CHAPTER 4 Insurance Contracts

Transcription

1 CHAPTER 4 Insurance Contracts A. Introduction. Understanding the legal aspects of contracts is of the utmost importance since all insurance relationships or purchases involve a contract. This chapter focuses on underlying legal principles that determine how insurance contracts are started, interpreted, and performed. B. What Is a Contract? 1. A valid contract is a legally enforceable agreement between two or more parties to do, or not to do, something. It is an agreement that a court will enforce in the event that one party fails to fulfill its duties. 2. A valid contract needs the following four characteristics to be enforceable: a. Offer and acceptance: must be clearly communicated, understood by both parties, and fully agreed to. In contract law, and in insurance practice, the contract may be oral or written. b. Consideration: something of economic value that is exchanged, including a promise to do (or not to do) something. For example, a promise to pay in the future is sufficient in property insurance but not life insurance. c. Capacity: having the legal ability to enter into a contractual arrangement. This ability or inability is determined by state law. Groups generally not having capacity are minors, the insane, the intoxicated, or those under duress. Because insurance may be considered a necessity for some minors, insurers are careful to have a parent or guardian enter the contract. Some states have reduced-age statutes recognizing the need for some minors to enter into insurance contracts. 82

2 Chapter 11/Insurance Contracts 83 d. Legal purpose: contracts for antisocial purposes, such as gambling or murder, will not be enforced. The contract cannot protect illegal activities. 3. Contracts lacking one or more of the above features are void from the beginning (ab initio). 4. Contracts where one party fails to perform required duties are said to be breached, and such breach allows the other party to avoid the contract if it chooses or have the court enforce the contract if it chooses. 5. Most insurance contracts are unilateral only the insurer makes an enforceable promise. The insured only has to act if the coverage is wanted or if the insurer is expected to perform. C. Insurance Binders 1. Binders are temporary contracts used exclusively in property insurance. They are not used in life insurance because life insurance agents do not have the authority to bind their principals. Binders must meet all the requirements of valid permanent contracts, despite the fact that the offer and acceptance may be oral and the consideration (premium) is undetermined and promised. When oral binders or contracts are reduced to writing, no evidence of conflicts between the oral contract and the written one can be introduced in court. The written one applies based on the parole evidence rule. 2. Life insurance companies issue conditional receipts if the first premium accompanies the application. Such agreements do not require the insurer to issue a policy nor pay for a loss unless all evidence of insurability (including a medical examination) is complete before the loss. (In other words, coverage is generally provided for the period between the medical exam and the issuance of the policy, if the premium has been paid.) Great variation in the wording of conditional receipts is found.

3 84 Chapter 11/Insurance Contracts D. Elements of a Valid Insurance Contract 1. Offer and acceptance a. Must be a meeting of the minds agreement to the same terms b. May be oral or written c. An insurance applicant makes the offer and the insurer accepts the offer 2. Consideration in insurance is two parts a. Property/liability: the value that exchanges hands (can be a promise to pay) and abiding by the considerations and stipulations in the contract (this second part is very important) b. Life: paying actual premium and making truthful statements in the application for insurance c. Insurance is unilateral only one party is bound to its promise - the insurer 3. Capacity the legal ability to enter into enforceable contracts a. Minors, the insane, and the intoxicated do not have capacity. 4. Legal purpose a. Must not be against public policy or protect illegal ventures E. Distinguishing Characteristics of Insurance Contracts 1. Indemnity a. Making the insured whole ; placing the insured in the same financial position after the loss as before. This is easy in concept but is more difficult in application. b. Exceptions to the indemnity principle: i. Life insurance ii. Replacement cost coverage iii. Valued insurance policies iv. Valued policy laws

4 Chapter 11/Insurance Contracts Insurable interest a. A person must be able to show he would suffer a financial loss if the insured event were to occur in order to demonstrate an insurable interest. b. In life insurance, insurable interest must exist when policy is taken out. The owner of the policy (not the beneficiary) must have the interest. (In some cases the owner will be the beneficiary [the estate], but this isn t necessary.) c. In nonlife insurance, insurable interest must exist when the loss occurs. 3. Actual cash value: ACV = replacement cost less depreciation a. Generally replacement cost (new) less appropriate depreciation. Depreciation is a measurement of betterment and has nothing to do with accounting depreciation concepts. b. Not necessarily synonymous with fair market value 4. Subrogation (means a substitution of rights) a. The substitution of one person for another person s legal rights; occurs when a person pays a debt (insurance claim) on another person s behalf. b. An example occurs in auto insurance when an insured collects from her own insurer under her collision coverage, for damages caused by another driver s negligence. The auto company who pays its insured s claim is then subrogated to the right to sue the negligent driver. Such subrogation prevents the insured from profiting from her loss by collecting twice from the negligent driver and the insurer. Thus, subrogation enforces the principle of indemnity. c. Subrogation does not exist where indemnity does not exist, i.e. life insurance. d. Subrogation is always waived for an insured under the contract otherwise insurance would be practically worthless. 5. Contract of adhesion: Because insurance contracts are written by the skilled personnel of the insurance company and offered to the public to accept without modification, all ambiguities are construed against the writer of the contract. (Manuscript contracts are possible, usually in the commercial area, and are written specifically for the insured).

