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9.3 Distinguishing Characteristics of Insurance Contracts
In this section we elaborate on the following:
- The concept and importance of utmost good faith in insurance contracts
- The feature of adhesion and why it plays a significant role in the event of contract disputes
- The importance of indemnity and how it is enforced
- The personal nature of insurance contracts
In addition to the elements just discussed, insurance contracts have several characteristics that differentiate them from most other contracts. Risk managers must be familiar with these characteristics in order to understand the creation, execution, and interpretation of insurance policies. Insurance contracts are the following:
- Based on utmost good faith
- Contracts of adhesion
- Contracts of indemnity
Based on Utmost Good Faith
When an insurer considers accepting a risk, it must have accurate and complete information to make a reasonable decision. Should the insurer assume the risk and, if so, under what terms and conditions? Because insurance involves a contract of uberrimae fideiUtmost good faith., or utmost good faith, potential insureds are held to the highest standards of truthfulness and honesty in providing information for the underwriter. In the case of contracts other than for insurance, it is generally assumed that each party has equal knowledge and access to the facts, and thus each is subject to requirements of “good faith,” not “utmost good faith.” In contrast, eighteenth-century ocean marine insurance contracts were negotiated under circumstances that forced underwriters to rely on information provided by the insured because they could not get it firsthand. For example, a ship being insured might be unavailable for inspection because it was on the other side of the world. Was the ship seaworthy? The underwriter could not inspect it, so he (they were all men in those days) required the insured to warrant that it was. If the warranty was not strictly true, the contract was voidable. The penalty for departing from utmost good faith was having no coverage when a loss occurred. Today, the concept of utmost good faith is implemented by the doctrines of (1) representations and (2) concealment.Warranties are no longer as prevalent. However, they are stringent requirements that insureds must follow for coverage to exist. They were considered necessary in the early days of marine insurance because insurers were forced to rely on the truthfulness of policyholders in assessing risk (often, the vessel was already at sea when coverage was procured, and thus inspection was not possible). Under modern conditions, however, insurers generally do not find themselves at such a disadvantage. As a result, courts rarely enforce insurance warranties, treating them instead as representations. Our discussion here, therefore, will omit presentation of warranties. See Kenneth S. Abraham, Insurance Law and Regulation: Cases and Materials (Westbury, NY: Foundation Press, 1990) for a discussion.
When people are negotiating with insurers for coverage, they make statements concerning their exposures, and these statements are called representationsStatements concerning an insured’s exposures.. They are made for the purpose of inducing insurers to enter into contracts; that is, provide insurance. If people misrepresent material factsInformation that influences a party’s decision to accept a contract.—information that influences a party’s decision to accept the contract—insurers can void their contracts and they will have no coverage, even though they do have insurance policies. In essence, the contracts never existed.
Note that “material” has been specified. If an insurer wants to void a contract it has issued to a person in reliance upon the information she provided, it must prove that what she misrepresented was material. That is, the insurer must prove that the information was so important that if the truth had been known, the underwriter would not have made the contract or would have done so only on different terms.
If, for example, you stated in an application for life insurance that you were born on March 2 when in fact you were born on March 12, such a misrepresentation would not be material. A correct statement would not alter the underwriter’s decision made on the incorrect information. The policy is not voidable under these circumstances. On the other hand, suppose you apply for life insurance and state that you are in good health, even though you’ve just been diagnosed with a severe heart ailment. This fact likely would cause the insurer to charge a higher premium or not to sell the coverage at all. The significance of this fact is that the insurer may contend that the policy never existed (it was void), so loss by any cause (whether related to the misrepresentation or not) is not covered. Several exceptions to this rule apply, as presented in chapters discussing specific policies. In the case of life insurance, the insurer can void the policy on grounds of material misrepresentation only for two years, as was discussed in Chapter 1 "The Nature of Risk: Losses and Opportunities".
It is not uncommon for students to misrepresent to their auto insurers where their cars are garaged, particularly if premium rates at home are lower than they are where students attend college. Because location is a factor in determining premium rates, where a car is garaged is a material fact. Students who misrepresent this or other material facts take the chance of having no coverage at the time of a loss. The insurer may elect to void the contract.
