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The Insured and the Insurance Contract: Bridging the Gap.

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The growing need for insurance in our everyday life cannot be overemphasized. Insurance is an essential financial component that need to be considered when making sound financial decisions. Insurance in its real sense is a means of protection from financial loss and as such must be critically assessed when engaging in any policy (contract).

Generally, when insurers give the policy document (insurance contract) to the insured, all he does is glance through the policy and pile it up with the other bunch of financial papers forgetting he is bound by every single word in the policy. A lot of people fail to take their time to read their contracts and when issues arise, they get caught up by surprises in the contract document.

This is an issue that bothers on the relationship between the insured and the insurer. To avoid this, the insured is expected to understand the nitty-gritties of every detail in the contract.

Essentials of a Valid Insurance Contract

  • Offer and Acceptance
    When applying for insurance, the first thing you do is get the proposal form of the particular insurance company. After filling in the requested details, you send the form to the company (sometimes with a premium check). This is your offer. If the insurance company agrees to insure you, this is called an acceptance. In some cases, your insurer may agree or accept your offer after making some changes to your proposed terms.
  • Consideration
    This is the premium or the future premiums that you have to pay to your insurance company. For insurers, consideration also refers to the money paid out to you should you file an insurance claim. This means that each party to the contract must provide some value to the relationship.
  • Legal Capacity
    You need to be legally competent to enter into an agreement with your insurer. If you are a minor or mentally ill, for example, then you may not be qualified to make contracts. Similarly, insurers are considered to be competent if they are licensed under the prevailing regulations that govern them.
  • Legal Purpose                                                                                                                                                    If the purpose of your contract is to encourage illegal activities, it is invalid.

Contract Values

Most insurance contracts are indemnity contracts. Indemnity contracts apply to insurances where the loss suffered can be measured in terms of money.

  • Principle of Indemnity
    This states that insurers pay no more than the actual loss suffered. The purpose of an insurance contract is to leave you in the same financial position you were in immediately prior to the incident leading to an insurance claim. In other words, you will be remunerated according to the total sum you have assured.
  • Premium or Full Insurance

This requires paying the full value of an insured asset so that when it comes to its claims you get the full value as a remuneration.

  • Under-Insurance
    Often, in order to save on premiums, you may insure a percentage of the total value of the asset and when there is a partial loss, your insurer also pays that proportion while you have to dig into your savings to cover the remaining portion of the loss. This should be tried to be avoid as much as possible.

Not all insurance contracts are indemnity contracts. Life insurance contracts and most personal accident insurance contracts are non-indemnity contracts. When you purchase a life insurance policy at a certain amount that does not imply that your life’s value is equal to that amount. Because you can’t calculate your life’s net worth and fix a price on it, an indemnity contract does not apply.

Insurable Interest

The legal right to insure any type of property or any event that may cause financial loss or create a legal liability is called insurable interest. When it comes to insurance, it is not the house, car or machinery that is insured. Rather, it is the monetary interest in that house, car or machinery to which your policy applies.

It is also the principle of insurable interest that allows married couples to take out insurance policies on each other’s lives, on the principle that one may suffer financially if the spouse dies. Insurable interest also exists in some business arrangements, as seen between a creditor and debtor, between business partners or between employers and employees.

Principle of Subrogation

Subrogation allows an insurer to sue a third party that has caused a loss to the insured and pursue all methods of getting back some of the money that it has paid to the insured as a result of the loss.

For example, if you are injured in a road accident that is caused by the reckless driving of another party, you will be compensated by your insurer. However, your insurance company may also sue the reckless driver in an attempt to recover that money.

Good Faith

Doctrine of Utmost Good Faith
All insurance contracts are based on the concept of “uberrima fidei”, or the doctrine of utmost good faith. This doctrine emphasizes the presence of mutual faith between the insured and the insurer. In simple terms, while applying for insurance, it becomes your duty to disclose your relevant facts and information truthfully to the insurer. Likewise, the insurer cannot hide information about the insurance coverage that is being sold.

  • Duty of Disclosure: You are legally obliged to reveal all information that would influence the insurer’s decision to enter into the insurance contract. Factors that increase the risks – previous losses and claims under other policies, insurance coverage that has been declined to you in the past, the existence of other insurance contracts, full facts and descriptions regarding the property or the event to be insured – must be disclosed. These facts are called material facts. Depending on these material facts, your insurer will decide whether to insure you as well as what premium to charge. For instance, in life insurance, your smoking habit is an important material fact for the insurer. As a result, your insurance company may decide to charge a significantly higher premium as a result of your smoking habits.
  • Representations and Warranty: In most kinds of insurances, you have to sign a declaration at the end of the application form, which states that the given answers to the questions in the application form and other personal statements and questionnaires are true and complete. Therefore, when applying for fire insurance, for example, you should make sure that the information that you provide regarding the type of construction of your building or the nature of its use is technically correct.

