Managing Your Risk
How to read an insurance policy: Part I

By Michael Kelly
Risk Management Director

Let's face it: Insurance policies hardly make for riveting reading – that is unless you are desperately trying to find out if an occurrence or situation that has just happened would be covered. During my 32-plus years in the insurance and risk management business, whenever I have received a phone call that begins with "Hey Michael, I was reading my insurance policy the other day …" 99 times out of 100, I know something has already has happened and they are doing just exactly that – checking coverage. No one tends to read their insurance policy just for fun.

This month's Managing Your Risk column begins a discussion to help you better read and understand an insurance policy – or at least develop a systematic method to go at it. Knowing where and how to look is a big part of coverage analysis.

First we should cover some basics. The principals behind an insurance policy's design characteristics are somewhat different than those found in other types of legal contracts. Understanding these fundamentals will serve you well as a risk manager.

An insurance policy is designed to respond to events that are unexpected or accidental in nature – commonly called fortuitous losses. In order for a loss to be fortuitous there needs to be a reasonable level of uncertainty about its probability or chances of happening at all.

Insurance contracts are designed with the idea of indemnity – meaning the policy is constructed to compensate for the value of the loss and there should be no betterment to the insured as a result from a covered loss. In reality, due to deductibles, self-insured retention, maximum dollar sub-limits or other conditional policy provisions, an insurance contract will not necessarily be able to restore an insured to the exact financial position held prior to the loss. In addition, it also will not address nor provide remedy for the hassle and disruption in having to deal with the loss in the first place.

There is a principal of "utmost good faith" that is inherent in the issuance of an insurance contract, meaning the buyer is expected to act with complete honesty and to disclose all relevant facts. This is necessary for an insurance carrier to be able to effectively underwrite and price their exposure to loss. If an insured purposefully omits pertinent facts, the insured may be undercharged for their exposures, and it eventually becomes impossible to actuarially establish accurate rates.

The cornerstone principal of sound underwriting is charging a rate that is commensurate and reflective of an insured's true exposures. It is for this reason that denial of coverage for a loss can be based on the doctrines of fraud, concealment or misrepresentation, which are all derived from this principal of utmost good faith.

The insurance policy tends to be a contract of adhesion – often referred to as a "take it or leave it" basis – in that one party (the insured) must follow or adhere to the guidelines written by the other party (the insurance company). This exchange of responsibility is on an uneven basis in that the insurance carrier draws up the agreement with little or no input from the insured, and the insured can do little to change its primary provisions.

It also is an exchange of uneven amounts of financial responsibility, because the insured is paying a much smaller dollar amount (premium) to guarantee a promise of payment in a much larger dollar amount from the carrier for a covered loss (limits of liability purchased).

This essentially balances out in that the intangible value for the reduction of volatility of losses for the insured is offset by the value of the promise to pay for the given loss through the charge of a premium. Absent any loss, the insurance carrier retains the premium as profit after deduction of its operational expenses. Further, although arguably not equal, they may be at least equitable in that the premium charged to an insured is actuarially reflective of the insured's expected losses.

This relationship between insured and insurance company is further leveled in that any policy language the courts construe to be ambiguous is often interpreted in the insured's favor. Contrary to what one might think, it is for this reason that a good faith effort is typically made to write policies in such a way to not be ambiguous. Doing so works in the best interest of both parties. It is expensive to litigate policy language and is always better if an insured understands the policy's limitations before an uncovered loss occurs.

In addition, insurance policies are considered conditional contracts, which simply stated is an agreement whereby one or more parties must perform or respond only under certain specifically outlined conditions. An example might be the requirement to cooperate with the insurance carrier such as allowing the carrier's adjuster to inspect damaged property after a fire loss. If the insured is unwilling to allow that inspection, the insurance carrier is not obligated to fulfill its obligations to pay for the loss.

Lastly, insurance policies are generally non-transferable, at least from the insured's perspective. The agreement is specific to the parties involved, i.e. carrier/insured, and as such the insured may not assign or transfer the policy to a third party without the carrier's written permission. In most instances, however, this is only true for the insured, and the typical insurance policy will not include similar language that applies to an issuing insurance carrier, which may and often does transfer or assign its interests to a third party without any necessary consent from the insured.

In next month's column, I will discuss the primary sections commonly found in all insurance contracts and how understanding those provisions can help a risk manager review their insurance policies for both improved comprehension as well as general coverage analysis.

NCACC Risk Management Director Michael Kelly writes a regular column on risk management for CountyLines. With more than 32 years of risk management/insurance experience, he holds the Associate in Risk Management for Public Entities, Certified Risk Manager and Certified Insurance Counselor professional designations. He can be reached at michael.kelly@ncacc.org or (919) 719-1124. Archived versions of the column can be found online at www.ncacc.org/managingyourrisk.html.