Principles of Life Insurance

7/27/2019 Principles of Life Insurance

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CHAPTER 2

PRINCIPLES OF LIFE

ASSURANCE

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LIFE INSURANCE

CONTRACTS

What is a contract?

A contract is an agreement between two

or more parties to do, or not to do

something, so as to create a legally

binding relationship.Insurance contracts involves two parties

the insured and the insurer.


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The term insured refers to the party effectingthe insurance, may be an individual, partnershipfirm, a corporate body or any institution with legal

status. Prior to the completion of the contract, theinsured is known as the proponent.

The term insurers refers to the party grantingthe protection under an insurance policy.

A contract of insurance is an agreement wherebyone party, called the insurer, undertakes, inreturn for an agreed consideration, called thepremium, to pay the other party, namely, theinsured a sum of money upon the occurrence ofa specified event resulting in loss to him.


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LIFE INSURANCE

CONTRACTS

Essentials of a simple contract:

Offer and Acceptance.

Consideration

Capacity to contract


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Continued

Consensus ad idem

Legality of Object or purpose

Capability of performance

Intention to create legal relationship

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How different is Life Insurance

Contract? A Life Insurance Policy is a contract, interms of the Indian Contract Act, 1872.

Insurance is a specialised type of contract.

Principle of Utmost Good Faith & Principle

of Insurable Interest are applicable to both

life and non-life contracts apart from the

usual aforesaid essentials of a validcontract.


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Offer & Acceptance

The Proposer offers his proposal to be

accepted by the Insurer. If the Insurer,after considering the proposal and other

related information, is willing to insure a

policy, he sends a letter termed Letterof Acceptance. The letter of

acceptance is counter offer.


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Consideration

In Insurance contract, the payment of

the premium is consideration for thecontract on the part of the life assured

and the undertaking of the insurer to

pay a sum of money when the claimarises is consideration on the part of the

insurer.


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Capacity to Contract

The parties to an assurance contract

must be capable of entering intocontracts. Every person is competent tocontract who is of the age of majority,who is of sound mind and is notdisqualified from contracting by any lawto which he is subject. Thus, minors andpersons of unsound mind cannot enter

into insurance contracts.


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Consensus

Two or more persons are said to consent

when they agree upon the same thing in thesame sense. A contract must be founded on

a true agreement and the parties must be of

one mind. There will be no consensus if

either of the parties or both of them are undera wrong impression as to some circumstance

affecting the contract.


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Legality of object or purpose

Every agreement wherein the consideration

or object is unlawful, is void. Therefore, for avalid contract there should be proper

consideration and legally valid object. The

object or the purpose of an agreement must

be lawful i.e. it should not be forbidden by lawor it should not be fraudulent. For example,

stolen goods cannot be insured.


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PRINCIPLE OF UTMOST GOOD

FAITH UBERRIMAE FIDES

Commercial contracts are normally

subject to the principle of Caveatemptor i.e. let the buyer beware. Each

party can verify the correctness of the

statements of the other party and proofcan be asked for.


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continued

The seller under a commercial contract has

no duty to disclose any information about thesubject-matter of the contract to the buyer.The seller cannot deliberately mislead thebuyer but it is the duty of the buyer to inspect

the goods to see if there are any defects.Example:For a purchase of a car, the buyerhas to take all precautions by inspecting thecar for any defects. The seller has no duty todisclose the defects.


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continued

However, Life Insurance contract is a

contract of Uberrimae Fides i.e.contracts in which the Utmost Good

Faith is required. The proposer has a

legal duty to disclose everything that isrelevant to the subject-matter of

insurance, because the insurer knows

nothing about it.


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continued

The duty of full disclosure rests on bothparties.

The duty exists on the part of the proposertodisclose and furnish all material informationfor proper assessment of the risk by theinsurer. The insurer cannot possibly be aware

of all the details of the health, family history,habits and other matters relevant to theassessment of the risk and has frequently nomeans of verifying them.


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continued

It is true that the underwriter can have a

survey for fire insurance or medicalexamination of life for health insurance,carried out, but even then there arecertain aspects of the risk which are not

apparent at the time of survey ormedical examination, for example, theprevious loss or medical history and so

on.


