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CHAPTER 11
Insurance Contracts
I. SUGGESTED CLASSROOM TIME: 160–180 MINUTES
II. CHAPTER OVERVIEW
A previous chapter defined insurance as a contractual arrangement. This chapter is
the first of five chapters dealing with the specifics of insurance contracts. The
purpose of this chapter is to introduce insurance contract terminology and the
principles of contract law applying to the insurance transaction. Many of these
principles stem from English Common Law and have been codified into American
III. LECTURE OUTLINE
A. Introduction. Understanding the legal aspects of contracts is of the utmost
importance since all insurance relationships or purchases involve a contract.
This chapter focuses on underlying legal principles that determine how
insurance contracts are started, interpreted, and performed.
B. What Is a Contract?
1. A valid contract is a legally enforceable agreement between two or more
parties to do, or not to do, something. It is an agreement that a court will
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c. Capacity: having the legal ability to enter into a contractual
arrangement. This ability or inability is determined by state law. Groups
3. Contracts lacking one or more of the above features are void from the
beginning (ab initio).
4. Contracts where one party fails to perform required duties are said to be
C. Insurance Binders
1. “Binders” are temporary contracts used exclusively in property insurance.
They are not used in life insurance because life insurance agents do not
have the authority to bind their principals. Binders must meet all the
2. Life insurance companies issue conditional receipts if the first premium
accompanies the application. Such agreements do not require the insurer to
D. Elements of a Valid Insurance Contract
1. Offer and acceptance
a. Must be a meeting of the minds—agreement to the same terms
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2. Consideration in insurance is two parts
a. Property/liability: the value that exchanges hands (can be a promise to
3. Capacity—the legal ability to enter into enforceable contracts
a. Minors, the insane, and the intoxicated do not have capacity.
4. Legal purpose
a. Must not be against public policy or protect illegal ventures
E. Distinguishing Characteristics of Insurance Contracts
1. Indemnity
a. Making the insured “whole”; placing the insured in the same financial
position after the loss as before. This is easy in concept but is more
2. Insurable interest
a. A person must be able to show he would suffer a financial loss if the
insured event were to occur in order to demonstrate an insurable
3. Actual cashvalue: ACV = replacement cost less depreciation
a. Generally replacement cost (new) less appropriate depreciation.
4. Subrogation (means a substitution of rights)
a. The substitution of one person for another person’s legal rights; occurs
when a person pays a debt (insurance claim) on another person’s behalf.
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b. An example occurs in auto insurance when an insured collects from her
own insurer under her collision coverage, for damages caused by
another driver’s negligence. The auto company who pays its insured’s
5. Contract of adhesion: Because insurance contracts are written by the skilled
personnel of the insurance company and offered to the public to accept
without modification, all ambiguities are construed against the writer of the
6. The personal feature
a. Individual characteristics are considered by the insurer before property
insurance contracts are written; thus the insurer (nonlife) will not allow
the policy to be assigned without the company’s written permission
7. Utmost good faith
a. Insurance contracts require a higher level of integrity and honesty when
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b. Warranty
i. A condition of the contract that when breached destroys coverage
ii. Stems from marine insurance which is quite strict, especially
English marine
c. Representations—Statement made, oral or written, to induce a party to
enter the contract.
i. Generally: statements made in the insurance application, relied on
by the insurer and used for underwriting and rating decisions.
d. Concealment
i. Silence when obligated to speak.
ii. In general (states differ somewhat), in order to avoid a contract the
e. The entire contract clause—life insurance
i. Any statements made in the application must be attached physically
to the contract.
f. Incontestability—life insurance
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10. Basic parts of an insurance policy
a. Declarations
b. Insuring agreement
IV. ANSWERS TO REVIEW QUESTIONS
1. How do binders differ from conditional receipts? Binders are
temporary contracts used in property insurance. They are not used in life
insurance because life insurance agents do not have the authority to bind their
2. What are the important differences between a valid contract, an
invalid contract, and a voidable contract? A valid contract is one that will
be enforced by a court because it possesses all four essential characteristics: 1)
Offer and acceptance (of the same terms); 2) the parties to the contract have
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3. List the four elements of a valid contract. What is the legal result if
only three of the four elements are present?
