Essential Elements of an Insurance Contract

An insurance contract is fundamentally based on the utmost good faith of all parties to the contract. The applicant is relying on the promise to pay made by the insurer. The insurer is relying on the truthfulness of the statements made by the applicant on the application. Insurance is also based on the law of contract. For any contract to be valid and enforceable, four conditions must be met:

1. There must be consideration by both parties.
2. An offer must be made by one party and acceptance of that offer made by the other party.
3. All parties to the contract must be legally capable of entering into a contract.
4. The purpose of the contract must be legal.

Consideration

There must be an exchange of consideration for the contract to be valid. The insurer's consideration is its promise to pay policy benefits should the insured suffer a covered loss (acceptance of the risk). The applicant’s consideration is the premium.

Offer and Acceptance

The offer made by one party must be accepted by the other on an unconditional basis. An applicant makes the offer by completing an application. It is either accepted by the insurer as is, or the insurer may make a counter offer by proposing a rated policy. In the end, both parties either agree to the final terms of the policy or there is no contract.

Legal Capacity

Both parties must be legally capable of entering into a contractual agreement. If the insurer is admitted or authorized in the state, it has legal capacity. The applicant has legal capacity unless he/she is a minor, is mentally incompetent, is intoxicated or under the influence of narcotics.

Legal Purpose

A valid contract must be for a legal purpose and not against public policy. A life insurance policy purchased with intent to have the insured killed is an obvious example of an invalid contract. For an insurance contract to be valid there must be an insurable interest between the applicant/owner and the insured.

Insurance contracts are unique in that the applicant must purchase the policy as written without any opportunity to modify or clarify the contract language. Through the years, the court system has used the Doctrine of Adhesion to interpret ambiguous contract terms or conditions in favor of the insured, since they had no chance to alter the contract at time of application.

Insurers go to great lengths to make their contract language clear and avoid any misunderstandings about the terms of the policy. Still, questions and conflicts do arise. When they do, they often involve the concepts of warranties and representations.

A warranty is a guarantee that a statement is truthful.

Representations are statements made on the application that are substantially true to the best knowledge of the applicant.

If a statement is made on an application that the applicant knows is false, it is a misrepresentation and may constitute fraud. If the insurer can prove that the misrepresentation was made intentionally, it may void the contract and may be punishable as a class 6 felony.

Producers Responsibilities

Producers have certain responsibilities to the insurer and the insured. Under the law of agency, they have the financial responsibility of collecting premiums and submitting them to the company. An agent has a duty to act with a degree of care that a reasonable person would exercise under similar circumstances. This “prudent person” rule is to protect the insurer and the insured from unreasonable insurance transactions on the part of the agent.

Producers are also entrusted with a fiduciary responsibility. A fiduciary is anyone in whom another party has placed its financial trust. Life and health producers are entrusted with the handling of funds and general insurance needs of clients. Producers are responsible for assisting clients in identifying and evaluating their insurance needs by:

• Gathering pertinent financial data, most of which will be confidential in nature.
• Establishing financial goals and objectives.
• Making fair and complete comparisons of differing policies that may be appropriate and recommending policies that best meet the needs of the client.
• Explaining policy provisions to the client.
• Taking an application after determining that the prospect represents an insurable risk.
• Submitting applications and premiums promptly to the insurer.
• Periodically reviewing all of the client's policies so that any necessary changes can be made.
• Promptly delivering policies to the client and explaining the nature and purpose of their provisions, riders, exclusions, and ratings.

Types of Receipt

When an agent or broker accepts an initial premium deposit with the application, the applicant is given a receipt. The type of receipt given can be very important in the settlement decision of any claims that may arise during underwriting.

Binding Receipt

A binding receipt is the most restrictive from the insurer's viewpoint. When an agent gives a binding receipt, the company is bound to the terms of the contract being applied for. For example, an agent gives a binding receipt to an applicant for a $100,000 life insurance policy and it turns out that the applicant is uninsurable, but in the 4 weeks that it takes for the application to move through the underwriting process, the applicant dies. In this example, the insurer is bound to the terms of the contract and must pay the beneficiary $100,000.

Conditional Receipt

This receipt still binds the insurer to the terms of the contract in the event that the applicant dies before the underwriting is complete, but only if the company finds that the applicant was insurable. If the applicant was found to be uninsurable, the premium paid with the application would be returned to the applicant's estate.

Note: For binding or conditional receipt to exist, offer and consideration must be in place. That is, the producer must receive the application for insurance and the initial premium. If the applicant does not pay the initial premium at time of application, no coverage is in force during underwriting and the insurer may require a statement of continued good health at policy delivery.

Lesson Summary

An insurance contract is based on utmost good faith with the applicant relying on the insurer's promise to pay, and the insurer relying on the truthfulness of applicant statements. Legal contract conditions include consideration by both parties, offer and acceptance, legal capacity of parties, and a legal purpose. Consideration involves the exchange of promises, with the insurer promising benefits for covered losses in return for the applicant's premium.

Offer and acceptance require an unconditional agreement. The applicant offers by completing an application, which the insurer can accept as is or propose changes. Legal capacity means both parties must be able to enter into a contract. The contract's purpose must also be legal, not against public policy. An insurable interest must exist between the applicant/owner and the insured for a valid contract.

• Insurance contracts have unique features:
• Applicants must accept policies as written without modification.
• The Doctrine of Adhesion favors insured parties in case of ambiguous terms.
• Insurers strive for clear contract language to prevent misunderstandings.

Warranties guarantee truthfulness, while representations are substantially true statements. Misrepresentations, if intentional, can void the contract and may constitute fraud. Producers' responsibilities include collecting premiums, acting prudently, and fulfilling fiduciary duties. They assist in identifying insurance needs, comparing policies, explaining provisions, taking applications, and promptly submitting them to the insurer.

Types of receipts include:

• Binding Receipt: The most restrictive as the insurer is bound to the contract terms being applied for.
• Conditional Receipt: Binds the insurer if the applicant is found to be insurable; otherwise, the premium is returned.

For both types of receipts to exist, the producer must receive the application and initial premium. If no initial premium is paid, the insurer may require a statement of continued good health at policy delivery.