Chapter 10 Structure and Analysis of Insurance Contracts

Period of Coverage

All insurance policies specify the period of coverageThe time duration for which coverage applies., or the time duration for which coverage applies. Life and health policies may provide coverage for the entire life of the insured, a specified period of years, or up until a specified age. Health policies and term life policies often cover a year at a time. Most property insurance policies are for one year or less (although longer policies are available). Perpetual policies remain in force until canceled by you or the insurer. Liability policies may be for a three-month or six-month period, but most are for a year. Some forms of automobile insurance may be written on a continuous basis, with premiums payable at specified intervals, such as every six months. Such policies remain in force as long as premiums are paid or until they are canceled. Whatever the term during which any policy is to be in force, it will be carefully spelled out in the contract. During periods when insureds may expect a turn to hard markets in the underwriting cycles, they may want to fix the level of premiums for a longer period and will sign contracts for longer than one year, such as three years.

Limitations of Liability

All insurance policies have clauses that place limitations of liabilityThe maximum amount payable by an insurance policy. (maximum amount payable by the insurance policy) on the insurer. Life policies promise to pay the face amount of the policy. Health policies typically limit payment to a specified amount for total medical expenses during one’s lifetime and have internal limits on the payment of specific services, such as a surgical procedure. Property insurance policies specify as limits actual cash value or replacement value, insurable interest, cost to repair or replace, and the face amount of insurance. Limits exist in liability policies for the amount payable per claim, sometimes per injured claimant, sometimes per year, and sometimes per event. Remember the example in Chapter 9 "Fundamental Doctrines Affecting Insurance Contracts" of the dispute between the leaseholder and the insurer over the number of events in the collapse of the World Trade Center (WTC) on September 11, 2001. The dispute was whether the attack on the WTC constituted two events or one. Defense services, provided in most liability policies, are limited only to the extent that litigation falls within coverage terms and the policy proceeds have not been exhausted in paying judgments or settlements. Because of the high cost of providing legal defense in recent years, however, attempts to limit insurer responsibility to some dollar amount have been made.

Retained Losses

In many situations, it is appropriate not to transfer all of an insured’s financial interest in a potential loss. Loss retention benefits the insured when losses are predictable and manageable. For the insurer, some losses are better left with the insured because of moral hazard concerns. Thus, an insured might retain a portion of covered losses through a variety of policy provisions. Some such provisions are deductibles, coinsurance in property insurance, copayments in health insurance, and waiting periods in disability insurance. Each is discussed at some length in later chapters. For now, realize that the existence of such provisions typically is noted in the declarations section of the policy.

Variation in Insuring Clauses

Some policies have relatively simple insuring clauses, such as a life insurance policy, which could simply say, “The company agrees, subject to the terms and conditions of this policy, to pay the amount shown on page 2 to the beneficiary upon receipt at its Home Office of proof of the death of the insured.” Package policies are likely to have several insuring clauses, one for each major type of coverage and each accompanied by definitions, exclusions, and conditions. An example of this type is the personal automobile policy, described in Chapter 1 "The Nature of Risk: Losses and Opportunities".

Some insuring clauses are designated as the “insuring agreement,” while others are hidden among policy provisions. Somewhere in the policy, however, it states that the “insurer promises to pay….” This general description of the insurer’s promises is the essence of an insuring clause.

Open-Perils versus Named-Perils

The insuring agreement provides a general description of the circumstances under which the policy becomes applicable. The circumstances include the covered loss-causing events, called perilsThe causes of loss.. They may be specified in one of two ways.

A named-perils policyPolicy that covers only losses caused by the perils listed in the policy. covers only losses caused by the perils listed in the policy. If a peril is not listed, loss resulting from it is not covered. For example, one form of the homeowner’s policy, HO-2, insures for direct loss to the dwelling, other structures, and personal property caused by eighteen different perils. Only losses caused by these perils are covered. Riot or civil commotion is listed, so a loss caused by either is covered. On the other hand, earthquake is not listed, so a loss caused by earthquake is not covered.

An open-perils policyPolicy that covers losses caused by all perils except those excluded. (formerly called “all risk”) covers losses caused by all perils except those excluded. This type of policy is most popular in property policies. It is important to understand the nature of such a policy because the insured has to look for what is not covered rather than what is covered. The exclusions in an open-perils policy are more definitive of coverage than in a named-perils policy. Generally, an open-perils policy provides broader coverage than a named-perils policy, although it is conceivable, if unlikely, that an open-perils policy would have such a long list of exclusions that the coverage would be narrower.

