Policyholder Beware: The Insurance Application Can Come Back to Haunt You

The process of buying insurance begins with an application. This is true whether the coverage is relatively commonplace, like homeowners insurance, or highly sophisticated, like professional liability and directors’ and officers’ (D&O) liability. An insurance application, typically, is a preprinted form that asks for information an underwriter needs to decide whether to sell you an insurance policy. In the case of more sophisticated risks, the applicant must also attach additional information that is germane to the risk, such as financial statements, SEC filings, proxy forms, patents, and employee handbooks and manuals.

In an ideal world, underwriters and insureds would have so-called "perfect" information about each other before deciding whether to enter into an insurance contract together. The cost of obtaining "perfect" information, however, would make insurance too difficult and expensive for anyone to buy. Thus, insurance companies and policyholders, over the years, have learned to live with a certain amount of imperfect information. In exchange, insureds expect insurance companies to disclose certain information about their financial condition, while insurance companies expect policyholders to be truthful when answering questions on insurance applications.

Avoid Misrepresentation During the Application Process

Sometimes the information provided on or attached to an insurance application may turn out to be false, which can result in a loss of coverage. In most states, even an unintentional misrepresentation or false warranty can result in no coverage if the inaccurate statement is material to the insurance company’s acceptance of the risk. In Illinois, for example, this rule is codified in Section 154 of the Illinois Insurance Code.

For significant claims, an insurance company will likely review the application and its attachments very carefully for evidence of a misrepresentation. If false information is discovered, the insurance company may attempt to rescind the policy—a result that can be devastating to an insured.

Policyholders can minimize the risk of losing coverage due to application problems by paying careful attention to the content of the questions and how they are worded. Always work closely with your broker when completing an application for insurance. For those risks that are critical to your business, you should also consult with your lawyer before answering the questions and signing the form.

For certain types of risk—particularly professional liability and D&O liability—“severability” is another critical issue. As painful as it may be to lose coverage over your own innocent misrepresentations, it is even worse if you, personally, had nothing to do with the false information. Many insurance policies provide for “severability of the application,” which protects innocent insureds from losing coverage due to the misrepresentations of others. Not all “severability of the application” clauses are the same, however, so it is absolutely essential to consult with your broker or your lawyer about this issue. Most importantly, you should have this conversation when you are selecting and applying for coverage—not after a policy has been issued.

Businesses of every size spend large amounts of money on insurance. Be sure to protect that significant investment by working closely with your brokers and your legal team. They are a valuable resource that can help you avoid costly mistakes during the application process.