CHAPTER FOUR:

LEGAL PRINCIPLES OF INSURANCE CONTRACT

4.1. INSURANCE PRINCIPLES

1) THE PRINCIPLE OF INDEMNITY

Indemnity states that the insurer agrees to pay no mare than the actual amount of the loss, which
means the insured should not profit from the loss or placing the insured in the same position
financially as he or she or it was in before the loss or damage took place. The two fundamental
purposes of this legal principle are: (a) to prevent the insured from profiting from loss, & (b) to
reduce moral hazard

Indemnity is different for different types of insurance:

In property insurance indemnifying the insured is based on the actual cash value of the damaged
property at time of loss. In liability insurance the insurer pays up to policy limit. In business
income insurance, the amount paid is the loss of profits and continuing expenses when the
business is shut down because of loss from a covered peril.

Exceptions to the principle of indemnity:

A policy that Pays the face amount or payment for the antiques

For example, suppose Ethiopian Airlines has 10-year-old office furniture that is destroyed by
fire. How do you think should the loss be valued? Should it be valued at what it would cost to
replace the furniture with new furniture or with comparable 10-year-old furniture (if such could
be found)?

Although replacement with new furniture would technically violate the principle of indemnity,
such is done in many property policies. You may know someone in your surrounding who might
have suffered losses due to a car accident. The car that has been destroyed could be old but when
the insurer pays compensation to the insured, a new car might be bought; hence violation of the
principle of indemnity.

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 Life insurance

When the insured dies, no attempt is made to measure the amount of the loss. Instead, the full
amount of life insurance policy is made upon the death of the insured.

2) PRINCIPLE OF INSURABLE INTEREST

A fundamental legal principle that strongly supports the principle of indemnity is that of
insurable interest, which states that the insured must be in a position to lose financially if a los
occurs, or to incur some other kind of harm if the loss takes place

Purposes of principle of insurable interest:

i. To prevent gambling

ii. To reduce moral hazard

iii. To measure the amount of the insured loss ( in property insurance)

Insurance contracts must be supported by an insurable interest.

There is difference between an insurable interest in property and liability and life insurance.

Insurable interest in property and liability insurance:

a. Ownership of property can support an insurable interest because he /she losses

financially if his /her property is damaged.

b. Potential legal liability also can support an insurable interest in the property of
customer because these firms are legally liable for damage to the customer goods
caused by their negligence.

E.g. Garage operators have an insurable interest in the stored automobiles for which they have
assumed liability.

c. Secured creditors also have an insurable interest in the property pledged to them.

E.g. Mortgagees, have an insurable interest in the property on which they have worked because
they have a mechanic’s lien.

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 d. A contractual right also can support an insurable interest

e.g. The holder of a contract to receive oil royalties has an insurable interest in the oil property so
that in the event of an insured loss, indemnity can be collected, the amount of the indemnity
being measured by the reduction in royalty resulting from the insured loss.

e. The legal ownership of the property can support an insurable interest.

E.g. St. Mary’s College might have leased a building under a long-term lease whereby the lease
may be cancelled if a fire destroys a certain percentage of the value of the building. In this case
the College has insurable interest though it does not own the building.

Insurable interest in life insurance:

There is no question of insurable interest if the life insurance is purchased on their own life and
any one the beneficiary regardless of whether the beneficiary has an insurable interest. If the life
insurance policy is purchased on the life of another person this person should have an insurable
interest on that person’s life. Close ties of blood or marriage or a pecuniary interest will satisfy
the insurable interest requirement in life insurance. a business firm may insure the life of a key
employee because that person’s death would cause financial loss to the firm. A wife may insure
the life of her husband because his continued existence is valuable to her and she would suffer a
financial loss upon his death. Likewise, a husband may insure the life of his wife because her
continued existence is valuable to him and he could suffer a financial loss upon her death. The
same statement may apply to almost anyone who is dependent on an individual. A father may
insure the life of a minor child, but a brother may not ordinarily insure the life of his sister. In the
latter case there would not usually be a financial loss to the brother upon the death of his sister,
but in the former case the father would suffer financial loss upon the death of his child. A
creditor has an insurable interest in the life of a debtor because the death of the debtor would
subject the creditor to possible loss.