Telling the truth in response to explicit application questions may seem to be enough, but it is not. One must also reveal those material facts about the exposure that only he or she knows and that he or she should realize are relevant. Suppose, for example, that you have no insurance on your home because you “don’t believe in insurance.” Upon your arrival home one afternoon, you discover that the neighbor’s house—only thirty feet from yours—is on fire. You promptly telephone the agency where you buy your auto insurance and apply for a homeowner’s policy, asking that it be put into effect immediately. You answer all the questions the agent asks but fail to mention the fire next door. You have intentionally concealed a material fact you obviously realize is relevant. You are guilty of concealmentIntentionally withholding a material fact. (intentionally withholding a material fact), and the insurer has the right to void the contract.
If the insurance company requires the completion of a long, detailed application, an insured who fails to provide information the insurer neglected to ask about cannot be proven guilty of concealment unless it is obvious that certain information should have been volunteered. Clearly, no insurance agent is going to ask you when you apply for insurance if the neighbor’s house is on fire. The fact that the agent does not ask does not relieve you of the responsibility.
In both life and health insurance, most state insurance laws limit the period (usually one or two years) during which the insurer may void coverage for a concealment or misrepresentation. Other types of insurance contracts do not involve such time limits.
Contracts of Adhesion
Insurance policies are contracts of adhesionSituation in which insureds have no input in the design of a policy’s terms., meaning insureds have no input in the design of a policy’s terms. Unlike contracts formulated by a process of bargaining, most insurance contracts are prepared by the insurer and then accepted or rejected by the buyer. The insured does not specify the terms of coverage but rather accepts the terms as stipulated. Thus, he or she adheres to the insurer’s contract. That is the case for personal lines. In most business lines, insurers use policies prepared by the Insurance Services Office (ISO), but in some cases contracts are negotiated. These contracts are written by risk managers or brokers who then seek underwriters to accept them, whereas most individuals go to an agent to request coverage as is.
The fact that buyers usually have no influence over the content or form of insurance policies has had a significant impact on the way courts interpret policies when there is a dispute.Some policies are designed through the mutual effort of insurer and insured. These “manuscript policies” might not place the same burden on the insurer regarding ambiguities. When the terms of a policy are ambiguous, the courts favor the insured because it is assumed that the insurer that writes the contract should know what it wants to say and how to state it clearly. Further, the policy language generally is interpreted according to the insured’s own level of expertise and situation, not that of an underwriter who is knowledgeable about insurance. When the terms are not ambiguous, however, the courts have been reluctant to change the contract in favor of the insured.
A violation of this general rule occurs, however, when the courts believe that reasonable insureds would expect coverage of a certain type. Under these conditions, regardless of the ambiguity of policy language (or lack thereof), the court may rule in favor of the insured. Courts are guided by the expectations principle (or reasonable expectations principle), which may be stated as follows:
The objectively reasonable expectations of applicants and intended beneficiaries regarding the terms of insurance contracts will be honored even though painstaking study of the policy provisions would have negated those expectations.See Robert E. Keeton, Basic Text on Insurance Law (St. Paul, MI: West Publishing Company, 1971), 351. While this reference is now almost forty years old, it remains perhaps the most popular insurance text available.
In other words, the expectations principleThe event of a dispute, courts will read insurance policies as they would expect the insured to do. holds that, in the event of a dispute, courts will read insurance policies as they would expect the insured to do. Thus, the current approach to the interpretation of contracts of adhesion is threefold: first, to favor the insured when terms of the contract drafted by the insurer are ambiguous; second, to read the contract as an insured would; third, to determine the coverage on the basis of the reasonable expectations of the insured.
