Why are Insurance Policies Called Aleatory Contracts?

What Is an Aleatory Contract?

An aleatory contract is one in which the parties agree that they will not have to take a specific action until a specific, triggering event occurs. Natural disasters and death are examples of events that neither party can control. In insurance plans, aleatory contracts are frequently employed.

The insurer, for example, is not required to pay the insured until an event occurs, such as a fire that causes property loss. Aleatory contracts, also known as aleatory insurance, are beneficial since they usually assist the buyer in reducing financial risk.

An aleatory contract is a contract between two parties in which neither party is required to take any action unless a specific trigger event happens. Such trigger events are beyond the control of either party, such as

Such contracts are common in insurance policies where the insurer doesn’t have to pay the insured until a triggering event occurs, such as the vehicle being stolen or damaged due to a natural disaster.

Aleatory contracts, also known as aleatory insurance, turn out to be helpful because they support the insured person to deal with the financial risk.

KEY TAKEAWAYS

  • An aleatory contract is one in which the parties agree that they will not have to do something until a certain event occurs.
  • Natural disasters or death are examples of trigger events in aleatory contracts that neither party can control.
  • Insurance policies use aleatory contracts, which require the insurer to wait until an event occurs, such as a fire that results in property loss, before paying the insured.

Understanding an Aleatory Contract

Aleatory contracts are historically related to gambling and appeared in Roman law as contracts related to chance events. In insurance, an aleatory contract refers to an insurance arrangement in which the payouts to the insured are unbalanced.

Until the insurance policy results in a payout, the insured pays premiums without receiving anything in return besides coverage. When the payouts do occur, they can far outweigh the sum of premiums paid to the insurer. If the event does not occur, the promise outlined in the contract will not be performed.

In the insurance sector, the aleatory contract can be thought of as an insurance agreement with an unbalanced payout to the insured. The insured pays the premiums without receiving anything in return besides coverage until the policy pays out.

In the event of a payout, it can far outweigh the premiums paid. Sometimes, the policy may lapse, and the event for payout may not occur at all.

In another case, if the insured happens to miss the premium payments, the insurer may not be obliged to pay the policy benefit. In the case of life insurance policies, if the insured doesn’t die during the policy term, the insurer will not pay anything on policy maturity.

How Aleatory Contracts Work

Risk assessment is an important factor to the party considering entering into an aleatory contract. Life insurance policies are considered aleatory contracts, as they do not benefit the policyholder until the event itself (death) comes to pass.

Only then will the policy allow the agreed amount of money or services stipulated in the aleatory contract. The death of someone is an uncertain event as no one can predict in advance with certainty when the insured will die.

However, the amount which the insured’s beneficiary will receive is certainly much more than what the insured has paid as a premium.

In certain cases, if the insured has not paid the regular premiums to keep the policy in force, the insurer is not obliged to pay the policy benefit, even though the insured has made some premium payments for the policy. 

In other types of insurance contracts, if the insured doesn’t die during the policy term, then nothing will be payable on maturity, such as with term life insurance.

Are aleatory contracts enforceable?

Yes, aleatory contracts are legally enforceable. Like other contracts, they feature the six essential factors of contract enforceability:

  1. Offer
  2. Acceptance
  3. Awareness
  4. Capacity
  5. Legality
  6. Consideration.

Although aleatory contracts’ consideration is unequal, that doesn’t mean they don’t offer consideration. Remember that consideration refers to the value that has been agreed upon, whether that’s money, an action, or a promise.

This means that services, property, and risk management are all legitimate examples of consideration. As such, aleatory contracts provide sufficient consideration because they offer protection from potential threats in exchange for premiums.

Types of aleatory contracts

Insurance policies

As one of the most popular types of aleatory contracts, insurance policies don’t give any benefits to the policyholder until a specific event (death, an accident, or natural disaster) happens. This means that the insured party or policyholder will continue paying premiums without receiving anything in return other than coverage until the event occurs.

