What is an insurance contract?

Insurance is a contract wherein an individual or entity gets financial protection from the insurance company for any damages or losses incurred. The individual or entity is called the insured, whereas the insurance company is called the insurer. The insured and the insurer enter a legal contract for a fixed term called the insurance term, and the contract is called an insurance policy.

What are the components of an insurance contract?

Firstly, an insurance contract should mention the amount needed to purchase the insurance coverage, also known as the insurance policy premium. The insured can pay this premium to the insurer annually, bi-annually, or quarterly. Secondly, an insurance contract should mention the policy limit, the amount of coverage that the insurer provides to the insured. Finally, the insurance contract should mention the deductibles, the amount or percentage that the insured agrees to pay before the insurer sets in to pay the compensation.

Principles of insurance

• Principle of utmost good faith: The insured and the insurer should act in good faith towards each other. The insured must disclose all information to the insurer as required for purchasing the insurance policy, and the insurer should provide clear, concise, and unambiguous information on the policy terms to the insurer.
• Principle of proximate cause: This is also called the principle of Causa Proxima or the nearest cause. This principle states that the insurer should find the cause that is closest to causing loss or damage. The insured is liable to receive compensation only if the proximate cause results in a loss that the company insures.
• Principle of insurable interest: The insured is liable to incur financial as well as non-financial loss in the event of any unforeseen event. Insurable interest safeguards the insured person against all such losses. This principle states that the insured should have an insurable interest in the object for which insurance coverage has been sought. For example, the owner of a steel manufacturing unit, which has been insured with an insurance company, has an insurable interest in the manufacturing unit as he/she is earning income from it. If he/she sells off this unit, then he/she will cease to have an insurable interest in it.
• Principle of indemnity: This principle states that the insurance coverage provides protection against any unforeseen losses or damage accruing to the insured. The insured should not try to earn profits from the insurance contract. In other words, the insurer will compensate the insured only to the extent of actual losses covered by the insurance policy. Any losses in excess of the amount mentioned in the insurance policy are not liable to be paid by the insurer to the insured.
• Principle of subrogation: The principle of subrogation states that once the insurance company has compensated the insured for the losses incurred by him/her, the ownership of the property is transferred to the insurance company. Subrogation allows the insurer to claim the amount of loss from the third party who is responsible for the loss. For instance, take a scenario of a road accident where two parties are involved, one of them being the insured. The cause of the accident is the reckless driving of one party. In this case, the insurer will provide the insurance claim amount to the insured as well as sue the other party that caused the accident.
• Principle of contribution: This principle is applicable when the insured has more than one insurance policy providing insurance coverage for the same type of losses. For example, a property worth $50 million is insured with insurance company A for $10 million and with B for $40 million. In the event of losses or damages worth $10 million accruing to the property owner, he or she can claim the entire amount of losses either from insurance company A or insurance company B, but not from both. If he claims the losses from both the insurance companies, both the insurance companies will compensate the insured in a proportional manner.
• Principle of loss minimization: The principle states that the insured has an obligation to take the utmost care of his/her assets in a non-negligent manner. Just because the asset is insured, it does not mean that the insured can act in a negligible manner to bring about any losses or damages to the insured asset.

Types of insurance contract

Insurance contracts can be of two types based on the type of object for which the insurance coverage is sought by the insured. If an insurance contract provides coverage against the insured's loss of life, it is called a life insurance contract. All other insurance contracts that provide coverage for objects other than life are called non-life or general insurance contracts. Life Insurance contracts can further be categorized based on profit-sharing of the insurer into participating and non-participating insurance policies.

Life insurance contract

Life insurance is a contract between the insured and an insurance company wherein the insurance company pays a lump sum amount to the policyholder or their nominees mentioned in the insurance policy in the event of maturity of the policy or death of the policyholder. A life insurance contract provides risk coverage throughout the policy period. On the expiry of the policy term, the insurance company pays bonuses and dividends to the policyholder as survival benefits. In the event of the policyholder's death during the policy term, the sum insured under the policy, along with the vested bonus, is paid to the policyholder's nominee, as mentioned in the insurance contract.

Types of life insurance contract

There are three major types of life insurance contracts based on the period of risk coverage: term insurance contract, whole life insurance contract, and universal life insurance contract. These three are the basic types of life insurance contracts, but the market is flooded with several life insurance policies that combine these three types of life insurance contracts.

