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Rise in Foreclosures + An Increase in Mortgage Fraud = More Homeowner Fires

According to recent reports, many insurers have experienced an increase in the number of fire claims since the onset of the subprime mortgage crisis.  Allegedly, many of these fires were intentionally set by homeowners facing foreclosure.  Not surprisingly, when homeowners’ monthly mortgage payments increase after their low introductory rates expire or when falling home values and stricter lending practices reduce the possibility of restructuring or refinancing loans, the natural result is an increase in the number of foreclosures and an increase in homeowner fires.

 That’s not the only problem facing the insurance industry.  Insurers are also experiencing an increase in fires associated with the rise in mortgage fraud, which is also running rampant across the United States.  Mortgage fraud is generally defined as the intentional misstatement, misrepresentation, or omission by an applicant or other interested party relied on by a lender or underwriter to provide funding for a mortgage loan. 

Victims of mortgage fraud include borrowers, mortgage industry entities, and those living in the neighborhoods affected by mortgage fraud. As properties affected by mortgage fraud are sold at artificially inflated prices, properties in surrounding neighborhoods also become artificially inflated. When property values are inflated, property taxes increase as well. Legitimate homeowners also find it difficult to sell their homes. When properties foreclose as a result of mortgage fraud, neighborhoods deteriorate and surrounding properties depreciate.

Legal Issues and Developing Law

  • Insurable Interest by the Insured

The threshold question in many cases involving mortgage fraud and its effect on insurance coverage is whether the insured has an insurable interest in the property at the time of a loss.  An insurable interest at the time of loss is essential to the validity of an insurance policy.  Hawkeye Security Ins. Co. v. Reeg, 128 Ill. App. 3d 352, 470 N.E.2d 1103 (Ill. App. Ct. 1984).  Generally speaking, a person has an insurable interest in property whenever he or she would profit or gain some advantage by a property’s continued existence, and suffer loss or disadvantage by its destruction. Lieberman v. Hartford Fire Ins. Co., 6 Ill.App.3d 948, 287 N.E.2d 38 (Ill. App. Ct. 1972).

To determine whether an individual has an insurable interest in property, a court will usually examine whether an economic benefit or detriment inures to the named insured under any set of circumstances.  In cases involving a straw person, a close examination of the facts might reveal that in every conceivable manner an insured did not contribute a single cent towards the purchase of the insured property or its maintenance.  That is, an investigation might reveal that every payment towards the purchase or maintenance of the insured premises was made by a straw person, that is, the property’s unidentified buyer-in-fact. 

Therefore, a proper investigation would seek to determine whether a buyer-in-fact paid for the insurance, paid the initial down payment, the mortgage payments, and for all upkeep and necessary expenses, and whether he or she paid for every attendant cost for the property.  In these cases, the actual insured will likely not incur economic loss due to the damage suffered by the insured premises, nor gain economically from any recoverable insurance proceeds.  Simply put, the primary question is whether there was an actual relationship between the insured and the insured premises, or whether the insured’s relationship to the insured premises is illusory. 

  • Mortgagee’s Duty to Notify Insurer of Foreclosure Proceedings

An insurer is often unaware of a pending foreclosure on property that it insures until after a fire has occurred.  Must a mortgagee, as a condition to receiving coverage, give notice to the insurer when that mortgagee initiates foreclosure?  A recent case in Tennessee is instructive in analyzing this question (See: U.S. Bank, N.A. v. Tennessee Farmers Mut. Ins. Co., 2007 WL 4463959).

In this case, a homeowner and insured fell behind on her monthly mortgage payments and the mortgagee, U. S. Bank, N.A., initiated foreclosure.  The bank sent a letter to the homeowner stating that it started foreclosure, but the bank neglected to give notice of the foreclosure to the property insurer, Tennessee Farmers Mutual Insurance Company.  Before the foreclosure process was completed, the homeowner and her husband filed for bankruptcy, which stayed the foreclosure proceedings.  Shortly thereafter, the house was destroyed by fire.