Representations: These are the written statements made by you on your application form, which represent the proposed risk to the insurance company.

Warranties: They are imposed by the insurer to ensure that the risk remains the same throughout the policy and does not increase.

Breach of Utmost Good Faith

As already mentioned, insurance works on the principle of mutual trust. It is your responsibility to disclose all the relevant facts to your insurer. Normally, a breach of the principle of utmost good faith arises when you, whether deliberately or accidentally, fail to divulge these important facts. There are two kinds of non-disclosure:

  • Innocent non-disclosure relates to failing to supply the information you didn’t know about.
  • Deliberate non-disclosure means providing incorrect material information intentionally.

When you supply inaccurate information with the intention to deceive, your insurance contract becomes void.

  • Fraudulent non-disclosure means knowing about a material fact and purposely holding it back from the insurer.

If this deliberate breach was discovered at the time of the claim, your insurance company will not pay the claim.

If the insurer considers the breach as innocent but significant to the risk, it may choose to punish you by collecting additional premiums.

In case of an innocent breach that is irrelevant to the risk, the insurer may decide to ignore the breach as if it had never occurred.

Other Policy Aspects

Doctrine of Adhesion

The doctrine of adhesion states that you must accept the entire insurance contract and all of its terms and conditions without bargaining. Because the insured has no opportunity to change the terms, any ambiguities in the contract will be interpreted in his or her favor. 

Principle of Waiver and Estoppel

A waiver is voluntary surrender of a known right. Estoppel prevents a person from asserting those rights because he or she has acted in such a way as to deny interest in preserving those rights.

Presume that you fail to disclose some information in the insurance proposal form. Your insurer doesn’t request that information and issues the insurance policy. This is waiver. In the future, when a claim arises, your insurer cannot question the contract on the basis of non-disclosure. This is estoppel. For this reason, your insurer will have to pay the claim.

Endorsements

Endorsements are normally used when the terms of insurance contracts are to be altered. They could also be issued to add specific conditions to the policy. 

Co-insurance

Co-insurance refers to the sharing of insurance by two or more insurance companies in agreed proportion. For the insurance of a large shopping mall, for example, the risk is very high. Therefore, the insurance company may choose to involve two or more insurers to share the risk.

Coinsurance can also exist between you and your insurance company. This provision is quite popular in medical insurance, in which you and the insurance company decide to share the covered costs in the ratio of 20:80. Therefore, during the claim, your insurer will pay 80% of the covered loss while you shell out the remaining 20%.

Reinsurance

Reinsurance occurs when your insurer “sells” some of your coverage to another insurance company. Suppose you are a famous rock star and you want your voice to be insured for $50 million. Your offer is accepted by the Insurance Company A. However, Insurance Company A is unable to retain the entire risk, so it passes part of this risk – let’s say $40 million – to Insurance Company B. Should you lose your singing voice, you will receive $50 million from insurer A ($10 million + $40 million from insurer B). This practice is known as reinsurance.

Generally, reinsurance is practiced to a much greater extent by general insurers than life insurers.

So, when applying for insurance, ensure to understand the terminologies so you will not be found wanting.

 

 

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Insurance

How Much Life Insurance Should an Individual Carry?

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Very few people enjoy thinking about the inevitability of death. Fewer yet take pleasure in the possibility of an accidental or early death. If there are people who depend on you and your income, however, it is one of those unpleasant things you have to consider. In this narrative, I’ll approach the topic of life insurance in two ways: First I’ll point out some of the misconceptions, then I’ll look at how to evaluate how much and what type of life insurance one needs.

 

Does Everyone Need Life Insurance?

Buying life insurance doesn’t make sense for everyone. If you have no dependents and enough assets to cover your debts and the cost of dying (funeral, estate lawyer’s fees, etc.), then it is an unnecessary cost for you. If you do have dependents and you have enough assets to provide for them after your death (investments, trusts, etc.), you still do not need life insurance.

However, if you have dependents (especially if you are the primary provider) or significant debts that outweigh your assets, you likely will need insurance to ensure your dependents are looked after if something happens to you.

 

Insurance and Age

One of the biggest myths aggressive life insurance agents perpetuate is “insurance is harder to qualify for as you age, so you better get it while you are young.” To put it bluntly, insurance companies make money by betting on how long you will live. When you are young, your premiums will be relatively cheap. If you die suddenly and the company has to pay out, you were a bad bet. Fortunately, many young people survive to old age, paying higher and higher premiums as they age (the increased risk of them dying makes the odds less attractive).

Insurance is cheaper when you are young, but it is no easier to qualify for. The simple fact is insurance companies will want higher premiums to cover the odds on older people, but it is a very rare that an insurance company will refuse coverage to someone who is willing to pay the premiums for their risk category. That said, get insurance if you need it and when you need it. Do not get insurance because you are scared of not qualifying later in life.

 

Is Life Insurance an Investment?

