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Risk Management & Insurance Chapter -4- Legal Principles of Insurance Contracts

CHAPTER 4

LEGAL PRINCIPLE OF INSURANCE CONTRACT

4.1.PRINCIPLE OF INDEMNITY

The principle of indemnity is one of the most important principles in insurance which applies to

only non-life insurance, (not applicable to life & personal accident insurance).

Indemnity means security, protection & compensation given against damage, loss or injury.

According to the principle of indemnity, an insurance contract is signed only for getting protection

against unpredicted financial losses arising due to future uncertainties. Insurance contract is not

made for making profit else its sole purpose is to give compensation in case of any damage or loss.

In an insurance contract, the amount of compensations paid is in proportion to the incurred losses.

The amount of compensations is limited to the amount assured or the actual losses, whichever is

less. The compensation must not be less or more than the actual damage. Compensation is not paid

if the specified loss does not happen due to a particular reason during a specific time period. Thus,

insurance is only for giving protection against losses and not for making profit.

However, in case of life insurance, the principle of indemnity does not apply because the value of

human life cannot be measured in terms of money

The principle of indemnity states that the insurer agrees to pay no more than the actual amount of the loss;

stated differently, the insured should not profit from a loss.

Most property and casualty insurance contracts are contracts of indemnity. If a covered loss occurs,

the insurer should not pay more than the actual amount of the loss. A contract of indemnity does

not mean that all covered losses are always paid in full. Because of deductibles, Birr limits on the

amount paid, and other contractual provisions, the amount paid is often less than the actual loss.

The principle of indemnity has two fundamental purposes.

The first purpose is to prevent the insured from profiting from a loss. For example, if Mr. X’s home

is insured for Br. 200,000, and a partial loss of Br. 50,000 occurs, the principle of indemnity would

be violated if Br. 200,000 were paid to him. He would be profiting from insurance.

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The second purpose is to reduce moral hazard. If dishonest policyholders could profit from a loss,

they might deliberately cause losses with the intention of collecting the insurance. If the loss

payment does not exceed the actual amount of the loss, the temptation to be dishonest is reduced.

Indemnity can take different forms: cash payment, replacement of the property or reinstatement of

the property.

Actual cash value

The concept of actual cash value underlies the principle of indemnity. In property insurance, the

standard method of indemnifying the insured is based on the actual cash value of the damaged

property at the time of loss. Courts use three major methods to determine actual cash value:

 Replacement cost less depreciation

 Fair market value

 Broad evidence rule

A. Replacement cost less depreciation

Under this rule, actual cash value is defined as replacement cost less depreciation. This rule has

been traditionally used to determine the actual cash value of property in property insurance. It

takes in to consideration both inflation and depreciation of property values over time. Replacement

cost is the current cost of restoring the damaged property with new materials of like kind and

quality. Depreciation is a deduction for physical wear and tear, age and economic obsolescence.

Actual cash value can calculated as follows.

Actual cash value = Replacement cost - Depreciation

For example, Sara has a favorite house that burns in a fire. Assume she bought the house five years

ago, the house is 50 percent depreciated, and a similar house today would cost $1000. Under the

actual cash value rule, Sarah will collect $500 for the loss because the replacement cost is $1000,

and depreciation is $500, or 50 percent. If she were paid the full replacement value of $1000, the

principle of indemnity would be violated. She would be receiving the value of a new house instead

of one that was five years old. In short, the $500 payment represents indemnification for the loss of

a five-year-old house.

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B. Fair market value

Fair market value is the price a willing buyer would pay a willing seller in a free market. The fair

market value of a building may be below its actual cash value based on replacement cost less

depreciation. This may be due to several reasons, including a poor location, deteriorating

neighborhood or economic obsolescence of the building.

C. Broad evidence rule

This means that the determination of actual cash value should include all relevant factors an expert

would use to determine the value of the property. Relevant factors include replacement cost less

depreciation, fair market value, present value of expected income from the property, comparison

sales of similar property, opinions of appraisers and numerous other factors.

4.2.PRINCIPLE OF INSURABLE INTEREST

The principle of insurable interest is another important legal principle.

