Legal Aspects of Insurance Notes

Legal Aspects of Insurance

Module Introduction

• Insurance purchases involve contracts and is a distinct branch of contract law.
• The module will explain contract terminology, types, and characteristics.
• The online portion takes an average student approximately 2.5 hours to complete.
• Upon completion of this module, you should be able to:
  • Discuss various contract terminology
  • List the essential elements of a valid contract
  • Explain three exceptions to the rule that insurance contracts are contracts of indemnity
  • Identify the ways an insurance contract may be ended.

Insurance Contract

• A general knowledge of contract law is essential to understanding insurance.
• The lesson will cover contract terminology and valid elements of a contract.
• Upon completion of this lesson, you should be able to:
  • Explain the term contract
  • Discuss voidable contract
  • Define a void contract
  • Describe a binder
  • Discuss conditional receipt
  • Describe the valid elements required for a contract.

Contract Terminology

• Basic terminology necessary to understand insurance contracts:
  • Contract
  • Voidable contract
  • Void contract
  • Binder
  • Conditional receipt

Contract

• A contract is a legally binding agreement creating rights and duties for those who are parties to it.
• If one party fails to perform its duties without a legal excuse, the contract is breached.
• If breached or disputes arise, courts can enforce judgments and settle disputes using remedies.

Voidable Contract

• A voidable contract allows one party the option of breaking the agreement due to a breach by the other party.
• The party with the right to void can also choose to have the contract enforced.
• An insurance example is when the insured has attempted to defraud the insurer; after the insurer establishes fraud, it will be released from obligations, and the contract can be set aside or voided at the insurer's option.

Void Contract

• A void contract is a contract that a court will not enforce because it lacked one or more features of a valid contract from the beginning.
• If an incompetent person (e.g., legally insane) enters into an insurance contract, it's considered "void ab initio," meaning void from the beginning.
• In legal terms, the court is saying that a contract never existed.

Binder

• A binder is a temporary contract in property insurance, often used before the formal policy issuance.
• It must meet all requirements for a legal contract and is distinguished by its temporary nature (often 30 days or less).
• The purpose is to provide coverage during application processing.
• A binder may be oral or written; oral binders should be followed by a written document to reduce disputes.
• Written binders specify the amount of insurance, the effective period, and the parties to the binder.

Conditional Receipt

• A conditional receipt can provide temporary coverage, contingent on an applicant's ability to present evidence of insurability.
• Life insurance agents give applicants a conditional receipt when they submit a premium payment with the application.
• With one common type, coverage begins from the date of the receipt if evidence of insurability exists (including good health and occupation).
• The conditional receipt affords the life insurance applicant temporary coverage during the underwriting process.
• Agents should always encourage an applicant to submit an initial premium payment with the application in order to receive such a receipt.
• If the agent does not educate the applicant of this when a conditional receipt is available, and the applicant dies in an accident after all medical testing had been completed, the agent could be sued by the deceased applicant's heirs for failure to provide advice that is expected of a licensed professional.

Valid Elements of a Contract

• All valid contracts must have the following four elements:
  • Offer and acceptance
  • Consideration
  • Capacity
  • Legal purpose

Offer and Acceptance

• Deals begin when one person makes a proposal to exchange something of value with another person. The proposal to make an exchange is called the offer.
• The offer must be reasonably definite and communicated clearly.
• If the second person agrees to the exchange, this is called acceptance.
• The acceptance must be unconditional, unequivocal, and communicated clearly.
• The offer and acceptance may be oral or in writing. The law recognizes both forms.
• In property insurance, most states allow oral insurance binders and contracts, but they are usually put in writing as soon as possible to provide protection for the insured and insurer.
• The legally binding arrangement that explains the basic promise of the insurance company is known as the insuring agreement.

Consideration

• The value exchanged between the parties to the contract is the consideration.
• The consideration is what each party gives to the other.
• Consideration may take a tangible form, such as money, or it may take the form of a promise to do or not to do a particular activity.
• There must be an exchange of consideration to have a valid contract.
• In an insurance contract, the consideration the insurer gives is a contingent promise to pay the insured; that is, the insurer agrees to make payment only if a covered loss occurs.
• If such an event does not occur, the insurer need not make payment.
• In return for the insurer's promise, the insured gives two things - money and a promise to follow the provisions and stipulations in the insurance contract.

