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Insurance Policies as Contracts

Author: Nancy Germond

While contract law is a specialty for many lawyers, insurance contracts have special legal characteristics that are important to understand. It's essential as a new producer or customer service rep that you understand some basics of contract law. The insurance contract – the policy – is a personal, unilateral contract between the insurer and the insured. You, whether you're licensed as an agent or a broker, can get drawn into contractual disputes that arise.

Insurance as a Contract of Indemnity

Insurance is a “contract of indemnity." A contract of indemnity means that the insurer only owes the cost to make the insured whole, subject to the terms of the policy, of course. To “indemnify" according to Cornell Law School means to  “…compensate that party for losses that party has incurred or will incur as related to a specific incident." In the insurance industry, you'll probably hear the phrase related to indemnity as “To make whole."

This means that insureds should not profit from their losses; loss payments should return them to the position they were in pre loss. For example, if your insured has a homeowner's policy that does not provide replacement cost coverage on contents, and a burglar steals their five-year old television set, the amount they receive for the loss is the value of that five-year old set.

Rest assured, they won't be happy, so whenever possible recommend your insured purchase replacement cost coverage on homeowners policy to avoid this frustration, which would provide a new similar model television for that older model. While this may seem to violate the principle of indemnity, your insured pays a little more premium for that policy enhancement.

Insurance is a Unilateral Contract

The insurance carrier is the party obligated to do certain things under the contract, mainly to indemnify and defend the insured in the event of a covered loss. Therefore, courts consider the insurance contract as a unilateral contract.

While there are policy conditions the insured must follow, that does not make the policy anything but unilateral. These main conditions are to pay premiums, report losses and cooperate after a loss.

Insurance is a Contract of Adhesion

The above paragraph also makes the policy a contract of adhesion. This means the carrier draws up the contract and the insured either buys and agrees to it or not. Only with sophisticated clients do underwriters make substantial changes to policy wording by endorsement. Other endorsements are usually more boilerplate, designed by insurance advisory organizations to reduce or enhance coverage.  

Any ambiguity in policy wording usually means the insured receives the benefit of that wording, because the insured has no choice in how the insurer writes the policy.

Insurance is a Non-Transferable Contract

Two parties agree to the insurance contract, the insurer and the insured. Your insured cannot sell his or her home, for example, then transfer that policy to the home buyer. The insurer retains the ability to re-underwrite that policy after reviewing the new home buyer's loss history and any other applicable concerns.

The same holds true when an insured dies. The policy does not automatically cover heirs, except for a limited time as they may work to settle an estate.

My parents were agents in a retirement community, and they continuously subscribed to two local newspapers to read obituaries for that very reason. Of course, it also helped that their good friend and insured owned the town's only funeral home at the time.

Insurance is a Contract of Utmost Good Faith

This to me is the most important aspect of the contract, the responsibility of the insurer and the insured to act in “utmost good faith."

This means that the insured should make full disclosure of any risks to his or her agent and to the carrier. This allows the insurer to properly underwrite the risk. We see this important principle in family pets and any bite history, for example. While the insurer may not exclude a certain breed, they would want to know if that dog had ever bitten someone. Failure to disclose that information could breach the principle of utmost good faith, whether the failure to report lies with the insured or the agent, who was aware of the bite history but failed to tell the underwriter.

Failure by the insured or agent to disclose a material fact could result in policy recission. In recission, the insurer could rescind the policy back to inception, leaving the insured without coverage.

Why are Insurance Policies So Hard to Read and Understand?

While the industry has worked for years to develop simpler wording, contract law requires insurers to develop clear and unambiguous language that clearly outlines coverage and conditions.

This is a very basic overview of insurance contract language. As you work more closely with various policies and see claims scenarios play out, you'll learn that a semi-colon versus a comma in a policy, or an “and" where it should have been an “or," can dramatically change the coverage outcome for a loss. 

Contract law is rigorous, so don't become overwhelmed. Consider learning more about contract law by continuing your insurance education. 

Last Updated: January 24, 2024


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