Many insurance contracts are contracts of indemnity. IndemnityThe insurer agrees to pay no more (and no less) than the actual loss suffered by the insured. means the insurer agrees to pay no more (and no less) than the actual loss suffered by the insured. For example, suppose your house is insured for $200,000 at the time it is totally destroyed by fire. If its value at that time is only $180,000, that is the amount the insurance company will pay.In some states, a valued policy law requires payment of the face amount of property insurance in the event of total loss, regardless of the value of the dwelling. Other policy provisions, such as deductibles and coinsurance, may also affect the insurer’s effort to indemnify you. You cannot collect $200,000 because to do so would exceed the actual loss suffered. You would be better off after the loss than you were before. The purpose of the insurance contract is—or should be—to restore the insured to the same economic position as before the loss.
The indemnity principle has practical significance both for the insurer and for society. If insureds could gain by having an insured loss, some would deliberately cause losses. This would result in a decrease of resources for society, an economic burden for the insurance industry, and (ultimately) higher insurance premiums for all insureds. Moreover, if losses were caused intentionally rather than as a result of chance occurrence, the insurer likely would be unable to predict costs satisfactorily. An insurance contract that makes it possible for the insured to profit by an event insured against violates the principle of indemnity and may prove poor business to the insurer.
The doctrine of indemnity is implemented and supported by several legal principles and policy provisions, including the following:
- Insurable interest
- Actual cash value provision
- Other insurance provisions
If a fire or auto collision causes loss to a person or firm, that person or firm has an insurable interest. A person not subject to loss does not have an insurable interest. Stated another way, insurable interestFinancial interest in life or property that is subject to loss. is financial interest in life or property that is subject to loss. The law concerning insurable interest is important to the buyer of insurance because it determines whether the benefits from an insurance policy will be collectible. Thus, all insureds should be familiar with what constitutes an insurable interest, when it must exist, and the extent to which it may limit payment under an insurance policy.
Basis for Insurable Interest
Many situations constitute an insurable interest. The most common is ownership of property. An owner of a building will suffer financial loss if it is damaged or destroyed by fire or other peril. Thus, the owner has an insurable interest in the building.
A mortgage lender on a building has an insurable interest in the building. For the lender, loss to the security, such as the building being damaged or destroyed by fire, may reduce the value of the loan. On the other hand, an unsecured creditor generally does not have an insurable interest in the general assets of the debtor because loss to such assets does not directly affect the value of the creditor’s claim against the debtor.
If part or all of a building is leased to a tenant who makes improvements in the leased space, such improvements become the property of the building owner on termination of the lease. Nevertheless, the tenant has an insurable interest in the improvements because he or she will suffer a loss if they are damaged or destroyed during the term of the lease. This commonly occurs when building space is rented on a “bare walls” basis. To make such space usable, the tenant must make improvements.
If a tenant has a long-term lease with terms more favorable than would be available in the current market but that may be canceled in the event that the building is damaged, the tenant has an insurable interest in the lease. A bailee—someone who is responsible for the safekeeping of property belonging to others and who must return it in good condition or pay for it—has an insurable interest. When you take your clothes to the local dry-cleaning establishment, for example, it acts as a bailee, responsible for returning your clothes in good condition.
A person has an insurable interest in his or her own life and may have such an interest in the life of another.Although a person who dies suffers a loss, he or she cannot be indemnified. Because the purpose of the principle of insurable interest is to implement the doctrine of indemnity, it has no application in the case of a person insuring his or her own life. Such a contract cannot be one of indemnity. An insurable interest in the life of another person may be based on a close relationship by blood or marriage, such as a wife’s insurable interest in her husband. It may also be based on love and affection, such as that of a parent for a child, or on financial considerations. A creditor, for example, may have an insurable interest in the life of a debtor, and an employer may have an insurable interest in the life of a key employee.
When Insurable Interest Must Exist
The time at which insurable interest must exist depends on the type of insurance. In property insurance, the interest must exist at the time of the loss. As the owner of a house, one has an insurable interest in it. If the owner insures himself against loss to the house caused by fire or other peril, that person can collect on such insurance only if he still has an insurable interest in the house at the time the damage occurs. Thus, if one transfers unencumbered title to the house to another person before the house is damaged, he cannot collect from the insurer, even though the policy may still be in force. He no longer has an insurable interest. On the other hand, if the owner has a mortgage on the house that was sold, he will continue to have an insurable interest in the amount of the outstanding mortgage until the loan is paid.