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continued

Duty on the part of the Insurer:

The proposer also because of his lack oftechnical knowledge has to depend on thegood faith of the Company to ensure that theterms of the contract are fair and equitable.

The insurer or his agent has to make truestatements at the time of sale of insurance,advise the proposer properly about the termsand conditions of the policy without

withholding any information.


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Disclosure of Material Facts

In the event of failure to disclose material

facts, the contract can be held to be void abinitio i.e. from the beginning itself.

Material Fact: Every circumstance that would

have a bearing on the judgment of a prudent

insurer in fixing the premium or determining

the acceptability of the proposal for insurance

is a material fact.


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continued

The proposer cannot defend non-disclosure

by contending that he did not think that thefact was material to be disclosed (correctionon page 27, point 7, last line- the fact wasmaterial)

Facts of common knowledge, facts of law,facts revealed by a survey or facts whichcould be reasonably discovered by referenceto previous policies and records available

with the insurer need not be disclosed.


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Duty of Disclosure

The duty of disclosure in life insurance,operates till the risk commences.

However, if the policy is issued with acondition that any change in occupation mustbe notified to the insurer or if the terms of thepolicy are to be altered or if a lapsed policy is

to be revived or a surrendered policy is to bereinstated, there would be a duty to discloseall material facts at that time since whatfollows is a contract novell or a newcontract.


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Breach of Principle of Utmost

Good Faith

The breach of the principle of utmost good faitharises due to misrepresentation or non-disclosure of material facts.

Any statement made in the Proposal forinsurance or any report of a Medical Examiner orrefree or friend of the insured or any other

document leading to the policy, was on a materialmatter fraudulently suppressed by the policyholder who knew at the time of making it that thestatement was false, amounts tomisrepresentation or non-disclosure.


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Declaration

In a proposal for life insurance, the proposermakes a declaration to the effect that all thestatements in the proposal form are true and thathe agrees that these statements as also anyfurther statement made or to be made by himbefore the medical examiner shall be the basis of

the contract between him and the insurer and ifany untrue statement be contained therein, theinsurer would be entitled to treat the contract asnull and void and forfeit all the moneys paidtherefor.


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Section 45 of the Indian

Insurance Act,1938

The effect of the declaration at the foot of theproposal form by the proposer is to turn therepresentations in the proposal into warrantieswhich must be complied in toto.

Any incorrect or inaccurate answers to aquestion on the proposal form will render the

contract voidable at the option of the insurer,irrespective of the fact whether it is material tothe risk or not. The answers are required to beliterally true and absolutely correct.


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Insurable Interest

Insurable Interest is necessary for a

valid contract of insurance, the insuredwho is to benefit from the proceeds

must be in a relationship with the

subject of insurance, whereby hebenefits from its safety and well-being

and would be prejudiced by its loss or

damage.


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continued

Insurable interest is required to support

the contract of insurance in order tomake it enforceable at law. In absence

of insurable interest, no contract of

insurance can come into existence.Lack of insurable interest will render the

contract void.


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It is not the house, ship, machinery or

life that is insured but it is the pecuniaryinterest of the insured in that house,

ship, machinery, etc. which is insured.


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Difference between Wagering

Contract and Insurance Contract

Wagering contract involves a speculative risk

which is not insurable. This type of contract isillegal in terms of section 30 of the Indian

Contract Act and therefore invalid.

In an Insurance contract, the insured must

have an insurable interest in the subject of

insurance and the event insured against is

not subject to the control of the Insured.


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Examples of Insurable

Interest

A person has unlimited insurable interest inhis own life.

A husband has insurable interest in the life ofhis wife and vice-versa.

An employer has insurable interest in hisemployee to the extent of the value of his

services. An employee has insurable interest in the life

of his employer to the extent of hisremuneration for the period of notice.


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continued

A creditor has an insurable interest in

the life of the debtor, to the extent of thedebt which he may lose if the debtor

dies before repaying the loan.

Partners have insurable interest in thelives of each other because they stand

to lose in the event of death of any of

them.


