Elements of Insurance Contract (How it Works)

Insurance may be defined as a contract between two parties whereby one party called insurer undertakes, in exchange for a fixed sum called premiums, to pay the other party called insured a fixed amount of money on the happening of a certain event.

The insurance, thus, is a contract whereby

  1. Certain sum. called premium, is charged in consideration
  2. Against the said consideration, a large sum is guaranteed to be paid by the insurer who received the premium
  3. The payment will be made in a certain definite sum. i e , me loss or the policy amount whichever may be, and
  4. The payment is made only upon a contingency

Since Insurance is a contract, certain sections of Contract Act are applicable.

Elements of Insurance Contract (How it Works)

Section 10 of this Act says,

All agreements are contracts if they are made by free consent of the parties, competent to contract, for a lawful consideration and with a lawful object and which are not hereby declared to be void.

Elements of Insurance Contract can be classified into two sections;

  1. The elements of general contract and
  2. The elements of special contract relating to insurance: the special contract of insurance involves principles: insurable interest, utmost good faith, indemnity, subrogation, warranties. Proximate cause, assignment and nomination, return of premium.

Insurance may be defined as a contract between two parties of whereby one party called insurer undertakes, in exchange for a fixed sum called premiums, to pay the other party called insured a fixed amount of money on the happening of a certain event.

Since insurance is a contract, certain sections of Contract Act are applicable.

This Act says that all agreements are contract if they are made by free consent of the patties, competent to contract, for a lawful consideration and with a lawful object and which are not hereby declared to be void”.

The insurance contract involves—(A) the elements of general contract, and (B) the element of special contract relating to insurance.

The special contract of insurance involves principles:

  1. Insurable Interest.
  2. Utmost Good Faith.
  3. Indemnity.
  4. Subrogation.
  5. Warranties.
  6. Proximate Cause.
  7. Assignment and Nomination.
  8. Return of Premium.

So, in total, there are eight elements of insurance contract which are discussed below:

General Contract

The valid contract, according to Section 10 of Indian Contract Act 1872, must have the following essentialities;

  1. Agreement (offer and acceptance),
  2. Legal consideration,
  3. Competent to make contract,
  4. Free consent,
  5. Legal object.

Offer and Acceptance

The offer for entering into contract may generally come from the insured.

The insurer may also propose to make the contract. Whether the offer is from the side of insurer or from the side of insured, the main fact is acceptance. Any act that precedes it is offer or a counter-offer. All that precede the offerer counter-offer is an invitation to offer.

In insurance, the publication of prospectus, the canvassing of the agents are invitations to offer.

When the prospect (the potential policy-holder) proposes to enter the contract it is an offer and if there is any alteration in the offer that would be a counter-offer.

If this alteration or change (counter-offer) ill accepted by the proposer, it would be an acceptance.

In absence of counter-offer, the acceptance of offer will be an acceptance by the insurer. At the moment, the notice of acceptance is given to other party; it would be a valid acceptance.

Legal Consideration

The promisor to pay a fixed sum at a given contingency is the insurer who must have some return or his promise. It need not be money only but it must be valuable.

It may be sums, right, interest, profit or benefit Premium being the valuable consideration must be given for starting the insurance contract.

The amount of premium is not important to begin the contract. The fact is that without payment of premium, the insurance contract cannot start.

Competent to make contract

Every person is competent to contract;

  1. Who is of’ is age of majority according to the law,
  2. Who is of sound mind, and
  3. Who is not disqualified from contracting by any law to which he is subject.

A minor is not competent to contract. A contract by a minor is void excepting contracts for necessaries. A minor cannot sign a contract.

A person is said to be of sound mind for the purpose of making a contract if at the time when he makes it, he is capable of understanding it and of forming a rational judgment as to its effect upon his interests.

A person who is usually of unsound wind, but, occasionally of sound mind may .make a contract when he is of sound mind. An alien energy, an un-discharged insolvent and criminals cannot enter into contract. Contract made by incompetent party/parties will be void.

