RLLI Section 9

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.