2. Property & Casualty Contract Law and Underwriting · 2019-08-17 · i 2. Property & Casualty...

2. Property & Casualty

Contract Law and

Underwriting

In this chapter, we’ll discuss a lot of legal terms as it relates to Property and Casualty (P&C) insurance.

You may see some of the terms and concepts discussed in other lessons as well; however, repetition

will help you gain better understanding and memory of these key terms and concepts.

What is a Contract?

A contract is a legal document or agreement between two or more

parties. Most legal contracts are bilateral, meaning there are two sides that

are legally responsible for fulfilling the terms of the contract. Most legal

contracts are also commutative contracts, meaning that an approximate

or equal value is exchanged, such as a real estate contract. For example,

if you purchase a house for $200,000, the seller receives the $200,000

and you receive the house in exchange. Approximate or equal value was

exchanged in the transaction.

With insurance, the contract states that in return for paying the premium,

the insured will receive specific levels and types of coverage. And, the

insurance company promises to pay for any loss covered under the policy.

Contract of Utmost Good Faith Utmost good faith means that you and the insurer are bound by a

good faith bond of honesty and fairness. When you apply for insurance

coverage, the insurer relies on you to be honest and truthful in completing

the application, and not to falsify any claims during the term of the policy.

In turn, you trust that the insurer will fulfill its obligation by paying the

claim if you have a loss.

2 Property & Casualty Contract Law and Underwriting 2

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4 Essential Requirements

There are 4 requirements for any valid contract, including insurance policies. If a contract is missing

any of these essential elements, it is considered a void contract that will not be enforced by law.

1. Offer and acceptance;

2. Consideration;

3. Legal purpose; and

4. Legal capacity.

1 - Offer and Acceptance

Simply, the insurance applicant makes an offer to the insurance company to purchase a policy by

submitting an application for insurance. The insurance company may accept the offer, decline the

offer, or make a counter offer with different terms or premium amount than what the applicant

applied for.

Applicant makes

offer to insurer

Insurer accepts,

declines, or counter

offers

2 - Consideration

With insurance, consideration is the premium given in exchange for the insurer’s promise to pay

benefits according to the terms of the policy. The consideration by the applicant is the premium

payment and statements on the application that promises to comply with the provisions of

the policy, while in return, the insurance company’s consideration is promise to pay in

accordance with the terms of the contract.



3 - Legal Purpose

A contract must have a legal purpose. This means that the intention of the contract and the purpose

of the parties to enter into the agreement must be legal. A contract must not violate the law by

engaging in an illegal activity.

In property and casualty insurance, Insurable interest exists if the insured suffers a financial loss.

Insurable interest states that before an individual or business can directly benefit from insurance, the

person or business must be subject to economic loss as the result of the insured loss.

Note that, for life insurance, insurable interest must exist at the time of application, but not necessarily

at the time of loss. For property or casualty insurance, insurable interest must exist at the time of loss.

4 - Legal Capacity (Competent Parties)

The parties to a contract must be capable of entering into a contract legally. Generally, this requires

that both parties be of legal age, are mentally competent to understand the contract, and are not

under the influence of drugs or alcohol. Contracts entered into by individuals who are incompetent

are not valid.

5 Unique Characteristics of Insurance

Contracts

1- Contract of Adhesion

Insurance policies are also contracts of adhesion, which means that the policyowner agrees to accept

the terms of the policy as offered—there is no negotiation. An insurance contract is developed by

the insurer and the applicant must accept it as it is. For this reason, uncertainty or vagueness in a

Property and Casualty policy will be determined in favor of the policyowner.

Doctrine of Reasonable Expectations

No, this is not an advanced degree program leading to a Ph.D. in Reasonable Expectations. That would

be "doctorate" by the way. The Doctrine of Reasonable Expectations is a principle that courts use to

interpret insurance policy language. If the policy does not expressly state that there is a particular



coverage, but a reasonable person would assume by the nature of the policy that the particular

coverage should be provided, then the court may use this doctrine to interpret the language in favor

of what is expected.

