Business Insurance
The
Basics: Insurance Contracts
Chapter One
No person can be a specialist in all things. Just as doctors specialize, many other professionals also specialize, including agents. Many agents claim to know the products associated with business needs but relatively few could be considered specialists in the field. The true business insurance specialist is a valuable asset to the business community.
Marketing group insurance brings with it the responsibility of understanding state and federal requirements. This course cannot undertake all the various state laws so we will be dealing in generalities. It is the responsibility of each agent to be aware of their own states laws.
Group Insurance Principles
Group insurance can include any type of policy that covers groups of people that have come together for a common purpose. That purpose may be employment, but it can also include fraternities, labor unions, or any type of organized group. It is important to note that the group may not be formed for the sole purpose of buying insurance. Group insurance can include virtually any type of product, including auto insurance, but usually we think of group insurance in terms of health coverage. Group products benefit the groups in several way, but we most often associate it with reduced premium cost and group underwriting (versus individual underwriting).
Eligible Groups
As it relates to employer sponsored group insurance, one eligibility requirement is sure to include employment by the party sponsoring the coverage. Exactly what constitutes a group, however, can be far more encompassing. What constitutes an eligible group for group insurance purposes is regulated by law since it pertains to specific tax benefits.
Single Employer Groups
When XYZ Company brings in an insurer to underwrite a medical plan for its employees, XYZ becomes a member of the most popular group: a single employer making group benefits available to its workers. Employers can be sole proprietors, partnerships, or corporations. All sizes of companies can make group insurance plans available to the employees even if only one employee exists. However, it is medium and large-sized companies that are most likely to do so.
Multiple Employer Trusts (
When the group
is comprised of two or more small employers who have come together to purchase
a single group plan, they are called multiple employer trusts, or
A separate trust is formed to handle the group business, including collection of premium and filing claims. Multiple Employer Trusts are sponsored and administered by insurance companies and non-insurance organizations.
Organized unions are groups of workers who perform the same type of job or work in the same type of field, such as construction. Federal law requires a trust to be established to collect funds and administer the employee benefits.
The group does not have to be an employer or labor union. Any group of people can form an association or other type of group and purchase insurance on a group basis. Types of eligible groups in this classification must adhere to state laws on group eligibility. The group can be old car collectors, members of a community club, lawyers, or any group of people that come together for a common purpose (other that that of obtaining group insurance benefits). The group need only have a common relationship that is recognized by law.
When an individual borrows money they may become part of a creditor-debtor group. Creditor-debtor group insurance is offered by a lender to those who borrow money from them. Usually a form of disability or life insurance, its purpose is to protect the creditor if the debtor becomes disabled or dies prior to the debt being paid. Some credit policies are individually issued rather than group issued.
As we know group insurance is based on a common purpose of its members. In the case of creditor-debtor groups, the common purpose is the lending and borrowing of money from a common institution (a bank, savings-and-loan institution and so forth). Labor groups and other associations may offer this type of protection based on the group association as employers or members of the group. Credit unions offer such protection to their members, for example. Credit card companies also offer creditor-debtor insurance; their common purpose is the credit card itself.
In most types of group insurance, it is the group that is qualified and the insurer can usually be sure that the health or other risk factor involved is well mixed. When a credit card company or other loosely defined group markets creditor-debtor disability or life insurance products, members choose individually whether or not to accept the group coverage. Since those most likely to accept would have a reason for doing so (poor health for example) the possibility of adverse selection is much greater. Adverse selection is the likelihood of high-risk individuals outnumbering healthy ones.
A major advantage of group insurance is the ability to avoid individual underwriting. As a result, all members of the group have equal access to the benefits involved. Of course, insurers are still concerned about adverse selection (having primarily high-risk members), but this is much less likely to happen in a mixed group of people coming together for a common purpose other than obtaining insurance. Insurers view the group and underwrite it as a group. The effect of this is balancing of risk. The younger and healthier members will balance out the risks of those who are older and less healthy. Group plans also tend to have a shifting membership. In a company, some employees will stay for many years, while others will stay only a short time. There is a constant shifting of ages, health conditions, and other factors that relate to group underwriting. Group plans require the participation of a high percentage of eligible people to ensure that the plan is not composed primarily of those who are likely to have claims.
Group plans have requirements regarding when employees or other members join the group insurance plan. For employees, it is usually required that they sign up for coverage soon after being employed, usually within the first month. This prevents the employees from only joining the group insurance plan when they know they will need the benefits.
When
the group is a
As we know, it is an advantage for the insurer to have a large group since the law of large numbers then lessens their risk. The law of large numbers says that a sufficiently large unit of insureds will balance out the risk of claims. The younger and healthier enrollees will have fewer claims than older or sicker members, yet pay the same approximate premium rate. The larger the numbers involved the easier it is for the insurer to evaluate their potential risk and set the premium accordingly.
Just as large numbers help insurers, it also benefits those that are members of the group. The advantage that most enrollees are most familiar with is price. Another advantage is group acceptance regardless of existing health conditions or other claim risks. Group acceptance means that every person has equal access to insurance protection.
Group underwriting is becoming stricter, however. As the costs of medical care continue to rise, and since it is primarily health insurance that is underwritten for groups, insurers are looking closer than ever before at the people who make up the group.
Even when a business appears to have insured the necessary risks, it is prudent to constantly review the insurance portfolio. Most professionals feel an annual or even semi-annual review is necessary. Probably everyone would like to be able to simply submit an application into a vast marketplace that brings instant results, and to some degree this may be possible. Independent agents will submit proposals through multiple insurers, but that doesnt guarantee that all risks have been recognized. It is seldom that simple. While there have been online sites for pricing automobile insurance with multiple companies (often through a single broker) business insurance has been slow to follow suit. Part of the reason is the complexity of business insurance. It is unlikely that a business owner shopping online would realize all of his or her potential risks. Therefore, he or she could overlook some financially devastating possibilities.
Agents and brokers rarely appreciate consumer price shopping but it does actually benefit nearly everyone. When insurance companies must become competitive they tend to put out better products and promote service. In the end, this is a benefit not only to consumers but also to the servicing agents.
It can be time consuming to continually price shop for existing clients, but such service often brings about a loyalty that would not exist otherwise. Loyalty also brings about referrals. In addition it is generally harder to seek out and obtain new accounts. It is easier to renew and update existing business.
A common complaint from consumers is the difficulty of comparing apples-to-apples. Insurance companies each have their own format even when state regulations exist. Some types of insurance contracts have been better at regulating applicable forms than others. Of course, this is often due to state or federal legislation requiring companies to do so. A prime example is the Medicare supplemental insurance business. Congress mandated ten standardized forms that all companies were required to follow. This simplified a very complicated field of insurance. Other lines may have basic similarities for the convenience of the insurers (seldom for the convenience of the buyers).
Most consumers, regardless of the type of coverage being considered, want to know one thing: how much money for how much protection? Because consumers feel inadequate they often remain with an unsatisfactory coverage because they have no idea how to compare or who to compare with.
Agents realize that rock bottom prices are not always in their best interest when it comes to earned commissions. It may also not be in the best interest of the consumer if the company giving rock bottom prices are not financially stable or if the policy cuts price by cutting needed benefits.
Agents face a dilemma that may not have a satisfactory answer: the public perceives agents as greedy people who want to make a sale at any cost to the consumer. While there may be some agents that do fit this description the majority are professionals who are educated and strive to deliver products that fit the consumers needs. Of course, agents must earn enough commission to support themselves and their families, but seldom is that the first consideration for career agents. Unfortunately, many consumers will never believe that agents are concerned about their needs. Those who make a living downgrading the insurance industry strengthen this perception. While it is true that insurance buyers must realize that some insurance advice will be from those who gain a commission, this does not necessarily mean that the business owner is receiving inferior suggestions. Most insurance professionals are career professionals who depend upon referrals and policy renewals. It would not be sensible to give anything less than good recommendations to their clients.
It would be wonderful if all of our clients were informed on insurance products. While a few companies do have a person in charge of such things, most do not. Therefore, the agent must expect to spend enough time to fully explain all aspects of the proposed insurance. There is no doubt that it is easier to sell a product when no other agent is also offering a counter-proposal, but whether there is a competitive situation or not it is important that the buyer understand what they are purchasing. When the buyer is misinformed or does not understand the results can cause a backlash on the agent as well as the insuring company.
Most business owners do not feel they have the time or patience to fully shop their insurance needs. They are more likely to rely on an agent they hope is trustworthy and competent. Unfortunately, the consumer may pay a high price for being uninformed or misinformed, whether the fault lies with their agent or through their own lack of interest. Business owners find shopping and pricing insurance to be frustrating and time consuming and would prefer to spend their time on other matters.