Free Consent

Parties entering into the contract should enter into it by their free consent.

The consent will be free when it is not caused by—

(1) coercion,
(2) undue influence,
(3) fraud, or
(4) misrepresentation, or
(5) mistake.

When there is no free consent except fraud the contract becomes voidable at the option of the party whose consent was so caused. In case of fraud the contract would be void.

The proposal for free consent must sign a declaration to this effect, the person explaining the subject matter of the proposal to the proposer must also accordingly make a written declaration or the proposal.

Legal Object

In order to make a valid contract, the object of the agreement should be lawful. An object that is,

(i) not forbidden by law or
(ii) is not immoral, or
(iii) opposed to public policy, or
(iv) which does not defeat the provisions of any law, is lawful.

In proposal from the object of insurance is asked which should, be legal and the object should not be concealed. If the object of insurance, like the consideration, is found to be unlawful, the policy is void.

Insurable Interest

For an insurance contract to be valid, the insured must possess an insurable interest in the subject matter of insurance.

The insurable interest is the pectiniary interest whereby the policy-holder is benefited by the existence of the subject-matter and is prejudiced death or damage of the subject- matter. The essentials of a valid insurable interest are the following:

  1. There must be a subject-matter to be insured.
  2. The policy-holder should have monetary relationship with the subject-matter.
  3. The relationship between the policy-holders and the subject-matter should be recognized by law. In other words, there should not be any illegal relationship between the policy-holder and the subject-matter to be insured.
  4. The financial relationship between the policy-holder and subject-matter should be such that the policy-holder is economically benefited by the survival or existence of the subject-matter and or will suffer economic loss at the death or existence of the subject-matter.

The subject-matter is life in the life insurance, property and goods in property insurance, liability and adventure in general insurance.

Insurable interest is essentially a pecuniary interest, i.e., the loss caused by fire happening of the insured risk must be capable of financial valuation.

No emotional or sentimental loss, as an expectation or an anxiety, would be the ground of the insurable interest. The event insured should be one that if it happens the party suffers financially and if it does not happen, the party is benefited by the existence.

But a mere hope or expectation, which may be frustrated by the happening of some extent, is not an insurable interest.

Utmost Good Faith

The doctrine of disclosing all material facts is embodied in the important principle ‘utmost good faith’ which applies to all forms of insurance.

Both parties of the insurance contract must be of same mind (ad idem) at time of contract. There should not be any misrepresentation, non-disclosure or fraud concerning the material.

In case of insurance contract the legal maxim ‘Caveat Emptor” (let the buyer beware) docs not prevail, where it is regard of the buyer to satisfy himself of the genuineness of the subject-matter and the seller is under no obligation to supply information about it.

But in insurance contract, the seller, i.e., the insurer will also have to disclose all the material facts.

An insurance contract is a contract of uherrimae fidei, i.e., of absolute good faith both parties of the contract must disclose all the material facts and fully.

Material Facts

A material fact is one which affects the judgment or decision of both parties in entering to the contract.

Facts which count materially are those which knowledge influences a party in deciding whether or not to offer or to accept such risk and if the risk, is acceptable, on what terms and conditions the risk should be accepted.

These facts have a direct beaming on the degree of risk in relation to the subject of insurance.

In case of life insurance, the material facts or factors affecting the risk will be age, residence, occupation, health, income, etc., and in case of property insurance, it would he use design, owner and situation of the property.

Full and True Disclosure

The utmost Good Faith says that all the material facts should be disclosed in true and fill form. It means that the facts should be disclosed in that form in which they really exist.

There should be no concealment, misrepresentation, mistake or fraud about the material facts. There should be no false statement and no half-truth nor nay silence on the material facts.

Duty of Both the Parties

The duty to disclose the material facts lies on both the parties the insured as well as the insurer, but in practice the assured has to be more particular, about the; observance of this principle because it is usually in full knowledge of facts relating to the subject-matter which, despite all effective inspections of the insurer, would not be disclosed.