When the insurable interest must exist?

In property insurance, the insurable interest must exist at the time of the loss not at the inception
of policy. If at the time of the loss the insured no longer has an interest in the property, there is

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liability under the policy. E.g. suppose X Company owns and insures an automobile. Later X
sells the car to Y Company, and shortly thereafter the auto is destroyed. X Company, which has
no further financial interest in the car, cannot collect under the policy. Further, Y has no
protection under the policy because insurance is said to follow the person and not the property.
In other words, the policy purchased by X company is not transferred to Y when the car is sold.
Y would have to obtain its own coverage to be able to collect when the loss occurs.

In life insurance, the insurable interest must exist at the inception of the policy, not at the time of
the loss. The courts view life insurance as an investment contract. Assume that a wife who owns
a life insurance policy on her husband later obtains a divorce. If she continues to maintain the
insurance by paying the premiums, she may collect on the subsequent death of her former
husband even though she is remarried and suffers no particular financial loss upon his death. It is
sufficient that she had an insurable interest when the policy was first issued.

3) PRINCIPLE OF SUBROGATION

The principle of subrogation strongly supports the principle of indemnity. Subrogation means
substitution of the insurance in place of the insured for the purpose of claiming indemnity from a
third person for a loss covered by insurance. In other word one who has indemnified another’s
loss is entitled to recovery from any liable third parties that are responsible. Suppose somebody
by the name Daniel negligently causes damage to some other person’s property, say, Hanna’s. If
Hanna has already insured her property against accidental losses, her insurance company will
indemnify her to the extent of the loss. And now the insurer would have the right to proceed
against Daniel for any amounts it has paid out under Hanna’s policy. In other words the insurer,
after compensating the insured, would have every right to claim payment from the party that is
responsible for the loss.

Purposes of the principle of subrogation:

-To prevent the insured from collecting twice for the same loss.

In the example we have mentioned above, if Hanna’s insurer did not have the right of
subrogation, it would be possible for her to recover from the policy and then recover again in a
legal action against Daniel. In this way Hanna might collect twice. It would also be possible for

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Hanna to arrange an accident with Daniel, Collect twice, and then split the profit with him. This
obviously would result in a moral hazard; that is making insurance contract an instrument of
fraud rather than what it has been intended for.

- To hold the negligent person responsible for the loss.

In other words, negligent parties should not escape penalty because of the insurance mechanism.
But had it not been for this principle of subrogation, the loss caused by some one will be paid for
by the insurer and the party causing the loss might not be made to pay for the pain he/ she has
caused.

- To hold down insurance rates.

In some lines of insurance, particularly liability insurance, recoveries from negligent parties
through subrogation are substantial. Although no specific provision for subrogation recoveries is
made in the rate structure other than through those provisions relating to salvage, the rates would
tend to be higher if such recoveries were not permitted. But due to this principle, insurance
companies know that they are going to get part of what they have paid out as compensation and
hence tend to charge lower premiums.

Exception to the principle of subrogation:

The principle of subrogation does not normally exist in such lines as life insurance and most
types of health insurance. Also, subrogation does not give the insurer the right to collect against
the insured, even if the insured is negligent. Thus, a homeowner who negligently, but
accidentally, burns down the house while thawing a frozen water pipe with a blowtorch can
collect under a fire policy, but the insurer cannot proceed against the owner of the policy for
compensation. Otherwise, there would be little value in having insurance. Sometimes, an insurer
might agree to waive his right of subrogation. Another interesting point we may raise her in
connection with this principle is about the interesting ethical issues for the insurer and the
insured that the interaction between the subrogation clause and the need to waive subrogation
rights can raise. For illustrative purposes, consider the case of an insured who owned property, of
which a portion was leased to another individual, named Mohammed. Say, as part of the lease

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agreement, there was a waiver excusing Mohammed from liability for destruction of the property
by fire.

On the date within the insured’s policy period, a fire destroyed the property. The insured made a
claim for recovery of the damages from the insurer. After an investigation of the blaze, the
insurer determined that the damages were caused as a direct result of Mohammed’s negligence.
Thus, the insurer paid the amount of the damages to the insured and then started proceedings
against Mohammed defended on the grounds that the contract between him and the insurer
constituted a waiver-of –subrogation clause.