Obviously, agents must earn a commission in order to pay their own bills. While the public (and sometimes even the insurers) would prefer agents earn as little as possible, an agent cannot do a good job for their clients if they are unable to support themselves and their families. Agents, like the consumers, must constantly look for companies that will allow them to make a livable commission while still providing benefits at a price their clients will accept.
An agent cannot expect their clients to blindly stay with them year after year. Unlike individual policyholders, businesses are more likely to shop the marketplace on an annual basis. This means that, despite the work you may previously have provided, they are willing to change agents if prices or benefits seem better elsewhere. Agents working the business insurance market must continually offer prices and benefits that are competitive. Therefore, agents in this marketplace must continually price companies and products and be willing to change loyalties when necessary.
Some insurers will insist upon specific volumes of business in order to renew contracts. Many insurance companies find it more profitable to do business with fewer agencies as long as those agencies bring in large amounts of business for them. When required volumes are not met, the insurers will cancel the writing contracts with those agents or agencies unable to meet the volume criteria.
Some agents and agencies also prefer to consolidate their business into fewer companies. This eliminates the confusion of working with larger numbers of companies who may underwrite differently or have different paperwork requirements. It simplifies the agents business. It also means the agent is not able to recommend as many products.
As many agents realize, insurers do not usually communicate competitive information (unless it is in their favor). It is a fact of life that agents must investigate companies, including those they represent, in order to know what is going on. Companies simply are not good at providing information. All their literature is aimed at new clients, not at helping agents maintain existing clients. Part of this is understandable: companies must be on guard at all times to prevent lawsuits. The less information put in print, the better protected they are.
Part of an agents job is providing insurance quotes. This is one of the major steps in acquiring new business and keeping old business on the books. Most agents provide a new quote each year to existing clients. The new quote compares their current company to others the agent represents. Captive agents may not be able to do this since they represent a single company. In that case, their yearly quotes will be more of an annual review of the existing coverage.
Although there are variances, providing a quote tends to follow these steps:
Many agents initially mail the annual quote to their clients and then follow it up with a telephone call. Some agents may present the quote in person, especially if the agent feels a change in companies is necessary due to price changes or benefits available. Unlike the policies written on individuals, where constant replacement may be frowned on by regulating authorities, business insurance often changes from year to year. Such change is considered to be normal business routine.
Those who give advice on insurance make the quoting process seem much more difficult. The Buyers Guide to Business Insurance[1] lists seven steps to the quote process rather than the three we have listed. Their view is from the consumers standpoint and assumes that the agent is not operating in the clients best interest. While this can certainly be true in some cases, career agents have learned that the clients best interest is also their own. It is usually easier to keep a client than find a new one. Therefore, career agents try very hard to work in a way that will retain current business.
An effective agent will keep informal contact with all their clients. This might be something as simple as a timely birthday card, a quarterly newsletter, or occasional telephone calls. Business insurance is purchased as a means of avoiding loss. Therefore, it is very important that the agent act in the best interest of the business by offering coverage for potential losses. A quarterly newsletter can be an effective way of introducing ideas in business insurance. A business could be severely affected if the agent is negligent. A substantial loss could actually shut down a business. Of course, the business owner has some responsibility in maintaining adequate insurance, but if he or she is relying on the knowledge and professionalism of their agent, the blame may be legally placed on that agent in court. Therefore, besides the fact that commissions are lost when adequate insurance is not recommended, it is also a means of avoiding lawsuits.
Every agent that is not captive to a specific company owes it to their clients to shop the marketplace for products. Although the time spent can be considerable it is usually worth it. As an agent gathers quotes for one account, much of the information will carry over to other accounts as well. Therefore, while the time spent might seem great, when it is averaged over the number of accounts that benefit, the agent profits as well as his or her policyholders.
Nearly every business is advised to shop the marketplace. If the current agent does not offer this service, they are likely to find one that does. If an agent has not shopped the marketplace for a particular account for several years, the loss of that client is likely. This is especially true if their premium rate has continually climbed. Business owners typically notice any expense that rises year after year. If their agent has not adequately explained the price increase there is no doubt that the client will be exploring other options.
Agents do not always have sufficient policy options available to them for some types of accounts. Unfortunately, some types of business insurance are difficult to obtain at reasonable rates, especially for small companies with few employees. Even when the agent wants to provide benefits at an affordable rate, they may not be able to. When insurers withdraw from a specific field of coverage it typically means a hardening insurance market. Just like investments, some types of insurance experience both a soft market and a hard market. When markets become hard (rising costs to insure with a lowering profit margin) companies will opt out, canceling existing policies and refusing new business. Agents must search the marketplace for available coverage, sometimes with unsatisfactory results.
When the existing agent is unable to secure the coverage at desired rates it is likely the business will seek out other agents in the hope of obtaining the coverage they want at a price they are willing to pay. Of course, the business may not be successful, but it does open up the opportunity for another agent to pick up the client.
It is common for a business to use the services of multiple agents or agencies. This is not only common; it is sensible. Agents tend to have areas of expertise, but seldom do they know everything about various types of coverage. Agents who learn to work together, often through the same agency, are able to bring together the knowledge of multiple agents to the benefit of their clients. While we would like to be able to do it all this is not realistic. Experienced agents realize both their strengths and weaknesses. Knowing this is an asset since it allows agents to combine their efforts with other agents whose strengths and weaknesses compliment each other. When agents look at their job from the perspective of the client, it can only benefit both sides.
It is important to know those that participate in the legal arrangements we call insurance policies.
The organizations that issue the policies are called insurers. They must be formed to administer insurance plans. They might be corporations, partnerships, or syndicates of individual underwriters. The ability to insure effectively depends upon a large number of people who are acquired by insurers, often through sales representatives called agents. This group of people may be referred to as the field force. The agents may be either employees or independent contractors. Often insurers hire management people to provide any needed training and supervising they feel necessary, but this is not always the case. Many insurers offer very little training or supervision. In this case, agents are responsible for acquiring any training or extra knowledge that might be necessary to appropriately represent the companys products.
In order for a policy to be sold someone must agree to pay for it. The person who buys the policy is called the insured. There may be more than one insured on the same policy, but in business insurance this usually applies to the company itself (the entity named as the insured). Individuals buying personal policies are more likely to have more than one insured named in the same policy. A company may, however, have more than one type of risk or multiple locations covered under one policy. The term insured is not always used. Other terms that may better apply in some cases are policyowner, certificate owner, subject, beneficiary, claimants, or master policy owner. For practical purposes, insured merely means the person, property, or entity that is covered by the policy.
Since insurers deal in promises a legal document is required. That legal document is the insurance contract or insurance policy. These contracts define the promises made by the insurer to the insured. They define the exact circumstances under which the insurer will pay and the amount that will be paid. Lawyers must prepare the contracts so there is necessary legalese involved. Since lawyers do not always agree, even though one set of lawyers may write the contract, it is not unusual for another lawyer or group of lawyers to contest the meaning. One might believe that the insurance company would be the determining factor since their lawyers wrote the contract, but that is not necessarily the case. Since it involves a contract, the courts must often decide how payment is due under the contract (policy). Even if the intent of the original policy is misstated in the contract, the word of the contract prevails (or how the courts decide the contract reads).
There is the industry joke: How many lawyers does it take to write an insurance policy?
Answer: Three; one to write the policy, one to dispute it, and a third to decide who is right.
Of course, developing a policy is not just the job of an attorney. It also involves analysis of a risk and the number of people or companies that risk involves. There are technical and economic considerations in this process. Rates and restrictions must be applied in a way that would make the insured risk profitable for the company and applicable to enough people or companies to make the issuance of such a policy worthwhile. These decisions are made by underwriting specialists who take their job very seriously. An error can cause the insurer severe financial problems. Some of the specialists involved might include engineers, statisticians, physicians, meteorologists, and economists.
The success of an insurance policy depends upon the equitable distribution of cost among those participating in the risks, which are the insureds. Underwriters classify and rate each loss exposure to maintain a semblance of equity among the policyholders. For example, a business that manufactures brooms and wants to insure against burglary will be charged a rate comparable to other similar manufacturers. Premium costs will vary based on the probability of the burglary occurrence (location of the business is often a major factor) and the probable severity (what does he have that would be expensive to replace and likely to be stolen?).
To avoid adverse selection, it is necessary to have a large number of policyholders that want to insure against the same risk. Even so, the insurer may not be able to insure all that wish to be insured against the loss. Following the principles of insurance requires skill in the selection of applicants. Underwriters must refuse some because the likelihood of loss is too high. In some high-risk geographical areas it can be very difficult to obtain insurance at all. The incidence of burglary is just too high for insurers to want to issue policies. Or, the underwriters might choose to issue a limited amount of policies in a given area to limit the amount of risk they assume. Highly concentrated exposures run counter to sound underwriting principles. Additionally, underwriters may refuse an applicant due to the physical nature of the property or the moral character of its owner. In some industries this would be viewed as unethical, but in the insurance industry it is the premise on which underwriting is based. They are legally allowed to discriminate when issuing insurance policies.