As a result of the historical development of insurance practices, life insurance requires an insurable interest only at the inception of the contract. When the question of insurable interest in life insurance was being adjudicated in England, such policies provided no cash surrender values; the insurer made payment only if the person who was the subjectThe person whose death requires the insurer to pay the proceeds of a life insurance policy is usually listed in the policy as the insured. He or she is also known as the cestuique vie or the subject. The beneficiary is the person (or other entity) entitled to the proceeds of the policy upon the death of the subject. The owner of the policy is the person (or other entity) who has the authority to exercise all the prematurity rights of the policy, such as designating the beneficiary, taking a policy loan, and so on. Often, the insured is also the owner. of insurance died while the policy was in force. An insured who was also the policyowner and unable to continue making premium payments simply sacrificed all interest in the policy.
This led to the practice of some policyowners/insureds selling their policies to speculators who, as the new owners, named themselves the beneficiaries and continued premium payments until the death of the insured. This practice is not new but appears to have grown, as reported in the Wall Street Journal.Lynn Asinof, “Is Selling Your Life Insurance Good Policy in the Long-Term?” Wall Street Journal, May 15, 2002. Life-settlement companies emerged recently for seniors. Life-settlement companiesFirms that buy life insurance policies from senior citizens for a percent of the value of the death benefits. buy life insurance policies from senior citizens for a percentage of the value of the death benefits. These companies pay the premiums and become the beneficiary when the insured passes away. This is similar to viatical-settlement companiesFirms that buy life insurance policies from persons with short life expectancies., which buy life insurance policies from persons with short life expectancies, such as AIDS patients in the 1990s. An example of a life-settlement company is Stone Street Financial, Inc., in Bethesda, Maryland, which bought the value of $500,000 of life insurance for $75,775 from an older person. The person felt he was making money on the deal because the policy surrender value was only $5,000. Viatical settlement companies ran into trouble after new drug regimens extended the lives of AIDS patients, and investors found themselves waiting years or decades, instead of weeks or months, for a return on their investments. In contrast, life-settlement companies contend that, because there is no cure for old age, investors cannot lose in buying the policies from people over sixty-five years old with terminal illnesses such as cancer, amyotrophic lateral sclerosis (Lou Gehrig’s disease), and liver disease.Ron Panko, “Is There Still Room for Viaticals?” Best’s Review, April 2002. These companies don’t sell to individual investors, but rather package the policies they buy into portfolios for institutional investors. According to Scope Advisory GmbH (Berlin), which rates life-settlement companies, “Institutional investments helped increase the face value of life insurance policies traded through the life settlement market to about $10 billion in 2004, from $3 billion in 2003.”“Life Settlement Group Sets Premium Finance Guidelines,” National Underwriter Online News Service, April 5, 2005; “Firm to Offer Regular Life Settlement Rating Reports,” National Underwriter Online News Service, April 21, 2005; and Jim Connolly, “Institutions Reshape Life Settlement Market,” National Underwriter, Life/Health Edition, September 16, 2004. There is a regulatory maze regarding these arrangements.Allison Bell, “Life Settlement Firms Face Jumbled Regulatory Picture,” National Underwriter, Life/Health Edition, September 16, 2004.
