LEARNING OBJECTIVES
To understand the mechanism of insurance as a risk transfer system, a business
and a contract
To understand the application of the provisions of the Indian Contract Act to
insurance contracts
To study the fundamental principles governing general insurance contracts
To examine the various provisions required for enforcement of an insurance
contract
INTRODUCTION OF INSURANCE
Every individual family and business organization needs insurance, for inherent risk
exposures to which they are exposed. Insurance seeks to redress the assured from
the financial consequences of the loss exposures in the event of the uncertain event
happening, resulting in a loss of his assets, or properties or even income earnings.
Insurance is actually a combination of three elements
A transfer system
A business
A contract
Insurance as a Transfer System
As a transfer system, insurance enables a person, family or business to transfer the
costs of losses to an insurance company. In turn the company pays for the insured
losses and distributes the costs of losses among all insureds. Thus, the key elements
of insurance as a transfer system refers to the transferring of risks from the insured to
the insurance company which is financially sound and has the capacity and willingness
to take risks. The person transfers the consequences of a loss to the company, thereby
exchanging the possibility of a large loss for the certainty of a much smaller periodic
payment (premium). For transferring a cost of loss it is not necessary for a loss to
occur or exist. A mere possibility of a loss constitutes a loss exposure that can be
insured or transferred.
A Loss exposure can give rise to three types of losses, namely:
Property loss (including net income loss),
Liability loss, and
Human and personnel loss.
On the other hand, sharing of risks implies the pooling of premiums paid by the insureds
into a fund out of which the losses are paid as and when they occur.
Thus, the role of insurance is to protect insured’s assets from the financial consequences
of loss. But, not all risks are insurable. Insurance covers only pure risks. (Discussed
in Chapter I of Module I).
Insurance as a Business
As a business, insurance primarily attempts to meet its costs and expenses from
the premium that it earns and also make a reasonable margin of profit for its own
sustainability. As a business organization, it provides jobs to millions of people in life
and non-life insurance companies, agencies, brokerage firms. The various operations
of these companies include marketing, underwriting, claims handling, ratemaking and
information processing. As a business concern, it also needs to satisfy the regulators,
insureds and others of its financial stability. Therefore, to protect the consumers, the
regulator monitor the rates, policy forms, solvency margins, and also investigate
complaints and consumers’ grievances. In addition to payment of losses, the business
of insurance offers several benefits to individuals and families and to the society as
a whole such as:
Payments for the costs of covered losses
Reduction of the insured’s financial uncertain
Efficient use of resources
Support for credit
Satisfaction of legal requirements
Satisfaction of business requirements
Source of investment funds for infrastructure development
Reduction of social burden
However, the benefit of insurance is not cost free. There are some direct costs as well
as indirect costs which are incurred, such as the premiums paid, operating costs of
the insurers, opportunity costs, increased losses, and increased law suits.
Insurance as a contract
As a contract, an insurance policy is a legally enforceable contract. The contract is
between the insurance company and the insured. Through insurance policies, the
insured transfers the costs of losses to insurance company. In return for the premiums
paid by the insured, the insurers promise to pay for the losses covered under the
policy.
The policy contains all the terms and conditions for its enforceability, and the benefits
payable by the insurer. The breach of these conditions by either party will result in
the invalidation of the contract. Thus, through the coverage provided by insurance
polices, the individuals, families and businesses are enabled to protect their assets,
and minimize the adverse financial affects of losses. Hence, an insurance contract
needs to be interpreted and carefully designed so that, all fortuitous losses are covered
and insured against.
The most common four basic types of insurance (property, liability, life and health) are
generally divided into two broad categories:
1. Property/Liability insurance
2. Life/Health insurance
1. Property insurance provides coverage for property and net income loss
exposures. It protects an insured’s assets by paying to repair, or replace property
that is damaged, lost, or destroyed or by replacing the net income lost and extra
expenses incurred as a result of property loss.
Liability insurance covers the liability loss exposures. It provides for payments
on behalf of the insured for injury to others or damage to others’ property for
which the insured is legally liable.
2. Life and health insurance cover the financial consequence of human (personal)
loss exposures. Life insurance replaces the income-earning potential lost through
death and also helps to pay expenses related to insured’s death. Health insurance
provides additional income security by paying for medical expenses. Disability
income as popular in most of the Western countries, replaces as insured’s income
if the insured is unable to work because of injury or illness.
DEFINITION OF CONTRACT
An agreement enforceable by law is called a contract. It creates certain rights and
obligations for parties agreeing to it. A valid contract is one, which the court enforces.
Requirements of an insurance contract
Insurance contracts are also governed by the provisions of the Indian Contract Act,
1872. In general, there are four requirements that are common to all valid contracts. To
be legally enforceable, an insurance contract must meet these four requirements:
1. Offer and acceptance
2. Consideration
3. Capacity
4. Legal purpose
1. There must be valid offer and acceptance:
The first requirement of a binding
insurance contract is that there must be an offer and an acceptance of its terms.
In most cases, the applicant for insurance makes this offer, and the company
accepts or rejects the offer. An agent merely solicits or invites the prospective
insured to make an offer.
A legal offer by an applicant for insurance must be supported by a tender of the
premium and it should always be prior to commencement of the ‘coverage’. The
agent usually gives the insured a conditional receipt that provides that acceptance
takes place when the insurability of the applicant has been determined by the
Insurer.
In property and liability insurance, the offer and acceptance can be oral or
written.
2. Promises must be supported by the exchange of Consideration:
A
consideration is the value given to each contracting party. The insured’s
consideration is made up of the monetary amount paid in premiums, plus an
agreement to abide by the conditions of the insurance contract. The insurer’s
consideration is its promise to indemnify upon the occurrence of loss due to
certain perils, to defend the insured in legal actions, or to perform other activities
such as inspection or collection services, or loss prevention and safety services,
or as the contract may specify.
3. Parties must have legal capacity to contract:
This requirement of a valid
insurance contract is that each party to a contract must be legally competent.
This means the parties must have legal capacity to enter into binding contract.
Parties who have no legal capacity to contract include:
l Insane persons who cannot understand the nature (obligations and liabilities)
of the agreement
l Intoxicated persons
l Corporations acting outside the scope of their charters, bylaws, or articles of
incorporation, or authority
l Minor
NOTE:Minors normally are not legally competent to enter into binding insurance
contracts; but most states have enacted laws that permit minors, such as a
teenager age 15, to enter into valid life or health insurance contract.
4. Agreement must be for legal purpose: For insurance policies, this requirement
means that the contract must neither violate the requirements of insurable interest
nor protect or encourage illegal ventures. In other words, an insurance policy
that encourages or promotes something illegal and immoral is contrary to public
interest and cannot be enforced.
EXAMPLE:
A street pusher of heroin and other illegal drugs cannot purchase property insurance
policy that would cover seizure of the drugs by the police.