U.S. Bank filed a claim with the insurers, Tennessee Farmers, for the fire loss, but the insurer denied the claim because the bank had failed to notify Tennessee Farmers that a foreclosure had been initiated.  Tennessee Farmers stated that the foreclosure filing constituted an increase in hazard and, as such, the bank was required to notify the insurance company, and the bank's failure to provide this notice was a breach of the policy’s mortgage clause, which stated:

We will:

(a)        protect the mortgagee's interest in the insured building.  This protection will not be invalidated by any act or neglect of any insured person, breach of warranty, increase in hazard, change of ownership, or foreclosure if the mortgagee has no knowledge of these conditions

The trial court denied Tennessee Farmers’ motion for summary judgment and granted summary judgment to the bank.  The insurance company then filed an appeal.  On appeal, Tennessee Farmers argued that the foreclosure proceedings was an "increase in hazard" under the terms of the policy of insurance, and contended that the bank's bad faith claim was unfounded.  On the other hand, U.S. Bank argued that commencing foreclosure proceedings did not constitute an increase in hazard, and asked the court to adopt the Kentucky’s court’s opinion in Anderson v. Kentucky Growers Ins. Co., Inc., 105 S.W.3d 462 (Ky. Ct. App. 2003)

In Anderson, the policy’s mortgage clause stated that the insurance company's denial of the insured's claim would not apply to a mortgagee’s claim if the mortgagee had notified the insurer of a "substantial change in risk of which the mortgagee becomes aware.”  In that case, the house was destroyed by fire, and the insurance company argued that the filing of foreclosure proceedings constituted a "substantial change in risk of which the mortgagee became aware."  

The court in Anderson ruled against the insurer, noting that insurance contracts are liberally construed in favor of the insured: "While we agree that the filing of foreclosure proceedings constitutes a 'change of risk,' we do not agree that such a change is necessarily 'substantial."  The court then concluded that the policy did not "clearly and unambiguously" require the mortgagee to give the insurer notice when foreclosure was initiated.  The court in Andersonfurther held that commencing foreclosure proceedings, while certainly a "change of risk," did not constitute a "substantial change of risk" within the meaning of the mortgage clause.

The Tennessee Farmers’ court rejected the Anderson court’s analysis, noting that the mortgage clause in the Tennessee Farmer’s policy required notification of "any" increases in hazard, not just a "substantial" increase in hazard.  However, this issue remains a moving target.  Thus, after the Tennessee Court of Appeals agreed with the insurance company and reversed the trial court’s decision, U.S. Bank then appealed to the Tennessee Supreme Court.  The state’s high court held that the bank's commencement of foreclosure proceedings was not an increase of hazard requiring notification to insurance company under the standard mortgage clause in a fire insurance policy, and the bank's commencement of foreclosure proceedings was not an increase of hazard requiring statutory notification to insurance company. 

  • Mortgage Fraud and the Insurer’s Right of Rescission

By its very nature, mortgage fraud involves the intentional misstatement and misrepresentation of material information to a mortgagee.  Often, the same misrepresentations made to the mortgagee are also made to an insurer on an insurance application and give rise to a rescission action.  For an insurer to rescind a policy due to misrepresentation, the insured’s statement must be false, and the false statement must have been made with the intent to deceive or materially affect the acceptance of the risk or hazard by the insurer.  Illinois State Bar Assn. Mut. Ins. Co. v. Coregis Ins. Co., 335 Ill. App. 156, 821 N.E.2d 706 (Ill. App. Ct. 2004).  In such circumstances, an insurance policy becomes voidable, not void ab initio, and an insurer can waive its right to void if it does not invoke it promptly.

However, in some states an insurer has no general duty to investigate the truthfulness of answers to questions asked on an insurance application.  Those states have recognized that "an insurance company has the right to rely on the truthfulness of the answers given by an insurance applicant, and the insured has the corresponding duty to supply complete and accurate information to the insurer."  Commercial Life Insurance v. Lone Star Life Insurance, 727 F. Supp. 467, 471 (N.D. Ill. 1989).

