The rescission of an insurance policy is one of the most underutilized tools in handling insurance claims. If used properly, it unwinds the insurance transaction and the parties are restored to their position prior to the contract; it is as if the insurance contract never existed. Although rescission is primarily an equitable device, its use and scope is authorized by many state statutes. In situations where the insured has made material misrepresentations or fraudulently applied for a policy, it shields the insurer from unwarranted claims and unjust liability.

There are three types of state statutes regarding rescission: (1) states that allow rescission based on material misrepresentation; (2) states that limit rescission to a knowing or reckless misrepresentation; and (3) states that limit rescission to an intentional or fraudulent misrepresentation. Most commonly, statutes provide that a misrepresentation, omission, concealment, or incorrect statement will defeat recovery under an insurance policy in 3 instances. First, the policy may be rescinded when the omission, concealment, or incorrect statement is fraudulent. Second, the policy may be rescinded if the omission, concealment or incorrect statement was material either to the acceptance of the risk or to the hazard assumed by the insurer. Third, and finally, the policy may be rescinded if the insurer in good faith would not have issued a policy at the same premium or rate, or in as large an amount, or would not have provided coverage with respect to the hazard resulting in the loss, if the true facts had been known.

Typically, in the insurance context, a misrepresentation is deemed material if it would affect the premium charged or exposure to the risks of providing the coverage. For a policy to be rescinded, both (1) false statements, concealment of facts, omissions, or misrepresentations must have been made in the application and (2) the statements, omissions, concealment, or misrepresentations must be material. Almost every state requires that the insured’s misrepresentation be material in order to justify rescission of the policy. Though “materiality” varies among jurisdictions, it is commonly agreed that a material misrepresentation in an insurance application prevents recovery under the insurance policy. An underwriter can often be used to prove that the misrepresentation is material to the insurer.

Insurance carriers must also be mindful of whether their policy contains a contestable clause, which places a time limit for contesting the policy in the future and bars an insurer from rescinding a policy based on a misrepresentation or misstatement. If the policy contains a contestable clause, the insurer must act to rescind the policy within that time period (which is usually 2 years from the date of issuance).

When the decision to rescind is reached, the insurer must announce its intent to rescind, refund the premium, and act consistently with an intent to repudiate the insurance policy. If the insurer fails to announce its intent to rescind or acts contrary to that intent, some states recognize a waiver of the right to rescind. Therefore, it is very important that the insurer acts consistently with its intention to rescind the policy.

Insurance carriers rescinding policies have two options: (1) they may refund the premium and then file a declaratory judgment action seeking rescission; or (2) they may refund the premium and notify the insured that the policy is no longer in force. The latter functions as a voluntary rescission, provided the insured accepts the refund with the understanding the policy is null and void. The best practice for a voluntary rescission is to have the insured execute a policy release that has explicit language stating that the policy is being rescinded, the premiums have been refunded, and the policy is void ab initio. A policy release can protect the insurer if there is ever a challenge regarding the rescission.

Of course, an insurer should always be mindful of rescinding an insurance policy. If a court finds that an insurer rescinded in bad faith, some states will allow an insured to recover punitive damages and attorney’s fees. A bad faith denial occurs when an insurer’s refusal for coverage is frivolous or unfounded in law or in fact to comply with the demand of the policyholder to pay according to the terms of the policy.

In sum, insurance carriers should be cognizant of situations lending themselves to the potential rescission of the insurance policy. Where the insured has made material misrepresentations, the absence of which would have resulted in the insurer not underwriting the risk at the rate it did or not issuing the policy at all, the insurer can, and should, seek rescission of the insurance policy.