5 86 Chapter 11/Insurance Contracts Note that the state usually has to approve the wording of the contract, and it can only be changed in preapproved ways. a. Doctrine of reasonable expectations: In some states courts can require the insurer to pay a claim when the reasonable expectations would result in a claims payment even though the contract literally does not call for payment of the claim. 6. The personal feature a. Individual characteristics are considered by the insurer before property insurance contracts are written; thus the insurer (nonlife) will not allow the policy to be assigned without the company s written permission (exchanging who is the named insured under the contract). b. Life insurance contracts may be assigned with proper notification (permission is not needed) because assignment does not change the chance of loss (the insured life). Assignment transfers the ownership of the policy (e. g., the right to cash value, dividends, etc.) or provides security on loans collateral assignment. c. Assumption reinsurance is when an entire block of contracts are taken over by another insurance company. Sometimes the new company is outside the state, is financially weaker or the insured was not given adequate information to refuse the change. This practice seems to violate the personal feature and has come under scrutiny. 7. Utmost good faith a. Insurance contracts require a higher level of integrity and honesty when dealing with an insurer than ordinary contracts require of both parties (good faith contracts). b. Warranty i. A condition of the contract that when breached destroys coverage ii. Stems from marine insurance which is quite strict, especially English marine iii. Affirmative warranty applies currently but not in the future, e.g., the ship is seaworthy! Promissory warranty applies in the future, e. g., the sprinkler system will be properly maintained. Express warranties are written, and implied warranties are understood by all parties to the contract and are not written in the contract.

6 Chapter 11/Insurance Contracts 87 c. Representations Statement made, oral or written, to induce a party to enter the contract. i. Generally: statements made in the insurance application, relied on by the insurer and used for underwriting and rating decisions. ii. Only material and false representations allow the insurer to avoid the contract. (Materiality: if the truth were known, then a different underwriting or rating or wording decision would have been made.) iii. An incontestable clause in life insurance terminates the length of time that contract can be contestable. iv. The entire contract clause in life insurance means only statements attached to contract are contestable. d. Concealment i. Silence when obligated to speak. ii. In general (states differ somewhat), in order to avoid a contract the insurer must establish that the concealment was material and for the purpose of defrauding the insurer; there must be an element of deception. e. The entire contract clause life insurance i. Any statements made in the application must be attached physically to the contract. f. Incontestability life insurance i. After a period of one to two years, the insurer cannot contest the contract to void the policy. 8. Aleatory: Parties to the (insurance) contract know in advance that they will be exchanging unequal dollars. The insured pays a relatively small premium and receives in return either no dollars or potentially a relatively large amount. The reverse is the case

7 88 Chapter 11/Insurance Contracts for the insurer. In other (nonaleatory) contracts, the exchange of value is presumed equal. 9. Standardization of insurance contracts 10. Basic parts of an insurance policy a. Declarations b. Insuring agreement c. Deductibles d. Definitions e. Exclusions f. Endorsements g. Conditions and general provisions IV. ANSWERS TO REVIEW QUESTIONS 1. How do binders differ from conditional receipts? Binders are temporary contracts used in property insurance. They are not used in life insurance because life insurance agents do not have the authority to bind their principals. Binders must meet all the requirements of valid contracts. Life insurance companies issue conditional receipts if the first premium accompanies the application. Such agreements do not require the insurer to issue a policy nor pay for a loss unless all evidence of insurability (including a medical examination) is complete before the loss. (In other words, coverage is generally provided for the period between the medical exam and the issuance of the policy, if the premium has been paid and underwriting rules dictate issuance of the policy.) Great variation in the wording of conditional receipts is found. 2. What are the important differences between a valid contract, an invalid contract, and a voidable contract? A valid contract is one that will be enforced by a court because it possesses all four essential characteristics: 1) Offer and acceptance (of the same terms); 2) the parties to the contract have legal capacity to contract; 3) consideration (something of value has been given up by all parties to the contract); and 4) legal purpose (if the contract is fulfilled, no law will be violated). Buying a life insurance contract with the intent of murder