• Term life insurance policy: A term insurance contract is the simplest form of a life insurance contract. Term insurance contracts are entered into by the insurer and the insured for a fixed duration of time, and the provision for protection gets exhausted once the policy period is over. Also, in such contracts, there is no cash value remaining at the end of the policy period.
• Whole life insurance policy: Whole life insurance contracts do not have any clause relating to a specified policy period, and they provide risk coverage for the entire lifetime of the insured. Such insurance contracts accumulate a cash value that is not more than the face value of the insurance policy. Such policies have a provision to pay the cash value to the policyholder on maturity or surrender of the policy.
• Universal life insurance policy: Such insurance contracts have a provision for allowing the owner to decide the policy period, amount of premium, and the amount of death benefit required to be covered by the life insurance policy. Such policies have a provision wherein the insurer makes a monthly charge for general expenses and mortality costs and credits the amount of interest earned to the policyholder. Universal life insurance policies are further divided into type A and type B policies. Type A policies have a provision for a specified amount of death benefits, whereas type B universal life insurance policies have a provision for a specified amount of death benefits along with an accumulated cash value to be paid to the insured.

Life insurance contracts can further be classified as follows:

• Group life insurance policy: This type of insurance coverage is provided by employers to groups of employees.
• Industrial life insurance policy: Industrial life insurance policy consists of a large number of individual contracts with weekly or daily premiums.
• Credit life insurance: Credit life insurance is created when an individual purchases an asset on an installment basis. Such life insurance policies have a clause which states that if the insured dies before the payment of all the installments, the seller will be protected against any losses arising due to the non-payment of the remaining installments.

Non-life or general insurance contract

General insurance is a contract between the insured and the insurer wherein the insurance company provides risk coverage to any asset or object other than an individual's life in which the insured has a financial interest. Motor insurance, property insurance, and travel insurance are a few types of general insurance products sold by insurance companies. General insurance policies are issued for a period of one year and are renewable annually.

Types of general insurance products

• Motor insurance: A motor insurance policy is mandatory for driving legally in the country. Motor insurance policies can be of two types, namely, a third-party liability insurance policy or a comprehensive package policy. Third-party liability insurance has liability coverage for losses arising in a situation where the insured's motor vehicle causes damage to a third party, such as public property or some other vehicle. A comprehensive package policy has liability coverage for third-party losses as well as losses arising to the insured's motor vehicle for no fault of his, such as accident, theft, fire, natural calamities, or any other causes.
• Homeowners insurance: Homeowners insurance covers the entire range of risks and losses arising from burglary, theft, or natural calamities.
• Health insurance: Health insurance provides coverage against the expenses related to hospitalization, accidental illness, day-care procedures, psychiatric support, annual health check-up, maternity benefits, and critical illnesses.
• Accident insurance: Accidental coverage is a type of casualty insurance and protects an individual against out-of-pocket expenses arising to the insured in the event of an accident or physical injury.
• Travel insurance: Travel insurance covers financial liability if any when the insured is traveling within or beyond the boundaries of the country. The scope of coverage of this type of policy extends to loss of baggage, loss of passport, losses arising due to hijacking, medical emergencies during travel, and delayed flights.
• Disaster insurance: Disaster insurance covers losses arising to the insured due to multiple perils, such as extreme weather conditions as well as losses arising due to natural disasters, such as floods and earthquakes.
• Commercial line insurance: Such insurance policies provide coverage to business entities against losses arising due to moral hazards as well as any unforeseen events that disrupt the business operations. Property insurance, marine insurance, liability insurance, and employee benefits insurance are some examples of such insurance. Out of these, liability insurance can be further categorized into third-party liability insurance, public liability insurance, product liability insurance, and professional liability insurance.

Context and Applications

This topic is significant in the professional exams for both undergraduate courses & postgraduate courses and competitive exams, especially for:

• Masters of Business Administration (Finance)
• Bachelors of Business Administration (Finance)
• Bachelor of Commerce
• LOMA Certification

Practice Problems

Common Mistakes

Students often mistake health insurance to be a part of life insurance contracts. Life insurance contracts cover any losses arising due to the individual's loss of life. This is why life insurance policies mandate the contract to have the nominee's name in the insurance policy. In the event of the insured's death, the policy benefits are given to the nominee. On the other hand, health insurance covers only the losses arising due to various illnesses and hospitalization. It does not have any death benefits for the insured.

Related Concepts

While studying this topic, it is important to read the following topics to get a better knowledge:

• Liability insurance
• Insurance operations
• Insurance administration
• Marketing of insurance products