As noted in the Links section, many exclusions in property policies have been in the limelight. After September 11, 2001, the terrorism exclusion was the first added exclusion to all commercial policies but was rescinded after the enactment of TRIA in 2002 and its extensions. The mold exclusion was another new exclusion of our age. The one old exclusion that received major attention in 2005 in the wake of hurricanes Katrina and Rita is the flood exclusion in property policies. Flood coverage is provided by the federal government and is limited in its scope (see Chapter 1 "The Nature of Risk: Losses and Opportunities"). Additional exclusions will be discussed further in Chapter 11 "Property Risk Management" and Chapter 12 "The Liability Risk Management". In the 1980s, pollution liability was excluded after major losses. As noted in Chapter 6 "The Insurance Solution and Institutions", most catastrophes would be excluded because they are not considered insurable by private insurers. A most common exclusion, as noted above, is the war exclusion. The insurance industry decided not to trigger this exclusion in the aftermath of September 11. For a closer look, see the box below, Note 10.15 "The Risk of War".

Policies written on a named-perils basis cannot cover all possible causes of loss because of “unknown peril.” There is always the possibility of loss caused by a peril that was not known to exist and so was not listed in the policy. For this reason, open-perils policies cover many perils not covered by named-perils policies. This broader coverage usually requires a higher premium than a named-perils policy, but it is often preferable because it is less likely to leave gaps in coverage. The anthrax scare described in Chapter 4 "Evolving Risk Management: Fundamental Tools" is an example of an unknown peril that was covered by the insurance industry’s policies.

Very few, if any, policies are “all risk” in the sense of covering every conceivable peril. Probably the closest approach to such a policy in the property insurance field is the comprehensive glass policy, which insures against all glass breakage except those caused by fire, war, or nuclear peril. Most life insurance policies cover all perils except for suicide during the first year or the first two years. Health insurance policies often are written on an open-perils basis, covering medical expenses from any cause not intentional. Some policies, however, are designed to cover specific perils such as cancer (discussed in Chapter 2 "Risk Measurement and Metrics"). Limited-perils policies are popular because many people fear the consequences of certain illnesses. Of course, the insured is well-advised to be concerned with (protect against) the loss, regardless of the cause.

Exposures to Loss

Generally, the exposures to be covered are also defined (broadly speaking) in the insuring agreement. For example, the liability policy states that the insurer will pay “those sums the insured is legally obligated to pay for damages….” In addition, “the Company shall have the right and duty to defend….” The exposures in this situation are legal defense costs and liability judgments or settlements against the insured.

In defining the exposures, important information, such as the basis of valuation and types of losses covered, is needed. Various valuation methods have already been discussed. Actual cash value and replacement cost are the most common means of valuing property loss. Payments required of defendants, either through mutually acceptable settlements or court judgments, define the value of liability losses. The face value (amount of coverage) of a life insurance policy represents the value paid upon the insured’s death. Health insurance policies employ a number of valuation methods, including an amount per day in the hospital or per service provided, or—more likely—the lesser of the actual cost of the service or the customary and prevailing fee for this service. Health maintenance organizations promise the provision of services, as such, rather than a reimbursement of their cost.

The types of covered losses are also generally stated in the insuring agreement. Many property insurance policies, for example, cover only direct loss. Direct lossThe value of property that is physically destroyed or damaged, not including the loss caused by inability to use the property. to property is the value that is physically destroyed or damaged, not the loss caused by inability to use the property. Other policies that cover loss of use of property without physical damage to the property are called consequential or indirect lossA nonphysical loss such as loss of business.. In the aftermath of Hurricane Rita, many Texas coastal residents who evacuated encountered indirect loss without damage to their homes. This included the evacuation of Galveston and Houston. Coverage for these losses was disputed by insurers, such as Allstate, that tried to exclude these indirect losses. In addition, in the introduction to this chapter, it was explained how important the consequential loss coverage was to the businesses that suffered indirectly from the September 11 attacks. A report released by PricewaterhouseCoopers in New York City noted that business interruption claims came from a wide scope of industries, including financial services, communications, media, and travel industries, that were not in the attack zone.“9/11 Business Interruption Claims Analysis,” National Underwriter Online News Service, February 20, 2002. Many remote businesses were disrupted when the world transportation networks were paralyzed. It was estimated that losses up to $10 billion were caused by these indirect effects.Diana Reitz, “9/11 Spotlights Business Interruption Threat—What Is the Art and Science of Establishing the Accurate Limit of Coverage?” National Underwriter, Property/Casualty Edition, April 16, 2004, http://www.propertyandcasualtyinsurancenews.com/cms/NUPC/Weekly%20Issues/Issues/2004/15/p15911spotlights?searchfor= (accessed March 8, 2009).