Insurers are financial institutions; they collect, accumulate, and distribute funds. The nature of insurance requires that they be expert handlers of money. Some liability claims, for example, take years to settle. Insurance companies must invest large sums of money to insure that when claims are settled, there are sufficient funds to pay claims. As a financial institution, insurers have a significant effect on our economy.
The courts have determined that insurance affects the public interest. Much of the insurance regulation in our country has to do with protecting the public. In fact, public regulation affects nearly all aspects of the insurance industry. In nearly all cases, legislation has to do with financial aspects of the industry and how that affects the consumer. Anytime incompetence or dishonesty is involved in an insurance transaction, it affects the consumer in some way.
The concept of a business having a public interest is not new. It originated in 1676 with the British jurist Lord Chief Justice Matthew Hale. It took an additional 200 years, however, for the U.S. Supreme Court to establish first that a business was affected with the public interest and then apply due process. In this case, the Court affirmed the states right to regulate when a public interest existed. Under the Courts ruling, when people (a business) operate in a manner that involves the public, that grants the public an interest in the operation of the property or business. Therefore, the people or business must submit to control by the public for the common good. Such control was held to be a legislative question rather than a judicial one, which would have involved due process. Therefore the courts cannot substitute their judgment for the legislature on a regulatory policy under the guise of due process.
How does an individual know if their business has a public interest? According to the Court, there is a public interest when the action or product affects the community at large. Obviously, insurance products do affect the community. The Court says a public interest extends to any industry that needs to be controlled for the good of the public. Since insurance products affect those insured financially, regulation of the industry was certain to happen.
Insurance is regulated from the beginning of the process to the end. The formation of insurers, a companys liquidation, policy provisions, rates, expense limitations, valuation of assets and liabilities, how funds are invested, and agent licensing are all regulated by either the federal or state governments. Regulation is sometimes more intense for some forms of insurance than it is for others. For example, anything to do with the senior marketplace tends to receive greater focus because it is perceived that the elderly are more vulnerable. Regulation will vary from state to state and each agent must know their own states requirements. This is not optional. When an agent receives their license they are, from that point on, legally required to know and fully understand their states laws and follow them appropriately. As the saying goes: Ignorance of the law is not an excuse.
Insurance is important to the United States because it helps us provide social values that might not otherwise be possible. Policies eliminate barriers that would otherwise exist by allowing new business entities to develop, new technologies to be explored, and individuals to rise above their current financial status.
There seems to be an adequate supply of people who write and lecture against insurance, but their views are limited to what they perceive as inadequacies or poorly made consumer choices. Even our government uses insurance underwriting in order to allow certain activities to exist (Social Security is a good example of this). If insurance were not available, those who wished to open a business in low-income areas of the United States might not be able to do so. If insurance were not available it is likely that Americans would have to pay cash for their vehicles and homes. Lenders would probably not be willing to allow purchasers to pay on time using the item as collateral since a loss would mean the lender had no recourse for compensation. Insurance is a primary reason our credit system works in the United States. No matter how insurance is considered, it is necessary if we wish to maintain our current standard of living.
Perhaps those that dislike the insurance industry need to concentrate on specific details. One of the major problems relating to consumer choices is imperfect knowledge. Obviously the consumer believes they are purchasing a product that will adequately cover their needs, but that may not be the case. It might also be true that those who bash the industry are actually bashing the agents that are not sufficiently educated so their advice is flawed. In either case, someones knowledge is imperfect. Insurance is merely a tool we use to meet specific goals. Insurance is neither bad nor good. How it is used may be good or bad in that it either does or does not succeed in the desired goal.
Imperfect knowledge is also why we desire insurance. We do not know if our business will suffer a fire, wind damage, or theft. If we knew, the purchase of insurance would certainly be easier (where are all those crystal balls?). The purchase of insurance offsets the lack of knowledge. By purchasing insurance the uncertainty of financial loss (resulting from a specified set of causes) decreases one of the obstacles to competition.
Through loss prevention activities insurers also contribute to the economy by decreasing the chance of loss for those who buy insurance. Insurers maintain large engineering staffs that monitor and study accidents to see why they happened. This brings about new ways to prevent future losses due to similar circumstances. Of course, they also support safety measures and research, medical research, and health education.
We previously mentioned that insurance plays a very important role in the credit system for Americans, both in a private capacity and in a business capacity. What good is an ironclad loan made on the security of property if a fire occurs and the building is not covered for the loss? If that happened, the lender would be in no better position to collect than if he or she had loaned on the mere signature of the borrower.
Insurance companies certainly play an active role in finance. They influence investment and financial markets around the world. Insurers fund the growth of basic industries and engage in financing government projects.[2] Conglomerates of insurers have organized mutual funds, real estate investment trusts, financial consulting services, and investment brokerage firms. Some insurer activities might be more accurately called extracurricular business operations since they are outside of the routine insurance transactions.
Insurance is used to solve social problems as well as provide personal financial security. Compensating victims of industrial accidents is handled by compulsory workers compensation insurance, for example. We use social insurance for the problems associated with old age, unemployment, disability, death, and medical care for the elderly or disabled.
There are social costs associated with social insurance. Not all premiums that are paid by policyholders are used to pay losses. Operating expenses are not always contained as efficiently as they should be. Of course, we realize that any kind of company has overhead and this is also the case for insurers. However, there are cases where overhead is not effectively managed.
There is another social cost of insurance that has nothing to do with how companies manage their funds: fraudulent losses. Insurers are the victims of arson, murder, disability, and theft claims. This list is not inclusive as there may be other types of fraud involved. When a person or company willfully destroys property or takes lives in order to collect from an insurance policy we recognize the financial fraud involved, but we should not overlook the less obvious social cost. Insurance may reduce the incentive to protect property from loss. It may also encourage one individual to harm another for the sake of greed. Additionally, since a third party makes payment, the insurer interferes with normal cost control mechanisms between consumer and provider. We especially see this in the health marketplace. Healthcare premiums have skyrocketed as individuals seek more and more services (as long as someone else is paying the bill).
We know that insurance is said to be affected with the public interest but what does that really mean? Certainly insurance affects us as it allows us to buy on credit, insure the future of our family, or offset the potential losses we would otherwise face. That still doesnt define how the public is affected. Some professionals believe that insurance should be regulated as railroads and public utilities are, while others favor increased competition as a way of controlling costs and other factors. The exact role of insurers has continued to be in dispute, with some favoring additional restrictions and others favoring less. Insurers have helped reduce many of our social problems, but can we expect private industry to be responsible for doing so? Choosing to financially assist our social issues and being required to assist are two different paths. Few businesses would want public interest to be a requirement (although some safety and environmental requirements do exist).
It is interesting to note that the objectives of the insurance industry may actually conform to many of our social goals. For example we want those who are disabled to be able to support themselves without public funds (taxpayers dollars), so when insurers make a profit selling disability insurance both parties benefit. Achieving a high degree of loss predictability by reducing social unrest, minimizing the chance of unexpected loss, lessening damage from catastrophes, and encouraging loss prevention all provide useful social functions in addition to stabilizing insurers profitability.
Risk management deals with two fundamental functions: loss financing and loss control. This often means the purchase of an insurance policy sold by a licensed insurance agent. Since insurance is the cornerstone of most risk management loss financing programs it is important that the agents selling these policies understand them.
An insurance policy is a legal contract establishing the rights and duties of both the policyowner and the insurer. The policy is a complete document. Even so, it may be necessary to refer to statutes and previous court rulings for its correct interpretation.
The types of insurance contracts can be vastly different since they insure vastly different types of risk. As a result, it is not possible to give a precise definition of an insurance contract; the definition will always be basic rather than precise. In a broad sense the definition is:
Insurance is a financial arrangement where one party agrees to compensate another for a loss if it results from occurrence of a specified event.[3]
This definition, while adequate, does not address policy specifics. It does not include all the variations that a policy contains. Additionally, it could be attached to contracts that are not even an insurance policy. For example, some agreements provide compensation to another for a loss subject to the occurrence of a specified event even though it is not an insurance contract (such as some types of maintenance agreements provided by dealers and manufacturers).
Insurance and non-insurance that both meet the broad definition are different because non-insurance does not include loss by external causes, such as fire or theft. Additionally, anything that is classified as insurance becomes automatically subject to insurance regulation by the individual states and federal government. Common law and statutes peculiar to insurance determine the rights of parties in an insurance contract. Corporations operate under charters that limit their activities. Any company that wrote insurance without the necessary charters and licenses would be committing an ultra vires act, meaning beyond the authority.