Because the legal concept of requiring an insurable interest only at the inception of the life insurance contract has continued, it is possible to collect on a policy in which such interest has ceased. For example, if the life of a key person in a firm is insured, and the firm has an insurable interest in that key person’s life because his or her death would cause a loss to the firm, the policy may be continued in force by the firm even after the person leaves the firm. The proceeds may be collected when he or she dies. This point was brought to light with the publication of the Wall Street Journal story “Big Banks Quietly Pile Up ‘Janitors’ Insurance.”Theo Francis and Ellen E. Schultz, “Big Banks Quietly Pile Up ‘Janitors’ Insurance,’” Wall Street Journal, May 2, 2002. The article reports that banks and other large employers bought inexpensive life coverage—or janitor’s insuranceInexpensive life insurance coverage.—on the lives of their employees. This practice did not require informing the employees or their families. Coverage was continued even after the employees left the company. Upon the death of the employees, the employer collected the proceeds and padded their bottom-line profits with tax-free death benefits. Many newspapers reported the story as a breach of ethical behavior. The Charlotte Observer (North Carolina) reported that employers were not required to notify workers of corporate-owned life insurance (COLI)Policies in which employers own life insurance policies on employees. policies in which employers own life insurance policies on employees. However, the newspaper continued, “some of the Charlotte area’s biggest companies said they have notified all employees covered by the policies, but declined to say how they informed the workers. Use of COLI policies has raised outcries from human rights activists and prompted federal legislation calling for disclosure.”Sarah Lunday, “Business Giants Could Profit from Life Insurance on Workers,” The Charlotte (North Carolina) Observer, May 12, 2002: “Some of Charlotte’s biggest companies—Bank of America Corp., Wachovia Corp. and Duke Energy Corp. included—stand to reap profits from life insurance policies purchased on current and former workers. In some cases, the policies may have been purchased without the workers or their families ever knowing.” The National Association of Insurance Commissioners (NAIC) formed a special working group to study these issues. Dissatisfaction with the janitor insurance scandal led the state of Washington to instate a law requiring employers to obtain written permission from an employee before buying life insurance on the employee’s life. Key employees can still be exempt from the law. In 2005, members of the U.S. House of Representative also proposed legislation to limit such practices.Arthur D. Postal, “House Revives COLI Bill,” National Underwriter Online News Service, May 12, 2005.
Extent to which Insurable Interest Limits Payment
In the case of property insurance, not only must an insurable interest exist at the time of the loss, but the amount the insured is able to collect is limited by the extent of such interest. For example, if you have a one-half interest in a building that is worth $1,000,000 at the time it is destroyed by fire, you cannot collect more than $500,000 from the insurance company, no matter how much insurance you purchased. If you could collect more than the amount of your insurable interest, you would make a profit on the fire. This would violate the principle of indemnity. An exception exists in some states where valued policy laws are in effect. These laws require insurers to pay the full amount of insurance sold if property is totally destroyed. The intent of the law is to discourage insurers from selling too much coverage.
In contrast to property insurance, life insurance payments are usually not limited by insurable interest. Most life insurance contracts are considered to be valued policiesContracts to pay a stated sum upon the occurrence of the event insured against, rather than to indemnify for loss sustained.,Some property insurance policies are written on a valued basis, but precautions are taken to ensure that values agreed upon are realistic, thus adhering to the principle of indemnity. or contracts that agree to pay a stated sum upon the occurrence of the event insured against, rather than to indemnify for loss sustained. For example, a life insurance contract provides that the insurer will pay a specified sum to the beneficiary upon receipt of proof of death of the person whose life is the subject of the insurance. The beneficiary does not have to prove that any loss has been suffered because he or she is not required to have an insurable interest.
Some health insurance policies provide that the insurance company will pay a specified number of dollars per day while the insured is hospitalized. Such policies are not contracts of indemnity; they simply promise to make cash payments under specified circumstances. This makes such a contract “incomplete,” as discussed in the introduction to this chapter. This also leads to more litigation because there are no explicit payout amounts written into the contract while improvements in medical technology change the possible treatments daily.