Business interruptionLosses that occur when an organization is unable to sell its goods or services and/or unable to produce goods for sale because of direct or indirect loss. losses occur when an organization is unable to sell its goods or services, and/or unable to produce goods for sale because of direct or indirect loss. Generally, these losses are due to some property damage considered direct loss. Such lost revenues typically translate into lost profits. The 1992 Chicago flood, for example, required that Marshall Fields downtown store close its doors for several days while crews worked to clean up damage caused by the flood waters.In April 1992, part of Chicago’s underground tunnel system was flooded when the river pushed back a wall far enough to cause a rapid flow of water into the tunnels. Water levels rose high enough to damage stored property, force electrical supplies to be shut off, and cause concern about the stability of structures built above the tunnels. When loss is caused by property damage not owned by the business, it is considered a contingent business interruptionLoss caused by property damage not owned by the business.. If Marshall Fields reduced its orders to suppliers of its goods, for instance, those suppliers may experience contingent business interruption loss caused by the water damage, even though their own property was not damaged.

Alternatively, some organizations choose to continue operating following property damage, but they are able to do so only by incurring additional costs known as extra expense lossesAdditional costs incurred by organizations that choose to continue operating following property damage.. These costs also reduce profits. Continuing with the 1992 Chicago flood example, consider the various accounting firms who could not use their offices the second week in April. With the upcoming tax filing deadline, these firms chose to rent additional space in other locations so they could meet their clients’ needs. The additional rental expense (and other costs) resulted in reduced profits to the accounting firms. Yet a variety of service organizations, including accountants, insurance agents, and bankers, prefer to incur such expenses in order to maintain their reputation of reliability, upon which their long-term success and profits depend. Closing down, even temporarily, could badly hurt the organization.

Individuals and families too may experience costs associated with loss of use. For example, if your home is damaged, you may need to locate (and pay for) temporary housing. You may also incur abnormal expenses associated with the general privileges of home use, such as meals, entertainment, telephones, and similar conveniences. Likewise, if your car is unavailable following an accident, you must rent a car or spend time and money using other forms of transportation. Thus, while a family’s loss of use tends to focus on extra expense, its effect may be as severe as that of an organization.

Liability policies, on the other hand, may cover liability for property damage, bodily injury, personal injury, and/or punitive damages. Property damageLiability that includes responsibility both for the physical damage to property and the loss of use of property. liability includes responsibility both for the physical damage to property and the loss of use of property. Bodily injuryPhysical injury to a person, including the pain and suffering that may result. is the physical injury to a person, including the pain and suffering that may result. Personal injuryNonphysical injury to a person, including damage caused by libel, slander, false imprisonment, and the like. is the nonphysical injury to a person, including damage caused by libel, slander, false imprisonment, and the like. Punitive damagesAwards intended to punish an offender for exceptionally undesirable behavior. are damages assessed against defendants for gross negligence, supposedly for the purpose of punishment and to deter others from acting in a similar fashion. Examples of punitive damages in recent cases and their ethical implications are featured in the box “Are Punitive Damages out of Control?”

Reasons for Exclusions

Let us review the reasons for the existence of exclusions. As noted in Chapter 6 "The Insurance Solution and Institutions", one reason exclusions exist is to avoid financial catastrophe for the insurer, which may result if many dependent exposures are insured or if a single, large-value exposure is insured. Because war would affect many exposures simultaneously, losses caused by war are excluded in most policies in order to avoid insuring catastrophic events. Exclusions also exist to limit coverage of nonfortuitous (that is, not accidental) events. Losses that are not accidental make prediction difficult, cause coverage to be expensive, and represent circumstances in which coverage would be contrary to public policy. As a result, losses caused intentionally (by the insured) are excluded. So, too, are naturally occurring losses that are expected. Wear and tear, for instance, is excluded from coverage. Adverse selection and moral hazard are limited by these exclusions.

Adverse selection is limited further by use of specialized policies and endorsements that standardize the risk. That is, limitations (exclusions) are placed in standard policies for exposures that are nonstandard. Those insureds who need coverage for such nonstandard exposures purchase it specifically. For example, homeowner’s policies limit theft coverage on jewelry and furs to a maximum amount ($2,500). Exposures in excess of the maximum are atypical, representing a higher probability (and severity) of loss than exists for the average homeowner. Insureds who own jewelry and furs with values in excess of the maximum must buy special coverage (if desired).