Not everyone has always agreed on the distinction between insurance and non-insurance contracts. This was recognized by the courts in State V Hogan in 1899 when the courts said:
Necessarily, in defining insurance in a single sentence, only the most general terms can be used, and any general definition must be extended to cover the ever-changing phases in which the subject is presented to the public.
With the problems that exist in defining insurance it should not surprise any agent that multiple versions of the definition exists. Another that you will commonly see is: Insurance is defined as a device for reducing risk by combining a sufficient number of exposure units to make their individual losses collectively predictable. The predictable loss is then shared proportionately by all units in the combination.[4]
Throughout this course you will be told that every selling agent has the responsibility of reading the actual policies they sell. This is not only a responsibility it is prudent. The courts have determined that agents are, by the very nature of their chosen career, contract specialists. Therefore, agents are legally responsible, as well as ethically responsible, for errors in placing appropriate contracts. An agent that has not read the policies they are selling (not just the insurer brochures) may find himself or herself in a legal dispute due to a misplaced product.
There are two basic instruments used in insurance transactions: the application for coverage and the insurance binder.
The function of the insurance agent is to sell policies. The internet system we have today has eliminated the agent entirely in the selling process of some contracts. The consumer can simply go online and select the product they desire. Of course, the elimination of an agent is not new. There have been insurance products sold through the mail (without use of an agent) for years. However, agents still remain the most effective way for insurance companies to market their products. From the consumer standpoint, the function of the agent may be to find the products they desire. Consumers may not have the education or experience to find the necessary products on their own. Some types of insurance products require a written application on forms supplied by the insurers. This would include life, health, hail, livestock, and credit insurance applications. Historically, property and liability insurance applications have been oral and informal, especially for personal lines, such as auto and homeowners insurance. Even today, many of these contracts are oral, although the trend is to use standardized model application forms.
An oral application can cause errors in interpretation, which might result in a lawsuit. A written application eliminates potential problems since signatures are obtained outlining the types of coverage being purchased or applied for. A written application usually includes such things as detailed policy information (what is being purchased and for how much) including loss exposures. Some applications indicate whether or not the agent has binding powers. Nearly all written applications contain the notice that agents do not have the authority to modify the terms of the application or the policy.
The primary purpose of an insurance application is for underwriting and identification of the applicant. Some applications for insurance may have legal consequences in contract formation since they must be formatted as prescribed by either state or federal insurance authorities. One such example of this would be Medicare supplemental insurance policies, which must follow strict federal guidelines. Other types of insurance applications contain a number of statements that affect the contract after it is made. In life and health insurance, the application is made a part of the contract because most states prohibit insurers from using statements of the insured in contesting a claim unless these statements are part of the written contract. By including the actual application as part of the contract, their health statements and other elements are then part of the written contract. Why does this matter to the insurer? Consider this example:
Mollys daughter, Jennifer, has noticed that her mother is increasingly forgetful. Molly leaves the stove on, forgets to pay her water bill, and fails to show up at her scheduled doctors appointments. When Jennifer consults her mothers doctor, she is told that her mother is likely in the early stages of a mental disorder, such as Alzheimers disease. Since no tests have been done, he cannot conclusively say this is true, but all the facts of her forgetfulness indicate it. Of course, the doctor makes notes in Mollys file to further investigate this.
Jennifer decides she should immediately obtain a nursing home policy for her mother in case the doctors initial conclusion is correct. She sets up an appointment with a local agent, Jim Brown. When Mr. Brown is filling out the application for nursing home coverage, he asks Molly and Jennifer if she has been diagnosed with any type of mental disorder, such as Alzheimers disease. He explains that this would include diagnosis or treatment, including medication. Jennifer feels she is right is saying no to his question because she does not feel an actual diagnosis has been made by medical personnel.
When a claim arises in the first year after the policy has been issued for treatment of Alzheimers disease, the doctors files on Molly are requested. At this time the insurer notes the conversation he had with Jennifer suggesting Molly has a mental disorder. Therefore, the claim is denied. If Jennifer takes this denial to court she could lose since the application is part of the policy and the conversation with the doctor was not disclosed.
Declarations are informational statements about the exposures to be covered and usually form the basis for decisions by the underwriters regarding issuance of the policy and rating of the insurance. In some types of insurance, the declarations are included in a written application attached to the policy. When a written application is not required a declaration schedule is in the policy and becomes part of the actual contract once it has been accepted.
The applicant or the broker provides the information in the declaration. The declaration would include the name of the insured, location of the exposure, type of business, and other pertinent information necessary to issue the policy. In personal auto insurance the declarations include information about the covered automobile, such as make, model, year of manufacture, body type, list price, date purchased, use, distance traveled to work, and the principal area where the car is driven, such as urban, suburban, or rural. The declarations will also ask about specific driver characteristics, including gender, age, occupation (including student status), and driving record. Not all states allow the insurer to include age and gender but the insurer will use this information when possible since it indicates the likelihood of a future driving accident.
Lately there has been the disclosure that insurers have also included credit histories of those requesting insurance. Insurers state that a persons credit history might indicate the amount of claims that will be filed (suggesting that those with money problems may be more likely to file false claims). Several states have taken steps to prohibit this practice since it seems to be biased against the poor.
A binder is a temporary contract, pending the issuance of the actual policy. While binders may be either written or oral, they have traditionally been oral. For example:
Gerald purchased a new car. When he got home, he called his agent on the telephone and requested coverage. His agent gave Gerald a binder over the telephone (an oral promise of coverage) effective on the date he called.
While this is a common practice, the disadvantage of an oral contract is the difficulty of proving its existence. Even so, such oral binders often precede their written confirmation.
In some types of coverage, insurance takes effect once the agent convinces the consumer that such insurance protection is necessary. Once the consumer says I want it and the agent replies with some version of You have it a legal oral binder has been executed. Of course, it is subject to legal contract requirements, legal purpose, and so on. Once an oral binder has occurred, the agent is responsible for recording the binder, the terms of its coverage, and the parties involved. Geralds agent, for example, immediately wrote up the coverage following the telephone call and submitted it to Geralds insurer (and to the financing institution in many cases). Agents routinely follow an oral binder with a written record stating the terms of coverage, the parties involved, and the cost of the insurance. The desire is to prevent disputes due to misunderstandings of what was purchased and for how much. It is especially important to issue a written binder on contracts that are not standardized. When policies are standardized, the courts assume that the binder conforms to the required standard policy provisions.
As we have stated, not all policy types allow agents to bind them. Property insurance agents usually do have the power to bind the insurer and issue the policy. Even so, for certain types of coverage, insurers will request their agents to delay writing the policy until the insurers have inspected the exposure to see if it meets underwriting standards. In some cases, it will be the agent themselves that inspect the exposure for the insurance company. Some types of exposure require investigation of the applicants moral character and financial status. When other underwriting factors are favorable, insurers are often willing to bind coverage temporarily while the investigation is conducted. The policy itself is not likely to be issued until the insurer knows they will accept the applicant.
Binders are not used in all types of coverage. Individual life insurance and health insurance does not use binders, for example. Life insurance sales typically use agents who solicit the business; they are considered soliciting agents rather than contract-writing agents. Soliciting agents seldom have the power to bind a policy. That is typically a power given to contract-writing agents. Polices, such as life contracts, are noncancellable and insurers want applications approved in the home office prior to issuing the policies. As it applies to life and health insurance, insurers are not willing to be bound, even temporarily, by an agent. The possibilities of large claims are just too great.
Some types of insurance could attract those who are unscrupulous if binders were available. For example, an agent may bind a policy, but when it arrives the buyer may refuse it. Although the client is legally obligated to pay the premium for the period it was activated, most agents merely cancel the entire policy rather than collect the premium for a short period of time. Suppose binders were available for health insurance:
Adam does not have the funds for a health policy so he devises this plan: He goes to agent A and has him bind a health insurance policy. It takes the insurer 30 days to underwrite and issue the policy. When it arrives, since no claims have occurred, he cancels the policy upon receipt of it. If a claim would have occurred, Adam would have accepted the policy and paid the premium (while receiving payment for his claim).
Since no claim occurred Adam refuses the policy, never paying a premium. He then goes to agent B and has Agent B bind a health insurance policy. Again, when it arrives, since no claim occurred, Adam refuses the policy.
If Adam can find twelve agents who have binding ability for health insurance, he could end up with free health insurance throughout the year. Of course, it is not likely that Adam would find an agent who could bind health insurance, but this gives you an idea of why some types of contracts do issue binding ability to their agents.
