Mortgage in Your Future

Since 2008, the foreclosure crisis has created a bog full of economically unstable mortgages. Many of the properties are about to go under; many already have. What's worse, claims professionals don't really have their sea legs and aren't ready to grapple with claims on these properties. The details of mortgages, mortgage fraud and foreclosure proceedings can drown a claims team in wave after wave of complexities.

The threshold question in many cases involving mortgage fraud and its effect on insurance coverage is whether the policyholder has an insurable interest in the property at the time of a loss. In Hawkeye Security Ins. Co. v. Reeg, it was determined that an insurable interest at the time of loss is essential to the validity of an insurance policy. Generally speaking, one has an insurable interest in a property whenever one would profit or gain some advantage by a property's continued existence and would suffer loss or disadvantage by its destruction.

To determine whether an entity has an insurable interest in a property, a court will usually examine whether an economic benefit or detriment inures to the named insured under any set of circumstances. Some cases involve a "straw person," an unidentified buyer-in-fact who has made every payment towards the purchase or maintenance of the insured premises. The named insured, it could turn out, is someone who never contributed a single cent towards the property's purchase or maintenance.

A proper investigation should seek to determine whether a buyer-in-fact paid for the insurance, the initial down payment, the mortgage payments, and for all upkeep and necessary expenses, and whether that entity paid for every attendant cost for the property. In these cases, the named insured likely will 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 if there was an actual relationship between the insured and the insured premises or if, instead, the insured's relationship to the insured premises is illusory. If the insured doesn't have a demonstrable and actual interest in the property, a question of validity of coverage may arise.

An insurer is often unaware of a pending foreclosure on property that it insures until after a claim is made. Must a lender, as a condition to coverage, give notice to the insurer when that mortgagee initiates foreclosure? A recent case in Tennessee is instructive in analyzing this question.

In U.S. Bank, N.A. v. Tennessee Farmers Mut. Ins. Co., a homeowner and insured fell behind on her monthly mortgage payments, and the mortgagee, U.S. Bank, initiated foreclosure. The bank sent a letter to the homeowner stating that it had 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 insurer, 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, because of that, the bank was required to notify the insurance company. It argued that the bank's failure to provide this notice was a breach of the policy's mortgage clause, which stated:

The trial court denied Tennessee Farmers' motion for summary judgment and granted summary judgment to the bank. In the insurer's appeal, it again argued that the foreclosure action constituted an increase in hazard. The plaintiff, U.S. Bank, asked the court to adopt a Kentucky court's opinion in Anderson v. Kentucky Growers Ins. Co., in which the court 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 appellate court in the Tennessee Farmers' appeal rejected the Anderson court's analysis, noting that the mortgage clause in the Tennessee Farmers' policy required notification of "any" increases in hazard, not just a "substantial" increase in hazard. However, this issue remains a moving target.

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 the insurance company under the standard mortgage clause in a fire insurance policy. It also found that the bank's commencement of foreclosure proceedings was not an increase of hazard requiring statutory notification to the insurance company. So under both tort and contract law, the bank didn't have to inform the insurer of the foreclosure action.

By its very nature, mortgage fraud involves the intentional misstatement and misrepresentation of material information to a lender. 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. Generally, 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. 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.

In some states, an insurer has no general duty to investigate the truthfulness of answers to questions asked on an insurance application. Those states, as in the case of Commercial Life Insurance v. Lone Star Life Insurance, 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."

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 his own conclusions or answers inconsistent with the facts. 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 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 themselves from exposure, while still enjoying potential profits from sales or insurance proceeds. In these cases, a court will likely recognize this deceptive arrangement and acknowledge 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.

Most mortgage clauses do not address rescission of the contract or describe the mortgagee's rights in the context of rescission because these rights are, arguably, extinguished by rescission. A novel approach for insurers in cases involving fraud on the insurance application is to file a declaratory judgment action seeking rescission (thereby voiding the policy in toto which could 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.

Some courts have held that an insurer's right to rescind or deny coverage on the basis of fraud applies only to the claims of the insured, not to claims of innocent third parties that are injured by the insured's acts. But a mortgagee is not a third party; it is tantamount to a first-party insured. Moreover, contract law—rather than tort law—governs the alleged wrongful acts of the insured.

To conduct a more effective investigation when faced with mortgage fraud and foreclosure issues, claims handlers should check the market history of the insured premises; 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 value and ownership history and to verify that the insured owns the property. Interviewing and completing background checks on the appraisers and real estate brokers that were involved in a transaction could also yield important information.

Know the policy, know the mortgagee and know the policyholder. If your company receives applications for coverage from brokers or agents, make sure there's a system in place to verify policy information. Having a solid footing could help your claims team tread successfully through the expected second wave of foreclosures.

Rick Hammond is an equity shareholder with the Chicago law firm of Johnson & Bell, Ltd. He concentrates his practice on matters relating to first-party insurance coverage, arson, fraud and bad faith litigation.