Many people see life insurance as an investment, but when compared to other investment vehicles, referring to insurance as an investment simply doesn’t make sense. Certain types of life insurance are touted as vehicles for saving or investing money for retirement, commonly called cash-value policies. These are insurance policies in which you build up a pool of capital that gains interest. This interest accrues because the insurance company is investing that money for their benefit, much like banks, and are paying you a percentage for the use of your money.

However, if you were to take the money from the forced savings program and invest it in an index fund, you would likely see much better returns. For people who lack the discipline to invest regularly, a cash-value insurance policy may be beneficial. A disciplined investor, on the other hand, has no need for scraps from an insurance company’s table.

 

Cash Value vs. Term

Insurance companies love cash-value policies and promote them heavily by giving commissions to agents who sell these policies. If you try to surrender the policy (demand your savings portion back and cancel the insurance), an insurance company will often suggest that you take a loan from your own savings to continue paying the premiums. Although this may seem like a simple solution, keep in mind that if the loan is not paid off by the time of your death, it will be subtracted from the death benefit.

Term insurance is insurance pure and simple. You buy a policy that pays out a set amount if you die during the period to which the policy applies. If you don’t die, you get nothing (don’t be disappointed, you are alive after all). The purpose of this insurance is to hold you over until you can become self-insured by your assets. Unfortunately, not all term insurance is equally desirable. Regardless of the specifics of a person’s situation (lifestyle, income, debts), most people are best served by renewable and convertible term insurance policies. They offer just as much coverage, are cheaper than cash-value policies, and, with the advent of internet comparisons driving down premiums for comparable policies, you can purchase them at competitive rates.

The renewable clause in a term life insurance policy allows you to renew your policy at a set rate without undergoing a medical exam. This means if an insured person is diagnosed with a fatal disease just as the term runs out, he or she will be able to renew the policy at a competitive rate despite the fact the insurance company is certain to have to pay a death benefit at some point.

The convertible insurance policy provides the option to change the face value of the policy into a cash-value policy offered by the insurer in case you reach 65 years of age and are not financially secured enough to go without insurance. Even if you are planning on having enough retirement income, it is better to be safe, and the premium is usually quite inexpensive.

 

Evaluating Your Insurance Needs

A large part of choosing a life insurance policy is determining how much money your dependents will need. Choosing the face value (the amount your policy pays if you die) depends on:

  • How much debt you have. All of your debts must be paid off in full, including car loans, mortgages, credit cards, loans, etc. If you have a $200,000 mortgage and a $4,000 car loan, you need at least $204,000 in your policy to cover your debts (and possibly a little more to take care of the interest as well).
  • Income replacement. One of the biggest factors for life insurance is for income replacement. If you are the only provider for your dependents and you bring in $40,000 a year, you will need a policy payout that is large enough to replace your income plus a little extra to guard against inflation. To err on the safe side, assume that the lump sum payout of your policy is invested at 8% (if you do not trust your dependents to invest, you can appoint a trustee or select a financial planner and calculate his or her cost as part of the payout). Just to replace your income, you will need a $500,000 policy. This is not a set rule, but adding your yearly income back into the policy (500,000 + 40,000 = 540,000 in this case) is a fairly good guard against inflation. Once you determine the required face value of your insurance policy, you can start shopping around. There are many online insurance estimators that can help you determine how much insurance you will need.
  • Insuring others. Obviously there are other people in your life who are important to you and you may wonder if you should insure them. As a rule, you should only insure people whose death would mean a financial loss to you. The death of a child, while emotionally devastating, does not constitute a financial loss because children cost money to raise. The death of an income-earning spouse, however, does create a situation with both emotional and financial losses. In that case, follow the income replacement calculation we went through earlier with his or her income. This also goes for any business partners with which you have a financial relationship (for example, shared responsibility for mortgage payments on a co-owned property).

 

Other Ways to Calculate Your Needs

Most insurance companies say a reasonable amount for life insurance is six to 10 times the amount of annual salary. Another way of calculating the amount of life insurance needed is to multiply your annual salary by the number of years left until retirement. For example, if a 40-year-old man currently makes $20,000 a year, under this approach, the man will need $400,000 (20 years x $20,000) in life insurance.

The standard of living method is based on the amount of money the survivors would need to maintain their standard of living if the insured died. You take that amount and multiply it by 20. The thought process here is the survivors can take a 5% withdrawal from the death benefit each year (which is equivalent to the standard of living amount) while investing the death benefit principal and earning 5% or better.

 

Alternatives to Life Insurance

If you are getting life insurance purely to cover debts and have no dependents, there is another way to go about it. Lending institutions have seen the profits of insurance companies and are getting in on the act. Credit card companies and banks offer insurance deductibles on your outstanding balances. Often this amounts to a few dollars a month and in the case of your death, the policy will pay that particular debt in full. If you opt for this coverage from a lending institution, make sure to subtract that debt from any calculations you are making for life insurance—being doubly insured is a needless cost.

 

 

 

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