The Doctrine of Reasonable Expectations simply says that your policy should do for you what you

could reasonably expect it to do. If your homeowners’ policy completely excluded fire, it probably

would not be approved for sale in any jurisdiction.

2 - Aleatory

The insured will likely receive benefits that far exceed the premiums paid to the insurer. Therefore,

the insurance policy is a contract of unequal values.

With a homeowners policy, the policyowner agrees to pay premiums in exchange for the promise of

the insurance company to pay a certain sum if the home is damaged by certain perils. In many

cases, the amount of the claim paid exceeds the premiums paid.

On the other hand, the policyowner may never file a claim as long as he or she owns the home. In this

case, the insurance company has received more in premiums than they paid out in claims.

In both situations, one party received more than the other party—unequal values.

Aleatory

The amount paid by either you or

the insurance company is unequal or

one-sided.

3 - Unilateral

"Uni" means one. Insurance contracts are one-sided contracts because the policy is legally binding

on the insurance company only. Most other types of contracts are bilateral, which are legally binding

on both contracting parties.

A policyowner is not contractually obligated to pay the premiums, and the insurance company cannot

legally force the insured to pay. However, the insurer is legally obligated to pay benefits according to

the terms of the policy. If you choose not to pay your premiums, the insurance company cannot sue

you for payment. They may terminate your coverage according to the cancellation provision in your

policy, but they cannot take you to court because you are behind on your premium payments. If the

insurer refuses to pay a claim arbitrarily, a court of law can be required to the insurance company to

pay.



4 - Personal Contracts

Personal insurance contracts are individual by design. You couldn't buy a policy on your neighbor's

home since you have no insurable interest in it. Even if you bought your neighbor's house, you

would have to buy your own homeowners policy—you couldn't just assume your neighbor's

policy.

The last one in our top 5 countdown is...

5 - Conditional Contracts

The insured must meet certain conditions before the insurer is required to pay any benefit. An

insurance contract is conditional upon the insured paying the required premiums and furnishing

proof of loss to the insurer when a claim is filed. For example, you cannot receive payment for a

claim under your auto or homeowners policy until you suffer a covered loss. You must then notify

the company and complete a proof of loss form. These are conditions that must occur first before

the contract will pay any loss.

Other Important Legal Terms

Warranties

No, you do not receive a 5 year/50,000 mile warranty with each policy

sold. This has nothing to do with free repairs to your auto. A warranty is a

statement that is guaranteed to be true. Insurance policies are considered warranties. The language

insurers include in their policies are considered warranties issued by the insurer. If the insurer states

that they will cover accidental fire losses in your homeowners policy, then that is considered to be

a warranty.

Representations

You are expected to tell the truth, the whole truth, and nothing but the truth... to the best of your

knowledge1 when applying for insurance coverage. Your answers to questions in an insurance

application are known as representations.

1 Read more: Dictionary of Insurance Terms, 5th edition, by Harvey W. Rubin, Ph.D., CLU, CPCU, published by Barron's Educational Series, Inc.

http://www.answers.com/topic/representations

http://www.answers.com/topic/representations



When answering the questions on an application, the statements do not have to be completely

accurate, as long as we answer to the best of your knowledge. For example, in completing a

health insurance application, you answer "no" to all of the questions asking if you have a heart

condition, because you believe this to be true. You feel great and your annual medical exams have

not revealed any heart issues. Unbeknownst to you is a silent heart blockage forming in your left

anterior descending coronary artery—the dreaded widow maker!

Misrepresentation

If an applicant does not give accurate information, it is a misrepresentation.

Unlike warranties, representations are not part of the contract and are only required to be truthful

if material to the risk. A material fact is any fact that would have caused the company to decline the

policy or issue the policy on a less favorable basis if it were known at the time of underwriting. If an

insurance company rejects a claim on the basis of misrepresentation, the company must prove that

the misrepresentation was material to the risk.

Concealment

If an applicant fails to reveal a fact that materially affects the contract, he or she is guilty of concealment.