Unilateral Contract

• In unilateral contracts, only one party makes an enforceable promise.
• Insurance contracts are unilateral in that only the insurer makes a binding promise.
• The insured can cancel the policy at any time without recourse, while the insurer is limited to specific situations (such as failure of the insured to pay premiums) when it may cancel a policy.
• The insured does not promise to pay the premiums and cannot be sued for failure to do so.
• Insureds cannot collect for losses if they do not pay premiums, because timely payment of the premium is a condition of the contract.
• Contracts in which both parties make enforceable promises are called bilateral contracts. Insurance is not considered a bilateral contract.
• The most popular term insurance policies these days are those that come with a premium guarantee period, for example, 20-year level term.
• The insurance company is committed to honoring the contract and not raising the premium for 20 years.
• The policyholder however, is not committed to keeping the policy for 20 years, and can cancel at any time.

Capacity

• Not every person legally has the capacity to enter into a contract.
• State law defines the period of minority as ending at age 18.
• If a 13-year-old were to enter into a contract, it would be voidable at the youngster’s option.
• If a minor chose not to void the contract, the youngster could ratify or affirm it when reaching age 18.
• Many state laws allow older minors (often beginning at age 15) to make binding agreements for insurance in specific instances.
• Insurance companies also must be qualified to enter into contracts.
• They must have a license to operate in each state in which they do business.
• The unauthorized insurer would be subject to fines and penalties by the courts if an insured were injured because of having dealt unknowingly with an unqualified insurer.

Legal Purpose

• A contract must have a legal purpose, an end or intention permitted by law.
• Contracts having an antisocial purpose are legally unenforceable.
• No court will aid the parties to such a contract.
• An insurance policy purchased as a gamble on a famous person's life or on any life in which the contract owner has no legal interest is an example of an unenforceable contract.
• If a beneficiary attempted to collect proceeds from contracts where an insurable interest was lacking, a court would hold the contract void.
  *Example: Mr. Smith fraudulently purchased a life insurance policy on the life of his girlfriend's child without her knowledge, claiming he was the child's father. When the young boy died under suspicious circumstances, Mr. Smith submitted a claim. It was determined that he had lied about his relationship to the child and had no legal right to apply for the policy. The insurer denied the claim as the contract was not a contract for a legal purpose. Mr. Smith did not have an insurable interest (legally recognizable economic relationship) in the child at the time he applied for the policy.

Section One Summary

• A general knowledge of contract law is essential to understanding insurance.
• Contract: A legally binding agreement creating rights and duties for those who are parties to it.
• Voidable contract: Allows one party the option of breaking the agreement because of an act or omission of an act (a breach) by the other party.
• Void contract: A contract that a court will not enforce because from it lacks one or more features of a valid contract.
• Binder: A temporary contract in property insurance and is often used before the issuance of the formal insurance policy.
• Conditional receipt: Provides temporary coverage, contingent on an applicant's ability to present evidence of insurability.
• Offer and acceptance: When one person makes a proposal to exchange something of value with another person. The proposal to make an exchange is called the offer. If the second person agrees to the exchange, this is called acceptance.
• Consideration is the value exchanged between the parties to the contract.
• Capacity: Not every person legally has the capacity to enter into a contract. Minors, those who are legally incompetent, and those who are intoxicated cannot enter into a binding agreement, for reasons of social welfare.
• Legal purpose is a requirement of a contract. It is an end or intention permitted by law.

Contract Characteristics

• This lesson provides an overview of the characteristics and principles involved with insurance contracts.
• To ensure that you have an understanding of insurance contracts the following topics will be covered in this lesson:
  • Principles of indemnity
  • Discharge of contracts
• Upon completion of this lesson, you should be able to:
  • Discuss the principles of indemnity
  • Explain the three exceptions to the rule that insurance contracts are contracts of indemnityDefine actual cash value
  • Define subrogation
  • Discuss discharge of contracts, including rescission and reformation.

Principles of Indemnity

• Insurance contracts provide compensation for an insured's losses.
• The insured should not profit from an insurance transaction, to avoid inducement to fraudulently cause losses or overstate claims.
• Indemnity means the insured should be restored to the same financial position occupied before the insured's loss.
• Any departure from this rule should be on the side of undercompensation.
• Insurers enforce the principle of indemnity through the insurable interest requirement, actual cash value settlements, and the operation of subrogation clauses.
  *Example: George has his 2015 car insured against collision damage. He has an accident that damages his car's hood beyond repair. The insurance adjuster tells him the local junkyard has located the exact 2015 hood in great condition, and his insurance company will pay for it to be installed and painted. George is upset because he wants a new hood. Which solution is more in line with the concept of indemnity? If George drives away with a 2015 hood, hasn't the insurer fulfilled its promise to put him back in the same economic position he was in prior to the loss? If he had received a brand-new hood even though the 2015 hood was available, wouldn't he have been in a better situation than he was prior to the accident?

Exceptions

• The three exceptions to the rule that insurance contracts are contracts of indemnity are:
  • Life insurance
  • Replacement-cost insurance
  • Valued insurance

Life Insurance

• Because the economic value of a human life cannot be measured precisely before death, life insurance cannot be a contract of indemnity.
• One could not be put in exactly the same financial position occupied before a loss because that position cannot be foretold.

