In Defense of Contestability: If Post-Issuance Investigations Amount to Bad Faith, Then What's the Point of Contestability?
February 13, 2008
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If Post-Issuance Investigations Amount to Bad Faith, Then What's the Point of Contestability?
Some people lie on insurance applications. Most do not, but some do.
Some people carelessly complete an insurance application. Most do not, but some do.
A California Court of Appeal recently added its voice to a growing chorus of plaintiffs' attorneys, regulatory agencies and consumer advocates who argue that life insurance and health insurance companies should unilaterally bear the burden of this conduct. See Hailey v. California Physicians' Service, 2007 Cal. App. LEXIS 2083, *1 (Cal. Ct. App. December 24, 2007). Yet, in providing false or inaccurate information to a life or health insurance company, a cost is created – that of undervalued risk. Who bears this cost, the insured or the insurance company (and by extension its policyholders), is a policy determination each state must make. To account for this risk, virtually all states have established a legal and regulatory system that protects the many from the few – that allows prompt access to life insurance and health insurance coverage while permitting post-issuance investigations to identify the relative few whose conduct prevented the insurer from accurately assessing the risk it was being asked to assume.
Under the misnomer of "post claims underwriting," courts are being urged to ignore the status quo's carefully orchestrated regulatory structure and find that a life or health insurer should bear the cost of undervalued risk once the policy is issued. In other words, if the insurer wants to investigate an insured's application answers, it needs to do so before the policy is issued, regardless of whether the application raises any cause for concern. This paradigm, however, is completely contrary to the status quo and would result in a system that benefits no one: effectively forcing individuals seeking insurance protection to wait weeks or months while the insurance company conducts an investigation for the sole purpose of confirming that the applicant is not lying.
Public Policy Dictates a Legal Framework That Protects Both Insureds and Insurers
Life insurance and health insurance is, fundamentally, a social good. Unfortunately, the provision of insurance is complicated by, among other things, carelessness and fraud – serious problems costing life and health insurers millions of dollars every year. Such conduct prevents the insurance company from accurately assessing the risk it is asked to assume. Thus, public policy dictates that mechanisms be in place to detect, remedy and prevent this type of life and health insurance fraud. To this end, most states have implemented a legal framework that allows insurers to conduct investigations following policy issuance and, in certain circumstances, rescind a policy that would not have been issued but for the fraud or carelessness.
Fundamental Rules of Insurance Law Support the Status Quo
Unlike the paradigm advocated by many plaintiffs, the status quo permits both the applicant and the insurer to rely on the other's honesty and integrity during the application process. "[A]n insurer has no general duty to investigate the truthfulness of answers given to questions asked on an application for insurance . . . an insurance company has the right to rely on the truthfulness of the answers given by an insurance applicant, and the insured has the corresponding duty to supply complete and accurate information to the insurer." See Brandt v. Time Ins. Co., 704 N.E.2d 843, 846 (Ill. App. Ct. 1998); Smith v. AF & L Ins. Co., 147 S.W.3d 767, 777 (Mo. Ct. App. 2004) (acknowledging that "insurers generally are not required to make further inquiry where the application is complete on its face"). This practice is widely condoned and used throughout the country as a means of providing individuals timely access to life and health insurance coverage.
The application becomes the primary basis on which the insurer assesses the risk it is being asked to assume, and obtaining complete and accurate answers is, therefore, vital to the utility of the underwriting process. As the United States Supreme Court stated long ago, "[e]ven the most unsophisticated person must know that in answering the questionnaire and submitting it to the insurer, he is furnishing the data on the basis of which the company will decide whether, by issuing a policy, it wishes to insure him." Stipcich v. Metropolitan Life Ins. Co., 277 U.S. 311, 316–17 (1928). Other courts have reached the same conclusion, For example, the Kentucky Supreme Court wrote "[q]uestions contained in an application for insurance concerning an applicant's state of health, past medical treatment, consultation and the like are of the gravest importance, and it is the duty of the applicant to exercise good faith and answer them truthfully." Prudential Ins. Co. of America v. Lampley, 180 S.W.2d 399, 401 (Ky. 1944).