Although an insurable interest must exist at the inception of a life insurance contract to make it enforceable, the amount of payment is usually not limited by the extent of such insurable interest. The amount of life insurance collectible at the death of an insured is limited only by the amount insurers are willing to issue and by the insured’s premium-paying ability.Life and health insurance companies have learned, however, that overinsurance may lead to poor underwriting experience. Because the loss caused by death or illness cannot be measured precisely, defining overinsurance is difficult. It may be said to exist when the amount of insurance is clearly in excess of the economic loss that may be suffered. Extreme cases, such as the individual whose earned income is $300 per week but who may receive $500 per week in disability insurance benefits from an insurance company while he or she is ill, are easy to identify. Life and health insurers engage in financial underwriting to detect overinsurance. The requested amount of insurance is related to the proposed insured’s (beneficiary’s) financial need for insurance and premium-paying ability. The life insurance payout amount is expressed explicitly in the contract. Thus, in most cases, it is not subject to litigation and arguments over the coverage. The amount of the proceeds of a life insurance policy that may be collected by a creditor-beneficiary, however, is generally limited to the amount of the debt and the premiums paid by the creditor, plus interest.This is an area in which it is difficult to generalize; the statement made in the text is approximately correct. The point is that the creditor-debtor relationship is an exception to the statement that an insurable interest need not exist at the time of the death of the insured and that the amount of payment is not limited to the insurable interest that existed at the inception of the contract. For further discussion, see Kenneth Black, Jr., and Harold Skipper, Jr., Life Insurance, 12th ed. (Englewood Cliffs, NJ: Prentice-Hall, 1994), 187–88.
The principle of indemnity is also supported by the right of subrogation. SubrogationSituation that gives the insurer whatever claim against third parties the insured may have as a result of the loss for which the insurer paid. gives the insurer whatever claim against third parties the insured may have as a result of the loss for which the insurer paid. For example, if your house is damaged because a neighbor burned leaves and negligently permitted the fire to get out of control, you have a right to collect damages from the neighbor because a negligent wrongdoer is responsible to others for the damage or injury he or she causes. (Negligence liability will be discussed in later chapters.) If your house is insured against loss by fire, however, you cannot collect from both the insurance company and the negligent party who caused the damage. Your insurance company will pay for the damage and is then subrogated (that is, given) your right to collect damages. The insurer may then sue the negligent party and collect from him or her. This prevents you from making a profit by collecting twice for the same loss.
The right of subrogation is a common law right the insurer has without a contractual agreement. It is specifically stated in the policy, however, so that the insured will be aware of it and refrain from releasing the party responsible for the loss. The standard personal auto policy, for example, provides that
if we make a payment under this policy and the person to or for whom payment was made has a right to recover damages from another, that person shall subrogate that right to us. That person shall do whatever is necessary to enable us to exercise our rights and shall do nothing after loss to prejudice them.
If we make a payment under this policy and the person to or for whom payment is made recovers damages from another, that person shall hold in trust for us the proceeds of the recovery and shall reimburse us to the extent of our payment.
Actual Cash Value
This clause is included in many property insurance policies. An insured generally does not receive an amount greater than the actual loss suffered because the policy limits payment to actual cash value. A typical property insurance policy says, for example, that the company insures “to the extent of actual cash value…but not exceeding the amount which it would cost to repair or replace…and not in any event for more than the interest of the insured.”
Actual cash valueThe replacement cost at the time of the loss, less physical depreciation including obsolescence. is not defined in the policy, but a generally accepted notion of it is the replacement cost at the time of the loss, less physical depreciation, including obsolescence. For example, if the roof on your house has an expected life of twenty years, roughly half its value is gone at the end of ten years. If it is damaged by an insured peril at that time, the insurer will pay the cost of replacing the damaged portion, less depreciation. You must bear the burden of the balance. If the replacement cost of the damaged portion is $2,000 at the time of a loss, but the depreciation is $800, the insurer will pay $1,200 and you will bear an $800 expense.
Another definition of actual cash value is fair market valueThe amount a willing buyer would pay a willing seller., which is the amount a willing buyer would pay a willing seller. For auto insurance, where thousands of units of nearly identical property exist, fair market value may be readily available. Retail value, as listed in the National Automobile Dealers Association (NADA) guide or the Kelley Blue Book, may be used. For other types of property, however, the definition may be deceptively simple. How do you determine what a willing buyer would be willing to pay a willing seller? The usual approach is to compare sales prices of similar property and adjust for differences. For example, if three houses similar to yours in your neighborhood have recently sold for $190,000, then that is probably the fair market value of your home. You may, of course, believe your house is worth far more because you think it has been better maintained than the other houses. Such a process for determining fair market value may be time-consuming and unsatisfactory, so it is seldom used for determining actual cash value. However, it may be used when obsolescence or neighborhood deterioration causes fair market value to be much less than replacement cost minus depreciation.
