Principles of Risk and Insurance - Contract Requirements

An insurance policy is a contract. Contracts are agreements that are enforceable by law. We have contracts in insurance to allow two parties, typically an insurance company and an insured, to reach a mutual agreement to bind each other to certain promises- such as the insurer covering a particular risk of loss, and the insured agreeing to pay a premium (cost) for this protection. However, in order for a contract to be valid and enforceable, it must contain certain fundamentals.

To be Legally Binding an insurance contract must have the following five elements:

1) Offer and Acceptance
To be legally enforceable, a contract must be made with a definite, unqualified offer by one party and the acceptance of its exact terms by the other party.

The Offer
- with many insurance contracts, the offer is made when the applicant submits the application with the initial premium.
The Acceptance- the acceptance is confirmed when the insurance company accepts the offer and issues a policy. The company may counteroffer and then the applicant has the choice to accept or reject the new terms.
No Initial Premium- When the applicant does not submit an initial premium with the application, the role of offer and acceptance is reversed. The insurer can respond by issuing a policy (the offer) that the applicant can accept by paying the planned premium when the policy is delivered.

2) Consideration
In order for an insurance contract to be legally binding, there must be an exchange of value. Consideration is the value given in exchange for the services sought after.
The submission of the completed application (offer) plus the payment of the initial premium (consideration) to the insurance company generally creates a binding contract provided that the application passes the underwriting process.

3) Legal Intent
The subject of the insurance contract must be of legal purpose and/or a legal business entity in order for the contract to be enforceable. A contract whereas one party agrees to commit a crime for payment of services would not be enforceable in court because the subject matter is not of legal content.

4) Competent Parties
To cement a valid contract, the parties involved (individuals, groups, or businesses) must be capable of entering into a contract per the law. For an insurance contract, the insurer (insurance company) is considered competent if it is licensed or approved by the state or states in which it conducts business.
The applicant is presumed to be a competent party, unless one of these exceptions apply:

  • Mentally Incompetent
  • Minor
  • Under the influence of alcohol or drugs

If one of the parties is not competent, then the contract is voidable by the incompetent party.

5) Legal Form
Contracts must also follow the laws and guidelines of state regulations. For example- not all contracts are required to be in written form, but state laws might mandate a written contract to make it binding.
State Insurance Regulation
attempts to accomplish the following (MAPS):
  • Maintain competition
  • Available coverage to all that want and need it
  • Protect policy owners against insurer mistreatment
  • Save the solvency of insurers

If an insurance contract lacks one of the five characteristics of a valid contract above, the contract will not posses legal effect and cannot be enforced by either party. Contract Characteristics


Related Articles
  1. Professionals

    Contract Characteristics

    Contract Characteristics
  2. Professionals

    The Legal Aspects of Insurance

    The Legal Aspects of Insurance
  3. Insurance

    Understanding Your Insurance Contract

    Learn how to read one of the most important documents you own.
  4. Professionals

    Business Law: Contracts

    Business Law: Contracts
  5. Home & Auto

    Exploring Advanced Insurance Contract Fundamentals

    Understanding your contract can help you protect our family's financial security.
  6. Home & Auto

    Intro To Insurance: Fundamentals Of Insurance

    By Cathy ParetoHow does insurance work? Insurance works by pooling risk.What does this mean? It simply means that a large group of people who want to insure against a particular loss pay their ...
  7. Professionals

    FINRA Conduct Rule 2820: Variable Contracts

    FINRA Series 6 Exam Study Guide - FINRA Conduct Rule 2820: Variable Contracts. About Variable contracts under NASD rule 2820 and Includes definitions, receipt of payment, transmittal, selling ...
  8. Insurance

    Explaining Insurance

    Insurance is a form of contract between an individual and an insurance company that spreads risk in exchange for premium payments.
  9. Home & Auto

    Intro To Insurance: Conclusion

    By Cathy ParetoInsurance is an integral part of any personal financial plan. The type of insurance and the amount of coverage you obtain all depends on your unique financial and family circumstances, ...
  10. Investing Basics

    The Industry Handbook: The Insurance Industry

    As a result of globalization, deregulation and terrorist attacks, the insurance industry has gone through a tremendous transformation over the past decade. In the simplest terms, insurance of ...
RELATED TERMS
  1. Third Party Beneficiary

    A person who will benefit from a contract made between two other ...
  2. Continuous Contract

    A reinsurance contract that does not have a fixed contract end ...
  3. Conditional Binding Receipt

    A receipt involved in life, health and certain property insurance ...
  4. Transfer Of Risk

    The underlying tenet behind insurance transactions. The purpose ...
  5. Annual Renewable Term (ART) Insurance

    A form of term life insurance that offers a guarantee of future ...
  6. Insurance Premium

    The amount of money that an individual or business must pay for ...
RELATED FAQS
  1. Can your life insurance company sue you?

    Find out when life insurance companies have the right to recover claims. Learn about the most common reasons why a life insurance ... Read Answer >>
  2. Can your insurance company cancel your policy without notice?

    Learn about your rights as an insured when it comes to your insurance policy being canceled, including how to access your ... Read Answer >>
  3. What is the average return on total revenue for the insurance sector?

    Learn about the three main segments of the insurance industry, and find out what the average return on revenues is for the ... Read Answer >>
  4. Why is my insurance premium so high/low?

    Insurance premiums can be affected by many factors including: type and amount of risk size of deductible amount of coverage ... Read Answer >>
  5. What is the difference between forward and futures contracts?

    Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell ... Read Answer >>
  6. What is a tax-free 1035 Exchange?

    A Section 1035 Exchange refers to the replacement of an annuity or life insurance policy for a new one without incurring ... Read Answer >>
Hot Definitions
  1. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  2. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  3. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  4. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  5. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  6. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
Trading Center