Agents could also abuse the ability to bind a policy. Some agents have indicated they could bind a policy, even though the insurer had not issued them that power. Usually these agents have falsely conveyed this ability to secure the sale of a policy, but it is a dangerous game to play. Issuing an oral binder when no binding authority exists puts the agent in a legally liable position if a loss occurs. It is always important to specifically inform the client that no binding power exists when that is the case. If a client believes they are guaranteed coverage (that the agent has binding ability) he or she may cancel an existing policy. If the newly applied for policy is denied there is no guaranteeing that the old policy can be reactivated. Additionally, if a claim occurs during the period that no policy was in force, the agent could be legally liable.
Contract Elements
While it might benefit company owners to be knowledgeable on legal forms and insurance conditions for valid contracts, it is essential that agents possess this knowledge. While such knowledge might prevent the buyer from a nasty surprise, if the agent acts responsibly there should be no surprises.
Contract Agreement (Offer and Acceptance)
An agreement consists of an offer made by one party and accepted by another. The buyer makes the offer for insurance when he or she submits the application. It would be unusual for the insurer to make the offer. The exception is found in life insurance where the insurer may make an offer if the first premium is not sent in with the application.
Since some types of insurance begin with an oral application, such as Gerald calling his agent to initiate coverage on his new car, there is immediate coverage if the agent accepts the requested risk. Offer and acceptance are completed because the agent has the power to bind. Obviously a telephone call would not bind unless the power to do so was given to the agent by the insurer.
As we know, not all contract types can be immediately effective with a simple telephone call. In those cases, the insurance is not effective until the policy is issued. Some policy types will allow the effective date to be the date the application was filled out and signed by the prospective buyer and the presenting agent. When the effective date requested is the same date as the application, it is necessary that premium be submitted at the same time. This does NOT guarantee that the policy will be issued. The buyer will receive a conditional receipt. Conditional means that the buyer must still qualify for the policy in order for it to be effective.
When a conditional receipt is issued, it typically states that the face amount (for life insurance) will be paid upon the insureds death even if the policy has not yet been issued. However, this is conditional upon the insured meeting the underwriting requirements of the company. This would include a medical examination if that is one of the requirements.
For Example:
Mitchell applies for a life insurance policy. The company requires that he receive a medical examination prior to policy issue. This requirement is met on Wednesday. On Thursday, a drunk driver hits Mitchell killing him instantly. Mitchell met all underwriting requirements of the issuing insurance company, so they paid the full face amount of the policy he was in the process of buying.
Jose applied for a life insurance policy on the same day that Mitchell did. His medical examination was also set for Wednesday. However, Jose died suddenly on Tuesday one day prior to meeting the underwriting requirements of the insurer. Because he did not meet all underwriting requirements the company will not pay his beneficiaries the full face amount of the policy (he did not meet all the conditions of the conditional receipt).
Not all companies or policy types will require a medical examination. If Jose had applied for a life policy that did not require a medical examination, then his insurer would have paid the death benefit because he had paid his first premium and met all other underwriting requirements. A conditional receipt is always conditioned upon meeting all underwriting requirements. In other words, the applicant would have been approved and issued a policy under normal circumstances.
It is important to note that state laws can vary. For example, in 1965 a New Jersey court ruled that if the premium is collected with the application the policy is in effect from that moment until the applicant is notified of rejection.[5] The pivotal point is the acceptance of premium. Therefore, some types of life insurance applications no longer allow the agent to collect any premium with the submitted application for coverage. Acceptance of premium grants insurance coverage, at least until a written denial of coverage is received from the insurer.
In most states, silence from the insurer does not mean the application has been accepted, but in some jurisdictions silence is considered acceptance. All of these rulings have placed additional responsibility on the writing agent to know and follow their states requirements. Who is responsible if the agent fails to understand their responsibilities?
For example:
John is a new insurance agent. He writes a policy for life insurance with a company that does not accept premium until the policy is issued. John does not realize this and collects one months premium from Lew at the time application is made. Lew dies from a heart ailment the next week. This was an existing, known condition that was stated on the application for insurance. The insurer would have rejected Lew due to his heart condition; he was not eligible for coverage under the underwriting guidelines of that insurer. Lews son finds the paperwork for insurance along with the receipt that John left at the time of application. He contacts the insurer demanding that they pay the face amount of the life application. Is the insurer liable for payment?
Yes. Even though John did not follow the insurers instructions and should not have collected the premium, the fact that he did made the insurer liable. The insured and the insureds family could reasonably believe that John had binding powers. The insurer does have the legal option of going after John for reimbursement but they must pay Lews beneficiaries.
If an insurer allows it, the consumer is always wise to pay a premium when applying for insurance. Once the policy is received, if the buyer does not cancel the policy, he or she is legally liable for paying the premium that is due. Many types of policies have specified time periods during which the buyer must cancel if they wish to avoid paying the premium. The time period varies by policy type and the jurisdictional state, but usually it is between 10 and 60 days.
Competent Parties
Insurance contracts require at least two parties: the seller and the buyer. For a policy to be valid, the parties involved must be legally competent to enter into a contract. As far as the insurer is concerned, as long as they have complied with the necessary regulations that permit them to write insurance, they will be considered competent. The buyers competence is much more complicated since it might involve minors (those under the legal age of consent) or individuals who are not mentally competent. The law often refers to minors as infants.
If a minor enters into a contract with an insurance company, the policy is voidable at the minors request. Even so, the insurer must honor the contract unless disaffirmed by the minor. The minor may also cancel the policy upon reaching legal age if he or she so desires. The disaffirmation must happen within a reasonable time (typically stated in the policy) and before committing an act constituting ratification of the contract. What would constitute ratification? Ratification would include any conduct that indicates approval or satisfaction with the contract. Certainly filing a claim would apply. Returning a signature form would as well. Many agents request a signature form as a result. It is not necessary to give a reason for canceling a contract.
There always seems to be an exception to any general rule. In this case, that exception applies to contracts made for necessaries. Such obligations may not be disaffirmed because the law holds minors responsible for the reasonable value of necessaries furnished to them. In other words, people of all ages need to have health insurance. If a minor person applies for health insurance, he or she is obligated to pay for it as long as the policy was accepted at issuance.
Necessaries are whatever is needed, measured by age and position in life, for the minors subsistence (food, clothing, shelter, medical services, education, and sometimes an automobile). Necessaries are distinguished from necessities in that the latter is considered the basic minimum essential for existence.
Many of the states have enacted statutes that reduce the age at which contracts for life and health insurance bind minors. Usually this applies only to policies on their own lives, although it may benefit others such as their parents or siblings (as beneficiaries).
It is much more difficult to define a mentally incompetent person. An agent is not necessarily qualified to know if they are dealing with a competent person. In fact, some Alzheimers patients are able to carry on a conversation in a very normal fashion. While a family member might be able to determine abnormal behavior or questionable conversation a stranger would not.
A person officially declared insane or mentally incompetent is not legally competent and may not enter into a valid insurance contract or any other legal obligation. A mentally incompetent person that has not been legally declared as such can enter into a contract, but may be voided at their option. Since an incompetent person has the legal ability to void the contract at any time it is in the insurers best interest to avoid issuing the policy, unless issuance would provide no financial hardship for the insurer. That would usually depend upon how claims would be made in the event of a loss.
The test of insanity is the ability to understand the nature of the transaction. The rigid application of this as it relates to insurance buyers would depend upon many factors, most of them relating to the type of coverage being purchased. Obviously one of the most important types of insurance coverage relating to mental competence would involve health insurance that pays benefits for mental care.
Insurer Incompetency
Before an insurance company can enter into a legal insurance agreement (policy) it must have the legal ability to do so. Companies are typically very careful about meeting all legal requirements. For the corporate insurer the legal capacity to contract is expressed in its charter or articles of incorporation. If a state declares an insurer incompetent to transact business (having failed to follow licensing or other requirements) all transactions will be voided and the premiums returned to buyers. Corporate officers are responsible for the ultra vires act and are subject to personal liability under the contract. Most courts uphold the insureds agreement with a legally incompetent insurer if the agreement was made by the insured in good faith, without knowledge of their failure to comply with a legal state or federal requirement. After all, there is no reason to void contracts desired by the buyer if the insured is not maliciously failing to comply with state or federal requirements. Additionally, the insured would have no way to know if the insurance company is in good standing or not. If an otherwise competent insurer writes contracts in a state without first complying with that states laws, it is bound by these contracts but its responsible officers are subject to penalties.
Public Interest
Obviously insurance contracts must address legal issues. No court would enforce a contract with an illegal purpose. In addition no court would enforce an insurance contract that promoted results contrary to the public interest. What exactly does that mean? It means it is possible to purchase insurance to cover losses but not to promote illegal activity. For example:
Gus can purchase an insurance policy that will pay him if another person burglarizes his home. He cannot purchase a policy that will pay him if he is injured while burglarizing his neighbors home.