The principle of insurable interest states that the insured must be in a position to lose financially if a

covered loss occurs.

For example, you have an insurable interest in your car because you may lose financially if the car

is damaged or stolen. You have an insurable interest in your personal property, such as a

computer, books, and clothes, because you may lose financially if the property is damaged or

destroyed.

Purposes of an insurable interest

To be legally enforceable, all insurance contracts must be supported by an insurable interest for the

following major reasons:

 To prevent gambling

 To reduce moral hazard

 To measure the loss

First, an insurable interest is necessary to prevent gambling. If an insurable interest were not

required, the contract would be gambling contract and would be against the public interest.

For example, you could insure the property of another and hope for a loss to occur. You could

similarly insure the life of another person and hope for an early death. These contracts clearly

would be gambling contracts and would be against the public interest.

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Second, an insurable interest reduces moral hazard. If an insurable interest is not required, a

dishonest person could purchase a property insurance contract on someone else’s property and

then deliberately cause a loss to receive the proceeds. But if the insured stands to lose financially,

nothing is gained by causing the loss. Thus, moral hazard is reduced. In life insurance, an insurable

interest requirement reduces the incentive to murder the insured for the purpose of collecting the

proceeds

Finally, an insurable interest measures the amount of the insured’s loss. In property insurance,

most contracts are contracts of indemnity and one measure of recovery is the insurable interest of

the insured. If the loss payment cannot exceed the amount of one’s insurable interest, the principle

of indemnity is supported.

4.3. PRINCIPLE OF SUBROGATION

The principle of subrogation strongly supports the principle of indemnity.

Subrogation means substitution of the insurer in place of the insured for the purpose of claiming indemnity

from a third party for a loss covered by insurance. Stated differently, the insurer is entitled to recover from a

negligent third party any loss payments made to the insured.

For example, assume that a negligent motorist fails to stop at a red light and smashes into Meaza’s

car, causing damage in the amount of $5000. If she has collision insurance on her car, her insurer

will pay the physical damage loss to the car (less any deductible) and then attempt to collect from

the negligent motorist who caused the accident. Alternatively, Meaza could attempt to collect

directly from the negligent motorist for the damage to her car. Subrogation does not apply unless

the insurer makes a loss payment.

However, to the extent that a loss payment is made, the insured gives to the insurer any legal

rights to collect damages from the negligent third party.

Purposes of Subrogation

Subrogation has three basic purposes. First, subrogation prevents the insured from collecting twice for

the same loss. In the absence of subrogation, the insured could collect from his or her insurer and

from the person who caused the loss. The principle of indemnity would be violated because the

insured would be profiting from a loss.

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Second, subrogation is used to hold the negligent person responsible for the loss. By exercising its

subrogation rights, the insurer can collect from the negligent person who caused the loss.

Finally, subrogation helps to hold down insurance rates. Subrogation recoveries are reflected in the rate

making process, which tends to hold rates below where they would be in the absence of

subrogation. Although insurers pay for covered losses, subrogation recoveries reduce the loss

payments.

Importance of subrogation

Subrogation has the following major importance:

1. By exercising its subrogation rights, the insurer is entitled only to the amount it has paid under

the policy.

2. The insured cannot impair the insurers’ subrogation right. The insured cannot do anything

after a loss that prejudices the insurer’s right to proceed against a negligent third party.

3. The insurer can waive its subrogation rights in the contract. To meet the special needs of some

insured, the insurance company may waive its subrogation rights by a contractual provision

for losses that have not yet occurred.

4. Subrogation does not apply to life insurance and to most individual health insurance contracts.

Life insurance is not a contract of indemnity, and subrogation has relevance only for contracts

of indemnity. The same principles are true for health insurance.

5. The insurer cannot subrogate against its own insured. If the insurer could recover a loss

payment for a covered loss, the basic purpose of purchasing the insurance would be defeated.

4.4.Principle of utmost good faith

Principle of Utmost Good Faith is a very basic and first primary principle of insurance. According

to this principle, the insurance contract must be signed by both parties (i.e insurer and insured) in

an absolute good faith or belief or trust. The person getting insured must willingly disclose and

surrender to the insurer his complete true information regarding the subject matter of insurance.

