Insurance is essentially a risk transfer mechanism to obviate a potential financial loss due to any fortuitous event. When a person perceives that he is likely to suffer financial loss that can be fairly estimated, due to any fortuitous event, he enters into an agreement with the insurance company offering to transfer the risk of loss. The Insurance Company agrees to the risk transfer and accepts the Risk for a consideration called the premium.
The premium charged by the Insurance Company is the cost of Risk Transfer for the person buying Insurance. This amount is substantially small compared to the potential loss that the person may suffer in the event of the occurrence of the fortuitous event.
From the Insurance Company’s side, the agreement involves specifying the events covered; the events excluded; the maximum loss agreeable to be indemnified; the period of coverage; Terms & Conditions, specific warranties; and the premium to be paid. On receipt of the premium amount, the Insurance Company issues the policy document as evidence of the existence of the contract between the Insured and the Insurer.
Thus, insurance buying essentially involves entering into a contract between the Insurer and the Insured, as evidenced in the policy document. Hence, Insurance being a contract, all the essential aspects of a valid contract apply to the Insurance contract also, however, with certain changes and some additional features.
Section 2(h) of the Indian Contract Act, 1872 defines a Contract as “an agreement enforceable by law”. Therefore, all agreements are not legally enforceable contracts, while all legally enforceable contracts are agreements.
Section 2(e) of The Indian Contract Act, 1872 defines “an agreement as ‘every promise’ and ‘every set of promises, forming the consideration for each other.”
Section 2(b) defines a promise as “a proposal when accepted becomes a Promise”. Thus the proposal and acceptance are the two essentials of an agreement.
Thus consideration for each party also becomes an essential part of an agreement. Therefore, when an agreement becomes a legally enforceable contract, it shall have two features emanating from the definition of an agreement and they are:
- Offer and acceptance
- Consideration
The Indian Contract Act of 1872 lays down the essential conditions for the agreement between the parties to be a legally enforceable contract. These essential conditions are derived from the Section 10 of the Contract Act, 1872 which states:
“All agreements are contracts if it is made by the free consent of the parties competent to contract, for a lawful consideration and with a lawful object, and are not hereby expressly declared to be void”.
From the above clause, one can understand other requirements that an agreement is required to satisfy for becoming a legally enforceable agreement. They are:
- Free consent of parties
- Parties competent to contract
- Lawful consideration
- Lawful object
- Not declared to be void.
The seven requirements of a legally enforceable contract listed above are common for any commercial contract including an Insurance Contract. However, to ensure the validity of an insurance contract, it should have two provisions in addition to the provisions required by the Indian Contract Act, 1872. This additional requirement comes from the specific nature of the Insurance domain that is required to operate following the Insurance Act of 1938
The two additional provisions of the Insurance Contract are:
- The existence of an Insurable Interest and
- The duty of utmost good faith
Thus, for an Insurance Contract to be legally enforceable, it should have all the features mentioned above and should be accordingly evidenced in the policy document. We may examine the relevance of each requirement to ensure the validity of the contract as a legally enforceable contract in a court of law.
Essentials of a Valid Insurance Contract
Offer and acceptance:
Any contract must have two parties, the one who makes the offer and the one who accepts the offer. In a normal commercial contract, the seller offers to sell while the buyer accepts to buy. In case the buyer does not accept to buy, then no agreement comes into existence.
However, in the case of insurance, it is exactly the opposite. Here the buyer of the Insurance makes the offer to buy the insurance through a proposal submitted to the Insurer, while the insurer accepts the proposal and agrees to sell the insurance. In case the insurer considers the proposal as a risk that is not acceptable, then the insurer may decline to accept the proposal and the agreement does not come into existence. It is thus the proposal form, submitted to buy insurance, becomes an essential requirement for a valid insurance contract.
This requirement implies that the Insurance Company cannot sell insurance without obtaining a signed proposal form from the insurance buyer. For this reason, it is generally stated that the “Insurance is a subject matter of solicitation by the insured.”
Lawful consideration:
Anything of value offered by one party to the other when making a contract can be treated as consideration. The consideration must not be against public policy or to harm someone etc. In a normal contract, both parties have consideration. For example, when you are buying a house, the money you paid to the seller is his consideration and the house you receive is your consideration.
However, in the case of Insurance, the premium paid by you is the consideration for the Insurer, while the conditional promise by the insurer to indemnify you is your consideration, which the insurer may or may not fulfil depending on whether the stipulated condition is satisfied or not.