However, an insurer is generally estopped from voiding a policy for untrue representations in the application if the insured discloses facts to the agent and the agent, in filling out the application, does not state the facts as disclosed to him, but instead inserts conclusions of his own or answers inconsistent with the facts.  See Boyles v. Freeman, 21 Ill. App. 3d 535, 539, 315 N.E.2d 899 (Ill. App. Ct. 1974). Typically, an insurer cannot rely on incorrectly recorded answers, even when the insured knows that the agent has entered answers different from the ones he or she provided, if the incorrect answers are entered under the agent's advice, suggestion, or interpretation.  Loganv. Allstate Life Insurance Co., 19 Ill. App. 3d 656, 660, 312 N.E.2d 416 (Ill. App. Ct. 1974).

Thus, the agent's knowledge of the truthfulness of the statements is imputed to the insurer.  Generally, only when an applicant has acted in bad faith, either on his or her own or in collusion with the insurer's agent, will a court refuse to impute the agent’s knowledge to the insurance company. 

Most laws that are enacted to regulate rescission actions are designed to prevent insurance companies from rescinding policies based on cursory or unintended misstatements by an insured.  However, in cases involving straw persons, an argument can be made that the buyers-in-fact act as puppet masters and typically arrange to have the insureds’ names placed on the mortgage and the insurance policies to shield him or herself from exposure, while still enjoying potential profits from sales or insurance proceeds.  In these cases, a court will likely recognize this deceptive arrangement, and that the buyer-in-fact elicited an insurance policy using the purported insured as a front.  Arguably, a court should order rescission of the insurance policy in these types of cases.

  • Rescission of the Mortgagee’s Right of Recovery

Most policies’ mortgage clause does not address rescission of the contract, nor does it describe the mortgagee’s rights in the context of rescission, because these rights are, in fact, extinguished by rescission.  Therefore, a novel approach in cases involving fraud in the application for insurance is to file a declaratory judgment action seeking rescission and voiding of the policy, which will possibly render the mortgage clause inapplicable, and asking a court to bar the mortgagee from receiving any benefits of that clause.  Thus, rescission could potentially wipe the entire policy away, and the insurer would owe no contractual duties to either the insured or the mortgagee.  Assuming rescission is granted, in effect, the policy will have never legally existed, and all parties that had any putative rights under that policy would have none.

 Importantly, some courts have held that an insurer's right to rescind or deny coverage on the basis of fraud only applies to the claims of the insured, not to claims of innocent third-parties that are injured by the insured’s tortuous acts.  However, this argument is inapplicable here, since a mortgagee is not a third party but is tantamount to a first-party insured.  Moreover, contract law governs the alleged wrongful acts of the insured rather than tort law.

  • Increasing the Effectiveness of an Insurance Claims Investigation

To conduct a more effective investigation when faced with mortgage fraud and foreclosure issues, the author encourages insurers, as part of their investigations, to check the sales history of the insured premises because several sales within a short period of time could indicate false, inflated values.  Also, it is advisable to conduct a title search, checking with the local tax assessment office or recorder of deeds, to analyze the property’s ownership history and to ensure that the insured owns the property.  Interviewing and completing background checks on the appraisers and real-estate brokers that were involved in a transaction are also advisable.

Finally, review information regarding recent comparable sales in the area, and other documents, such as tax assessments, to verify the property’s value.  Reviewing a title history can help determine if a property has been sold multiple times within a short period, which could indicate that the property has been “flipped” and that the value is falsely inflated. 

©2023 Johnson & Bell, Ltd. All Rights Reserved.National Law Review, Volume , Number 328

About this Author

Rick Hammond, Property insurance coverage, Johnson and Bell, Law Firm

Rick Hammond is an Equity Shareholder with the law firm of Johnson & Bell, Ltd., and he co-chairs the firm’s Insurance group.  He concentrates his practice on matters relating to property insurance coverage, arson and fraud and bad faith litigation.

He’s the President of the Illinois Association of Defense Trial Counsel, on the Board of Directors of the Insurance School of Chicago, and a columnist for the International Association of Special Investigative Units’ publication, "SIU Awareness." Mr. Hammond also serves as General Counsel for the Insurance Committee for Arson Control...