The insurer's liability gets void (i.e legally revoked or cancelled) if any facts, about the subject

matter of insurance are either omitted, hidden, falsified or presented in a wrong manner by the

insured. The principle of Utmost Good Faith applies to all types of insurance contracts.

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An insurance contract is based on the principle of utmost good faith. This means that a higher

degree of honesty is imposed on both parties to an insurance contract than is imposed on parties to

other contracts. The practical effect of the principle of utmost good faith today lies in the

requirement that the applicant for the insurance must make full and fair disclosure of the risk to

the agent and the company. The risk that the company thinks it is assuming must be the same risk

that the insured transfers. The application of the principle of utmost good faith may best be

explained in the discussion of representations, concealment, warranty and mistake.

I) Representations

Representations are statements made by the applicant for insurance before the policy is issued. For

example, if you apply for life insurance, you may be asked questions concerning your age, weight,

height, occupation, state of health, family history, and other relevant questions. Your answers to

these questions are called representations.

Although, representation need not be in writing, it is usually embodied in a written application.

An example of representation in life insurance would be answering yes or no to a question as to

whether or not the applicant had been treated for any physical illness by a doctor with in the

previous five years.

The legal significance of a representation is that the insurance contract is voidable at the insurer’s

option if the representation is material, false, and relied on by the insurer. Material means that if

the insurer knew the true facts, the policy would not have been issued or would have been issued

on different terms. False means that the statement is not true or is misleading. Reliance means that

the insurer relies on the misrepresentation in issuing the policy at a specified premium. An

innocent (unintentional) misrepresentation of a material fact, if relied on by the insurer also makes

the contract voidable. An innocent misrepresentation of a material fact is no defense for the

insured if the insurer elects to avoid the contract. Applicants for insurance speak at their own risk

and if they make an innocent mistake about a fact they believe to be true, they are held accountable

for their carelessness.

II) Concealment

Is intentional failure of the applicant for insurance to reveal a material fact to the insurer.

Concealment is the same thing as nondisclosure; that is, the applicant for insurance deliberately

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withholds material information from the insurer. Concealment has approximately the same legal

effect as a misrepresentation of material fact. It is the failure of an applicant to reveal a fact that is

material to the risk.

To deny a claim based on concealment, a non-marine insurer must prove two things: (1) the

concealed fact was known by the insured to be material and (2) the insured intended to defraud

the insurer.

III) Warranty

Is a statement of fact or a promise made by the insured, which is part of the insurance contract and

which must be true if the insurer is to be liable under the contract. A warranty is a clause in an

insurance contract holding that before the insurer is liable, a certain fact, condition or circumstance

affecting the risk must exist.

A warranty creates a condition of contract and any breach of warranty even if immaterial, will void

the contract. This is the central distinction between a warranty and a representation. A

misrepresentation does not void insurance unless it is material to the risk, whereas under common

law any breach of warranty even if held to be minor, voids the contract.

Warranties may be either express or implied. Express warranties are those stated in the contract,

whereas implied warranties are not found in the contract but are assumed by the parties to the

contract. A warranty also may be either promissory or affirmative. A promissory warranty

describes a condition, fact, or circumstance to which the insured agrees to be held during the life of

the contract. An affirmative warranty is one that must exist only at the time the contract is first put

into effect.

IV) Mistake

When an honest mistake is made in a written contract of insurance, steps can be taken to correct it

after the policy is issued. Generally, a policy can be reformed if there is proof of a mutual mistake

or a mistake on one side that is known to be a mistake by the other party, when no mention was

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made of it at the time the agreement was made. A mistake in the sense used here does not mean an

error in judgment by one party but refers to a situation where it can be shown that the actual

agreement made was not the one stated in the contract.

4.5. Principle of Contribution

It is the right of insurers who have paid a loss under a policy to recover a proportionate amount

from other insurers, who are liable for the same loss. This also supports the principle of indemnity.