It is possible to purchase insurance for loss that is not directly linked to illegal activity. Even though a building may be housing illegal activity, it is still possible to insure contents that are not linked to the activity. For example, it has been legally established by the courts that fire insurance can be written on furniture in a house of illegal prostitution.
Consideration
An insurance policy is only valid if both the buyer and seller give value or assumes some obligation to the other. Insurance contracts often state that the insureds consideration is the provisions and stipulations herein and of the premium specified. This does not mean that premium must be paid at application, only that premiums must be paid at some point. Otherwise, oral binders could not be used. It is the promise to pay that is the buyers consideration, not the actual payment. The insurers consideration is the promise to pay a loss covered by the issued policy.
Contract Characteristics
Insurance contracts have characteristics that are specific to the insurance industry. While some general characteristics might be found outside of the industry, others are peculiar to insurance policies.
Contracts are either commutative or aleatory. Most contracts are commutative. That is, each party gives up goods or services presumed to be of equal value. It is only necessary that each party believe the goods or service are of equal value; no outside authority need substantiate this. Insurance contracts are aleatory. Each party understands that the dollar amount to be exchanged will not be equal. For example:
Russell gives his insurance agent $150 for the first months premium on a disability policy. He does so for five months ($150 X 5 months = $750). After five months he suffers an accident that makes him unable to work. His insurer pays him $1,000 per month for the six months that he is unable to work ($1,000 X 6 months = $6,000). Russell has received $6,000 in exchange for the $750 in premiums that he paid his insurance company. Obviously, this was not an even exchange.
Maxwell took out the same policy Russell did. However, Maxwell never suffered any disability. He merely paid his premiums until his retirement fifteen years later. In this case the insurance company received his premium payments month-after-month, but never returned anything to Maxwell.
The distinguishing feature of an aleatory contract is the presence of chance. This characteristic does not mean that the insurance policy is worth more or less than the premiums paid and, in fact, it would not be possible to state one result or the other. There is no way to know who will experience a claim and who will not (although insurers go to great lengths to predict anticipated results). The insurer is anticipating collecting adequate premiums to cover losses and expenses. Both the buyers and sellers hope that no claims will result since that is the best outcome for both parties (who would desire a house fire or ill health?). Both buyers and sellers also realize that claims will happen; they just cant identify who they will happen to.
Adhesion
Most insurance contracts are contracts of adhesion. Adhesion contracts are prepared and made available by an insurer to the applicant who must either accept or reject it in the form offered. The agreement is typically prepared by attorneys although they must do so in the forms required by state and federal regulating authorities. The applicant is not empowered to make any changes or alterations to the coverage being offered; it is a take-it-or-leave-it offer of protection. It is not possible for the buyer to make a counter proposal. However, it is possible for the buyer to make alterations within the policy by choosing options, endorsements, or riders that are offered by the insured.
What many people would not realize is that a contract of adhesion, such as insurance policies, benefits the buyer. Courts have ruled that since the insurer drew up the contract, any ambiguity in the policy must be interpreted in favor of the insured. As a result, policies seem very long-winded with explicit language, explanation of terms, and repetitious policy exclusions. This has become necessary since the insurer does not want any misunderstandings or unintended interpretations in favor of the buyer.
Some court interpretations have caused policy revisions. The insurance company may believe they have clearly defined the circumstances under which benefits are available only to have the courts see it a different way. When this happens, insurers address the problem with additional clarification in the policy.
Courts have routinely advocated for the buyer rather than the seller of insurance policies; it is not a new development. On June 18th, 1536 Richard Martin, a marine underwriter operating in the Old Drury Ale House in London, suggested to some of his underwriting friends that they might be able to extend their business to include insuring human life. Richard Martin, full of self-confidence, proposed to insure the life of William Gybbons, described as a hail-fellow-well-met sort of individual, rubicund of jowl, healthy of person, and apparently destined to live the full biblical three score and ten, for 12 months in the amount of $2,000 for a premium of approximately $80. Fifteen other underwriters joined in the proposal. Gybbons accepted. He died on May 29th, 1537 only a couple of weeks before his policy would have expired.
Richard Martin was so upset at having to pay Gybbons beneficiaries that he contested the claim. Their plea to the court was that in insuring Gybbons for a period of 12 months they had in mind that the contract was to run for 12 lunar months of 28 days each (which would mean the policy had expired on May 20th - prior to his death). The courts did not accept this explanation from Martin and ordered him to pay the claim. To this day, courts have held to the principle of interpreting policy claims in favor of the insured unless the policy clearly does not extend coverage to the loss.
Unilateral Contracts
Contracts may be either bilateral or unilateral. A contract that exchanges a promise for a promise is bilateral. An exchange of an act for a promise is unilateral. Therefore, insurance policy contracts are typically unilateral. Once the buyer has paid his or her premium to the insurer (a guaranteed loss of the premium paid), only the insurer is then exposed to a legally enforceable promise of financial loss (the result of paying a claim). Except in assessment policies, the insured has made no legally enforceable promises and cannot, therefore, be held in breach of contract. The buyer is not even required to pay additional premium; he or she can allow the policy to lapse when the initial premium period expires. It is important to note that a few insurers, known as assessment companies, do reserve the right to assess policyowners additional premiums under specified circumstances.
Insurance policies are conditional. It requires the buyer to meet specific conditions in order to collect on a loss. However, these conditions are not legally enforceable. For example, the buyer may be responsible for removing flammable trash from a stairway, but the insurer has no legal way to require that they do so. There are many responsibilities given to the contract buyer; some will affect payment of loss and some wont. The only option the insurer has is to make the insurance uncollectible if the buyer fails to meet responsibilities that are clearly defined within the policy. Under the fire policy the insurer promises to indemnify the insured for losses caused by fire. The buyer is subject to specified conditions concerning filing proofs of loss but he or she is under no legal obligation to complete them. However, if the buyer fails to show proof of loss as defined in the policy, he or she will not receive payment for their loss.
Some types of buyer responsibilities may mean loss of claim payment but there is no way for the seller of insurance to legally enforce any action or nonaction on the part of the buyer.
Good-Faith Contracts
The majority of ordinary contracts are considered to be good-faith contracts (they may also be referred to as bona fide contracts). When it comes to insurance contracts, however, the greatest degree of good faith is required in the negotiations before a contract can be issued. Why? Because underwriters of the policy must rely on the honesty of the buyer. Yes, insurers will request medical records, driving records, or other types of proof for some types of contracts, but overall they are relying on the information supplied by the buyer.
What happens if the information provided is false or simply incomplete for competent underwriting to take place? The insurer has the option of voiding the contract (this is called rescinding the policy) under specified conditions. There are usually time requirements for voiding (rescinding) a policy. After the specified time has passed the insurer may not be able to void it, depending upon specific state or federal statutes relating to the type of policy issued. If the information provided was false or incomplete, the insurer may be able to avoid the contract on one of three grounds: warranty violation, concealment, or misrepresentation. Of course, the insurer must be able to prove that the policyholder has committed the act. For the insurer to void the policy or refuse a claim, it must prove falsity, materiality, and/or intention.
There can be some confusion between avoiding a policy and voiding a policy. In one, the policy stands, but the claim is not paid (avoiding). In the other the policy is terminated, as though it never existed, and no claim is paid (voiding).
The insurer would avoid the policy if the claim were the result of undisclosed information that should have been recorded on the policy application, but the policy would have been issued had they known the full facts. The insurer would void the policy if the information that was withheld would have prevented policy issue entirely.
For example:
Scenario #1: George knew he had been diagnosed with lung disease when he completed his application for long-term care insurance. However, he had previously been denied coverage with another company so he did not provide the information on his application for coverage. Although the insurer sent for Georges medical records during underwriting, they did not seek them from the doctor who made the diagnosis because they were not given his name. If a claim arises due to the lung disease within a specified period (usually two years), the insurer can either (a) refuse the claim but allow him to maintain the policy or (b) refuse the claim and void the policy.
Scenario #2: Harry had lung disease, but he was not aware of it. No doctor had diagnosed the condition and Harry had not sought medical treatment for the occasional breathing difficulty he experienced. He assumed he had allergies causing the occasional shortness of breath. When he applied for the long-term care policy he answered all of the medical questions to the best of his ability, concealing nothing he was aware of. When a claim was filed for care due to his lung disease, the insurer sent for his medical records (something they had also done during underwriting). His records clearly indicated that Harry was not aware of the existing condition at the time he applied for insurance, so the insurer will cover his loss.
It is important to note that many insurers also use the prudent man rule. It is expected that the applicants will act as a prudent man would, seeking medical advice or treatment when symptoms warrant it. In other words, if Harrys symptoms gave him warning that something was wrong, he would be expected to seek medical advice. It would not be appropriate to first take out the policy, and then seek medical advice. This is most applicable to health or dental insurance, where people may want to have their treatment covered. Obviously, it would not be possible to hit a tree with ones automobile and then go buy coverage to pay for the loss. With medical or life insurance it may be perceived that it is possible to purchase insurance when loss is imminent.
