Innocent Insured Doctrine Doesn’t Preclude Policy Rescission for Misrepresentation in the Application

The Illinois Supreme Court recently held that the innocent insured doctrine was inapplicable to prevent rescission for an attorney’s misrepresentation in a renewal application notwithstanding the misrepresentation was made without the innocent partner’s knowledge. In Illinois State Bar Ass’n Mut. Ins. Co. v. Law Offices of Tuzzolino and Terpinas, 27 N.E.3d 67 (Ill. 2015), the question presented to the Court was whether Illinois law permitted rescission of an insurance policy in its entirety for a material misrepresentation on the written application. The insurer argued that Illinois law permitted complete rescission where the misrepresentation materially affected the acceptance of the risk by the insurer and therefore the misrepresentation went to the formation of the contract itself. On the other hand, the insured lawyers argued that while rescission might be appropriate as to one insured, attorney Sam Tuzzolino, it was unfair and against public policy to rescind insurance coverage for another insured, attorney Will Terpinas, Jr., who was an innocent insured and who had no knowledge of Tuzzolino’s misdeeds and the alleged misrepresentation.

The Illinois Supreme Court began its analysis by recognizing that Section 154 of the Illinois Insurance Code stated that no misrepresentation or false warranty made by the insured or on his behalf in the negotiation for a policy of insurance could defeat or avoid the policy or prevent its attaching unless the misrepresentation was stated in the written application. Additionally, Section 154 required that the misrepresentation had to be made with actual intent to deceive or, in the alternative, the misrepresentation materially affected either the acceptance of the risk or the hazard assumed by the insurance company. See 215 ILCS 5/154 (West 2008). The Court noted that Section 154 expressly referred to misrepresentations that were either made by the insured or on the insured’s behalf and therefore were not necessarily misrepresentations made by the insured personally for purposes of Section 154.

Additionally, Section 154 set forth a two-prong test for determining whether the policy could be rescinded. First, the statement (misrepresentation) had to be false, and second, the statement (misrepresentation) either had to have been made with an actual intent to deceive or it had to materially affect the acceptance of the risk or hazard assumed by the insurance company. Citing Golden Rule Ins. Co. v. Schwartz, 203 Ill.2d 456, 464, 272 Ill.Dec. 176, 786 N.E.2d 1010 (2003). These provisions of Section 154 had to be read in the disjunctive so that either an actual intent to deceive or a material misrepresentation which affected either the acceptance of the risk or the hazard to be assumed could defeat or avoid the policy. Citing National Boulevard Bank v. Georgetown Life Ins. Co., 129 Ill.App.3d 73, 81, 84 Ill.Dec. 330, 472 N.E.2d 80 (1984).

The Illinois Supreme Court had previously recognized that Section 154 permitted rescission for an innocent misrepresentations. In the case of innocent misrepresentations, the misrepresentation had to materially affect the insurer’s acceptance of the risk. Regarding innocent misrepresentations that affected the insurance risk, it did not matter that one of the parties, or an insured, might not have been to blame for the misrepresentation. “In other words, it is unnecessary for the insurer to prove that a misrepresentation was made with the intent to deceive if it was material to the risk assumed.” Citing Ratcliffe v. International Surplus Lines Ins. Co., 194 Ill.App.3d 18, 25, 141 Ill.Dec. 6, 550 N.E.2d 1052 (1990).

The insureds did not dispute that the misrepresentation involved materially affected the acceptance of the risk for purposes of fulfilling Section 154 requirements. However, the insureds focused on the impact that rescission would have on Terpinas, an innocent insured, who did not cooperate or contribute to the loss. Accordingly, the insured argued that it would be “patently unfair . . . to rescind insurance coverage to Terpinas, when he had absolutely no knowledge of his partner’s misdeeds and the alleged misrepresentations on the insurance renewal invoice.” The insureds argued on public policy grounds that Section 154 was not to be used as a sword to vitiate insurance coverage, but rather as a shield that is to be utilized to protect insureds and the public, generally. In order to be compliant with public policy, it was necessary to apply the common law innocent insured doctrine to Section 154.

Addressing the insureds’ argument, the Court noted that the innocence of an insured mattered a great deal when another insured’s wrongdoing triggered a policy exclusion, and a dispute arose over whether the insurer had a duty to defend the innocent insured under a policy that undisputedly was in effect. That is the common setting in which the innocent insured doctrine is relevant. However, the Court found that in general situations where common rules concerning the interpretation of policy language are involved is significantly different from the question of whether an insurance policy should be enforced in the first place as opposed to being rescinded.

Rescission is an issue that was governed by Illinois statute and was not concerned with whether an insured was innocent of a misrepresentation that prejudiced the insured. In cases involving a misrepresentation that materially affected the acceptance of the risk, the issue was the effect of that misrepresentation on the validity of the policy as a whole. Misrepresentations regarding the policy application went to the formation of the contract. On the other hand, the innocent insured doctrine had a narrower focus, which typically dealt with situations where the insured’s wrongdoing triggered a policy exclusion giving rise to a question of whether the insurer had a duty to defend the innocent insured under the policy that was still in effect. Although the innocent insured doctrine would be relevant to issues of policy exclusions and insurance coverage, the doctrine was unsuited to cases involving rescission and contract formation.

Next, the Court addressed the issue of partially severing the policy to facilitate the application of the innocent insured doctrine. The policy contained a severability clause. The Court noted that severability clauses create a separate agreement with each insured and each separate agreement is made up of the “particulars and statements contained in the APPLICATION, binding on each insured.” (emphasis added) In the case at bar, the statements contained in the application included the false statement that no member of the firm was aware of the potential for a then-unreported claim. Thus, even if the policy was treated as a separate contract with each insured for purposes of severability, there was nothing to permit the application—or the misrepresentation if contained—to be split off from any individual contract.

The Court concluded by finding that Section 154 of the Illinois Insurance Code established Illinois public policy on the issue of rescission and allowed rescission when the relevant requirements of Section 154 were met.