Policy Rescission

A hasty rescission action can lead to extra-contractual
liability and, in this Massachusetts case, an unfortunate

judicial opinion.
by Harvey Weiner

Although the road to rescission of an insurance policy can be covered with obstacles and potholes, usually a failed rescission claim will only bring the insurer back to square one. It will still have defenses under the policy and under law. Except for attorneys fees (sometimes, those of both parties) and bruised egos, the insurer will rarely be worse off than before it attempted to rescind.

However, in a recent Massachusetts federal district court case, an insurer trying to rescind a $1 million executive protection policy ended up with a final judgment against it of $3,391,384.50 on November 28, 2005. Federal Insurance Company v. HPSC, Inc., 2005 U.S. Dist. Lexis 19713; 2005 WL 2206071 (U.S.D.C. Ma. 2005). How did that happen?

According to the opinion, HPSC, the insured, presented a $4.7 million crime and property loss to the insurer, which had insured HPSC continuously since 1988 against defalcations by employees. In essence, the loss resulted from an embezzlement scheme orchestrated by the executive vice president of a subsidiary of HPSC. The scheme was uncovered as a result of the insured’s investigation. In analyzing the reasons the scheme had gone undetected for five years, the insured’s investigation report noted that the embezzler had reconciled at least one account over which he had signatory authority. Question 12 of the policy application had asked whether employees who reconciled monthly bank statements “also either sign checks, handle deposits or have access to check signing machines or signature plates.” HPSC had answered the question “no.” The insurer concluded this was grounds for rescission and sued to rescind.

Rescission denied

However, after a trial, the jury found that HPSC’s failure to disclose that the employee had exercised check signing authority over only one account (petty cash with a balance ceiling of $10,000) did not materially increase the risk of loss and therefore the policy could not be rescinded.

Unfortunately, that is not the end of the story, as a series of events, both prior to and after the insurer’s decision to rescind, caused the respected trial judge to conclude that the insurer violated c.176D, the Massachusetts Unfair Insurance Practices Act, and that such violations were “knowing” or “willful,” leading to a doubling of the $1 million damages and a doubling of costs of $17,996.90 and of HPSC’s attorney’s fees of $437,313.88.

The trial judge found that an initial mistake was made by the insurer and it was never corrected, even after it was pointed out to the insurer’s counsel. The initial claims examiner had erroneously, but in good faith, tentatively concluded that the embezzler had signed checks and had reconciled the statements of all the subsidiary’s bank accounts. This mistaken perception was shared with two of her supervisors and another claims examiner, none of whom had personally read HPSC’s investigation report. The initial claims examiner spoke to an in-house attorney, who referred the matter to outside counsel, who then brought the rescission action. The trial judge noted that, other than consulting an underwriter as to the hypothetical increase in risk entailed by the failure of HPSC to segregate employee check writing and reconciliation duties, no additional investigation was undertaken by anyone before filing the complaint.

After suit was filed, the insurer was alerted that the embezzler reconciled only one small account and that someone else reconciled the remaining 15 accounts. At that point, the insurer shifted its litigation position to argue that the embezzler’s ultimate supervisory authority over the bank accounts and the accounting staff was the functional equivalent of writing checks and reconciling statements and that his supervision over one account was sufficient to sustain its rescission claim.

Compounded error

The trial judge concluded that the misreading of the insured’s investigation report during the initial investigation was a good faith mistake and was not actionable. However, he concluded that the insurer’s decision to file the lawsuit without asking the insured to respond to its concerns with respect to any potential misrepresentation and without making any inquiry into the underlying facts breached its statutory duty under the Massachusetts Unfair Insurance Practices Act, c. 176D, §3(9)(d), to conduct a reasonable investigation based upon all available information before rejecting a claim. The trial judge noted that the insured was “no stranger” to the insurer, having purchased insurance from it for some 14 years. Given this longstanding relationship, the trial judge stated that one a loyal customer might expect some consideration by the insurer.

The trial judge found also that once the insurer learned during litigation that the fundamental premise of its lawsuit was erroneous, its failure to make a reasonable offer at that time violated another section of the Massachusetts Unfair Insurance Practices Act, c.176D, §3(9)(f), which requires the insurer “to effectuate prompt, fair and equitable settlement of claims.” The insurer’s lack of good faith was further illustrated by a race to the courthouse to file its complaint before HPSC filed suit, a “stubborn refusal to admit error” and the bringing of a count which questioned whether the embezzler’s percolations amounted to “theft” within the meaning of the policy – a count that the insurer dismissed prior to trial.

There is always a risk that if an insurer waits too long to rescind, it will have waived its right to do so. However, an insurer’s investigation must be thorough, and, perhaps now in Massachusetts, must involve consultation with long-time insureds and must be updated to take into account new information learned, even after litigation has commenced. A hasty rescission action can lead to extra-contractual liability and, in this case, an unfortunate judicial opinion. A notice of appeal has been filed.

Harvey Weiner is a partner in the Boston office of Peabody & Arnold LLP, where he is chairman of the litigation department and founder of its professional liability practice. He can be reached at hweiner@peabodyarnold.com or at 617-951-2014. This article originally appeared in the March 2006 issue of the PLUS Journal, the monthly publication of the Professional Liability Underwriting Society. It is reprinted here with the permission of PLUS.

Topics Lawsuits Carriers Massachusetts