Contract Law Basics

An insurance policy is a legal contract. Before diving into the unique characteristics of insurance contracts, you need to understand what makes any contract legally valid and enforceable.

What Is a Contract?

A contract is a legally enforceable agreement between two or more parties. When you buy an insurance policy, you're entering into a contract with the insurance company. The company promises to pay benefits if certain events occur, and you promise to pay premiums.

---

Essential Elements of a Valid Contract

For any contract—including insurance—to be legally binding, it must contain five essential elements:

---

Offer and Acceptance

A valid contract requires a definite offer by one party and an acceptance of those exact terms by the other party.

In Insurance

• The Offer: Usually, the applicant makes the offer by completing an application and paying the initial premium
• The Acceptance: The insurance company accepts by issuing the policy as applied for

Counter-Offers

If the insurer doesn't accept the application exactly as submitted, they may make a counter-offer:

• Offering a policy with different terms
• Adding an exclusion or rider
• Charging a higher premium (rated policy)

The applicant can then accept or reject the counter-offer. No contract exists until both parties agree to the same terms.

Example

Sarah applies for life insurance at standard rates. The underwriter reviews her application and decides she qualifies only at a higher (substandard) rate due to health issues. The insurer's offer of coverage at the higher rate is a counter-offer. If Sarah accepts and pays the higher premium, a contract is formed.

---

Consideration

Consideration is something of value that each party gives to the other. Without consideration, there's no contract—just a gift or promise.

In Insurance

The insured's consideration is given upfront (the premium), while the insurer's consideration is conditional—it will only be paid if a covered loss occurs.

---

Competent Parties

All parties to a contract must have legal capacity—the ability to understand the contract and its consequences.

Individuals Lacking Legal Capacity

• Minors — Generally, anyone under age 18 (varies by state)
• Mentally incompetent persons — Those who cannot understand the nature of the contract
• Intoxicated persons — Those under the influence of alcohol or drugs at the time of contracting

Insurance Companies

An insurance company has legal capacity to contract if it is:

• Licensed (admitted) to do business in the state
• In good financial standing
• Operating within its charter

Contracts with Minors

Insurance contracts with minors are generally voidable—the minor can choose to void the contract, but the adult party cannot. Some states allow minors of certain ages (often 15 or 16) to enter into life insurance contracts.

---

Legal Purpose

A contract must have a legal purpose. Contracts to accomplish illegal objectives are void and unenforceable.

Examples of Illegal Purpose

• A life insurance policy taken out with intent to murder the insured
• Insurance on illegally obtained property
• Coverage for criminal activities

Important Note

The insurance transaction itself must be legal. A legitimate insurance contract doesn't become illegal just because the insured later commits a crime. However, insurance will not pay for intentional illegal acts by the insured.

---

Insurable Interest

Insurable interest exists when the policyholder would suffer a financial loss if the insured event occurred. This requirement prevents insurance from becoming a gambling contract.

When Insurable Interest Must Exist

Who Has Insurable Interest?

For Life Insurance:

• Every person has insurable interest in their own life (unlimited amount)
• Spouses have insurable interest in each other
• Parents have insurable interest in their minor children
• Business partners have insurable interest in each other
• Employers have insurable interest in key employees
• Creditors have insurable interest in debtors (limited to debt amount)

Why Insurable Interest Matters

Without insurable interest:

• The contract could become a gambling arrangement
• It would create a motive for causing the loss
• The contract would be void from inception

Key Point for Life Insurance

For life insurance, insurable interest is only required at the time of application, not at death. If a married couple divorces after a life insurance policy is issued, the policy remains valid even though the former spouse may no longer have an insurable interest.

---

Void vs. Voidable Contracts

Voidable in Insurance

An insurance contract may be voidable if:

• Material misrepresentation was made on the application
• Fraud was committed
• The applicant lacked legal capacity

The insurer typically can void the contract, but the insured cannot void it simply because they changed their mind.

---

Key Takeaways

• A valid contract requires: offer and acceptance, consideration, competent parties, legal purpose, and (for insurance) insurable interest
• The applicant usually makes the offer; the insurer accepts by issuing the policy
• Consideration for insurance is premium in exchange for the promise to pay claims
• Insurable interest for life/health insurance must exist at the time of application
• Contracts for illegal purposes are void; contracts with minors are typically voidable