Remedies for Misrepresentation in Applications in the Presence of Fraudulent Intent

By North, Charles M. | Atlantic Economic Journal, June 2001 | Go to article overview

Remedies for Misrepresentation in Applications in the Presence of Fraudulent Intent


North, Charles M., Atlantic Economic Journal


CHARLES M. NORTH [*]

Many contracts are based upon information provided in written applications, including insurance and employment contracts. However, the remedies used in these two contexts for material misrepresentation in the application differ. Insurers use the remedy of rescission and restitution, which returns the parties to status quo ante. Employers simply terminate the contract, leaving the parties where they are at the time of termination. This paper examines the role played by each remedy in the context of intentional misrepresentation. It is shown that rescission and restitution expands the situations in which mutually beneficial contracting will occur. It is also shown that insurers can offer lower premiums when the remedy of rescission and restitution is available. (JEL K12, C72, D82, G22, J23)

Introduction

In many types of legal relationships, especially contractual ones, information contained in an application provides the basis upon which the relationship is established. For example, people seeking bank loans must submit applications that request financial and other information. Similarly, lessors frequently require potential lessees to submit applications before renting residential property, and in a noncontractual relationship, universities decide admissions based upon applications from potential students. Applications are also common in two additional settings, insurance and employment, which provide the motivation for the present research. The pervasiveness of application-based relationships and the importance of such relationships in the economy naturally lead to the possibility that applicants will not tell the truth when responding to questions in the application. As a result, legal remedies have evolved that permit the application's recipient to end a relationship upon discovery of certain types of m isrepresentation, or false statements, in applications. Interestingly though, the remedies used for misrepresentation in applications vary from one type of relationship to another. This article presents an inquiry into why such variations might exist and persist in light of the fact that the wrongful behavior in each situation is essentially the same.

The focus here is on two particular remedies for misrepresentation in applications: rescission and restitution (typical in the insurance context) and termination (typical in the employment context). In both settings, it is shown that rescission and restitution expands the situations in which mutually beneficial contracting can occur. In addition, a model of the insurance application process shows that the use of rescission and restitution by insurers allows them to charge lower premiums than can profitably be charged under termination.

Before analyzing the two remedies, it will be helpful to describe the insurance and employment settings and the legal remedies typically used in each context when an applicant makes a misrepresentation. To obtain insurance of any type, including life, health, casualty, and liability insurance, the person seeking the insurance typically must submit an application. This application asks a number of questions related to the risk sought to be insured, and it usually contains a statement that any misrepresentation on the application can result in voiding the policy. Furthermore, most policies contain a provision governing fraud or concealment by the insured which, in essence, states that the policy is voidable in the event of any willful misrepresentation or concealment by the insured in connection with the insurance policy. Some states place additional judicial or legislative restrictions on the enforceability of these policy provisions, such as materiality or reliance. Thus, under most insurance policies, an in surer may declare a policy void ab initio if the insured makes an intentional, material misrepresentation on the application for insurance. This is simply applying the legal remedy of rescission and restitution to the insurance application setting. …

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