While the payment of the first premium satisfies the condition of consideration to the insurer for the contract to come into existence, failure to pay subsequent premiums does not make the contract void ab initio. The insurer cannot force the insured to pay a renewal premium. When the insured fails to pay the renewal premiums, the insurer stands discharged from his liability to indemnify the insured. However, various other provisions of the contract such as surrender value, paid-up policy etc. survive.
Free consent:
Free consent means both parties agreeing on the same thing in the same sense without coercion.
Section 13 of the Indian Contract Act, 1872 defines Consent as “two or more persons are said to consent when they agree upon the same thing in the same sense” and
Section 14 of the same Act defines Free Consent as “Consent is said to be not free when it is obtained by:
- Coercion
- Undue influence
- Fraud
- Misrepresentation; or
- Mistake
When an Insurance agent or any other intermediary ignores the requirement of free consent of the insured, we generally have serious complaints of mis-selling from the insured.
Additionally, in the case of an insurance contract, Section 41 of the Insurance Act, 1938, strictly prohibits offering any kind of inducement to obtain consent. It means that the insurance advisor or intermediary cannot offer cash back, freebies, Gifts or any other inducement to get the consent of the insured for buying insurance. This is illegal in insurance transactions.
Competency of the parties:
The parties entering into a contract should be legally competent to do so. Thus, the people who wish to enter into a contract should be of the age of 18 years and above; should be of sound mind; should not have been disqualified for any reason by law.
The proof of the proposer’s age is important for insurance contracts for two purposes i.e. for determining the validity of the contract, and for determining the premium rate.
Lawful Object:
The object or purpose of the contract must also be legal. Parties cannot enter into a contract for an illegal or a criminal object.
Not expressly declared to be void:
A contract is not valid if it is declared void or illegal by Law. For instance, one cannot enter into a contract with banned organizations.
All the above aspects of a valid contract apply to Insurance contracts along with other contracts, however with few changes as mentioned. Apart from these general aspects, the insurance contracts have certain unique features that are exclusive to the subject of Insurance. These aspects have a great impact on the adjudication process in the realm of insurance disputes. Any insurance buyer needs to have a sense of them to avoid many pitfalls.
Insurable Interest
We have seen earlier that insurance involves an asset vulnerable to suffering loss due to any fortuitous event and the loss must be measurable in financial terms.
Insurable interest means that the person buying insurance should have a legal relationship and financial interest in the asset, i.e. the object of insurance, and any loss to the asset should result in financial loss to that person.
For example, when you buy a new car you have an Insurable interest in the car because you suffer financial loss when the car is damaged or stolen. No other person has an insurable interest in your car. However, when you take a bank loan to buy the car, the banker acquires insurable interest in your car because the car stands mortgaged to the bank during the period of loan outstanding.
Every person has an insurable interest in his own life and immediate dependents such as his spouse and children. No third person can take a life insurance policy in your name. However, your employer can take policy in your name because your employer has an insurable interest in your life to the extent of the value of your service.
A person should have an insurable interest in the asset at the time of taking the insurance; he should have an insurable interest during the policy period as well as at the time of making the claim.
For example, you have an insurable interest in your house property and you have taken an insurance policy to cover the property. However, during the policy period, you have sold your house and transferred the asset to another person. Subsequently, the house gets destroyed due to fire. Though the policy taken by you is still in force, you cannot claim the policy because you have no insurable interest in the house at the time of loss.
One exception to this rule is found in marine insurance wherein the insurable interest in the goods moves in tandem with the change in the ownership of the goods during the period when the policy is in force. It would suffice if the claimant has an insurable interest at the time of making the claim.
One interesting provision in the Fire and Allied Perils Policy is the insurable interest in the goods held in trust. For example, you receive goods from your customer for job work. The goods do not belong to you. However, in case the goods are destroyed on your premises, you become legally liable to indemnify the owner of the goods. It is because of this legal liability; you acquire an insurable interest in the goods of an external party stored on your premises. Many people are ignorant of this provision and do not cover the goods held in trust and end up suffering avoidable losses.
The rule of Insurable Interest implies that you will not get insurance where you do not have insurable interest and you will not get the claim if you do not maintain Insurable Interest at the time of making the claim.
The Insurance Act of 1938 does not define insurable interest. However, rulings of the court have determined the conditions in which insurable interest is allowed to exist. A person has been held to have an unlimited insurable interest in his/her own life.
