Ernie and Oliver had no insurance experience, but they decided to buy an insurance agency; they exceedingly overpaid. The morning following their purchase, after a breakfast of eggplant omelets, the two visited their enormous office to get ready for business.

In our first E&O installment, we'll discuss the basics of contracts, the various parts of them and what they include.

In a typical insurance contract, the insurer agrees to pay for covered losses, provide a defense and perform any other listed services, while the insured agrees to pay the premium and fulfill all other policy requirements. The insurer has the legal ability to bind the agreement so long as it is licensed in the appropriate state. Contracts cannot be constructed for illegal activities.

Contract terminology:

Valid contract - One that includes all elements recognized by the courts and is legally binding.

Voidable contract - One that can be broken by one or more parties for a legal reason; this also includes contracts that lack genuine assent and those involving minors.

Unenforceable contract - One that won't be upheld by the courts, typically because of a rule of law.

Other Definitions:

Principle of indemnity - Restoring the insured to his or her status prior to the loss; this is the cornerstone of insurance. Neither rewards nor penalties will be given to the insured for the loss. The insured cannot be compensated with an amount greater than the economic loss.

Replacement cost coverage - Pays to replace the lost or damaged property with property composed of materials of like kind and quality; this coverage does not include a deduction for depreciation.

Valued policy - The insurer is legally obligated to pay the face value of the policy upon the total loss of the property, regardless of the property's actual cash value.

Insurable interest - This is the financial interest of an individual or business in the value of the subject of the contract; at the time of loss the holder of this interest must clearly prove a personal stake in the item being insured.

Unilateral contract - In this form of contract, only one party makes an enforceable promise; the insurer promises to pay a covered loss, while the insured makes few if any promises. The insured is required to fulfill certain conditions, like paying the premium.

Personal contract - These contracts cannot be transferred to other parties and the insured must meet certain underwriting standards, like a favorable loss history, good moral character, and a sound credit history.

Contract of adhesion - An insurance contract is a contract of adhesion. The insurer constructs the policy, and the insured must either accept it in full or decline it. Ambiguities favor the party with less knowledge; this typically is the insured.

Reasonable expectations - This term is used by courts when interpreting policy language. A court may rule that coverage applies if a reasonable person would assume, by the wording of the policy, that a specific circumstance should be covered

Good faith - Under this doctrine, the insurer promises to cover the insured for an event that may or may not occur in the future. This is considered "good faith" on the part of the insurer. It imposes a higher standard of honesty on both parties than do other commercial contracts.

Warranty - A statement of fact provided by the insured that if found not to be true will void the contract. An express warranty is stated in the policy whereas an implied warranty is not, but it is generally recognized by both parties.