Insurance Contracts and Mechanisms

How an insurance contract forms

A prospective policyowner, the person or entity that will hold the policy's control rights, completes an application and usually submits the initial premium, the amount paid for coverage.

• For coverage that uses individual underwriting, the insurer reviews the information and decides whether to accept the risk, decline it, or offer coverage on different permitted terms.
• Issuing and delivering the policy documents the accepted terms.
• When the offer or the insurer's decision changes, the contract may not take effect as the applicant expected until outstanding conditions are met.
• An offer of different coverage or a different premium is a counteroffer, not acceptance of every term originally requested. Determine whether the applicant accepts the revised terms.
• If a revised offer requires both a signed amendment and a premium payment by a deadline, check both acts and their dates. Completing just one does not satisfy those stated acceptance terms.
• Agreement and the coverage start date are separate questions. A contract can specify a later effective date or require an initial payment before coverage begins.
• A producer helps gather and explain information, while the insurer makes the underwriting decision within its authority. Do not treat submission of the application as approval.

The applicant and insurer exchange consideration.

• The applicant's premium and statements support the contract; the insurer's promise to pay a covered benefit is its consideration.
• Competent parties have the legal ability or authority to enter the agreement. This is called legal capacity.
• The contract must have a lawful purpose.
• The insurer’s enforceable promise supplies consideration before any claim occurs. Consideration does not require the insurer to have already paid a benefit.
• Accurate application statements and premium payment serve different functions. Extra premium does not replace truthful material information.
• Credit any initial payment against the accepted premium amount. If the required first-year premium is $900 and $600 has already been paid toward it, $300 remains due. The amount paid and the coverage start conditions are separate checks.

Exam Tip: Gotchas

• The policy determines when coverage begins. An application alone is not always proof of active coverage.

Identify the parties by their roles

• The insurer makes the contract’s coverage promise.
• The policyowner holds the policy's control rights, subject to its terms and other rights. Surrender ends coverage and pays any cash amount available under the policy's terms. Assignment transfers some or all policy rights.
• The insured is the person whose life or health is covered. The insured and owner can be different people.
• The beneficiary is the person or entity designated to receive the applicable proceeds.
• A business can own a policy on a key employee and receive the benefit, while the employee remains the insured.
• A revocable beneficiary designation can be changed under the policy's procedures. Changing that designation changes the proceeds recipient; it does not by itself change the owner or the person insured.

Four contract characteristics

Because the contract is aleatory, the value exchanged by the parties may be unequal: the insurer may pay a large covered benefit after receiving relatively few premiums, or it may pay no claim during the policy period.

These terms describe different features.

• “Unilateral” does not mean the insured has no duties.
• “Aleatory” does not mean the insurer must pay a claim outside the contract.
• Under a unilateral insurance arrangement, the owner may stop future premiums and allow coverage to lapse under the policy. This does not generally make all future scheduled premiums a personal debt. Cash-value and other continuation features must be checked separately.
• Once a claim meets the contract’s coverage conditions, the insurer’s promise is enforceable. “Unilateral” does not make that payment optional.
• Conditions can include payment, coverage dates, proof of loss, and the services or events covered. Satisfying one condition does not automatically satisfy all the others.
• Adhesion describes who prepared the standard form. It does not force a buyer to choose a particular insurer or make an applicant’s handwritten change binding without the required agreement. Compare the actual forms, and follow the authorized amendment process.

For example, a family pays premiums for a life policy, and the insured dies after coverage begins. The insurer may owe a benefit far larger than the premiums paid: that is aleatory. The insurer's promise is unilateral, but payment is conditional on the policy's terms. The insurer drafted the standard form, which is adhesion.

Exam Tip: Gotchas

• Identify the feature being tested: who promises, who drafts, which conditions apply, or why the amounts exchanged can differ.
• The four characteristics answer different questions: value, promise, conditions, and drafting.

What Is Insurable Interest?

Insurable interest is a legally recognized relationship to the person insured or the property covered.

• It helps ensure that a policy protects against financial loss instead of functioning as a wager.
• For life insurance, the required interest is generally evaluated when coverage is arranged, but state law defines the applicable relationship and exceptions.

How Are Benefits Calculated?

Life insurance generally pays a stated benefit when the insured dies during covered conditions.

• Health-expense coverage usually reimburses or pays eligible costs under plan terms.
• Disability-income coverage replaces part of earnings under a policy-defined disability.
• Indemnity means compensation for a loss. The policy determines how payment is calculated. Expense reimbursement uses eligible costs; fixed indemnity pays a stated amount rather than reimbursing the actual bill.
• Term life provides life coverage for a stated term. If the insured dies while coverage is in force and policy conditions are met, it pays the stated death benefit.
• Major medical applies deductibles, copayments, and other policy limits to covered hospital, medical, and surgical expenses.
• Hospital indemnity pays a fixed cash benefit based on a covered hospitalization or service rather than the actual expense.
• For a stated death benefit, use the policy’s payable amount rather than substituting a funeral bill or the total premiums paid. Loans or other stated adjustments can still affect proceeds.
• For expense reimbursement, start with eligible expenses and apply the stated limits and cost sharing.
• An allowed amount is the maximum amount the plan recognizes for a covered service. It may also be called the eligible expense or negotiated rate. If an explanation of benefits states a network adjustment, subtract it from the billed charge to find the allowed amount before applying cost sharing.
• A deductible is an amount the member pays before the specified plan payments begin; coinsurance divides eligible costs by percentage.
• Example: An expense-reimbursement plan pays 75% after a $400 deductible:
  • Start with $1,600 of eligible expenses.
  • Subtract the deductible: $1,600 − $400 = $1,200.
  • Apply the plan's share: 75% × $1,200 = $900 paid by the plan.
  • A separate $100,000 stated death benefit would not be recalculated from those medical expenses.

What Should You Check on Exam Day?

• Are all four formation elements present, including agreement to the accepted terms?
• Which contract feature explains the value exchanged, promise, conditions, or drafting?
• Who is the policyowner, insured, insurer, and beneficiary?
• Is the required insurable interest present at the time the applicable rules require it?
• Does the benefit use a stated amount, eligible expenses, or lost income?