Replacement-Cost Insurance

• Replacement-Cost Insurance is written when the insurer promises to pay an amount equal to the full cost of repairing or replacing the property without deduction for depreciation.
• If an insured loses an old, run-down building to a fire and a new building is built, the insured is obviously better off after the loss.
• Replacement-cost coverage is a typical feature of homeowners' insurance policies and is also found in other property contracts.

Valued Insurance Policies

• A valued insurance policy is an exception to the rule of indemnity.
• Valued policies pay the limit of liability whenever an insured total loss occurs.
• The value of the insured property is agreed to before the policy is written.
• If a total loss occurs, it may cause more or less damage than the stated amount. Nevertheless, the stated amount will be paid.
• The use of valued policies generally is limited to objects for which market value may fluctuate or be difficult to determine accurately after a loss, such as art objects and other collector's items.
• Underwriters do honor the principle of indemnity when writing valued policies and generally require insureds to get appraisals of their property to establish its insurable value.

Insurable Interest

• If individuals could insure property or a life in which they had no financial interest, insurance would become gambling.
• A policyholder would not be indemnified but enriched by a loss.
• Such contracts of insurance were written for a time in England. The fraud and murder associated with them caused laws to be passed in the eighteenth century prohibiting the issuing of insurance policies in which the policyholder lacked interest in the loss.

Property Insurance

• No one may collect insurance proceeds unless a personal loss can be shown from the insured event.
• In some cases, courts have allowed recovery where the insured had a contract to purchase a structure or the expectation of inheritance, but the transaction was not complete at the time of an insured loss.
• This description should make it clear that more than one party may have an insurable interest in the same property.
• In property insurance, this interest must be shown to exist when the loss occurs.
• A person may purchase insurance on property not yet owned. To collect the insurance proceeds, the person must demonstrate he or she suffered a financial loss from the insured event.

Life Insurance

• In life insurance, the policy owner must show a recognized interest in having the insured's life continue.
• This interest must be shown when the policy is purchased.
• People are presumed to have an unlimited insurable interest in their own lives and may purchase any amount of insurance on their own lives that an insurer will issue.
• The law presumes a husband and wife have an unlimited interest in each other's life.
• Beyond close family relationships, an insurable interest must be demonstrated.
• Interests that generally can be demonstrated include creditors in the lives of their debtors, partners in each other's lives, and employers in the lives of their key employees.

Owner

• It is the applicant who must demonstrate the insurable interest at the time of application.
• The insurer needs to know that the person who will be receiving the death benefit has an adequate relationship to the person being insured.
• The owner of the policy is the party who can enforce the contractual rights such as naming the beneficiary, assigning the policy, taking out loans from the insurer, and designating the dividend options.
• In most situations, the person being insured will be the owner of the contract. For estate planning purposes, a spouse or a trust may be the owner. In business situations, the company or the partners could be the owner of the life insurance contract.
• Beware of contract titling that places different individuals as the owner, insured, and beneficiary. For example, a life insurance contract on which one parent is the owner, the other parent is the insured, and the child is the beneficiary. This creates circumstances where a gift is made to the child from the surviving parent.

Beneficiary

• The beneficiary is the party receiving the funds at the insured's death.
• It is the beneficiary who must demonstrate the insurable interest at the time of application.
• The insurer needs to know that the person who will be receiving the death benefit has an adequate relationship to the person being insured.
  *Example: Insurable interest is commonly assumed for immediate family members such as a spouse, children, or grandchildren. Conversely, insurable interest would be needed from a beneficiary if he or she were an extended family member (e.g., second cousin), friend, or co-worker.
• Most often, the primary beneficiary is the spouse. Some divorce agreements now require that life insurance be maintained to provide for the children, naming the ex-spouse as beneficiary for the benefit of the children.
• To minimize estate taxes, the insured's estate should not be named as beneficiary.

Actual Cash Value

• Actual Cash Value (ACV) means replacement cost at the time of loss, less depreciation.
• $Replacement Cost - Depreciation = Actual Cash Value (ACV)$
• Actual Cash Value is one of the strategies used to implement the principle of indemnity.
• The insured can only recover the amount of the loss, even if the face value of the policy was higher because the property was over-insured.

Replacement Cost

• Replacement cost means the dollar amount required to rebuild a similar structure meeting the building code requirements in effect at the time of original construction.
• Replacement cost of a building does not equal fair market value of the property, because market value would include the value of the land and its location.
• Location can be an important factor in property value but not in replacement cost.
  *Example: It might cost the same to build a beautiful home in location A or location B. But if location B were downwind of an unpleasant-smelling agricultural plant, the home's market value would be less at location B.