It is applied in a situation where a person or firm, for some reasons, purchase insurance from two

or more insurers to cover the same subject matter against loss or damage. Under such

circumstance, the insured cannot collect compensation from each insurer. If this happens,

insurance becomes profit-making mechanism. So, the insured is paid only to the extent of the loss

he has suffered. But, each insurer will make contribution to settle the claim. The contribution may

be a proportional amount based on the sum insured under the respective insurers.

An insured party may have policies with two or more insurers covering the same risk, although

not necessarily with equal degrees of liability. Therefore, in the event of a claim, all of the insurers

should pay an equitable proportion of the claim payment. Contribution is the right of an insurer to

call upon the other insurers to share the costs of such a claim payment. The fundamental point is

that, if an insurer has paid a claim in full, it can recoup a proportion of the costs from the other

insurers of the risk.

4.6. Doctrine of Proximate Cause

The doctrine of Proximate (i.e Nearest) Cause, means when a loss is caused by more than

one causes, the proximate or the nearest or the closest cause should be taken into consideration to

decide the liability of the insurer. It states that to find out whether the insurer is liable for the loss

or not, the proximate (closest) and not the remote (farest) must be looked into. “The active and

efficient cause that sets in motion a train of events which brings about a result, without the intervention of

any force started and working actively from a new and independent source”

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An insurance policy will define the perils or insured events that cover is provided for. For

example, a building insurance policy will provide various covers as standard – such as fire,

lightning strikes and earthquakes – and cover for additional risks, such as escape of water, storm

or accidental damage, can be requested.

All contracts are subject to terms and conditions that will exclude certain causes of loss.

Therefore, in the event of a claim, it is important to ascertain the cause of the loss in order to

determine if that cause is insured or excluded. There may be multiple elements involved in a claim,

so it is the ‘proximate cause’ that is taken into account. The proximate cause is the dominant cause

that sets in play a chain of events. For example, if lightning damaged a building and weakened a

wall, following which the weakened wall was blown down by high winds, lightning would be

considered the proximate cause.

However, in case of life insurance, the proximate cause doctrine does not apply. Whatever may be

the reason of death (whether a natural death or an unnatural death) the insurer is liable to pay the

amount of insurance.

Requirements of an Insurance Contract

An insurance policy is based on the law of contracts. To be legally enforceable, an insurance

contract must meet four basic requirements: offer and acceptance, consideration, competent

parties, and legal purpose.

1. Offer and Acceptance

The first requirement of a binding insurance contract is that there must be an offer and acceptance

of its terms. In most cases, the applicant for insurance makes the offer, and the company accepts or

rejects the offer. An agent merely solicits or invites the prospective insured to make an offer.

2. Consideration
The second requirement of a valid insurance contract is consideration—the value that each party

gives to the other. The insured’s consideration is payment of the premium (or a promise to pay the

premium) plus an agreement to abide by the conditions specified in the policy. The insurer’s

consideration is the promise to do certain things as specified in the contract. This promise can

include paying for a loss from an insured peril, providing certain services, such as loss prevention

and safety services, or defending the insured in a liability lawsuit.

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3. Competent Parties

The third requirement of a valid insurance contract is that each party must be legally competent.

This means the parties must have legal capacity to enter into a binding contract. Most adults are

legally competent to enter into insurance contracts, but there are some exceptions. Insane persons,

intoxicated persons, and corporations that act outside the scope of their authority cannot enter into

enforceable insurance contracts.

4. Legal Purpose

A final requirement is that the contract must be for a legal purpose. An insurance contract that

encourages or promotes something illegal or immoral is contrary to the public interest and cannot

be enforced. For example, a drug dealer who sells heroin and other illegal drugs cannot purchase a

property insurance policy that would cover seizure of the drugs by the police. This type of contract

obviously is not enforceable because it would promote illegal activities that are contrary to the

public interest.