The following are some familiar instances where insurable interest is allowed to exist.
- Both spouses have an insurable interest in each other’s life.
- Parents have an insurable interest in the life of their child till the child becomes major. For this reason, the policies on the lives of the children incorporate a vesting clause, whereby the policy vests in the child on the attainment of majority.
- An employer has an insurable interest in his employees to the extent of the value of their service. Key man insurance is an example of this insurable interest.
- A creditor has an insurable interest in the life of the debtor. For example, when a bank advances a loan for the purchase of assets, it is entitled to cover those assets with insurance. When a claim situation arises, the indemnity amount will be paid by the insurance company directly to the bank following the bank clause incorporated in the policy document.
- Partners have an insurable interest in the lives of each other to the extent of the financial stakes.
Uberrima Fides – Utmost Good Faith
The Supreme Court, in LIC of India Vs. Asha Goel (Smt), held that insurance contracts, including life insurance contracts, are Uberrimae fidei contracts, implying that the contracts are based on the utmost good faith.
The principle of ‘Uberrima Fides’ or ‘Utmost Good Faith is the Holy Grail of Insurance. To understand this principle, we have to consider the general principle of ‘Caveat Emptor’ or ‘Buyer Beware’ that guides the behaviour of the buyer and seller in general.
‘Buyer Beware’ means that the seller need not disclose all the information he knows about the transaction. He may restrict his communication on the need to know basis. The onus of getting all the information required rests on the buyer by asking suitable questions and making enquiries.
For example, when you go to buy a washing machine, the salesman will tell you all the good things about the model he is interested in selling to you. He will not tell you anything about the problems faced by some customers who bought the same model earlier. Even if you ask him, he will deny knowledge of any complaints from the customers who bought the same model earlier. Not giving such information that is within his knowledge is not considered illegal as the onus of finding the information is on you by talking to some of your friends who bought the same model earlier. This is the principle of ‘Caveat Emptor or Buyer Beware.
When it comes to Insurance, the issue goes a step further and in place of ‘Buyer Beware, the principle of ‘Uberrima Fides’ or the principle of ‘Utmost Good Faith’ prevails.
‘Utmost Good Faith’ implies that both buyer and seller have to disclose all the information that is material to the transaction whether or not asked for. This principle has become the Holy Grail of insurance because the insurer is accepting the risk based on the information given by you. In case you do not disclose certain information to the Insurer that has the potential of changing the nature of the risk, then the Insurer is at a disadvantage and also it amounts to obtaining insurance by fraudulent means.
For example, when you are giving information by filling out the proposal form to take health insurance, you have to disclose your medical history truthfully. In case you do not disclose the information and the insurer suffers loss because of this, the insurer may repudiate your claim as you have not followed the principle of utmost good faith which otherwise would have helped the insurer to decline the risk in the first place. This simply means that the insurer would not have given you the policy in the first place had he known the adverse information at the time of your proposal.
From the Insurer's side, the principle of utmost good faith is equally applicable. The insurer has to disclose all the information required by you to make an informed decision. For example, when the insurer is selling health insurance to you, he has to disclose specific exclusions that are not covered by the policy.
This principle of utmost good faith has become the Holy Grail of insurance because the failure to adhere to this principle leads many a time to complaints against the insurance advisors for misspelling.
Warranties:
The Insurance contract also carries certain warranties listed clearly in the policy document. A warranty is a written assurance given by the insured, at the behest of the insurer that he will comply with the specified condition at all times during the policy period.
For example, a burglary policy may have a warranty stating that the insured is required to maintain the CCTV system in working condition; employ a security guard 24x7. A fire and allied perils policy may have a warranty to maintain a dedicated source of the fire hydrant.
It is very important to understand on the part of the insured that failure to meet the warranty conditions may lead to repudiation of the claim as it could be construed as a breach of contract.
Thus, from the above, we can see that a contract will be considered true and binding only when these essential elements are present, and an insurance contract is no exception. Therefore, the insured needs to read the policy document fully and understand various terms & conditions along with the warranties. In case, the insured is not satisfied with the contract, he is given a specified time called the ‘free look period and during this period the insured has the option of cancelling the contract and getting his premium refunded.
T.D.Prasad., B.E (Hons).,M.B.A.,F.I.I.I
(The author can be contacted at tdprasad53@gmail.com)