Depreciation

• Depreciation is calculated as a percentage.
• The numerator is the number of years the structure was in use.
• The denominator is an estimate of the useful life of the structure.
  *Example: A building used for 15 years having an expected useful life of 60 years would be one-quarter depreciated $(15/60)$ and three-quarters undepreciated $(45/60)$.
• This depreciation calculation is not the equivalent of the accounting concept because the accounting concept is based on purchase price, while depreciation for ACV calculations is based on replacement cost and an estimate of the asset's useful life.

Functional Replacement

• Sometimes insurers do not use an actual cash value provision in their policies.
• In cases where the replacement cost of a building is greater than its market value, as is often the case with older, inner-city structures, insurers provide coverage based on replacement cost with modern construction techniques.
• Insurers call this provision functional replacement.

Subrogation

• Subrogation is the legal substitution of one person in another's place.
• Subrogation is supported by the theory that if a person must pay a debt for which another is liable, such payment should give the person a right to collect the debt from the liable party.
• Subrogation prevents insureds from profiting on their insurance by collecting twice for the same loss.
• Subrogation also prevents negligent parties from escaping payment for their acts.
• In insurance, subrogation gives the insurer the right to collect from a third party after paying its insured's claim.
• A typical case of subrogation arises in automobile insurance collision claims.

Discharge of Contracts

• Contracts can be discharged on the grounds of the following conditions:
  • Performance
  • Condition precedent
  • Condition subsequent
  • Rescission
  • Reformed

Performance

• In the normal course of events, insurance contracts end by performance; that is, each party does what it has agreed to do.
• The insurer renders payment if a loss occurs or stands ready to do so if none occurs.
• In most cases, no loss occurs. The insurer still performed as required by standing ready to pay legitimate claims.
• Insureds discharge their duties by paying premiums and abiding by the conditions of the contract.

Condition Precedent

• A condition precedent is something that must be done by one party to activate the other party’s duty to perform.
• Policyholders must continue to pay premiums in order to keep the policy in force.
• The insured must satisfy this condition precedent (i.e., paying premiums) before the insurer is obligated to pay the claim.

Condition Subsequent

• A condition subsequent ends an existing duty of immediate performance.

Rescission

• Insurance contracts also may be ended by rescission.
• Rescission is an agreement (contract) by both parties to end a contract.
• All the requisites of a contract are required.
• If rescission is mutual, both parties voluntarily relinquish their rights and duties under contract.
• If one party feels it was the victim of fraud, it may ask the court to rescind the contract.
• Rescission is a well-recognized equitable remedy from English common law.
• Applicants for life insurance are sometimes tempted to lie about their cigarette smoking because the premiums are so much lower for non-smokers. If the insured dies within the contestable period, and the insurance company discovers the person smoked, the company will rescind the contract and the only payment to the survivors will be the return of premiums.

Reformed

• If mistakes have been made in a policy, the policy may be reformed; that is, the policy may be corrected so one party cannot take advantage of the other party’s mistake.

Section Two Summary

• All insurance purchases involve contracts.
• Each contract has certain characteristics and principles involved.
• Principles of indemnity: The insured should be in the same financial position after as before the insured loss
• Exceptions to the rules: The three exceptions to the rule that insurance contracts are contracts of indemnity are: life insurance Replacement-cost insurance and Valued insurance.
• Insurable interest applies to property insurance and life insurance.
• Discharge of contracts may be done on the grounds of the following conditions:
  • Performance
  • Condition precedent
  • Condition subsequent
  • Rescission
  • Reformed

Module Summary

• All insurance purchases involve contracts.
• Insurance is a distinct branch of contract law.
• A general knowledge of contract law and some basic vocabulary and rules of contract law is essential to understanding insurance.

Contract terminology

• The various terminology used to understand insurance include:
  • Contract
  • Voidable contract
  • Void contract
  • Binder
  • Conditional receipt

Valid contract elements

• A valid contract must include:
  • Offer and acceptance: When one person makes a proposal to exchange something of value with another person.
  • Consideration is the value exchanged between the parties to the contract.
  • Capacity: Not every person legally has the capacity to enter into a contract.
    For reasons of social welfare, minors, those who are legally incompetent, and those who are intoxicated cannot enter into a binding agreement.
  • Legal purpose is a requirement of a contract. It is an end or intention permitted by law.

Principles of indemnity

• Indemnity means the insured should be in the same financial position after as before the insured loss.

Exceptions

• The exceptions to the rule that insurance contracts are contracts of indemnity are:
  • Life insurance
  • Replacement-cost insurance
  • Valued insurance.

Discharge of contracts

• This may be done under the following conditions:
  • Performance
  • Condition precedent
  • Condition subsequent
  • Rescission
  • Reformation