Fraud

Fraud is an intentional deception or misrepresentation for the purpose of gaining an advantage over

another person. It is the intentional perversion of truth in order to induce another person to part

with something of value. The person relies on the information and suffers a loss.

Fiduciary

A fiduciary is a person in a position to whom trust has been given to protect

property or money. When your customers give your their premiums, you have

a fiduciary responsibility to the customer and the insurer not to

commingle the customer's money with your personal funds, or hold on to it as

a temporary loan or forget to turn it in to your company.

Fiduciary = Trust



Waiver and Estoppel

A waiver is voluntarily giving up a known right. For example, if a policy has a waiver of premium rider,

the insurer gives up the right to collect premiums if the insured becomes totally and permanently

disabled.

Estoppel is the loss of legal defense. Estoppel is the act of preventing an insurer from making a claim

or a denial that contradicts what the insurer had previously stated as a fact. The law does not allow

the insurer to deny facts when the insured has relied on and acted in accordance with the facts on

the basis of the insurer’s behavior. Let's say that you have consistently paid your premiums 4-5 days

after the due date for the last 3 years, and the insurer has accepted them without cancelling your

coverage. If the insurer suddenly decided to cancel your coverage for late payment, it is likely that

the insurer would be estopped from this action.

Binders

As a property and casualty insurance agent, you may be given binding authority by your company

for certain types of risks. Binders are legal agreements issued either by an agent or an insurer in

oral or written form to provide temporary evidence of insurance until coverage can be issued. The

binder should contain definite time limits and should be put in writing as soon as possible. The

binder should clearly designate the insurer that is binding the coverage. It should also indicate the

amount of insurance, the type of policy, and (in the case of property insurance) the perils insured

against.

Assume Joe Customer calls and tells you that he just purchased a new pick-up truck and needs

immediate coverage. Joe gives you the information you need to issue an oral binder while on the

phone. You ask Joe to come by your office within the next few days so that you can complete the

insurance application, collect his premium, and issue him a written binder.

Written binders are normally in effect for a short period of time and serve as a temporary insuring

agreement.

The binder terminates when:

1. Issuance of a policy;

2. Expiration of the binder;

3. Cancellation of the binder..

The binder does not guarantee that a policy will ultimately be issued. In underwriting the application,

the insurance company may decide that the insured may not meet the insurability criteria set forth

by the insurer.



Law of Agency

The law of agency controls the relationship between an agent and the insurance company. The

authority for an agent to conduct business is defined in an agency contract between the producer

and the insurance company. It provides the basis of the relationship in which the agent acts or

represents the insurer. This is an important responsibility for agents because the agency agreement

gives the agent the same authority as the insurance company in dealing with the public. The agent

has the power to bind the principal to contracts.

When a company provides a person with forms and other materials that create the appearance that

the person is an agent of the company, courts will likely hold that a presumption of agency exists.

The insurer is then bound by the acts of the person whether the person has the authority or not.

The elements of agency law are:

1. The acts of the agent within the scope of his or her authority are the acts of the principal;

2. A contract completed by an agent on behalf of the principal is a contract of the principal;

3. Payments made to an agent on behalf of the principal are payments made to the principal.

Agent/Principal

The legal definition of an agent is a person who acts for another person or entity. The other person or

entity is known as the principal. Under the law of agency, the insurer is referred to as the “principal,”

while the producer is referred to as the “agent.”

Agent Authority

The agent’s knowledge about the principal’s business is presumed to be the same as the principal’s

knowledge. This means that only the authorized actions an agent performs can legally bind the

principal.

However, the reality is that an agent’s authority is very extensive and binding.

Insurance agents have 3 different types of authority:

1. Expressed Authority

Expressed authority is explicit authority the principal gives to its agent. It is typically granted by

means of a written contractual agreement between the agent and the insurer.

The agency contract contains legal clauses dealing with the specific and general powers of the agent,

the scale of commissions, and the ownership of renewal commissions on policies sold.



2. Implied Authority

Implied authority is authority that is not expressly granted in writing, but that the agent is assumed

to have being in the position of an agent. Not every detail of an agent’s authority can be written into

the agent’s agreement.