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continued

A surety has an insurable interest in the life of

his co-surety to the extent of the debt andalso on the life of the principal debtor.

A company has an insurable interest in the

life of key valuable employee.

Parents have insurable interest in the life of a

child till the policy vests in him on attainment

of majority.


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Features of Insurable Interest

In case of life insurance policies, insurableinterest must exist at the inception of thepolicy and is not required at the time of claimunder the policy.

In case of Marine policies, insurable interestmust exist at the time of claim under the

policy and there need not be insurableinterest at the inception of the policy.

In other insurances, insurable interest mustexist at the time of inception as well as at thetime of claim.


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Principle of Indemnity

Insurance is meant to compensate losses

and cannot be used to make profit. The amount paid out as a claim cannot

exceed the amount of loss incurred.

Insurer should place the insured in the same

financial position after a loss as he enjoyed

before it, but not better.


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continued

Indemnity is defined as compensation

for loss or injury sustained. Insurancecontracts promise to make good the

loss or damage. However, payments

for loss or damage are limited to theactual amount of the loss or damage

subject to the sum insured.


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continued

For example, if an insured takes a policy of

Rs.1 lac on a house worth Rs.75,000/- andlater sells it during the policy period, no

payment is made under the policy if the

house is destroyed by fire because the

insured has suffered no loss. If the house isdestroyed before it is sold, the insured will be

paid only Rs.75,000/- because that is his

actual loss.


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continued

From the above example it is clear that an insuredcan recover a loss under a policy only if he hasinsurable interest and he can recover a loss only tothe extent of his insurable interest.

The object of the principle of indemnity is to place theinsured after a loss in the same financial position as

far as possible, as he occupied immediately beforethe loss to prevent the insured from making a profitout of his loss or gaining any benefit or advantage.


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continued

If it were possible to make profit out of

the happenings of loss or damage, theinsured would be tempted to

deliberately cause the loss or damage.

It would also tend to make the insuredcareless in maintaining the property in

good condition and in preventing the

loss.

Wh th th P i i l f


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Whether the Principle of

Indemnity applicable to Life

Insurance?

There is a link between indemnity and

insurable interest in the sense that theamount of claim cannot exceed the extent of

interest.

In case of life insurance however, because

the insurable interest is assumed to beunlimited, the principle of indemnity does

not apply.


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continued

The Principle of Indemnity is applied in

insurance where the loss suffered bythe insured is measurable in terms of

money. Thus the principle is applied to

insurances of physical property (i.e. fire,burglary etc.) and in insurances of

liabilities (employers liability)


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continued

The Principle of Indemnity does not apply to

life insurance where human life is the subjectmatter of these insurances, because of

difficulty in putting monitory value on human

life. It is not possible to measure the financial

loss caused by the death of the insured orbodily injury sustained by him due to

accident.


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continued

However, in practice the spirit of the

Principle of Indemnity is preserved inlife insurance policies by restricting thesum insured to an amount which iscommensurate to the financial status of

the insured and by insuring that themonthly benefit for disablement is in linewith the insureds normal earningcapacity.


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continued

For example, a person whose monthly salary

is Rs.1000/- will not be granted a personalaccident policy of Rs.1,00,000/- which wouldprovide a monthly benefit of Rs.4000/-. Thisamount is far in excess of his monthly incomeand, in the event of disablement due toaccident, the insured would be tempted toprolong his recovery to derive undue financialadvantage under his policy.


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continued

Insurers also try to control over-insurance. A

question is asked in the proposal formwhether the proposer has already covered

himself by previous policies on his life and the

sun insured thereunder. The sum insured is

fixed under the proposed insurance takinginto account the amount already insured

under the existing policy.


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Difficulties in settlement of claims

in General Insurance

Assessments of losses made by qualifiedsurveyors are often disputed.

The damaged parts that have been replaced,called salvage, may have some resalablevalue.

The insurer may have the option to settle the

claim by way of repair, reinstatement orreplacement.

In cases of liability or damages the level ofindemnity is vague and indeterminable.


