by Christopher Graham and Joseph Kelly

You’re a partner in a legal or other professional services firm. Or maybe you’re a director of a non-profit or private corporation. Your firm buys professional liability insurance. Or your non-profit or private company buys D&O insurance. There’s an application. And someone other than you answers the application questions, signs the application, and submits it to the insurer. You don’t review the application. Insurer issues a policy. Then there’s a claim against you. Insurer says “Sorry, no coverage. Your application included a materially false answer. We rescind.” You say, “But, I didn’t know the answer was false. I’m innocent!” You also say, “There’s wording making the contract severable as to each insured. You can’t rescind as to me. I’m innocent!”

If you read this blog regularly, you saw this scenario in our December 2013 blog post here about Illinois State Bar Association Mutual Ins. Co. v. Law Office of Tuzzolino and Terpinas, 2013 IL App. (1st) 122660 (Nov. 22, 2013). There, an Illinois appeals court held that the innocent insured, an attorney, wins, because of wording deemed to provide contract severability and the common law innocent insured rule.

Here is the legal malpractice policy “severability” wording that made the difference:

The APPLICATION, and any addendum or supplements and the Declarations, are the basis of the Policy. They are to be considered as incorporated in and constituting part of this Policy. The particulars and statements contained in the APPLICATION will be construed as a separate agreement with and binding on each INSURED. Nothing in this APPLICATION will be construed to increase the COMPANY’S Limit of Liability.

Recently, however, the Illinois Supreme Court agreed to review the appeals court decision. Presumably it will consider (1) whether there’s a separate contract between insurer and each insured, non-rescindable as to the innocent insured and (2) whether under the common law, the insurer can rescind a professional liability policy as to an innocent insured.

For partners in professional services firms and directors of non-profits and private companies severability is critical. You don’t want to learn you’re uninsured because a bad apple misrepresented material facts to the insurer.

Years ago it was not unusual for insurers to rescind D&O policies based on material misrepresentations in insurance applications, even for public companies and banks. Rescission was common following bank failures in the 1980’s. That could mean innocent D&O’s were uninsured because of misrepresentations someone else made.

Thereafter severability clauses became common in D&O policies. Later you saw separate Side A policies just for directors and officers, independent director policies, and non-rescindable public company D&O policies. With capacity and competition, insurers issued new policies for non-profit and private company boards based on renewal or other applications requiring little disclosure. Rescission in the D&O insurance world as a practical matter has not been much of a risk, in our experience. (Hey, readers. Do you agree? Please comment.)

But rescission is still an issue every insurance purchaser and broker should consider. Get the application answers right. But consider severability and, better yet, a non-rescindable policy. The common law innocent insured doctrine isn’t something to count on.

Stay tuned to this blog for our report on further developments in this important case.

Tags: Illinois, legal malpractice insurance, professional liability insurance, D&O insurance, management liability insurance, rescission, innocent insured doctrine, severability