Facts need not be disclosed by the insured

The following facts, however, are not required to be disclosed by the insured (0 Facts which tend to lessen the risk.

  1. Facts of public knowledge.
  2. Facts which could be inferred from the information disclosed.
  3. Facts waived by the insurer.
  4. Facts governed by the conditions of the policy.

Principle of Indemnity

As a rule all insurance contracts except personal insurance are contracts of indemnity.

According to this principle, the insurer undertakes to put the insured, in the event of loss, in the same position that he occupied immediately before the happening of the event insured against, in certain form of insurance, the principle of indemnity is modified to apply.

For example, in marine or fire insurance, sometimes, certain profit margin which would have earned in absence of the event, is also included in the loss. In true sense of the indemnity, the insured is not entitled to make a profit of his loss.

  1. To discourse over insurance the principle of indemnify it an essential feature of an insurance contract, in absence whereof this industry would have the hue of gambling and the insured would tend to effect over-insurance and then intentionally cause a loss to occur so that a financial gain could he achieved.So, to avoid this international loss, only the actual loss becomes payable and not the assured sum (which is higher in over-insurance). If the property is under-insured, i.e. the insured amount is less than the actual value of the property insured, the insured is generally regarded his own insurer for the amount if under insurance and in case of loss one shall share the loss himself.
  2. To avoid an Anti-social Act; if the assured is allowed to gain more than the actual loss, which is against the principle of indemnity, he will be tempted to gain by destruction of his own property after getting it insured against a risk.He will be under constant temptation to destroy the property. Thus, the whole society will be doing only anti-social act, i.e., the persons would be interested in gaining after destruction of the property. So, the principle of indemnity has been applied where only the cash-value of his loss and nothing more than this, though he might have insured for a greater amount, will be compensated.
  3. To maintain the Premium at Low-level; if the principle of indemnity is not applied, larger amount will be paid for a smaller loss and this will increase the cost of insurance and the premium of insurance will have to be raised.If premium is raised two things may happen first, persons may not be inclined to insure and second, unscrupulous persons would get insurance to destroy the property to gain from such act.Both things would defeat the purpose of insurance. So, principle of indemnity is here to help them because such temptation’ is eliminated when only actual loss and not more than the actual financial loss is compensated provided there is insurance up to that amount.

Conditions for Indemnity Principle

The following conditions should be fulfilled in full application of principle of indemnity.

  1. The insured has to prove that he will suffer loss on the insured matter at the time of happening the event and the loss is actual monetary loss.
  2. The amount of compensation will be the amount of insurance. Indemnification cannot be more than the amount insured.
  3. If the insured gets more amount than the actual loss, the insurer has right to get the extra amount back.
  4. If the insured gets some amount from third party after being fully indemnified by insurer, the insurer will have right to receive alt the amount paid by the third party.
  5. The principle of indemnity does not apply to personal insurance because the amount of loss is not easily calculable there.

Doctrine of Subrogation

The doctrine of subrogation refers to the right of the insurer to stand in the place of the insured, after settlement of a claim, in so far as the insured’s right of recovery from an alternative source is involved.

If the insured is in a position to recover the loss in full or-in part from a third party due to whose negligence the loss may have been precipitated, his right of recovery is subrogated to the insurer on settlement of the claim. The insurers, thereafter, recover the claim from the third party. The right of subrogation may be exercised by the insurer before payment of loss.

Essentials of Doctrine of Subrogation

Corollary to the Principle of Indemnity

The doctrine of subrogation is the supplementary principle of indemnity.

The latter doctrine says that only the actual value of the loss of the property is compensated, so the former follows that if the damaged property has any value left, or any right against a third party the insurer can subrogate the left property or right of the property because if the insured is allowed to retain, he shall have realized more than the actual loss, which is contrary to principle of indemnity.

Subrogation is the Substitution

The insurer, according to this principle’, becomes entitled to all the rights of insured subject matter after payment because he has paid the actual loss of the property. He is substituted in place of other persons who act on the right and claim of the property, insured.