1) Offer and acceptance (of the same terms)
4. Why is legal capacity required to enter into a valid contract? Society,
through its laws, seeks to protect certain classes of individuals from those who
would take advantage of their weakened position. Thus, laws preclude such
5. What is indemnity? Identify three ways the principle of indemnity is
enforced in property insurance contracts. Indemnity is compensation
paid to an insured for losses sustained. Indemnity means an insured should not
profit from the insurance contract, or to be indemnified means that the person
6. Are there any exceptions to the rule that insurance contracts are
contracts of indemnity, defined strictly? There are generally three
exceptions to the rule that insurance contracts are contracts of indemnity. Life
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property. Valued policies also violate indemnity. Valued policies are used when
it is impossible to value the loss after it occurs, so the insured and the insurer
agree on the value before the loss occurs—at the time the contract is made. An
7. Describe one difference between life insurance and property
insurance in the requirement for insurable interest. The most
important difference in the insurable interest doctrine between life and
property insurance is the time when the insurable interest must be present. In
8. Does actual cash value equal fair market value? Actual cash value does
not always coincide with the concept of fair market value. Actual cash value
9. How does subrogation prevent one from collecting twice for the
same debt, or from the same insured injury? Subrogation means one
person substitutes for another person’s legal rights. The substitution prevents
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10. Why are the rules on the right to assign a property insurance
contract different from the rules on the right to assign a life
insurance contract? Life insurance policies are freely assignable. Proper
notification of the assignment is desirable to reduce legal complications. Most
property insurance policies may be assigned only with the consent of the
11. Why are insurance contracts viewed as contracts of adhesion? If an
insurer issues a contract that includes ambiguities that an insured
challenges in court, how will the courts view the case? Because the
insurance company writes the contract and offers it to the insured without an
12. What difference does it make to an insured if a false statement made
by the insured is considered a warranty or a representation? The
doctrine of warranty, which comes from ocean marine insurance, is a very strict
doctrine. In its purest form, the doctrine is interpreted to mean any breach of a
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13. Explain the advantages of the incontestability clause in life
insurance from society’s standpoint. On the surface, the incontestability
clause appears to accept and validate undetected fraudulent applications for life
insurance because the effect of these laws is to prevent contests of life insurance
14. What are the advantages of using standardized insurance policies?
Standardized contracts benefit the insureds in that they can shift their buying
15. List and describe the different parts commonly found in an
insurance policy. The common parts are:
1) Declarations—statements made by the insured that are part of the
underwriting information and which become the basis of coverage
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16. Explain the reasons for including exclusions in an insurance policy.
There are several reasons for exclusions. The most important is the removal of
catastrophe perils. The second most important is the removal of perils not
V. ANSWERS TO OBJECTIVE QUESTIONS
1. Which of the following statements is true?
2. Which of the following coverages is not an exception to the rule of indemnity?
3. Subrogation in insurance means that
4. Because insurance contracts are considered contracts of adhesion, which of the
following statements is true?
5. What is the impact of the parol evidence rule?
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6. A temporary property insurance contract is called a(n)
7. What type of insurance policy is often used for artwork and collector’s items?
8. “Replacement cost at the time of loss less depreciation” is the definition of
9. Insurers use _____ to modify a standardized policy to fit an insured’s unique
coverage needs.
VI. IDEAS FOR INSTRUCTORS AND TEACHING METHODS
1. One method for teaching the ideas related to the legal aspects of insurance
contracts is to teach by case example. One source of legal cases addressing the
2. Have students discuss the legal implications and issues relative to using genetic
3. Work with a colleague who teaches business law to integrate the material
covered in this chapter with the general material used to teach contract law.
Raise questions such as: Is consideration different in insurance than in general
contracts? Are the rules relating to minors or the intoxicated the same? Are
breaches of contracts handled differently in insurance compared to general
contract law? Other questions can be added.
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4. Discuss in class how the transaction of insurance could be legally impacted
when buying or selling insurance over the Internet. As a purchaser, what