failure to Include a Special Endorsement Justify Reformation of the Policy?

In Illinois Central Railroad Company v. Dupont, No. 02-30613 (5th Cir. 4/01/03), 2003 WL 1704649, the U.S. Court of Appeals for the Fifth Circuit affirmed a lower court's grant of summary judgment in favor of an insurer, holding that the failure to include a special endorsement in the policy, even if required by regulations, cannot give rise to a reformation of the policy deeming the endorsement to be a part of the policy.

Underwriters Insurance Company (“Underwriters”) issued a business automobile policy to Denmar Logging, Inc. (“Denmar”). Illinois Central Railroad Co. (“Railroad”) sued Denmar after an accident in which one of Denmar's contract drivers collided with a Railroad train. Underwriters intervened in the suit seeking a declaratory judgment that its policy did not cover the accident. Underwriters moved for summary judgment on the grounds that the policy only covered one truck owned by Denmar. The Railroad argued that by virtue of a regulation promulgated under the Motor Carrier Act of 1980, Denmar was required to have a special endorsement in its insurance policy. The endorsement, known as the MCS-90, provides that the insurer will pay within the policy limits any judgment recovered against the insured motor carrier for liability resulting from the carriers' negligence, whether or not the vehicle involved in the accident is specifically described in the policy. The Railroad argued that the endorsement should be deemed a part of the policy because of the regulation.

The district court granted summary judgment in favor of Underwriters, holding that Denmar was exempt from the regulation requiring the endorsement because Denmar was hauling an “agricultural commodity” not subject to regulation, and that even if the endorsement was required, the Railroad was not entitled to a reformation of the policy. The Fifth Circuit affirmed on the latter grounds without resolving whether the regulation even applied to Denmar.

The Fifth Circuit refused to reform the policy to deem the endorsement to be a part of the policy. The Fifth Circuit noted that even if the endorsement was required, the regulations are directed at the motor carrier, not its insurer. The Fifth Circuit did not interpret the regulations as imposing a duty on the insurer to make sure that the motor carrier secured the required insurance. The Fifth Circuit noted that the penalty for non-compliance with the regulation was a fine against the “person … who knowingly violates” the financial responsibility rules.

The Fifth Circuit also rejected the Railroad's argument that public policy required that the endorsement be deemed a part of the policy. The Fifth Circuit questioned the fairness of placing a duty on insurance companies to determine the insured's status as a motor carrier and whether it is otherwise subject to the Motor Carrier Act. Additionally, holding that the endorsement is automatically a part of the policy, whether or not the insured requested or paid for such an endorsement, would create a perverse incentive not to comply with the regulations.

Finally, the Fifth Circuit distinguished Prestige Cas. Co. v. Mich. Mut. Ins. Co., 99 F.3d 1340 (6th Cir.1996), cited by the Railroad. In Prestige, one of the insurers conceded that the MCS-90 endorsement was incorporated into the policy such that the court was not called upon to decide the issue.