The Insurance Contract

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89Financial Planning HandbookPDP

Chapter 13


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90 Financial Planning Handbook PDP

The Insurance Contract

Insurance policies are based on the law of contracts. Each insurance contract must meet the followingessential requirementsOffer and Acceptance

Consideration

Competent Parties

Common Intention

Legality of Purpose

Let us look at these in more detail.

Essential Requirements of an Insurance Contract

Offer and Acceptance

As with all legal contracts in insurance contracts, there must be an offer and acceptance of its terms. Itshould be remembered that in insurance contracts, the person seeking insurance makes the offer. Thereforehe is also referred to as the Proposer. It is the insurance company or the insurer which accepts ordeclines the offer.

Consideration

Consideration is the value that each party to the contract provides to the other. Without consideration,there cannot be any contract. In case of insurance contracts, the consideration for the insured is thepremium payments and the agreement to abide by the terms of the policy. For the insurer, the considerationis the promise to make payment of the sum insured on occurrence of a specified event.

Competent Parties

Each party to the insurance contract must be legally competent to enter into contract. For the insured,this means that the proposer should be an adult of sound mind. For the insurer, this means that theinsurer must have a valid license to do insurance business.

Common Intention

Parties to a contract are said to have common intention when they understand the same thing in thesame manner at the same time.

For example, if the proposer intends to take a policy for theft then it should not be misunderstood withburglary. Burglary entails forced entry into the premises, but that is not the same in case of theft.

Legality of Purpose

The purpose of the insurance contract should be legal. A terrorist cannot insure his weapons againsttheft because the object of the contract is not legal and is contrary to the greater public interest.


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Distinct Characteristics of an Insurance Contract

Insurance contracts have distinct legal characteristics that make them different from general contracts.Some of the distinctive features have already been discussed in the chapter on Principles of Insurance.

Other distinctive characteristics of insurance contracts are that they are:

Let us look at these in more detail.

Aleatory Contracts

Aleatory contracts are those where the value exchanged is not equal but depends on an uncertain event.Depending on the occurrence of a chance event, one party to the contract may receive a value out ofproportion to the value that is given. For example, in case of a motor vehicle insurance contract, anindividual may pay Rs. 5,000 as premium, but collect Rs. 5,00,000 if the car is stolen or destroyed duringthe insurance period. Similarly, there may be cases where the insured pays premium but gets absolutelynothing in return if no event causing any loss occurs.

Unilateral Contracts

Unilateral contracts are those in which only one party makes a legally enforceable promise. In the caseof insurance contracts, only the insurer makes that promise. If the insured does not pay further premiumsafter the payment of the first premium, he cannot be legally forced to pay the balance premiums. Theinsurer can withhold payment of claims if premiums are not paid but cannot force the insured to pay thepremiums.

On the other hand, if the insured pays the premium, the insurer is under obligation to provide the insurancepromised under the contract. In general contracts, if one party fails to perform, the other party can insiston performance or sue for damages because of breach of contract.

Conditional Contracts

Conditional contracts are those which place certain restrictions or limitations on one or both parties. Ininsurance contracts, the insured must comply with policy conditions if he wants to collect payment forhis claims. In case of non-compliance of the policy conditions, the insurer can refuse payment.

Personal Contracts

An insurance contract is a personal contract. This means that the policy is personal to the insured. Withthe exception of life insurance, it may not be assigned to anyone else without the approval of the insurer.

Contract of adhesion

Contracts of adhesion are those that must be accepted in total, with all their terms and conditions. Ininsurance contracts, this means that the insured must accept the policy issued by the insurer as it is.The insured cannot insist on any changes or modifications to the contract.

Meaning of Insured

All insurance contracts invariably contain the precise meaning of the word insured in theDefinitions section. The contract generally indicates the insured person by name. In some insurancecontracts other parties are also covered even though they may not be named in the policy.

For example, a person may take a motor vehicle policy for the driver and the passengers of the car. Thiswould mean that any person driving the car and any passenger traveling in the car would be coveredunder the insurance policy. It goes without saying that the driver must hold a valid driving license and


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should be driving the vehicle for a legal purpose to be covered under the policy. The conditions foridentifying the insured in case of unnamed policies, are also clearly specified in the insurance policy.

Co-Insurance

The same property can be insured with multiple insurers. In such a case whenever a loss occurs, it is

paid by all insurers in the proportion of their respective insurance amounts.

When a person chooses to insure a property for less than its full value, he is considered to be insurer forself for the uninsured part. Accordingly in case of a loss, the insured has to bear the loss in the sameproportion as the uninsured part bears to the value of the property.

For example, if a property worth Rs. 5 lakhs is insured for only Rs. 4 lakhs, then the insured is consideredto be the insurer for self to the extent of Rs. 1 lakh. In case of a loss causing event where the propertysuffers damages to the tune of say Rs. 3 lakhs, the amount payable by the insurance company would becalculated as below:

Purpose

The purpose of co-insurance is to achieve equity in charging premiums. For example, consider twoadjoining properties valued at Rs. 5 Lakhs each. Suppose the owner of the first property Mr. A insures

his property for Rs. 4 Lakhs only while the owner of the second Mr. B insures his property for the fullvalue of Rs. 5 Lakhs. If the premium rate is Rs. 1 per thousand ,then Mr. A pays a premium of Rs. 400while Mr. B pays a premium of Rs. 500.

Further, suppose both properties suffer damages of Rs. 3 Lakhs. If the principle of co-insurance is notapplied both Mr. A and Mr. B will receive Rs. 3 Lakhs from the insurer. But Mr. B will be paying morepremium to get the same amount as Mr. A. This would be inequitable and implies penalizing individualswho insure their assets for their true value!

Hence Mr. A shall get i.e. 80% of the loss which works out Rs 2.40 lakhs only.

=

Amount of Insurance Carried

Value of Property Loss Amount of Recovery

Rs. 4,00,000

Rs. 5,00,000Rs. 3,00,000 = Rs. 2,40,000

or


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Exercise

The bungalow of an actor, Murali is on the seashore. It is furnished with the most exotic collection ofpaintings and furniture. Murali has a contract with National Insurance Company, to pay him damages tothe extent of Rs. 5 crores, if there is any damage to the house due to tsunami or fire. He will have to pay

a premium of Rs. 2 Lakhs pa, irrespective of whether the house will ever catch fire or a tsunami willdestroy it.

What characteristic of the contract is explained by this example?

Solution : Such a contract is an example of Aleatory contract.

Due to some unfortunate incident, fire indeed broke out due to some combustible explosives in thehouse. The kitchen got destroyed and Murali wanted to press charges against the damages. The claimsdepartment, on receipt of the request, ordered an enquiry. They discovered that there was some combustiblematerial in the house, which increased the risk of fire. This was not mentioned as a probability when theinsurance was drawn. Thus, NIC can refuse the payment.

What characteristic of the insurance contract does the example exemplify?Solution : This is a Conditional contract.

Murali for some reason was not too happy with this house. He noticed that a lot of negative things hadhappened to his career after moving into this house. So, he decided to bring this property into the market.There was an industrialist who was looking to buy a second house near the seashore and he liked thearchitecture of the house. The deal was struck and the money exchanged hands. But the industrialistalso took a more comprehensive house and property insurance. The insurance, which Murali had purchased,could not be transferred to the new buyers name.

What characteristic of the contract is this?

Solution : This is a Personal contract.


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The Insurance Contract

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