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continued

In General Insurance, property which ispartially saved from loss or damage is calledsalvage. If a motor car is damaged to such anextent that it is not worthwhile to repair it,because the cost of repairs would exceed thesum insured or its value, in such cases the

insurers would settle it as a total loss andtake over the salvage. If the salvage is left tothe insured, to that extent he would bebenefited which is against the principle ofindemnity.


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continued

In General Insurance, the insurer may have option tosettle the claim by way of repair, reinstatement or

replacement. Repair: Instead of making a cash payment, the

settlement of claims for loss or damage may beeffected by repair. This is the practice followed for

damage claims. The procedure is for the insured tosubmit a detailed estimate of the cost of repairs to theinsurer who will arrange an inspection of thedamaged vehicle to see that the repairs arenecessary and the cost reasonable.


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continued

Thereafter, the insurer, will authorise the

repair of the vehicle. On receipt of the final billof repairs and a satisfaction note from the

insured, the repairer is paid.

Replacement: The insurer may directly

arrange with a dealer to replace the property(e.g. jewellery) lost or damaged. This method

is rarely met with in practice.


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continued

Reinstatement: This method would apply in

respect of buildings or other propertydestroyed or damaged by fire. This method is

rarely used by insurers because once this

method is chosen, the insurers cannot

subsequently withdraw and offer cashsettlement. The responsibility for the way in

which reinstatement is carried out will be that

of the insurers.


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Risk Management

The life insurance business deals with therisks of death and old age. Insurance doesnot prevent these risks but can only mitigatethe consequences in those circumstances.Sickness and accident risks, includingdisability are insurable as supplementary

benefits under life insurance policies. The risks of sickness, accident andunemployment are insurable in non-lifeinsurance.


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Three ways of Risk

Management

Prevention or Avoidance: Death, old age,accidents, sickness and unemployment are not

preventable. The simplest way to deal with theproblem of any risk is to avoid it altogether. E.g. Ifa factory is to be located on the banks of a riverwhich is prone to serious floods every year thenthe firm may decide to shift the site to a saferlocation to avoid the major risk of flood damage.This technique is not always possible nor is itpractical in all cases.


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continued

Retention of Risk: Having ones own

resources to take care of the needs, likeputting aside savings to be used for therainy day. A firm may decide to bear onits own account some of the financial

losses caused by pure risks. Usuallythis is done where losses are small andtheir occurrence can be closelyestimated.


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continued

E.g. if goods in transit suffer minor damage

losses, the firm may not insure the risk butmay decide to treat the losses as normal

operating expenses of running the business.

Medical expenses for illnesses of employees

of big organisations like Railways may bedealt with through this method as they find it

cheaper to bear the risks themselves on

account of large number of employees.


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continued

Transfer of risk:

Insurance is a

mechanism for transfer

of risk to another

person like the State

takes over the

responsibility formedical care of its

citizens, or pays

benefits to elderly and

the unemployed.


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Different Insurance Needs of

Individuals

Protection of the standard of living of thefamily which is at risk on early death.

Future expenses on account of childrenseducation, marriage, start of some businessand so on.

Continuance of business, when financiers ask

for life insurance policies as collateralsecurity, or partners need to rearrangefinances on the death of a partner.

Substitute income when earning capacity

ceases due to old age or disabilities.


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continued

Continuance of business, when

financiers ask for life insurance policiesas collateral security, or partners need

to rearrange finances on the death of a

partner. Substitute income when earning

capacity ceases due to old age or

disabilities.


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Agents Role

Agents have to convince the people to go forinsurance by making them aware of their

insurance needs. While selling life insurance, it is necessary to be

aware of the needs of people. Different plans aredesigned with different benefits, so that they may

cater to the different needs of people dependingupon personal values, demands of society,family, age, occupation, habits, place ofresidence, and so on.


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continued

In selling life insurance, a sale can be

accomplished only when an appeal is madeto sentiments of love, of affection and of

concern like protecting the loved ones,

affording a good start in life for the children or

a desire for self-preservation in old age. Theagent has to study the insurance needs of

individual prospect and persuade them to buy

.


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