The postclaim underwriting trap

For years insurance companies have had a practice of denying claims or rescinding policies on the basis that policyholders misrepresent or omit information when answering questions on the insurance application. This practice is prevalent in life insurance, but it continues in all types of insurance -- even malpractice insurance for attorneys. Imagine your malpractice coverage being canceled after a claim is filed against you, or your life insurance canceled after you die, or your homeowners insurance canceled after your house burns down. Thanks to the courts and legislation, this odious practice, which is called postclaim underwriting, has been condemned and even prohibited in some areas of insurance, such as health insurance. See California Insurance Code Section 10384. But postclaim underwriting continues to imperil other insurance policyholders.

At the center of cases involving postclaim underwriting is the typical application for insurance, which can be a trap for unsuspecting consumers. Insurers require applicants to answer questions that are usually confusing, compound and designed to induce mistakes. It is only after a claim is filed that the company's employees start digging through medical or other records to find mistakes or inconsistencies on the application. The insurer then jumps on any mistakes or omissions in the application to deny the claim, rescind the policy or, worse yet, accuse the policyholder of fraud.

The one California court that has squarely addressed this issue has condemned the practice, pointing out that an insurance company has an obligation to investigate and determine an applicant's eligibility for coverage before issuing the policy and not after a claim is filed. In Hailey v. California Physicians' Service, 158 Cal. App. 4th 452 (2007), the court put it this way:

"An insurer has an obligation to its insured to do its underwriting at the time a policy application is made, not after a claim is filed. It is patently unfair for a claimant to obtain a policy, pay premiums and operate under the assumption that he is insured against a specific risk, only to learn after he submits a claim that he is not insured, and therefore cannot obtain any other policy to cover the loss. The insurer controls when the underwriting occurs ... if the insured is not an acceptable risk, then the application should be denied upfront, not after a policy is issued."

It is no surprise that the most recent appellate court decision to scrutinize the practice of postclaim underwriting has called it "patently unfair." Yet the practice still continues today to deny claims and induce rescissions.

BAD FAITH

The essential question relating to bad faith is whether an insurance company's rescission is reasonable under the facts, or whether it is simply an attempt to avoid payment of a claim. When an insurer rescinds a policy for reasons that are plainly invalid under the law, a strong argument can be made that the rescission itself constitutes bad faith.

For example, an insurer could be held liable for bad faith when it rescinds a policy even though the insured's nondisclosure of certain facts is not significant enough to materially affect the underwriting of the policy. This might be shown by demonstrating that, according to the company's underwriting manual, it would have written the policy even if the insured had disclosed the missing information. Also, many questions on the application require the applicant to recall information from 10 or 20 years ago, or in some cases even spanning a lifetime. Many applicants simply cannot remember events that far back and make innocent mistakes. The questions on the application usually only allow for a yes or no answer -- there is no space for "don't remember."

Many insurers will seize upon innocent mistakes to deny a claim or rescind a policy without doing a proper investigation, which should include obtaining the policyholder's version of what happened during the application process. In Thompson v. Occidental Life Insurance Co., 9 Cal. 3d 904 (1973), the California Supreme Court placed the burden on the insurance company to eliminate all plausible explanations for incomplete answers on a life insurance application and to inquire into the policyholder's understanding and state of mind when completing the application. The court noted that rescission based on misrepresentation is improper when an applicant had no knowledge of the facts sought or failed to appreciate their significance.

In my experience, many carriers do not fully investigate these facts before denying a claim or rescinding a policy. This can be bad faith. The California Supreme Court long ago imposed a duty on insurance companies to investigate all bases that might support the insured's claim. See Egan v. Mutual of Omaha, 24 Cal. 3d 809 (1979). In other words, when the carrier has notice of any inaccuracies or omissions on the application, it assumes a duty to investigate reasons that may explain those mistakes or omissions. Failure to do so may constitute bad faith.

Many times, the insurance agent who completed the application for the insured could be responsible for inaccuracies or omissions on application. But even here, bad faith is possible because the courts have held that an agent's knowledge, e.g., of inaccuracies on the application, can be imputed to the insurer. See O'Riordan v. Federal Kemper Life Assurance, 36 Cal. 4th 281 (2005).

With plaintiff lawyers across the country arguing powerfully against postclaim underwriting as an instrument to unfairly deny claims or rescind policies, it has become increasingly difficult for insurance companies to justify this unseemly practice. Ongoing litigation, spearheaded by plaintiff lawyers, may eventually bring it to an end. 