Courts often require insurers to return premiums (or at least offer to return them) when rescinding an insurance policy. Some states may even require it under statute. The reason is that rescission is an equitable remedy intended to place the parties in the same position they were before the policy was issued, and the insurer obviously does not receive any premiums until the policy is issued. On Monday, the U.S. Court of Appeals for the First Circuit rejected this general rule and determined that an insurer was entitled to retain premiums as special damages when it seeks to rescind an insurance policy based on rampant fraud.
In PHL Variable Insurance Co. v. P. Bowie 2008 Irrevocable Trust, No. 12-2243, 2013 WL 1943820 (1st Cir. May 13, 2013), an insurance broker (“Rainone”) and an attorney acting on behalf of a trust (“Baldi”) submitted an application on behalf of Peter Bowie seeking a $5 million life insurance policy naming the trust as the beneficiary. The application stated that Bowie had an annual salary of $250,000, and a personal net worth of approximately $7.5 million. Rainone and Baldi represented that the policy premiums would not be paid by any third-party, the policy was not being purchased as part of any program to transfer the policy to a third-party within the first five years, and neither Bowie nor the trust had any agreement for any other party to take legal or equitable title to the policy. Bowie confirmed this information to a third-party inspector working for PHL, and PHL issued the policy.
The representations made by Rainone, Baldi, and Bowie were false. Bowie turned out to be a retired city worker, used car salesman, and blackjack dealer who did not have a personal net worth anywhere near the $7.5 million he, Rainone, and Baldi claimed. Bowie also could not personally afford the policy’s premium. The premium was actually being paid by a company (“Imperial”) “whose business model consists of lending money to pay for life insurance policy premiums and, when borrowers default on those loans, taking possession of the policies as collateral”; indeed, Imperial’s loan terms made its loans virtually impossible to pay back. A subsequent amendment to the trust documents provided that the policy would be assigned to Imperial if its loan was defaulted on and, if PHL rescinded the policy, any premiums refunded to the trust would be delivered to Imperial.
PHL eventually discovered the scheme and filed an action against the trust in the U.S. District Court for the District of Rhode Island seeking to rescind the policy. PHL also sought to obtain the premiums paid in order to offset the damages it suffered in connection with issuing the policy. These included costs to underwrite and issue the policy, payment of commissions and fees in connection with issuing and servicing the policy, costs incurred to investigate the scheme, and costs to initiate its rescission action. Alternatively, PHL advised that it was ready, willing, and able to refund the premiums if the court required it to do so, and tendered the premium into the court’s registry.
Resolving cross-motions for summary judgment filed by PHL and the trust, the court determined that the sole issue was whether PHL was required by law to return the premiums, or if the court’s equity powers enabled it to permit PHL to retain the premiums as special damages. The court determined that it could permit PHL to retain the premiums, and the trust appealed. The First Circuit affirmed.
Initially, the court rejected the trust’s argument that Rhode Island case law required an insurer to return premiums when seeking to rescind an insurance policy. The court instead determined that the case law “do[es] not stand for such a broad and inflexible proposition,” and focused on equity principles that Rhode Island law permits courts to consider in attempting to make whole a party defrauded into entering a contract. Those principles include: (1) rescission seeks to create a situation the same as if no contract ever existed; (2) parties should gain no advantage from their own fraud; and (3) a court in equity can grant all relief necessary to make the aggrieved party whole so long as it is permitted by the pleadings. Because it concluded that PHL was deceived into issuing the policy as the result of a conspiracy, the First Circuit determined that:
these equitable principles provide ample support for the district court’s decision to make PHL whole by allowing it to retain the premium. PHL paid a commission to Rainone of $172,365 that it would not have paid but for the misrepresentations that led it to issue the Policy. Mere rescission of the contract would not have compensated PHL for this expense. While PHL apparently did not provide a precise accounting of the other costs in incurred with respect to the Policy, it was reasonable for the district court to conclude that the costs alleged in PHL’s complaint — including underwriting, administration, and servicing of the Policy, as well as investigation into the misrepresentations in the application — justified awarding PHL the remaining $19,635 from the premium, particularly in light of the Trust’s fraud.
Although insurers generally are permitted to rescind policies only when there is no other adequate remedy at law, PHL Variable acknowledges that even permitting an insurer to rescind may not make it whole. Rescission by itself does not compensate the insurer for all of the costs necessary to issue a policy, and even qualifying those costs as “overhead” does not acknowledge the insurer’s lost opportunity costs. Accordingly, unless a statute or case law absolutely requires an insurer to return premiums in order to rescind its policy, insurers should consider their right to retain premiums as special damages.