Property insurance is often written on a replacement costIndemnification for a property loss with no deduction for depreciation. basis, which means that there is no deduction for depreciation of the property. With such coverage, the insurer would pay $2,000 for the roof loss mentioned above and you would not pay anything. This coverage may or may not conflict with the principle of indemnity, depending on whether you are better off after payment than you were before the loss. If $2,000 provided your house with an entirely new roof, you have gained. You now have a roof that will last twenty years, rather than ten years. On the other hand, if the damaged portion that was repaired accounted for only 10 percent of the roof area, having it repaired would not increase the expected life of the entire roof. You are not really any better off after the loss and its repair than you were before the loss.
When an insured may gain, as in the case of having a loss paid for on a replacement cost basis, there is a potential moral hazard. The insured may be motivated to be either dishonest or careless. For example, if your kitchen has not been redecorated for a very long time and looks shabby, you may not worry about leaving a kettle of grease unattended on the stove. The resulting grease fire will require extensive redecoration as well as cleaning of furniture and, perhaps, replacement of some clothing (assuming that the fire is extinguished before it gets entirely out of control). Or you may simply let your old house burn down. Insurers try to cope with these problems by providing in the policy that, when the cost to repair or replace damage to a building is more than some specified amount, the insurer will pay not more than the actual cash value of the damage until actual repair or replacement is completed. In this way, the insurer discourages you from destroying the house in order to receive a monetary reward. Arson generally occurs with the intent of financial gain. Some insurers will insure personal property only on an actual cash value basis because the opportunity to replace old with new may be too tempting to some insureds. Fraudulent claims on loss to personal property are easier to make than are fraudulent claims on loss to buildings. Even so, insurers find most insureds to be honest, thus permitting the availability of replacement cost coverage on most forms of property.
Other Insurance Provisions
The purpose of other insurance provisionsClauses in in insurance contracts is to prevent insureds from making a profit by collecting from more than one insurance policy for the same loss. in insurance contracts is to prevent insureds from making a profit by collecting from more than one insurance policy for the same loss. For example, if you have more than one policy protecting you against a particular loss, there is a possibility that by collecting on all policies, you may profit from the loss. This would, of course, violate the principle of indemnity.
Most policies (other than life insurance) have some provision to prevent insureds from making a profit from a loss through ownership of more than one policy. The homeowner’s policy, for example, provides a clause about other insurance, or pro rata liability, that reads as follows:
If a loss covered by this policy is also covered by other insurance, we will pay only the proportion of the loss that the limit of liability that applies under this policy bears to the total amount of insurance covering the loss.
Suppose you have a $150,000 homeowners policy with Company A, with $75,000 personal property coverage on your home in Montana, and a $100,000 homeowners policy with Company B, with $50,000 personal property coverage on your home in Arizona. Both policies provide coverage of personal property anywhere in the world. If $5,000 worth of your personal property is stolen while you are traveling in Europe, because of the “other insurance” clause, you cannot collect $5,000 from each insurer. Instead, each company will pay its pro rata share of the loss. Company A will pay its portion of the obligation ($75,000/$125,000 = 3/5) and Company B will pay its portion ($50,000/$125,000 = 2/5). Company A will pay $3,000 and Company B will pay $2,000. You will not make a profit on this deal, but you will be indemnified for the loss you suffered. The proportions are determined as follows:
|Amount of insurance, Company A||$75,000|
|Amount of insurance, Company B||$50,000|
|Total amount of insurance||$125,000|
|Company A pays||$3,000|
|Company B pays||$2,000|
Insurance contracts are personalInsuring against loss to a person, not to the person’s property., meaning they insure against loss to a person, not to the person’s property. For example, you may say, “My car is insured.” Actually, you are insured against financial loss caused by something happening to your car. If you sell the car, insurance does not automatically pass to the new owner. It may be assigned,A complete assignment is the transfer of ownership or benefits of a policy. but only with the consent of the insurer. The personal auto policy, for example, provides that your rights and duties under this policy may not be assigned without our written consent.