8 Chapter 11/Insurance Contracts 89 would not constitute a legal purpose. An avoidable contract means the actions or omissions of one party to the contract will allow the other party to avoid their duties imposed by the contract. A void (invalid) contract is one lacking one or more of the four elements essential for a valid contract. Such a contract is void at its inception due to lack of consideration (for example, not abiding by the conditions in the contract). 3. List the four elements of a valid contract. What is the legal result if only three of the four elements are present? 1) Offer and acceptance (of the same terms) 2) The parties to the contract have legal capacity to contract 3) Consideration (something of value has been given up by all parties to the contract) 4) Legal purpose (If the contract is fulfilled, no law will be violated. A usurious loan contract would not have a legal purpose.) If any of the four elements are missing, the contract is void. 4. Why is legal capacity required to enter into a valid contract? Society, through its laws, seeks to protect certain classes of individuals from those who would take advantage of their weakened position. Thus, laws preclude such groups as minors, inebriates, prisoners, or enemy aliens from entering into valid contracts under most, but not all, circumstances. Other groups, most notably women, have been prevented from entering into valid contracts in the past, thus establishing the fact that society s norms on who will or will not be allowed to contract are subject to change. 5. What is indemnity? Identify three ways the principle of indemnity is enforced in property insurance contracts. Indemnity is compensation paid to an insured for losses sustained. Indemnity means an insured should not profit from the insurance contract, or to be indemnified means that the person is placed in the same financial position after a loss compared to before. However, payment in an amount slightly less than the loss, due to such things as a deductible, is spoken of as indemnity because the insured has agreed to pay the first dollars of the loss. The insurable interest requirement enforces the rule of indemnity since it means each insured must demonstrate a financial loss (in life insurance, certain insurable interests are presumed to exist) in order to collect. Subrogation prevents an insured from collecting twice for the same injury, since an insurer will be subrogated to the

9 90 Chapter 11/Insurance Contracts insured s right to sue a negligent third party if the insurer pays for such a loss. The actual cash value limitation on the payment amount in fire insurance policies would provide insufficient funds to replace old property with new property, since depreciation (the extent of betterment) is generally taken into account in actual cash value determination. 6. Are there any exceptions to the rule that insurance contracts are contracts of indemnity, defined strictly? There are generally three exceptions to the rule that insurance contracts are contracts of indemnity. Life insurance contracts are not contracts of indemnity because the concept of placing one back in the same financial condition after the loss cannot exist. Replacement cost contracts violate indemnity because the policy owner is better off after the loss than before, since new property is given for old property. Valued policies also violate indemnity. Valued policies are used when it is impossible to value the loss after it occurs, so the insured and the insurer agree on the value before the loss occurs at the time the contract is made. An example would be insuring a valuable and irreplaceable art object or painting. Valued policy laws also exist. These are state laws that force the insurer to pay the face amount when a total loss occurs. The incentive is for the agent to oversell coverage and insurers to accept the premium without question. So if a total loss occurs, the insured receives the face amount under certain situations to penalize the insurance company from allowing this to happen. This overcompensation violates indemnity. 7. Describe one difference between life insurance and property insurance in the requirement for insurable interest. The most important difference in the insurable interest doctrine between life and property insurance is the time when the insurable interest must be present. In property insurance, there must be insurable interest present when the loss occurs. If a person failed to have an insurable interest when the loss occurred (the building was sold before the loss occurred), the person cannot collect on the insurance policy. In life insurance, the owner of the policy must demonstrate (or be presumed to have) an insurable interest in the subject life when the policy is purchased. The interest may subsequently be lost (as by divorce), but the beneficiary will still collect the proceeds, provided the owner of the policy had an insurable interest at the inception of the policy. 8. Does actual cash value equal fair market value? Actual cash value does not always coincide with the concept of fair market value. Actual cash value means what it costs to repair or replace with like kind and quality of material less an amount for depreciation. Actual cash value and fair market value may be the same, for example, for a common