An important element is the point emphasized in the Links section at the beginning of the chapter. Some exclusions exist to avoid duplication of coverage by policies specifically intended to insure the exposure. As noted above, homeowners liability coverage excludes automobile liability, workers’ compensation liability, and other such exposures that are nonstandard to home and personal activities. Other policies specifically designed to cover such exposures are available and commonly used. To duplicate coverage would diminish insurers’ ability to discriminate among insureds and could result in moral hazard if insureds were paid twice for the same loss. A policy clause, termed other insurance clauseProvision in a policy that apportions the insurer’s financial responsibility so that payment in excess of the insured’s loss is avoided. (discussed in Chapter 9 "Fundamental Doctrines Affecting Insurance Contracts"), addresses the potential problem of duplicating coverage when two or more similar policies cover the same exposure. Through this type of provision, the insurer’s financial responsibility is apportioned so that payment in excess of the insured’s loss is avoided.

These reasons for exclusions are manifested in limitations on the following:

• Locations
• Perils
• Property
• Losses

The following is a discussion of the purposes of limiting locations, perils, property, and losses.

Excluded Locations

Some types of coverage are location-specific, such as to buildings. Other policies define the location of coverage. Automobile policies, for example, cover the United States and Canada. Mexico is not covered because of the very high auto risk there. In addition, some governmental entities in Mexico will not accept foreign insurance. Some property policies were written to cover movable property anywhere in the world except the Eastern bloc countries, likely because of difficulty in adjusting claims. With the breakup of the Communist bloc, these limitations are also being abandoned. Yet coverage may still be excluded where adjusting is difficult and/or the government of the location has rules against such foreign insurance. For a discussion of political risk—unanticipated political events that disrupt the earning or profit-making ability of an enterprise—see Chapter 11 "Property Risk Management".

Excluded Perils

Some perils are excluded because they can be covered by other policies or because they are unusual or catastrophic. The earthquake peril, for example, requires separate rating and is excluded from homeowners policies. This peril can be insured under a separate policy or added by endorsement for an extra premium. Many insureds do not want to pay the premium required, either because they think their property is not exposed to the risk of loss caused by an earthquake or because they expect that federal disaster relief would cover losses. Given the choice of a homeowners policy that excluded the earthquake peril and one that included earthquake coverage but cost $50 more per year, they would choose the former. Thus, to keep the price of their homeowners policies competitive, insurers exclude the earthquake peril. It is excluded also because it is an extraordinary peril that cannot easily be included with the other perils covered by the policy. It must be rated separately.

As noted above, perils, such as those associated with war, are excluded because commercial insurers consider them uninsurable. Nuclear energy perils, such as radiation, are excluded from most policies because of the catastrophic exposure. Losses to homeowners caused by the nuclear meltdown at Three Mile Island in 1979, which forced homeowners to evacuate the damaged property in the area, were not covered by their homeowners insurance. Losses due to floods are excluded and were a topic of much discussion after hurricanes Katrina and Rita. Losses due to wear and tear are excluded because they are inevitable rather than accidental and thus not insurable. Similarly, inherent vice, which refers to losses caused by characteristics of the insured property, is excluded. For example, certain products, such as tires and various kinds of raw materials, deteriorate with time. Such losses are not accidental and are, therefore, uninsurable.

Excluded Property

Some property is excluded because it is insurable under other policies. Homeowners policies, as previously stated, exclude automobiles because they are better insured under automobile policies. Other property is excluded because the coverage is not needed by the average insured, who would, therefore, not want to pay for it.

Liability policies usually exclude damage to or loss of others’ property in the care, custody, or control of the insured because property insurance can provide protection for the owner against losses caused by fire or other perils. Other possible losses, such as damage to clothing being dry cleaned, are viewed as a business risk involving the skill of the dry cleaner. Insurers do not want to assume the risk of losses caused by poor workmanship or poor management.

Excluded Losses

Losses resulting from ordinance or law—such as those regulating construction or repair—are excluded from most property insurance contracts. Policies that cover only direct physical damage exclude loss of use or income resulting from such damage. Likewise, policies covering only loss of use exclude direct losses. Health insurance policies often exclude losses (expenses) considered by the insurer to be unnecessary, such as the added cost of a private room or the cost of elective surgery.