So, insurers can use warranty violation, concealment, or misrepresentation to avoid the contract requirements (avoid paying a claim).
Warranties:
An insurance warranty requires all statements made in the policy application be true. The buyer signs the application or attached form to the application stipulating that full and correct information has been supplied. This statement is considered to be material if it affects the insurers underwriting and rating decision. Noncompliance with a warranty, or a falsely warranted statement furnishes grounds for the insurer to void the contract or avoid loss payment, depending upon the particular situation. To avoid the contract the insurer only needs to prove that a warranty has been violated. The warranty can be vastly different from policy type to policy type.
There are two types of warranties: promissory and affirmative. A promissory warranty states that a fact is presently true and will continue to be true (We have a watchman each night at the business location). The affirmative warranty states that a fact is true but makes no statement that it will continue to be true (Do you currently have lung disease? no yes). If a special rate were obtained due to a statement made in a warranty, that rate would only be guaranteed as long as that statement remained true. This can be a very important point.
For example:
ABC Company installed a sprinkler system and signed a warranty that it existed and was in good working order. The warranty required that the system continue to be kept in good working order. A few years later ABC Company experiences a fire. The fire department notes that the existing sprinkler system had been disconnected and was not working. As a result the insurer voids the claim (doesnt pay it) because the warranty was violated by the insured.
If there is no clear proof that a warranty is intended to be promissory the courts will construe it to be an affirmative warranty. As previously stated, this is important since a promissory warranty states that a fact is presently true and will continue to be true, whereas an affirmative warranty merely states that a fact is true at the point of signing the warranty but not necessarily true past that point. In the case of the disconnected sprinkler system, the insurer would cover the claim under an affirmative warranty, but would void the claim under a promissory warranty.
Warranties are in written form. Obviously it would be difficult to enforce one that was oral. Warranties are made part of the actual policy contract either by attaching it to the policy or by some specific reference in the policy. As always, there is an exception: in marine insurance where three warranties not written in the contract are implied: (1) the ship is seaworthy; (2) it moves on the customary course between ports named; and (3) it is used for a legal purpose. Only when it is necessary to avoid storms or to complete errands of mercy would there be a deviation. The shipper usually has no knowledge of the ship that will carry the goods, so these warranties are typically removed by the insurer from cargo policies.
The common-law doctrine of warranty has been softened by the courts refusal to consider immaterial statements as warranties if they are not formally warranted. In other words, warranties that were once assumed to exist may not actually be in effect. How does a warranty formally exist? Usually it must be introduced by similar words as: it is warranted that or provided that . . . Otherwise the statement is considered to be informal and not necessarily a warranty.
Warranties are getting harder and harder to keep valid. Courts have softened their use in most jurisdictions, applying payment in favor of the insured rather than the insurer. Courts tend to interpret warranties liberally, especially if the application shows only a superficial breach affecting the risk in a small way. This is especially the case where a warranty can be partially true, but not always true. For example, if the watchman is on the business premises most of the time during the night, even if a theft occurs during an hour when he left for dinner the courts are unlikely to consider this a breach of the warranty. The watchman was primarily there. The courts have not considered it reasonable to void a claim due to an hour when he was not present.
It is important to note the difference between a literal interpretation of a warranty versus a liberal interpretation. A literal interpretation would require that the night watchman always be present; even a moment of absence could void a claim. A liberal interpretation would not void the claim because the watchman was primarily present. The courts typically decide between the literal and liberal interpretation. This ends up in court because the insurer has refused to pay a claim that the insured feels should be covered.
Representations
Representations are usually not part of the insurance contract, but rather are statements made by the applicant to the insurer during underwriting or insurance application. Representations may be either oral or written. Of course, oral representations are difficult to prove so insurers prefer they be written. There are some types of contracts that usually include the application in the actual policy, which means they become part of the insurance agreement. Except for those policies that include representations in the application, the difference between a warranty and a representation is that one is part of the policy (warranties) and the other isnt (representations).
No presumption is typically made that a representation is material. If the contract becomes a subject of litigation the insurer has the burden of proving the materiality of the representation (which is why some types of policies include the application as part of it). The insurer must show that if the truth had been revealed to them they would not have issued the policy. This means that representations need to be both false and material for the insurer to be able to void the contract (rescind the policy).
There is another difference between a warranty and a representation: warranties must be absolutely true whereas any representation deals only with the applicants belief, intention, or opinion that is substantially true. This is an important point since the applicant may believe they are providing full disclosure even though that is not the case. Warranties are based on fact rather than beliefs or opinions. Unless the representation is fraudulently given (the applicant knowingly lies), opinions cannot be used by the insurer as a basis for avoiding a claim or voiding the policy. Incorrect information provided without fraudulent intent cannot be used by the insurer to avoid a claim or void the policy.
We have seen many court decisions blur the line between misrepresentation of opinion and misrepresentation of fact. This reflects the historical trend to side with the buyer rather than the seller of insurance. Most courts feel that the seller of insurance has at their disposal many legal minds whereas the buyer is not likely to have the same resources available to them. Therefore, it is felt that the buyer has an automatic disadvantage. The courts have said that as long as the buyer makes representations to the best of his or her knowledge or belief, it is adequate. This has especially been the case in disputes relating to life insurance policies.
Concealment
Concealment is the intentional failure to disclose complete facts or information (applicants conceal information on purpose). Since insurance deals with contracts made in the utmost good faith, the insured must reveal to the insurer every fact material to the issuance or cost of the contract. Of course, the applicant or insured must be aware of the information; obviously it is not possible to expect disclosure of information that is not known. Additionally it is subject to the applicant or insureds awareness that the information is material and not known by the insurer. These qualifying conditions (knowledge of the facts, knowledge that the facts are material, and knowledge that the insurer is not aware of the facts) apply only to non-marine insurance. Marine insurance in the United States adheres to the strict interpretation that failure to reveal a material fact, even without intent, will provide grounds for avoidance.
Concealment must involve a deliberate attempt on the part of the insured or applicant to deceive the insurer. There must be a motive for the concealment, such as issuance of a policy that would otherwise not be issued. For example:
Maryanne wants to purchase an annuity product, but she is one year older than allowed, according to the guidelines issued by the insurer. Therefore, she provides an incorrect birth year in order to qualify for the annuity. Maryanne knows she is concealing her true age and does so deliberately to acquire the product.
When concealment is revealed, the insurer bears the burden of proof. In other words, the insurance company must prove that the concealment was deliberate and that there was motive for doing so. In most cases, misstatement of age is not thought to be a serious offense and most companies have internal methods of dealing with it, other than voiding the policy. If it affects premium, the insurer will merely require the insured to pay the extra cost based on the correct age. In some cases, however, such as obtaining an annuity that would not otherwise be issued, the insurer may elect to void the contract and return all that Maryanne deposited (whether or not she will receive any interest will be determined by the insurer, unless a state statute dictates handling of this).
How does the insurer prove intent in cases of concealment? That can be difficult. Maryanne can say she did provide the correct birth date and the agent merely misunderstood her. If the date is in Maryannes own handwriting she will have a more difficult time claiming unintentional error. Even if the insured knows the facts are wrong, failure to disclose them does not always constitute fraud. Perhaps Maryanne did not know the annuity was not available to her at her correct age; perhaps she is merely vain and does not want others to know how old she is.
The insured is under no obligation to disclose facts of common knowledge or information that the insurer is expected to know. If a motive for concealment is merely to protect the applicants reputation rather than deceiving the insurer, (and if it does not affect how a policy would have been issued) courts are not likely to allow the insurance company to void the contract or avoid a claim. Even when it might affect how a policy would be issued, there have been cases where the courts ruled in favor of the insured since some facts are thought to be personal and not available to an insurer.
Some types of policies do not allow insurers to void the entire policy based on concealment of one element. If the insured under a health policy did not disclose a known condition (lung disease for example), the courts will allow the insurer to refuse payment of the claim relating to that particular condition, but not claims relating to other health matters.
Many states have softened the line between warranty and misrepresentation doctrines through court interpretations. Under one type of statute, called the entire-contract statute, the policy and the application attached to it constitute the entire contract even if the insurer would not have considered it as such (of course, all policies issued in the states must follow the state requirements). The entire-contract statutes usually apply only to life and health contracts. The intent is to prevent insurers from using the insureds misrepresentations as grounds for avoiding claims or voiding policies unless these misrepresentations are written in the application as part of the policy.