Based on the information gathered during the application process, the insurer assesses a premium proportionate to the amount of risk assumed. Stockinger v. Central Nat'l Ins. Co., 24 Wis. 2d 245, 255 (Wis. 1964) (noting "that premium rates are directly proportional to the risk involved"). In the life and health insurance context, the applicant and only the applicant has complete knowledge of matters relevant to the underwriter, such as health history, income/net worth, and involvement in activities that are especially risky. An insurer has the right to learn what an applicant knows concerning this history in order to properly assess the proposed risk. Thompson v. Occidental Life Ins. Co., 513 P.2d 353, 360 (Cal. 1973).
While life and health insurance applications typically notify the applicant of the importance of providing complete and accurate information on the application and the consequences of failing to do so, the unfortunate truth is that some applicants neglect or ignore their duty in this regard. Because these failures often result in the issuance of a policy based on incomplete or erroneous information, the question becomes who should bear the consequence of the applicant's error or fraud?
The Status Quo: Statutorily-Authorized Rescission and Contestability Investigations
To answer the above question, legislatures of virtually all states permit post-issuance investigations for up to two years after policy issuance and, in the appropriate circumstances, contractual rescission. For obvious reasons, insurance companies are generally permitted to rescind policies where material misrepresentations are made in the application. See, e.g., S.C. Code Ann. § 38-71-40 (2006) (stating that a false statement made with actual intent to deceive or materially affecting either the acceptance of the risk or the hazard assumed by the insurer bars the right to recover under the policy). While most jurisdictions permit policy rescission based on misrepresentations by the insured, the statutory standards for rescission vary. For example, some jurisdictions allocate the risk of applicant carelessness to the insured. See, e.g., Fla. Stat. § 627.409 (2007) (allowing rescission where a misrepresentation is material to the risk assumed or where the insurer would not have issued the policy if it had known of the true facts). While others require the insurer to show that the insured made a material misrepresentation with an intent to deceive, thereby allocating the risk of mere applicant carelessness to the insurer. Tex. Ins. Code Ann. § 705.051 (Vernon 2007)
The insurer's right to rescind under the status quo, however, is balanced with the insured's interest in knowing that coverage cannot be challenged under certain circumstances. For example, the insurer risks waiver if it chooses to ignore troubling information in its possession prior to policy issuance. In Dipasqua v. California Western States Life Ins. Co., the court noted that the insured omitted "material information" regarding his history of hospitalizations "to the company in response to their direct questions," which would ordinarily "entitle the company to avoid the policy." 235 P.2d 64, 66 (Cal. Ct. App. 1951). However, the company had received a written report from a separate source contradicting this statement. Id. Faced with this conflicting information, the insurer was placed on notice that "the insured was either deliberately lying and concealing material facts or that he was not a responsible person capable of correctly stating the facts." Id. Under these circumstances, "an insurance company cannot rely solely upon the insured's answers in his application." Id.
Further, through the use of incontestability provisions, states mandate that insurance companies investigate a policy for possible misrepresentations within the first two years of policy issuance. For example, in the life insurance context, California's Insurance Code requires that "[a]n individual life insurance policy delivered or issued for delivery in this state shall contain a provision that it is incontestable after it has been in force, during the lifetime of the insured, for a period of not more than two years after its date of issue." See, e.g., Cal. Ins. Code § 10113.5 (Deering 2007); Unlike other areas of contract law, which permit a contract's rescission upon discovery of fraud in the inducement, an insurance company is generally bound by the risk it assumed after two years, no matter the extent or severity of the misrepresentation. New Jersey is a notable exception to this rule. See Ledley v. William Penn Life Insurance Co., 651 A.2d 92 (N.J. 1995) (concluding that "even after the expiration of the contestability period, an insurer may deny a claim if the insured committed fraud in the policy application").