Notice and Proof of Loss

All policies require that the insurer be notified when the event, accident, or loss insured against occurs. The time within which notice must be filed and the manner of making it vary. The homeowners policy, for example, lists as one of the insured’s duties after loss to “give immediate notice to us or our agent” and to file proof of loss within sixty days. A typical life insurance policy says that payment will be made “upon receipt…of proof of death of the insured.” A health policy requires that “written proof of loss must be furnished to the Company within twelve months of the date the expense was incurred.” The personal auto policy says, “We must be notified promptly of how, when, and where the accident or loss happened.”

In some cases, if notice is not made within a reasonable time after the loss or accident, the insurer is relieved of all liability under the contract. A beneficiary who filed for benefits under an accidental death policy more than two years after the insured’s death was held in one case to have violated the notice requirement of the policy.Thomas v. Transamerica Occidental Life Ins. Co., 761 F. Supp. 709 (1991). The insurer is entitled to such timely notice so it can investigate the facts of the case. Insureds who fail to fulfill this condition may find themselves without protection when they need it most—after a loss.

Suspension of Coverage

Because there are some risks or hazardous situations insurers want to avoid, many policies specify acts, conditions, or circumstances that will cause the suspension of coverageRelease of the insurer from liability. or, in other words, that will release the insurer from liability. The effect is the same as if the policy were canceled or voided, but when a policy is suspended, the effect is only temporary. When a voidance of coverageTermination of coverage under an insurance policy. is incurred in an insurance contract, coverage is terminated. Protection resumes only by agreement of the insured and insurer. Suspension, in contrast, negates coverage as long as some condition exists. Once the condition is eliminated, protection immediately reverts without the need for a new agreement between the parties.

Some life and health policies have special clauses that suspend coverage for those in military service during wartime. When the war is over or the insured is no longer in military service, the suspension is terminated and coverage is restored. The personal auto policy has an exclusion that is essentially a suspension of coverage for damage to your auto. It provides that the insurer will not pay for loss to your covered auto “while it is used to carry persons or property for a fee,” except for use in a share-the-expense car pool. The homeowners policy (form 3) suspends coverage for vandalism and malicious mischief losses if the house has been vacant for more than thirty consecutive days. A property insurance policy may suspend coverage while there is “a substantial increase in hazard.”

You can easily overlook or misunderstand suspensions of coverage or releases from liability when you try to determine coverage provided by a policy. They may appear as either conditions or exclusions. Because their effect is much broader and less apparent than the exclusion of specified locations, perils, property, or losses, it is easy to underestimate their significance.

Cooperation of the Insured

All policies require your cooperation, in the sense that you must fulfill certain conditions before the insurer will pay for losses. Because the investigation of an accident and defense of a suit against the insured are very difficult unless he or she will cooperate, liability policies have a specific provision requiring cooperation after a loss. The businessowners policy, for example, says, “The insured shall cooperate with the Company, and upon the Company’s request, assist in…making of settlements; conducting of suits….”

It is not unusual for the insured to be somewhat sympathetic toward the claimant in a liability case, especially if the claimant is a friend. There have been situations in which the insured was so anxious for the claimant to get a large settlement from the insurer that the duty to cooperate was forgotten. If you do not meet this condition and the insurer can prove it, you may end up paying for the loss yourself. This is illustrated by the case of a mother who was a passenger in her son’s automobile when it was involved in an accident in which she was injured. He encouraged and aided her in bringing suit against him. The insurer was released from its obligations under the liability policy, on the grounds that the cooperation clause was breached.Beauregard v. Beauregard, 56 Ohio App. 158, 10 N.E.2d 227 (1937). The purpose of the cooperation clause is to force insureds to perform the way they would if they did not have insurance.

Protection of Property after Loss

Most property insurance policies contain provisions requiring the insured to protect the property after a loss in order to reduce the loss as much as possible. An insured who wrecks his or her automobile, for example, has the responsibility for having it towed to a garage for safekeeping. In the case of a fire loss, the insured is expected to protect undamaged property from the weather and other perils in order to reduce the loss. You cannot be careless and irresponsible just because you have insurance. Yet the requirement is only that the insured be reasonable. You are not required to put yourself in danger or to take extraordinary steps. Of course, views of what is extraordinary may differ.

Examination

A provision peculiar to some disability income policies gives the insurer the right to have its physician examine the insured periodically during the time he or she receives benefits under the policy. This right cannot be used to harass the claimant, but the insurer is entitled to check occasionally to see if he or she should continue to receive benefits. Property insurance policies have a provision that requires the claimant to submit to examination under oath, as well as make records and property available for examination by representatives of the insurance company.