Implied authority can present problems because it is neither in writing nor verbal; it is simply

understood. This allows the agent to perform all the normal and basic tasks to sell and service

customers, and to use the agent’s expressed authority.

As an example, the agency agreement may not specifically authorize the agent to have his or her

customers pay their premiums at the agent’s office. If the producer does this regularly and the

insurer accepts the premiums, the producer’s authority to do so is implied. Or, if certain types of

policies require medical underwriting, you have the authority to schedule a paramedical exam in

the applicant's home or office…even if scheduling paramedics is never mentioned in the agency

contract.

3. Apparent Authority

Apparent authority is the perception by a third party that the producer has been given the authority

by the insurer to transact insurance business on behalf of the insurer. There is the appearance of an

agency relationship. Under the law of agency, the principal (insurer) is liable for the acts of the agent.

If an agent appears to have been given authority by the principal, then the principal is responsible

for the acts of the person they allow to appear to have authority.

An example would be where an agent's contract has been terminated by the principle, but the

principle failed to collect its brochures, letterhead, applications, and/or other marketing materials in

the agent's office that would lead a reasonable person to assume that the agent has the authority

to transact business on behalf of the insurer. It is apparent to a third party that the agent has the

authority to conduct insurance on behalf of the insurer.



Underwriting

Underwriting is the process of classification, rating, and selection of risks. In order for the law of large

numbers to work, several factors must be present, as discussed below.

Elements of Insurable Risk

Not every risk can be insured. For a risk to be insurable, it must pass the following criteria:

Predictable Loss

An insurer must be capable of statistically predicting the possibility of the loss.

To do this, the insurer needs a large number of similar risks. Remember, that

companies use the Law of Large Numbers to help determine how many losses

will occur each year within a particular geographical area. It does not predict

who will have a loss—only the number of losses.

Measurable and Definitive

An insurable risk is a loss that has a known dollar value. If I insure your home, I need to know the

value of the home to measure or value a potential loss. Insurers cannot simply insure a risk with an

unknown value.

Financial Hardship

To be insurable, an item must cause a financial or economic hardship for the insured if a loss were to

occur. Losses that are too small to cause a financial hardship are not considered insurable.

For example, if someone borrowed a $20 hammer from you and forgot to return it, you wouldn't call

your homeowners agents to file a claim. The loss of a single hammer would not be an insurable risk.

Chance Occurrence

Insurance cannot be provided for losses that are certain to occur. The risk must be outside the

insured’s control—unexpected, accidental, or uncertain.

For example, the risk of loss from an automobile accident may be unexpected; however, the risk that

the tires on your car will eventually wear out is not an unexpected loss, and therefore not insurable.

Tires are expected to wear out sooner or later.



Underwriting Information Sources

There are three primary sources from which information is obtained to classify risks and establish

rates by insurance company underwriters. These primary sources are:

Source #1 - The application;

Source #2 - Inspection of the property in person; and

Source #3 - Consumer credit reports.

As the producer you will normally be the most involved with source #1 and possibly source #2. You

should be mindful of the consumer safeguards in the law regarding source #3.

Back to source #1- In the completion of the application, you must make sure that all questions are

answered in their entirety and honest to the best of their knowledge. In order for the home office

underwriters do their job, you must do yours.

More on source #2- You may or may not have some responsibility in field underwriting, but

this will depend on how your company is structured. In some cases, depending on the company, you

may be requ i red to go to the property reflected on the application, take pictures, and record

your findings of the property.

Compliance with Provisions of Fair Credit Reporting (FCRA) Credit scoring use is regulated under Federal law, notably the Fair Credit and Reporting Act, privacy

laws, state unfair trade practice and antidiscrimination laws, state filing requirements, and state

credit use laws that may be based on the National Conference of Insurance Legislators (NCOIL)

Model Credit Use Act.

So let's take a quick look at what you should know regarding underwriting source #3.