As you saw in Chapter 7 "Insurance Operations", underwriters are as concerned about who it is they are insuring as they are about the nature of the property involved, if not more so. For example, if you have an excellent driving record and are a desirable insured, the underwriter is willing to accept your application for insurance. If you sell your car to an eighteen-year-old male who has already wrecked two cars this year, however, the probability of loss increases markedly. Clearly, the insurer does not want to assume that kind of risk without proper compensation, so it protects itself by requiring written consent for assignment.
Unlike property insurance, life insurance policies are freely assignable. This is a result of the way life insurance practice developed before policies accumulated cash values. Whether or not change of ownership affects the probability of the insured’s death is a matter for conjecture. In life insurance, the policyowner is not necessarily the recipient of the policy proceeds. As with an auto policy, the subject of the insurance (the life insured) is the same regardless of who owns the policy. Suppose you assign your life insurance policy (including the right to name a beneficiary) to your spouse while you are on good terms. Such an assignment may not affect the probability of your death. On the other hand, two years and two spouses later, the one to whom you assigned the policy may become impatient about the long prospective wait for death benefits. Changing life insurance policyowners may not change the risk as much as, say, changing auto owners, but it could (murder is quite different from stealing). Nevertheless, life insurance policies can be assigned without the insurer’s consent.
Suppose you assign the rights to your life insurance policy to another person and then surrender it for the cash value before the insurance company knows of the assignment. Will the person to whom you assigned the policy rights also be able to collect the cash value? To avoid litigation and to eliminate the possibility of having to make double payment, life insurance policies provide that the company is not bound by an assignment until it has received written notice. The answer to this question, therefore, generally is no. The notice requirements, however, may be rather low. A prudent insurer may hesitate to pay off life insurance proceeds when even a slight indication of an assignment (or change in beneficiary) exists.
In this section you studied the following:
- Insurance contracts are contracts of utmost good faith, so potential insureds are held to the highest standards of truthfulness and honesty in providing information (making representations) to the underwriter
- Insurance contracts are contracts of adhesion because the insured must accept the terms as stipulated; in disputes between insureds and insurers, this feature has led courts generally to side with insureds where policy ambiguity is concerned
Insurance contracts are contracts of indemnity (the insurer will pay no more or no less than the actual loss incurred); indemnity is supported by the concepts of the following:
- Insurable interest
- Actual cash value provisions
- Other insurance provisions
- Insurance contracts are personal, meaning that people are insured against losses rather than property; insurers often require written consent of assignment when insureds wish to assign coverage with the transfer of property
- Assume that you are a key employee and that your employer can buy an insurance policy on your life and collect the proceeds, even if you are no longer with the firm at the time of your death. Clearly, if you leave the firm, your employer no longer has an insurable interest in your life and would gain by your death. Would this situation make you uncomfortable? What if you learned that your former employer was in financial difficulty? Do you think the law should permit a situation of this kind? How is this potential problem typically solved? Relate your situation to the janitor’s insurance stories described in this chapter.
- Does the fact that an insurance policy is a contract of adhesion make it difficult for insurers to write it in simple, easy-to-understand terms? Explain.
- If your house is destroyed by fire because of your neighbor’s negligence, your insurer may recover from your neighbor what it previously paid you under its right of subrogation. This prevents you from collecting twice for the same loss. But the insurer collects premiums to pay losses and then recovers from negligent persons who cause them. Isn’t that double recovery? Explain.
- If you have a $100,000 insurance policy on your house but it is worth only $80,000 at the time it is destroyed by fire, your insurer will pay you only $80,000. You paid for $100,000 of insurance but you get only $80,000. Are you being cheated? Explain.
- Who makes the offer in insurance transactions? Why is the answer to this question important?