The statutorily-prescribed incontestability provision generally must be included in the life or health insurance contract itself. See N.Y. Ins. Law. § 3203 (Consol. 2007) (requiring the inclusion of a provision stating "that the policy shall be incontestable after being in force during the life of the insured for a period of two years from its date of issue"). Because of this, insureds are placed on notice of an insurer's right to conduct a post-issuance investigation. Further, generally speaking, policy forms must be filed with and approved by state regulators before being sold in a particular state. See, e.g., Tex. Ins. Code Ann. §§ 1701.051–061 (Vernon 2007). By approving a policy form, insurance regulators determine that it fairly sets forth the contractual rights and obligations of both the insured and insurer.
Given this carefully orchestrated structure, how can courts like that in Hailey conclude that an insurer's exercise of a statutorily-authorized right to conduct a post-issuance investigation, of which the insured had notice by virtue of policy language blessed by the State, gives rise to bad faith liability and the imposition of statutory and/or punitive damages?
Comparison: The Status Quo v. Plaintiff's Litigation Model
The current system is premised on both public policy and fundamental rules governing the first-party insurer/insured relationship. The status quo fosters prompt decisions regarding whether to provide life or health coverage and on what terms, thus allowing the applicant to obtain life insurance or health insurance in an efficient manner.
In contrast, the bad faith plaintiff attacking the insured's post-issuance review argues that the insurer should have conducted a full-blown investigation of each and every answer made by the applicant on the application prior to policy issuance – if for no other reason than to confirm that the applicant is not lying. For example, if the applicant denies any history of heart problems on the application, the insurance company, according to some litigants, should conduct an investigation to determine whether the applicant is actually telling the truth. See Hailey, 2007 Cal. App. LEXIS 2083, *20. If an applicant discloses that he underwent a physical and results were within normal limits, the insurer is supposed to seek those records and delay a policy's issuance just to confirm that the physical's results were, indeed, within normal limits. The insurer is essentially required to treat the applicant as a liar until proven otherwise. This unprecedented model is unworkable and benefits neither the insured nor insurer.
Fully and completely investigating every application answer for every potential insured in an effort to discover undisclosed defects is unnecessary and unrealistic. See Golden v. N.W. Mut. Life Ins. Co., 551 A.2d 1009, 1014 (N.J. App. 1988) (noting that insurance companies rely on the "truthfulness of the insured's rendition of his medical history" as it would be "physically and economically impossible for an insurer to give every potential insured an elaborate medical examination which will disclose the less obvious defects in his health"). Moreover, insurance companies have no control over how quickly healthcare providers submit requested records to the insurance company. Insurers often wait weeks to receive medical records requested from providers during a contestability review. If insurers were required to conduct a full scale investigation prior to policy issuance, medical providers would be overrun with requests for medical records, resulting in an even longer response time to the insurer.
In truth, under the above model, an individual seeking life or health insurance coverage could be forced to wait weeks or even months before receiving the desired coverage – solely because the insurance company must confirm that the applicant has not provided false information or omitted information on the application. Consumers are essentially forced to remain uninsured for no rational reason.
Permitting Post-Issuance Investigations Benefits Both Insurer and Insured
Juxtaposed against each other, the status quo is a far more preferable system. Under the status quo, the insurer can rely on the veracity and accuracy of the information provided by the applicant and can make a decision as to whether and what type of coverage will be offered without undue delay to the applicant. Should the insurance company learn that information on an application is materially incorrect, it can take the necessary steps to neutralize the error's impact. However, balancing the needs of the insured, the insurer should carefully investigate issues reasonably raised prior to policy issuance and must take advantage of its options for remedial relief within two years of issuance; thus giving the insured peace of mind that the policy will not be dishonored at some remote time.
Conclusion
Public interest demands an efficient, cost-effective and fair system for the provision of life and health insurance, all the while mindful of the dangers of carelessness and insurance fraud. As described above, state legislatures around the country have dedicated processes for accomplishing this delicate balance, which courts should not be quick to disregard.