Once the event does happen, the insured party will receive a payout that can outweigh the sum of the payments they had previously made to the insurer.

There are five main types of insurance policies:

  • Life insurance: Life insurance protects people who are financially dependent on a particular family member. These policies give dependents, such as spouses, children, and parents, large payouts upon the death of the insured family member.
  • Homeowner’s insurance: This type of insurance covers damage and losses to your home and assets in the event of a disaster such as a fire.
  • Health insurance: Health insurance pays for potential surgical and medical expenses that you may incur in the future. Without health insurance coverage, you may have to pay exorbitant amounts to receive emergency care or an expensive treatment plan.
  • Long-term disability (LTD) insurance: Some people want to protect themselves in case they face an LTD in the future. LTD policies provide coverage so that you can continue your standard of living even if you can’t work anymore.
  • Automobile insurance: This type of insurance is required in most jurisdictions. Even if you’re not required to have it, you should get it. Without automobile insurance, you could lose all of your belongings if you are held liable for causing someone’s injuries.

Annuities and Aleatory Contracts

Another type of aleatory contract where each party takes on a defined level of risk exposure is an annuity. An annuity contract is an agreement between an individual investor and an insurance company whereby the investor pays a lump sum or a series of premiums to the annuity provider.

In return, the contract legally binds the insurance company to pay periodic payments to the annuity holder—called the annuitant—once the annuitant reaches a certain milestone, such as retirement.

However, the investor might risk losing the premiums paid into the annuity if they withdraw the money too early. On the other hand, the person might live a long life and receive payments that far exceed the original amount that was paid for the annuity.

Annuity contracts can be very helpful to investors, but they can also be extremely complex. There are various types of annuities each with its own rules that include how and when payouts are structured, fee schedules, and surrender charges—if money is withdrawn too soon.

Another Type of Aleatory Contract

There is another type of aleatory contract called an annuity, where each party has a defined set of risk exposure.

An annuity contract is an agreement between an insurance company and an individual investor where the investor agrees to pay a lump sum or a series of premiums to the annuity provider.

In return for the investment, the insurance company is bound to make regular payments to the annuity holder, annuitant, once a certain milestone event occurs, such as retirement.

There are two possibilities in this case:

  • If the investor withdraws the money early, the premiums paid into the annuity may be lost.
  • If the investor lives a long life, he will receive payments for a long time that may far exceed the original annuity amount paid.

Special Considerations

For investors who plan on leaving their retirement funds to a beneficiary, it’s important to note that the U.S. Congress passed the SECURE Act in 2019, which made rule changes for beneficiaries of retirement plans.

As of 2020, non-spousal beneficiaries of retirement accounts must withdraw all of the funds in the inherited account within ten years of the owner’s death. In the past, beneficiaries could stretch out the distributions—or withdrawals—over their lifetime.

The new ruling eliminates the stretch provision, which means all of the funds, including annuity contracts within the retirement account–must be withdrawn within the 10-year rule.

Also, the new law reduces the legal risks for insurance companies by limiting their liability if they fail to make annuity payments. In other words, the Act reduces the ability of the account holder to sue the annuity provider for breach of contract.

It’s important that investors seek help from a financial professional to review the fine print of any aleatory contract as well as how the SECURE Act might impact their financial plan

Wrapping up

Aleatory contracts are agreements where a party doesn’t have to perform contractual obligations unless a specified event happens.

These contracts also feature unequal consideration—for instance, an insured party will only receive coverage in return for premiums and won’t get a payout unless the specified event happens.

Common examples of these contracts include insurance policies, annuities, and guarantees.

Writing and managing aleatory contracts can be hard, particularly if you’re already up to your neck in contracts. That’s why you should consider using Ironclad. Ironclad is a premier digital contracting software that will simplify and accelerate the contract management lifecycle.

Our Data Repository and Workflow Designer will help you keep track of upcoming obligations, answer questions within seconds, and draft complex aleatory contracts in minutes.

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