Should Premiums Be Returned When Policies Are Obtained by Fraud?

September 2, 2011 | Appeals | Insurance Coverage

In 2004, the American Institute of Certified Public Accountants (“AICPA”) and Prudential Insurance Company of America entered into a group insurance contract through which AICPA members could obtain life insurance on the lives of their dependents. Pursuant to this arrangement, an application was filed with Prudential in the spring of 2004 for life insurance on the life of Shari Dukoff, the wife of Neil Dukoff, a member of AICPA. The application requested that Shari Dukoff describe any negative medical history she had within the previous five years, including surgery or symptoms of cancer. The applicant affirmed that Shari Dukoff had none. Based on this application, Prudential issued a Certificate of Coverage on Shari Dukoff’s life for $500,000, naming Neil Dukoff as the beneficiary. The policy was dated and began on June 1, 2004, and the Dukoffs paid all premiums due.

On May 23, 2006, Shari Dukoff died from complications stemming from cancer. On June 8, 2006, Neil Dukoff submitted a claim form to Prudential, and on September 20, 2006, Prudential sent him a letter approving the claim. On September 26, 2006, before the claim was paid, Prudential informed Mr. Dukoff by letter that it was denying the claim based on what it asserted were material misrepresentations made in the application for the insurance.

Prudential then brought suit, contending that the policy had been obtained by fraud and was void ab initio. Neil Dukoff and the estate of Shari Dukoff counterclaimed for the full value of the policy, $500,000, plus interest.

The defendants moved for summary judgment, arguing, among other things, that Prudential had been obligated to return the insurance premiums to seek to rescind the policy and that its failure to have done so until March 2007, despite it having denied the claim in September 2006, barred rescission of the policy.

The court, in Prudential Ins. Co. of America v. Dukoff,[1] rejected the defendants’ contention that they were entitled to judgment because of Prudential’s delay in returning the premiums. Significantly, however, the court acknowledged the general rule under New York law that where an insurer seeks to rescind an insurance contract for fraud, or on other grounds, equity required that it tender back the premium. The court then explained that an insurer seeking to rescind an insurance policy based on fraud need not return premiums to the insured until the claim goes to trial; Prudential’s tendering of the premiums in March 2007 satisfied this requirement, the court decided.

The rule cited by the court in Dukoff – namely, that an insurer that seeks to rescind an insurance contract for fraud must return premiums it had received – is long established in New York.[2] But what benefit does the rule provide? Why should an insurance company that is defrauded into issuing an insurance policy be compelled to return the premiums it had received in order for a court to determine that the policy was void ab initio? Does not such a rule provide incentive to procure policies by fraud, since there is no financial loss if the fraud is timely discovered and acted upon by the insurer? It would seem that not requiring insurers to return premiums might deter attempts to procure insurance policies by fraud. The recent decision by the U.S. Court of Appeals for the Eighth Circuit in PHL Variable Ins. Co. v. Lucille E. Morello 2007 Irrevocable Trust,[3] albeit under Minnesota state law, suggests the viability of such a rule.

The Minnesota Rule

The case arose after New Stream Insurance, LLC, indirectly loaned an insured money to purchase a $10 million life insurance policy from PHL Variable Insurance Company. After the insured’s death, the insurance carrier determined that the insured had fraudulently obtained the policy, prompting the insurer to deny the death benefit, sue the beneficiaries for rescission of the insurance contract as void ab initio due to the allegedly fraudulent misrepresentations made in the policy application, and retain all premiums paid – more than $500,000.

In response, New Stream intervened as a third party plaintiff to seek a declaratory judgment that the insurance carrier was not entitled to retain the premiums that New Stream had loaned to the insured. Eventually, the beneficiaries settled with the insurer, and the U.S. District Court for the District of Minnesota, over New Stream’s objection, entered an order adopting the beneficiaries’ and insurance company’s agreement that rescinded the policy ab initio and that allowed the insurer to retain the premiums.

