THE MISADVENTURES OF ERNIE AND OLIVER: CONTRACTS
New series reviews errors and omissions basics
Ernie and Oliver had no insurance experience when they decided to buy an agency; they exceedingly overpaid. The morning after their purchase—after a breakfast of eggplant omelets—the two visited their enormous office to get ready for business. They purchased envelopes and oilpaper and energetically opened their doors.
What are the odds that these two gentlemen will be slapped with an E&O claim early in this misadventure? I’d say extremely obvious. How about a little E&O review? It can’t hurt, right?
In our first E&O installment, we’ll discuss the basics of contracts, the various parts of them and what they include.
When a court addresses representations of good faith, it considers the information on the application, so a completely filled-out form with truthful answers is essential.
When having a client fill out an application, it should be a no-brainer to make sure the application is filled out completely—the Ts crossed, the Is dotted, the whole nine yards. As an agent, it is then your duty to deliver the contract to the insurer, where it can accept, reject or counteroffer.
In a typical insurance contract, the insurer agrees to pay for covered losses, provide a defense and perform any other listed services, while the insured agrees to pay the premium and fulfill all other policy requirements. The insurer has the legal ability to bind the agreement so long as it is licensed in the appropriate state. Contracts cannot be constructed for illegal activities like murder for hire or drug dealing. Save that for the movies or select episodes of Snapped.
Contracts come in many different forms. Let’s look at some terminology.
- Valid contract—one that includes all elements recognized by the courts and is legally binding
- Void contract—one without legal effect; it’s missing one or more elements, like consideration or offer and acceptance
- Voidable contract—one that can be broken by one or more parties for a legal reason; this also includes contracts that lack genuine assent and those involving minors
- Unenforceable contract—one that won’t be upheld by the courts, typically because of a rule of law; perhaps the statute of limitations has expired
Several characteristics make insurance contracts unique. Let’s look at some more terms.
Term. A word or phrase used to describe a thing or to express a concept, especially in a particular kind of language or branch of study. You still with us? Just checking.
Principle of indemnity. This states that the insurer will pay to replace what has been lost or damaged, restoring the insured to his or her status prior to the loss; this is the cornerstone of insurance. Neither rewards nor penalties will be given to the insured for the loss. The insured cannot be compensated with an amount greater than the economic loss.
Replacement cost coverage pays to replace the lost or damaged property with property composed of materials of like kind and quality; this coverage does not include a deduction for depreciation. Coverage also can be provided on an actual cash value basis; here the insurer does make a deduction for depreciation.
Under a valued policy, the insurer is legally obligated to pay the face value of the policy upon the total loss of the property, regardless of the property’s actual cash value. State valued policy laws are intended to prevent insurers from writing policies with limits that exceed the value of the property so as to collect higher premiums.
Insurable interest. This is the financial interest of an individual or business in the value of the subject of the contract; at the time of loss the holder of this interest must clearly prove a personal stake in the item being insured. Some reasons for requiring a business or individual to have an insurable interest in a contract:
- Without it, the policy becomes a wager or gambling contract and is against the public interest
- Decreases moral hazard
- Helps measure the amount of the financial loss
Unilateral contract. In this form of contract, only one party makes an enforceable promise; the insurer promises to pay a covered loss, while the insured makes few if any promises. The insured is required to fulfill certain conditions, like paying the premium.
Conditional contract. Two conditions are used for this kind of contract:
- Condition precedent—an action must be performed to trigger the other party’s duty; the insured must notify the insurer of an accident
- Condition subsequent—termination of an existing obligation; the insured has one to two years to file suit against the insurer
Personal contract. These contracts cannot be transferred to other parties and the insured must meet certain underwriting standards, like a favorable loss history, good moral character and a sound credit history.
Contract of adhesion. The word “adhesion” refers to the fact that where ambiguity is found to exist in the contract, the terms of the contract “stick” to the maker of the contract. An insurance contract is a contract of adhesion. The insurer constructs the policy and the insured must either accept it in full or decline it. Ambiguities favor the party with less knowledge; this typically is the insured.
Aleatory contract. In this kind of contract, the consideration or monetary value agreed to by the parties is not equal. The insured could continuously pay the premium and collect nothing in return if no loss ever occurs. The insured could also pay premiums for a short period and then sustain a large loss. If a loss does occur, the insured may collect considerably more than the premium amount.
Subrogation. The term subrogation—when used in insurance—is defined as the substitution of one party for another party to pursue any rights the insured may have against a third party that is liable for a loss that was paid by the insurer.
The purpose of subrogation is to prevent over-indemnification (e.g., the insured collecting payment twice for the same loss). It holds the tortfeasor—the one who has committed the legal wrong—responsible for the loss, and it is intended to keep premiums reasonable.
- Elements of subrogation include:
- The insurer is contractually obligated to pay for a loss
- The insurer is secondarily liable for the loss
- The third party is primarily responsible for the loss
Doctrines of reasonable expectations and good faith
Doctrines often are incorporated into contracts. Let’s look at the doctrines of reasonable expectations and good faith as they appear in insurance policies.
Reasonable expectations. This term is used by courts when interpreting policy language. A court may rule that coverage applies if a reasonable person would assume—by the wording of the policy—that a specific circumstance should be covered. This places the burden on the insurer to make sure that coverages and exclusions are communicated clearly and accurately.
Good faith. Under this doctrine, the insurer promises to cover the insured for an event that may or may not occur in the future. This is considered “good faith” on the part of the insurer. It imposes a higher standard of honesty on both parties than do other commercial contracts.
An insurance contract typically includes a warranty, which is a statement of fact provided by the insured that if found not to be true will void the contract. An express warranty is stated in the policy whereas an implied warranty is not, but it is generally recognized by both parties.
When a court addresses representations of good faith, it considers the information on the application, so a completely filled-out form with truthful answers is essential. Dishonest answers may cause the contract to be voided. Concealment—willfully holding back pertinent information—also may void a contract.
An insurer’s good faith obligations require it to refrain from:
- Refusing to pay for a covered loss
- Causing an unfounded delay in making a payment
- Deceiving the insured
- Exercising any unfair advantage to pressure an insured into an unfavorable settlement
I want to thank Mark O’Reilly, CPCU, CIC, CRM, certified inbound sales director, instructor and consultant at inBuzz Group, for presenting the E&O course in which a large portion of this information was provided. In our next installment, we’ll cover policy types, formatting and contract analysis. Here’s hoping that Ernie and Oliver don’t mess up too much with their new misadventure in the meantime.
Until next time …
By Christopher W. Cook