An insurance contract is fundamentally based on the utmost good faith of all parties to the contract. The applicant is relying on the promise to pay made by the insurer. The insurer is relying on the truthfulness of the statements made by the applicant on the application. Insurance is also based on the law of contract. For any contract to be valid and enforceable, four conditions must be met:
There must be an exchange of consideration for the contract to be valid. The insurer’s consideration is its promise to pay policy benefits should the insured suffer a covered loss (acceptance of the risk). The applicant’s consideration is the premium. All premiums are calculated on an annual basis, but the policy’s mode of payment may be more frequent. When a policy owner makes a premium payment, part of the premium is used to meet expenses, and part is held in reserve to meet future claim commitments. These funds are placed in investments that earn interest. The net effect is to reduce the amount of premium that would otherwise be required.
The offer must be accepted unconditionally to form a valid insurance contract. Typically, the applicant makes the offer by submitting an application, often along with the first premium. The insurer may accept the offer as is or respond with a counteroffer, such as a rated policy or modified terms. If both parties agree to the final terms, a contract is formed; if not, no contract exists.
Both parties must be legally capable of entering into a contractual agreement. If the insurer is admitted or authorized in the state, it has legal capacity. The applicant has legal capacity unless he/she is a minor, is mentally incompetent, intoxicated, or under the influence of narcotics.
A valid contract must be for a legal purpose and not against public policy. A life insurance policy purchased with the intent to have the insured killed is an obvious example of an invalid contract. For an insurance contract to be valid, there must be an insurable interest between the applicant/owner and the insured.
Insurance contracts are unique in that the applicant must purchase the policy as written without any opportunity to modify or clarify the contract language. Through the years, the court system has used the Doctrine of Adhesion to interpret ambiguous contract terms or conditions in favor of the insured, since they had no chance to alter the contract at time of application.
Insurers go to great lengths to make their contract language clear and avoid any misunderstandings about the terms of the policy. Still, questions and conflicts do arise. When they do, they often involve the concepts of warranties and representations.
A warranty is a guarantee that a statement is truthful.
Representations are statements made on the application that are substantially true to the best knowledge of the applicant.
If a statement is made on an application that the applicant knows is false, it is a misrepresentation and may constitute fraud. If the insurer can prove that the misrepresentation was made intentionally, it may void the contract and may be punishable as a Class 6 felony.
An insurance contract is based on utmost good faith, with the applicant relying on the insurer’s promise to pay, and the insurer relying on the truthfulness of applicant statements. Legal contract conditions include consideration by both parties, offer and acceptance, legal capacity of parties, and a legal purpose. Consideration involves the exchange of promises, with the insurer promising benefits for covered losses in return for the applicant’s premium.
Offer and acceptance require an unconditional agreement. The applicant offers by completing an application, which the insurer can accept as is or propose changes. Legal capacity means both parties must be able to enter into a contract. The contract’s purpose must also be legal, not against public policy. An insurable interest must exist between the applicant/owner and the insured for a valid contract.
Insurance contracts have unique features:
Applicants must accept policies as written without modification.
The Doctrine of Adhesion favors insured parties in case of ambiguous terms.
Insurers strive for clear contract language to prevent misunderstandings.
Warranties guarantee truthfulness, while representations are substantially true statements. Misrepresentations, if intentional, can void the contract and may constitute fraud.
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