Subrogation only up to the amount, of payment

The insurer is subrogated all the rights, claims, remedies and securities’ of the damaged insured property after indemnification, but he is entitled to gel these benefits only to the extent of his payment.

The insurer is, thus, subrogated to the alternative rights and remedies of the insured, only up to the amount of his payment to the insured.

In the same way if die insured is compensated for his loss from another party after he has been indemnified by his insurer he is liable to part with the compensation up to the extent that the insurer is entitled to.

In one U.S. case it was made clear “if the insurer, having paid the claim to the insured, recovers from the defaulting third party in excess of the amount paid under the policy, he has to pay this excess to the insured though he may charge the insured his share of reasonable expenses incurred in collecting.

The Subrogation may be applied before Payment

If the assured got certain compensation, from third party before being fully indemnified by the insurer, the insurer can pay only the balance of the loss.

Personal Insurance

The doctrine of subrogation does riot apply to persona’ insurance because the doctrine of indemnity is not applicable to such insurance. The insurers have no right of action against the third party in respect of the damage.

For example, if ah insured dies due to. the negligence of a third party his dependent has right to recover the amount of the loss from the third party along with the policy amount No amount of the policy would be subrogated by the insurer.


There are certain conditions and promises in the insurance contract which are called warranties.

According to Marine Insurance Act, “A warranty is that by which the assured undertakes that some particular thing shall or shall not be done, or that some conditions shall be fulfilled, or whereby he affirms or negatives the existence of a particular state of facts”.

Warranties which are mentioned in the policy are called express warranties. There are certain warranties which are not mentioned in the policy.

These warranties are called implied warranties. Warranties which are answers to the question arc called affirmative warranties. The warranties fulfilling certain conditions or promises are called promissory warranties.

Warranty is the very important condition in the insurance contract which is to be fulfilled by the insured. On breach of warranty the insurer becomes free from his liability.

Therefore insured must have to fulfill the conditions and promises during the insurance contract whether it is important or not in connection with the risk.

The contract can continue only when warranties are fulfilled. I f warranties are riot followed, the contract may be cancelled by the other party whether risk has occurred or not or the loss has occurred due to other reason than the waiving of warranties.

However, when the warrant is declared illegal and there is no reverse effect on the contract, the warranty can be waived.

Proximate Cause

The rule; is that immediate and not the remote cause is to be regarded. The maxim is “sed causa proximo non-remold-spectature”; see the proximate cause and not, the distant cause.

The real cause must be seen while payment of the loss. If the real cause of loss is insured, the insurer is liable to compensate the loss; otherwise the insurer may not be responsible for loss.

Proximate cause is not a device to avoid the trouble of discovering the real ease or the common sense cause.

Proximate cause means the active efficient cause that sets in motion a train of events which brings about result, without intervention of any force started and working actively from a new and independent source.

The determination of real cause depends upon the working and practice of insurance and circumstances to losses. A loss may not be occasioned merely by one event.

There may be concurrent causes or chain of causes. They may occur in a sequence or in broken chain. Sometimes, certain causes arc excepted by (he insurance contract and the insurer is not liable for the accepted peril.

The efficient cause of a loss is called the proximate cause of the loss.

For the policy to cover the loss must have an insured peril as the proximate cause of the loss or also the insured peril must occur in the chain of causation that links the proximate cause with the loss.

The proximate cause is not necessarily, the cause that was nearest to the damage either in time or in place, but is rather the cause that was actually responsible for loss.