Most insurance companies are now basing the cost of some property and casualty insurance policies

on your credit score. If your credit score is bad, you could pay more for your insurance or be denied

coverage. As the applicant, you have the right to obtain a free credit report when you receive a

notice of adverse action.

Let's play insurance agent for a minute. What role will you play as the agent? Specifically, your clients

must be notified in writing if a credit report will be ordered. This is usually part of the application.

If an applicant is rated (charged more premium) or denied coverage based on a credit report, he

or she must be given the opportunity to contact the credit reporting agency and question the

legitimacy of any information that agency used in compiling the report.



If there is alleged error, the credit agency is required to investigate, revise and reissue the

reports that contained inaccurate information which they have may have transmitted over the

last 6 months. The act limits their use and retention of negative information to 7 years, or 10 years

for bankruptcy.

State and Federal Laws

In this section, we will discuss a few generic state laws and regulations found in most states. Specific

state laws and regulations can be found in your state law and regulation lesson.

State Property and Casualty Insurance Guaranty Fund

As we discussed earlier, insurance contracts are unilateral in design meaning that the insurer is

legally obligated to make good on the promises in the contract. But what happens if the insurer

is unable to make good on the contract due to financial troubles? That would not be good news,

especially if you needed to file a claim. What can you do? There is no FDIC for insurance is there? The

answer is no, but there is something close.

The state property and casualty guaranty fund system comes to the rescue—a fund that you

may not have heard of. Don't feel bad, not many people have. Put simply, guaranty funds provide

an essential safety net for policyholders—one that helps policyholders deal with losses should their

insurance company fail. The fund would pay for policyholder losses up to certain limits if that were

to occur.

The states’ property and casualty insurance guaranty funds are generally divided into two separate

accounts:

1. The automobile insurance account; and

2. The account for all other insurance.

Public Law 107-297. Terrorism Risk Insurance Act of 2002

(TRIA)

As a result of the terrorist attacks on the United States on September 11, 2001, Congress enacted and

the President signed into law the Terrorism Risk Insurance Act (TRIA) of 2002. This Federal legislation

enacted guarantees the availability of insurance coverage against acts of international terrorism.

Under the Act, commercial insurers are required to offer insurance coverage against such terrorist

incidents, and are reimbursed by the federal government for paid claims subject to deductible and



retention amounts. This legislation was modified and extended by the Terrorism Risk Insurance

Extension Act (TRIEA) in 2005.

15 USC 6701, Public Law 109-144. Terrorism Risk Insurance

Extension Act of 2005 (TRIEA)

On December 22, 2005, legislation was signed by the President extending the Terrorism Risk

Insurance Act of 2002 (TRIA) for two years—through 2007.

As enacted, the Terrorism Risk Insurance Extension Act of 2005 follows closely the provisions of

the Senate TRIA extension bill passed on November 18, with the exception that the threshold for

declaring a certified act of terrorism remains at $5 million. This Federal legislation extended the

Terrorism Risk Insurance Act (TRIA) through December 31, 2007. It also made some changes to the

TRIA reinsurance program and exempted the following coverages from the application of TRIA:

commercial auto, burglary and theft, surety, professional liability (other than officers and directors

liability), and farm owners multiple peril.

Financial Modernization Act of 1999

Previously, federal law restricted banks, insurers, and security firms to their respective businesses. The

Financial Modernization Act of 1999 (aka Gramm-Leach-Bliley Act, GLBA) removed this restriction.

Now banks, insurers, and investment firms can sell banking, investment services, and insurance.

GLBA also required that states standardize their licensing requirements so that agents and brokers

can do business more easily in multiple states.

Lesson Wrap-Up

To pass the state insurance exam, you will need to master all of the following:

Memorize all contract and legal terms and definitions in this chapter—all of them! Don't proceed to

the next lesson without mastering this lesson first. You will get bogged down later if you do.

There is no secret to this—no magic formula. Take notes, review this lesson several times, and

then proceed to your lesson Driller-end of chapter open book quiz. You can do this!

2. Property & Casualty Contract Law and Underwriting · 2019-08-17 · i 2. Property & Casualty...

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