10 Chapter 11/Insurance Contracts 91 automobile. But when property cannot be separated from other values, such as land, location, tax, and services, the actual cash value, the replacement cost, and the market value may be greatly different, as in the case of a home. 9. How does subrogation prevent one from collecting twice for the same debt, or from the same insured injury? Subrogation means one person substitutes for another person s legal rights. The substitution prevents the first party from collecting twice for the same injury or the same obligation. In insurance, the insurer often must pay insureds in cases where the damage is caused by negligent third parties. The insured is made whole by contract and releases the tort right to the insurer. The insurer may then collect from the negligent third party. Were it not for subrogation, the substitution of the insurer to the insured s right to sue the negligent third party, either the insured could try to collect twice for the loss, or the negligent party would be relieved of paying for the damage inflicted. Subrogation in insurance prevents both of these unfair results. 10. Why are the rules on the right to assign a property insurance contract different from the rules on the right to assign a life insurance contract? Life insurance policies are freely assignable. Proper notification of the assignment is desirable to reduce legal complications. Most property insurance policies may be assigned only with the consent of the insurer. Assignment of a life insurance policy does not change the subject life; it changes the individual(s) who may exercise the policy rights assigned, e.g. who may borrow the cash value, designate a beneficiary, or collect any dividends. The risk to the life insurer is not changed; hence, the insurer demands only proper notification (so that it is informed of the assignment and can act accordingly). In property insurance, the character, capacity, and history of an insured are carefully considered when the insurance contract is written. The premium reflects the characteristics of a particular insured as well as the property involved. Thus, when A sells his automobile or house to B, he may not freely transfer the insurance covering the property to B, since the premium reflects such things as A s driving record and A s financial capacity. If property insurance policies were freely assignable, the insurer might find its exposure to loss much greater than originally anticipated. (After a loss has occurred it is generally recognized that the payment for the loss is freely assignable, e.g., an insured may assign the loss payment to the construction company making repairs.) 11. Why are insurance contracts viewed as contracts of adhesion? If an insurer issues a contract that includes ambiguities that an insured challenges in court, how will the

11 92 Chapter 11/Insurance Contracts courts view the case? Because the insurance company writes the contract and offers it to the insured without an opportunity to bargain its terms, the contract is considered a contract of adhesion. Generally, ambiguous provisions are interpreted by the courts in favor of the insured because of the unequal position held by the parties at the inception of the contract. 12. What difference does it make to an insured if a false statement made by the insured is considered a warranty or a representation? The doctrine of warranty, which comes from ocean marine insurance, is a very strict doctrine. In its purest form, the doctrine is interpreted to mean any breach of a warranty will allow the insurer to avoid paying for a loss. Thus, questions of materiality of the breach or whether the breach contributed to the loss are not appropriate to the strict doctrine of breach of warranty. On the other hand, the doctrine of representation requires that a representation be material and false before the insurer can avoid the contract. The standard test of materiality is a negative answer to the question, Would the insurer have written the same contract at the same rate if the misrepresented facts had been truly known? That is, if the premium or wording to the contract would have been different or the insurer would have declined the contract if the truth were known. In a warranty the insurer must show only a breach. In a representation, the insurer must show the statement was false and material. The insured would want the statement to be a representation rather than a warranty. 13. Explain the advantages of the incontestability clause in life insurance from society s standpoint. On the surface, the incontestability clause appears to accept and validate undetected fraudulent applications for life insurance because the effect of these laws is to prevent contests of life insurance policies (after a one- or two-year period) based on alleged fraud at the inception of the policy. Given more penetrating analysis, however, the laws add a great deal of stability to the life insurance contract. When an insured dies, possibly at a point long after the inception of the policy, the policy matures as a death claim. If the insurer were allowed to contest a policy at this point, the best witness (or witnesses) will be unavailable for testimony; memories and facts tend to disappear or become cloudy over time. Also, families relying on speedy settlement of claims in order to continue meeting expenses would be greatly disadvantaged if the insurer contested the policy at this point. Hence, the insurer has a relatively brief period to investigate the application and applicant, and if it fails to find any negative factor during this time period, it will be bound to the contract, even if fraud can subsequently be proved beyond a doubt. The reasoning is that far more people will be protected by this law than there will be insurers defrauded. One will

12 Chapter 11/Insurance Contracts 93 also note that this is a statute of limitation from the beginning of the contract, not from the discovery of the injury. 14. What are the advantages of using standardized insurance policies? Standardized contracts benefit the insureds in that they can shift their buying criteria to price and service. The contract terms will not vary across insurers. Standardized contracts benefit insurers in that they are better able to price their coverage. 15. List and describe the different parts commonly found in an insurance policy. The common parts are: 1) Declarations statements made by the insured that are part of the underwriting information and which become the basis of coverage 2) Insuring agreement the enforceable promise made by the insurance company 3) Deductibles the first dollar part of losses that the insured agrees to bear 4) Definitions key terms such as bodily injury and property damage that will be the basis of loss settlements 5) Exclusions perils and property not covered by the insurance 6) Endorsements additions to the policy that can change the declarations or add coverage 7) Conditions and general provisions the boilerplate or rules of the road or operation of the policy, for example, the terms under which the insurance company might cancel the contract 16. Explain the reasons for including exclusions in an insurance policy. There are several reasons for exclusions. The most important is the removal of catastrophe perils. The second most important is the removal of perils not contemplated in the rate structure. An example of this is that commercial fire insurance does not cover losses of money. To do so would raise rates dramatically for all insureds. Instead, those with this exposure buy crime insurance and share losses only with those who have the exposure. **************************