Subjective Standard Applies to Rescission of E&O Policy Based on Response to Application Question

The United States District Court for the Southern District of Ohio, applying California law, has held that an errors and omissions insurer is not entitled to rescission of its policy based on an alleged misrepresentation by the insured on the application for the policy.  Maxum Indem. Co. v. Nat’l Condo & Apartment Ins. Grp., 2016 WL 6628490 (S.D. Ohio Nov. 9, 2016).  In so holding, the court applied a subjective standard to the question of the insured’s knowledge because the language of the application did not specifically indicate that an objective standard applied.

The insured wholesale insurance broker had entered into a business relationship whereby it issued quotes and binders for property insurance coverage to a retail insurance broker, which the retail broker then issued to its own clients.  Although the quotes and binders issued by the wholesale broker listed two insurance carriers, those companies had never issued or approved the policies.  Upon learning of their lack of valid insurance, some of the property owners filed suit against the retail broker, which in turn filed third-party claims and cross-claims against the wholesale broker.  The wholesale broker sought coverage for the retail broker’s claims under its E&O policy.

The E&O carrier filed a declaratory judgment action to rescind the policy or alternatively for a declaration that the policy’s prior knowledge exclusion barred coverage.  It pointed to a cease-and-desist letter sent to the wholesale broker by one of the purported insurance carriers prior to the application date.  The E&O insurer also pointed to several additional communications received by the wholesale broker before the policy incepted, including a cease-and-desist letter by the other purported insurance carrier and a letter from the Illinois Department of Insurance advising that the wholesale broker had issued binders that may not constitute legally valid insurance.

The district court granted summary judgment in favor of the insurer on the prior knowledge exclusion, which barred coverage for any claim arising out of or resulting from any wrongful act or related information of which the insured had knowledge prior to the policy inception date and which may result in a claim.  However, the U.S. Court of Appeals for the Sixth Circuit reversed and held that the policy covered the claims by the retail broker as a matter of law because a subjective standard governed the application of the exclusion, and the communications at issue did not give the wholesale broker knowledge of a wrongful act that may result in a claim.

On remand, the insurer moved for summary judgment on its entitlement to rescind the policy based on the wholesale broker’s failure to disclose the communications in response to an application question which asked if the applicant had “any knowledge of any potential errors or omissions claims.”  The court held that the application question regarding potential claims had the same meaning as the prior knowledge exclusion.  Because the Sixth Circuit had already held as a matter of law that the communications at issue did not implicate the exclusion, the court held the insurer likewise could not rescind based on the application response.

The insurer argued that an objective standard should apply to the question of rescission—i.e., that it need only show that an objectively reasonable person would consider the communications to be potential claims—even though a subjective standard governed the applicability of the exclusion.  The court rejected this argument because the application did not contain any language indicating that an objective standard would apply, and California law requires that ambiguities in insurance policies and applications be construed in favor of coverage.

The court concluded that the insurer breached the policy by refusing to defend or indemnify the wholesale broker.  The court further held that the retail broker, as a judgment creditor of the wholesale broker, was a third-party beneficiary under the policy and had standing to recover against the insurer.

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