Normally, when statements are in the application as part of the policy, they become warranties. To prevent adverse effects of the stricter interpretation of warranties over representations, state statutes require that all statements made by the insured in the application be deemed representations not warranties. Again, most of these state statutes apply only to life and health insurance. Their effect is to require the insurer to prove the materiality and falseness of statements when seeking to void a policy or avoid a claim on breach of warranty grounds.
We will see new case law as AIDS and other personal lifestyle cases come to court. We are already seeing some states make rulings on how underwriters can view some personal lifestyle facts. For example, is it fair for life insurers to refuse applicants based on where they live? Does living in some towns, such as San Francisco, allow an insurer to refuse insurance to men between the ages of 20 and 40 based solely on their address? These are questions that will have to be answered across the United States.
Principle of Indemnity
Some types of contracts are very personal and do not travel from one element to another. The property insurance contract is very personal, for example. Both the insured and the insurer rely on the good faith of the other. The property is insured in this case rather than the person purchasing the insurance. Although the insurance is attached to the property, it does not move with it if the property is sold to another (except by insurer approval). A life insurance policy is not a personal contract. A new owner of a life insurance policy does not affect the risk since it is based not on the owner of the policy, but rather on the life of the insured.
Property and liability insurance contracts are typically contracts of indemnity because they provide compensation to the insured only for the amount of the loss or damage. It is always necessary, with indemnity, to prevent the insured from making a profit. The principle of indemnity forbids it. Therefore, it is a problem when applying the indemnity principle if measuring the exact amount of required compensation (to prevent either profit or loss) is not clearly visible. For example, how does one measure the value of a human life? Since it is clearly not easy (perhaps even impossible) to measure the value of a life, life insurance policies are not contracts of indemnity. Rather they pay a face value based on the policy purchased.
Health insurance may be written as indemnity. Some types of health insurance policies pay a specific amount for a specified illness or injury. Most long-term care policies have traditionally been indemnity plans, basing payment on a specified amount per day of institutionalization ($150 per day for example). In both health and long-term care policies it is likely that deductibles, elimination periods, or coinsurance may apply. Long-term care insurance is not always a daily payment amount; many of the newer policies use integrated plans that are based on the amount of actual costs. Although some types of health indemnity plans do not base payment on whether or not a profit is made, many more do include a clause that restricts payment to no more than the actual cost, even if more than one policy will be paying benefits. If there is more than one policy paying benefits, including Medicare in many cases, one plan becomes the primary payer and the other becomes a secondary payer (picking up what the first policy did not pay). Group health insurance contracts contain coordination-of-benefits clauses that prevent the insured from collecting more than their losses. It is when policies do not contain coordination-of-benefits clauses that a profit may conceivably be made.
In property insurance the indemnity principle may be defeated if valued policies exist that provide payment of a specified amount for the total loss. Objects that are difficult to appraise, such as artwork, are often covered by valued policies (valued-policy basis). Most states have made valued policies in fire insurance illegal since it is thought that it would encourage arson. Even so, some states have a valued-policy law requiring the insurer to pay the policy face amount for a total loss of real property regardless of its actual cash value at the time of the loss.
Insurable Interest and Subrogation
Obviously we insure those things in our lives that would affect us financially. We insure those that provide our families with income, we insure the objects that are necessary to our lives, and we insure the costs of maintaining our health. The principle of having an insurable interest is basic to the structure of insurance. In property and casualty insurance, an exposure to a financial loss must exist to create an insurable interest. There is a reason for this: our laws require an insurable interest to prevent policies from becoming a gambling device or a tool for profit by those who would gladly use it. As it is, some still see insurance as a way to gain financially, which is why we have arson for hire, theft of property, and sometimes even murder.
There must be an insurable interest regardless of whether it involves property or someones life. The insurable interest is obvious in some policies: fire insurance on our homes, auto insurance on our cars, and life insurance on the family breadwinners. There are some insurable interests that are less obvious, such as interests based on relationships with others. Business entities take out insurance, for example, on key employees since their death could adversely affect the company. Simple possession of goods, even if not directly owned, gives an insurable interest, especially if loss of the goods would mean liability for the holder of the items.
Legal liability from a tort or a breached contract exposes an individual or company to loss. As a result, the person or company has an insurable interest in protecting those assets from claims of others. The insurable interest is only required to be present at the time of the loss. Even so, insurance companies have specific underwriting rules that prohibit writing policies if the insurable interest does not seem apparent at the time of application. It would not be possible to insure an automobile that has not yet been purchased, for example. The car must first be selected so that the insurer can review the property for value and be sure that the insured has possession of it.
When an item is insurable, seldom will the insurer issue a policy greater than its actual value. Even if a policy is issued for a greater amount of insurance than the items value the policy would only pay up to its actual value in case of loss. Therefore, the extra premium paid for excess coverage would be a foolish expenditure.
When purchasing life insurance it is still necessary to have an insurable interest in the life being insured. Unlike property insurance where the person buying the insurance is typically the owner of the item, life insurance can be purchased on the lives of others. Parents can purchase insurance on their children, with the child being the insured and the parent being the owner of the policy and beneficiary. When a life insurance policy is purchased on the life of another, there is the expectation that the insureds death would pose a financial loss in some way. The parent purchasing the policy on a child is assumed to be responsible for funeral costs, for example.
A policy can be purchased on the life of another if there is the expectation that there would have been a benefit had the person lived. Typically the benefit would have been their earnings from a job or some other type of performance. It is not required that there be a legal basis as is the case in property insurance. A general credit has an insurable interest in the life of the debtor because he or she is expected to repay a loan or a purchase price of a piece of property.
There is an exception in the purchase of life insurance: an individual may buy a policy on their own life even though their death will not pose a financial hardship to themselves (it may to others who must handle their finances following their death). Any person of legal age and competence can purchase a life insurance policy on their own lives.
There are three terms that apply to insurable interests in life insurance: subject, owner, and beneficiary. The subject is the person whose death is insured. It is his or her death that triggers policy payment. The owner of the policy is the person who has the authority to exercise all rights of the policy. It is possible for the insured and the owner to be the same person; it is also possible for them to be two different people. Only the legal policy owner may receive policy dividends, if there are any, assign the policy, surrender the policy, change the beneficiaries of the policy, and execute any loans available under the policy. The owner is typically the one who purchased the policy contract, though it is not necessarily required to be. The beneficiary is the person or persons who will financially benefit from the death of the insured. All three titles (subject, owner, and beneficiary) may be the same person. Generally, the rule of insurable interest in life insurance is that either the owner or the beneficiary must have an insurable interest in the subject (the insured person) of the insurance. This rule is called the subject-owner-beneficiary rule, or the SOB rule.
Insurable interests are not always clearly definable. At one time the courts held that insurable interest in life insurance occurred only when the policy buyer could prove a monetary interest in the continued life of the subject. Then the widely accepted principle involved closeness of blood or legal relationships. In this case it was presumed to be an insurable interest without proof of financial ties. In todays world of changing family structure it is easier to purchase life insurance for the benefit of those that would not have been considered some years ago. Now, love and affection may be considered an insurable interest even if there is no legal or blood relationship. If there is doubt as to whether an insurer will issue a policy without clearly defined blood or legal ties, it is always possible to purchase a policy on ones own life and then transfer ownership to another.
Even when there is a legal or blood relationship to the subject of a life insurance policy, typically the insured must still give consent to the purchase of the policy. This will vary by state statute, but the reason for this is sound: prevention of one person profiting from the death of another without the subjects consent. The exception to this usually exists when it concerns legally married spouses. One spouse may purchase insurance on the other without obtaining consent. Parents may also purchase life insurance on their minor children without the subjects consent. Again, it is important to check with your states statutes.
An insurable interest is only required at the time of purchase. As the policy matures, changes may be made without thought to insurable interest. At all times, the amount of insurable interest is not important and is not considered by the underwriters or state statutes. In fact, how would insurable interest possibly be measured? Since they are not contracts of indemnity, it simply is not considered to be a factor of importance. The exception is life insurance purchased by a creditor on the life of the debtor. In this case, the amount of insurance is directly related to the amount owed the creditor by the debtor. Even so, it is possible to obtain insurance larger than the amount owed. Why? Because it is assumed that there are expenses beyond the actual debt, including the cost of the premiums and interest that might be owed.
Subrogation is a right in equity independent of the life insurance contract. A legal principle, other than in life and health insurance, is that the insurer who pays a claim to an insured is entitled to all the insureds legal and equitable rights of action against responsible third parties. Most insurance policies provide that the insurer can require the insured to assign all rights of recovery against another party if they caused the loss. In other words, if the insurance company pays for a loss the insured suffered, but that loss was caused by another person the insurance company has the right to act on behalf of their insured to recover their loss. The insurer wants to be able to recover the amount they paid out from the person responsible for it.
Thank you,
United Insurance Educators, Inc.
End of Chapter One