Valid Contract

Updated: 09 June 2023

What Does Valid Contract Mean?

A valid contract, in the context of insurance, is a legally enforceable contract made between insurers and policyholders as well as between insurers and reinsurers. It involves the transfer of risk in exchange for a premium payment. The insured promises to pay a premium and the insurance company promises to pay compensation if a specific object of insurance is damaged by an insured peril.

An insurance policy contract is not unlike ones that may be entered into in the regular course of one’s life (i.e., buying a home, leasing a car or taking out a loan) or in business (i.e., entering into a contract with a vendor or customer). Contracts impose requirements upon all parties entering into them, so careful consideration must be taken.

Contracts generally require five elements in order to be legally enforceable. However, since insurance contracts are more sensitive in nature, valid insurance contracts generally require three additional elements for enforceability.

Insuranceopedia Explains Valid Contract

For a contract to be valid, it must comprise the following five elements:

  • Offer and acceptable: One party must make an offer and another party must accept the exact terms. In terms of insurance, an applicant makes an offer in applying for a policy, and the insurer accepts in issuing a policy.
  • Consideration: An exchange of value is necessary for a valid contract. The offer (application) and payment of the initial premium (consideration) constitutes the beginnings of a binding contract.
  • Legal intent: The insurance contract must not entail illegal activities. For instance, it cannot insure the risk of injury while the policyholder commits a crime.
  • Competent parties: The parties involved must all be considered legally competent for a contract to be valid. An applicant is assumed to be competent unless they are a minor, under the influence of drugs or alcohol, or mentally incompetent.
  • Legal form: Valid contracts follow state laws and guidelines. Some may require a written contract to be binding.

A contract that lacks one of these elements is not valid, and therefore, legally unenforceable. In many jurisdictions, insurance contracts also require three additional elements to be enforceable:

  • Insurable interest: Only those who would actually suffer a financial loss due to the loss of insured property are entitled to benefit from an insurance contract or policy. For example, one would not be able to purchase an insurance policy on another’s house because that person would not be hurt financially from its loss. Similarly, a mortgage lender would be able to purchase insurance on one’s home because they would be affected financially if the property were to be lost. That is why most mortgage lenders require that they be listed on home insurance as an additional insured, which grants them an entitlement in any insurance monies paid out.
  • Indemnity: This establishes the amount of entitlement insureds on the policy can get.
  • Utmost good faith: This imposes a stricter requirement for honesty and fair dealing than regular contracts. Because insurance contracts rely upon representations made by the insured during the application process, insurance contracts require that both parties be open, honest and comply with all policy terms and conditions. For the insured, they are required to provide true information. For insurers, they are required to ensure the policy is written clearly and that they handle claims promptly and fairly.

An insurance contract that lacks any of these eight elements would be considered void or voidable.

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