The district court reasoned first that, “[p]ursuant to Minnesota law, a life insurance policy should be declared void when there is a statement made, in procuring the insurance, that is willfully false or intentionally misleading.” Second, the district court determined that “under Minnesota law, where the insurer is induced to enter into a contract for insurance by the actual fraud of the insured, the insurer is not required to return the premiums paid.” New Stream appealed to the Eighth Circuit, arguing that the district court had erred in applying a procured-by-fraud exception to what it contended was the general rule that “rescission requires the return of unearned premiums.”

The Eighth Circuit found that Minnesota law foreclosed New Stream’s appeal. It explained that the Minnesota Supreme Court, in the “seminal case” of Taylor v. Grand Lodge A.O.U.W. of Minnesota,[4] held that the general rule requiring return of premiums in the event of rescission was inapplicable when the underlying policy was procured by the actual fraud of the insured.

In Taylor, the insured decedent had applied for and gained membership into the Grand Lodge of the Ancient Order of United Workmen of the State of Minnesota, an organization that provided life insurance to its members. As a membership limitation, the Grand Lodge disallowed any new members older than 45. The insured died, his wife applied for the death benefit, and the Grand Lodge discovered that the insured had falsified his age on his original membership application, concealing his real age of 47. The Lodge sued to rescind the insurance contract as void ab initio because it was procured by fraud.

The Minnesota Supreme Court, in holding that the trial court erred in concluding that rescission required the return of the premiums paid, stated the following rule:

Although not expressly stated in all the cases which recognize the right to the return of the premium [in the event of rescission], there is a well-recognized exception by which the insurer is relieved from any duty to return the premium when it was induced to enter into the contract by the actual fraud of the insured. In this case, the trial court found in substance that the untrue statement as to his age was knowingly made by the applicant for the fraudulent purpose of obtaining membership in the lodge. It was, then, a case of actual fraud, not a mere innocent or unintentional breach of warranty or conditions.

The Eighth Circuit observed that a decade later, in National Council of Knights & Ladies of Security v. Garber,[5] the Minnesota Supreme Court affirmed Taylor’s rule under virtually identical facts, declaring that “[i]f intentional fraud on the part of the insured rendered the contract void, the insured is not entitled to a return of the premiums under any circumstances.”

New Stream argued that the underlying rationale of this rule was to prevent insurance fraud from becoming a zero-sum game in which an insured had no pecuniary risk in attempting to perpetrate fraud. New Stream contended that its case did not present that concern because it was an innocent third party lender.

The Eighth Circuit was not persuaded, however, explaining that New Stream cited no Minnesota case compelling the return of premiums to a fraudulent insured, or an insured’s assignee, on that basis. Moreover, it continued, although the Minnesota Supreme Court likely did not anticipate or account for the complexities of modern-day structured finance when it crafted its procured-by-fraud exception, that alone did not give the Eighth Circuit license to ignore Minnesota’s interpretation of its own law. Because of “actual fraud,” the insurance contract was rendered void at its inception and relieved the insurer of any duty it otherwise may have owed to return premiums already paid, the Eighth Circuit concluded.

Conclusion

Where an insurance company victimized by fraud is limited to efforts to rescind a policy in court, there is little to stop individual applicants from making false statements to obtain insurance policies. If the risk is enhanced so that parties engaging in fraud face the loss of premiums paid as well as the benefits they seek, they may think twice before scheming to defraud insurance companies.

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[1] 674 F. Supp. 2d 401 (E.D.N.Y. 2009).

[2] See, e.g., La Rocca v. John Hancock Mut. Life Ins. Co., 286 N.Y. 233, 238 (1941) (when a contract of insurance has been rescinded, “the law implies an obligation on the part of the insurer to refund the consideration to the insured”); Kiss Constr. NY, Inc. v. Rutgers Cas. Ins. Co., 61 A.D.3d 412 (1st Dep’t 2009) (“Since we now declare the policy void ab initio, Rutgers is obligated to refund plaintiff’s premium payments.”).

[3] 2011 U.S. App. LEXIS 14338 (8th Cir. July 14, 2011).

[4] 105 N.W. 408, 411 (Minn. 1905).

[5] 154 N.W. 512, 513 (Minn. 1915).

This article is reprinted with permission from the September 2, 2011 issue of the New York Law Journal. Copyright ALM Properties, Inc. Further duplication without permission is prohibited. All rights reserved.

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