Second Circuit Holds That Policy May Be Rescinded Before a Claim is Submitted for Coverage

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The Second Circuit has held that an insurer need not wait until a claim is submitted under its policy in order to seek rescission of the policy based on a material misrepresentation by the insured. U.S. Underwriters Ins. Co. v. Orion Plumbing & Heating Corp., 18-2286-CV, 2019 WL 1253325.

The dispute arose under a policy issued in May 2012, which was later cancelled as a result of the insured’s failure to pay premiums. However, an incident involving bodily injury occurred prior to the policy’s cancellation that led to a lawsuit being filed against the insured. The lawsuit against the insured was ultimately dismissed, and while the plaintiff sought to appeal the dismissal, the insurer filed a separate action to rescind the policy based on the insured’s material misrepresentations in the application for insurance.

In the coverage action, the insurer sought a declaration that it had no duty to indemnify the insured for the personal injury action and sought to rescind the policy ab initio, due to the insured’s material misrepresentations in its application. After the insured failed to timely answer the complaint, the insurer sought a default judgment. The District Court for the Eastern District of New York denied the insurer’s motion for a default judgment based on lack of subject matter jurisdiction, concluding that the insurer failed to present a case or controversy. The district court reasoned that there was no dispute properly before it because “an attenuated chain of contingencies” (i.e., a successful appeal by the underlying plaintiff and, ultimately, an award against the insured) would have to occur before the insured could be entitled to coverage under its policy.

On appeal, the second circuit disagreed with the district court and held that the insurer had indeed presented a justiciable controversy by asserting that it could face liability based on reinstatement of the underlying litigation or any further litigation involving its insured potentially covered by the policy. The second circuit also held that the insurer’s complaint, which alleged that the insurer would have charged a higher premium for the policy, issued a different policy, or declined to issue any policy to the insured had it known of the misrepresentations in the policy application, alleged sufficient facts to raise an actual controversy about the appropriateness of rescission. The second circuit’s holding provides important guidance to insurers evaluating a rescission claim. Once a material misrepresentation is uncovered, an insurer generally has two choices: cancel or rescind. Although cancellation is generally less contentious, it only terminates coverage prospectively, such that an insurer may still owe coverage on pending claims or claims that arise before the date of cancellation. In contrast, rescission extinguishes a policy ab initio — as if the policy never existed — which allows insurers to avoid liability for claims arising prior to rescission and also on pending claims. Although, insurers frequently uncover evidence to support policy rescission while investigating a claim presented under the policy, the second circuit’s holding clarifies that an insurer may seek rescission proactively at any time before or after a claim is made. This will permit insurers to seek rescission before having to defend a claim, which will reduce costs and avoid any argument that the insurer has “waived” its right to rescind by failing to raise rescission as basis.