Distinct Legal Characteristics of Insurance Contracts

Insurance contracts have distinct legal characteristics that make them different from other legal

contracts. Most property insurance contracts are contracts of indemnity; all insurance contracts

must be supported by an insurable interest; and insurance contracts are based on utmost good

faith. Other distinct legal characteristics are as follows:

A. Aleatory Contract

B. Unilateral Contract

C. Conditional Contract

D. Personal Contract

E. Contract of Adhesion

A) Aleatory Contract

An insurance contract is aleatory rather than commutative. An aleatory contract is a contract where

the values exchanged may not be equal but depend on an uncertain event. Depending on chance,

one party may receive a value out of proportion to the value that is given. For example, assume

that Jessica pays a premium of $600 for a $200,000 homeowner’s policy. If the home were totally

destroyed by fire shortly thereafter, she would collect an amount that greatly exceeds the premium

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paid. On the other hand, a homeowner may faithfully pay premiums for many years and never

have a loss.

In contrast, other commercial contracts are commutative. A commutative contract is one in which

the values exchanged by both parties are theoretically equal. For example, the purchaser of real

estate normally pays a price that is viewed to be equal to the value of the property.

Although the essence of an aleatory contract is chance, or the occurrence of some fortuitous event,

an insurance contract is not a gambling contract. Gambling creates a new speculative risk that did

not exist before the transaction. Insurance, however, is a technique for handling an already existing

pure risk. Thus, although both gambling and insurance are aleatory in nature, an insurance

contract is not a gambling contract because no new risk is created.

B) Unilateral Contract

An insurance contract is a unilateral contract. A unilateral contract means that only one party

makes a legally enforceable promise. In this case, only the insurer makes a legally enforceable

promise to pay a claim or provide other services to the insured.

After the first premium is paid, and the insurance is in force, the insured cannot be legally forced

to pay the premiums or to comply with the policy provisions. Although the insured must continue

to pay the premiums to receive payment for a loss, he or she cannot be legally forced to do so.

However, if the premiums are paid, the insurer must accept them and must continue to provide

the protection promised under the contract.

In contrast, most commercial contracts are bilateral in nature. Each party makes a legally

enforceable promise to the other party. If one party fails to perform, the other party can insist on

performance or can sue for damages because of the breach of contract.

C) Conditional Contract

An insurance contract is a conditional contract. That is, the insurer’s obligation to pay a claim

depends on whether the insured or the beneficiary has complied with all policy conditions.

Conditions are provisions inserted in the policy that qualify or place limitations on the insurer’s

promise to perform. The conditions section imposes certain duties on the insured if he or she

wishes to collect for a loss. Although the insured is not compelled to abide by the policy

conditions, he or she must do so to collect for an insured loss.

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The insurer is not obligated to pay a claim if the policy conditions are not met. For example, under

a homeowner’s policy, the insured must give immediate notice of a loss. If the insured delays for

an unreasonable period in reporting the loss, the insurer can refuse to pay the claim on the

grounds that a policy condition has been violated.

D) Personal Contract

In property insurance, insurance is a personal contract, which means the contract is between the

insured and the insurer. Strictly speaking, a property insurance contract does not insure property,

but insures the owner of property against loss. The owner of the insured property is indemnified if

the property is damaged or destroyed. Because the contract is personal, the applicant for insurance

must be acceptable to the insurer and must meet certain underwriting standards regarding

character, morals, and credit.

A property insurance contract normally cannot be assigned to another party without the insurer’s

consent. If property is sold to another person, the new owner may not be acceptable to the insurer.

Thus, the insurer’s consent is required before a property insurance policy can be validly assigned

to another party. In practice, new property owners get their own insurance, so consent of the

previous insurer is not required. In contrast, a life insurance policy can be freely assigned to

anyone without the insurer’s consent because the assignment does not usually alter the risk or

increase the probability of death.

E) Contract of Adhesion

A contract of adhesion means the insured must accept the entire contract, with all of its terms and

conditions. The insurer drafts and prints the policy, and the insured generally must accept the

entire document and cannot insist that certain provisions be added or deleted or the contract

rewritten to suit the insured. Although the contract can be altered by the addition of endorsements

and riders or other forms, the contract is drafted by the insurer. To redress the imbalance that

exists in such a situation, the courts have ruled that any ambiguities or uncertainties in the contract

are construed against the insurer. If the policy is ambiguous, the insured gets the benefit of the

doubt.

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