Determination of Proximate Cause

  1. If there is a single cause of the loss, the cause will be the proximate cause and further if the peril (cause of loss) was insured, insurer will have to indemnify the loss.
  2. If there are concurrent causes, the insured perils and excepted perils have to be segregated. The concurrent causes may be first, separable and second, inseparable. Separable causes are those which can be separated from each other. The loss occurred due to a particular cause may be distinguishing known.In such a case if any cause, is excepted peril, insurer will have to pay up to the extent of loss which occurred due to insured perils. If the circumstances are such that the perils are inseparable, then the insurers are not liable at ail when there exists any excepted peril.
  3. If the causes occurred in form of chain, they have to be observed seriously.
    • If there is unbroken chain the excepted and insured peril has to be separated. If an excepted peril precedes the operation of the insured peril so that the loss caused by the latter is the direct and natural consequences of the excepted peril, there is no liability. If the insured peril is followed by an excepted peril there is valid liability.
    • If there is a broken chain of events with no excepted peril involved, it is possible to separate the losses. The insurer is liable only for that loss which caused by an insured peril; where there is an excepted peril, the subsequent loss caused by an insured peril will be a new and indirect cause because of the interruption in the chain of events.The insurer will be liable for the loss caused of insured peril which can be easily segregated. Similarly, if the loss occurs by an insured peril and there is, subsequently loss by an excepted peril, the insurer will be liable for loss occurred due to the insured peril.

In brief, if the happening of an excepted peril is followed by the occurrence of an insured peril, as a new and independent cause there is a valid claim. If an insured peril is followed by the happening of an excepted peril, as a new and independent cause, there is a claim excluding loss or damage; caused by the excepted peril.

Assignment or Transfer of Interest

It is necessary to distinguish between assignment of (a) the subject-matter of insurance, (b) the policy, and (c) the policy money when payable.

Marine and life policies can be freely assigned but assignment under fire and accident policies, are not valid without the prior consent of the insurers—except changes of interest by will or operation of law.

Moreover, assignments under fire and accident policies must be made before tine insured parts with his, interest. Once he has lost the interest the policy is void and cannot be assigned.

The life policies can, be assigned whether the assignee has an insurable interest or not.

Life policies are frequently charged, assigned or otherwise dealt with, for they are valuable securities. A marine policy is freely assignable unless it contains terms expressly prohibiting assignment.

It assigned either before or after loss. A marine policy may be assigned by endorsement thereon or in other customary manner.

In practice, a marine cargo policy is frequently endorsed in blank and becomes in effect a quasi-negotiable instrument.

Thus, it will be appreciated, adds considerably to the convenience of mercantile transactions as the policy can be negotiated through a bank along with other documents of title.

Assignment in fire insurance cannot be recognized without prior consent of the insurer, change of interest in fire policies (unless by will or operation of law) are not valid unless and until the consent of the insurer has been given.

The fire policies are not in the nature of assignment nor intended to be assigned from one person to another without the consent of the insurer. Assignment in fire insurance constitutes a new contract.

Return of Premium

Ordinarily the premium once paid cannot be refunded. However, in the following cases the refund is allowed.

By Agreement in the Policy

The assured may pay full premium while affecting the insurance but it may be agreed to return it wholly or partly in the happening of certain events. For example, special packing may reduce the risk.

For Reasons of Equity

  1. Non-attachment of risk: Where the subject-matter insured or part thereof, has never ten imperiled for example, term insurance with returnable premium where premium is returned to the policy-holder if death does not occur during period of insurance.
  2. Undeclared balace of on open policy: The policy may be cancelled and premium may be returned for short interest allowed provided there was no further interest in the policy.
  3. Payment of Premium is apporiionable. The apportioned part of -the consideration is refundable when a part of policy interest is not involved. For example, insurance may be taken for a voyage in stages, each stage being rated separately. In such a case if some stages are not completed the premium relating to incomplete stage is returnable.
  4. Where the assured has no insurable interest throughout the currency of the risk, the premium is returnable provided the policy was not attached by way of wagering.
  5. Unreasonable delay in commencing the voyage may also entitle the insurer to cancel the insurance by returning the premium.
  6. Where the assured has over-insured under an unvalued policy a proportionate part of the premium is returnable.

Over-insurance by Double Insurance

If there is over-insurance by double insurance, a proportionate part of the several premiums is returnable provided that if the policies are taken at different times and any earlier policy has at any time born the entire risk or if a claim has been paid.

On the policy in respect of the foil insured thereby, no premium is returnable in respect of that policy and when double insurance is affected knowingly by the assured no premium is returnable.

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