Say the court decided in favor of Mohamed. The court held that the owner’s fire insurer was not
entitled to subrogation against Mohammed for the fire loss paid to the owner. The insurer’s right
to subrogation could not extend beyond the insured’s own rights, and the lease agreement limited
the ability to subrogate for fire losses. Thus, because the owner had no rights to collect from
Mohammed, the insurer had no subrogation rights against him either.

Finally, note that the insurer is entitled to subrogation only after the insured has been fully
indemnified. If the insured has borne part of the loss (perhaps due to inadequate coverage), the
insurer may claim recovery only after these costs have been repaid. The only exception to this
rule is that the insurer is entitled to legal expenses incurred in pursuing the subrogation process
against a negligent third party. For example, assume that X Company’s building, valued at
600,000 Birr and insured for 500,000 Birr, is totally destroyed through the negligence of
contractor Y. X Company’s insurer subrogates against Y and collects 500,000 Birr and has legal
expenses of 500,000 Birr. The insurer receives 500,000 Birr for legal expenses, Company X
receives the 100,000 by which he was underinsured, and the insurer receives the remaining
500,000 Birr.

4) Principle of utmost good faith

The principle of utmost good faith states that both parties to an insurance contract must exercise
“utmost good faith” which means that the insured must disclose all material facts about the item
or risk to be insured to the insurers, whilst the insurers must disclose to the insured the full
details and terms of the insurance to be provided. Both parties should not engage in intentional
concealment, misrepresentation and fraud. This principle of utmost good faith is supported by

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four important legal doctrines: representation, concealment, breach of warranties and
mistakes.

1. Representation:

It is a statement made by an applicant for insurance before the policy is issued or it is a statement
of his/her age, weight, occupation, state of health, family and personal history. An example of a
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 condition or illness by a doctor within the
previous five years. If a representation is relied on by the insurer in entering into the contract and
if it proves to have been false at the time it was made or becomes false before the contract is
signed there exists a legal ground for the insurer to avoid the contract as the insured has violated
the principle of utmost good faith.

But every misrepresentation does not lead to avoidance of the contract. The misrepresentation
must be material enough for the insurer to cancel the contract.

Misrepresentation is said to be material if the information concealed or misrepresented

significant that, if the truth had been known, the contract either would not have been issued
would have been issued on different terms. Therefore, the insurer will waive the subrogation
clause in the manufacturer’s insurance policy because to enforce it would mean that the insured
would not be compensated at all. Inserting a waiver of subrogation clause in the manufacturer’s
insurance policy can perform this waiver. It is a common practice in insurance contracts includes
such clauses.

An insured who acts in such a way as to destroy or reduce the value of the insurer’s right of
subrogation violates the provisions of most subrogation clauses and forfeits all rights under the
policy. For instance, suppose Abebe collides with Eyob in an automobile accident. Abebe writes
Eyob term. If the misrepresentation is inconsequential, its falsity will not affect the contract.
However, a misrepresentation of a material fact may make the contract voidable at the option of
the insurer. The insurer may decide to affirm the contract or to avid it. Failure to cancel contract
after first learning about the falsity or a material misrepresentation may operate to defeat the
insurer’s rights to cancel at a later time.

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What if the misrepresentation is unintentional?

Sometimes an insured might give wrong information unintentionally and this information might
be material enough to affect the contract. Thus if they make an innocent mistake about a fact
they believe to be true, They are held accountable for their carelessness. Thus, suppose W/o
Tsehay applies for insurance on her automobile and states that there is no driver under age 25 in
her family. However, it turns out that her 16-year-old son has been driving the family car without
his mother’s knowledge. Lack of this knowledge is no defense when the insurance company
refuses to pay a subsequent claim on the grounds of material misrepresentation. It is not
necessary for the insurer to demonstrate that a loss occurred arising out of the misrepresentation
in order to exert its right to avoid the contract. Thus, in the preceding case, assume Tsehay has an
accident and it is then learned for the first time that she has a 16-year-old son driving. Since this
situation is contrary to the information Tsehay had previously stated, the insurer might legally
refuse payment in most of the cases.

If the court holds that a statement given in the application was one of opinion, rather than fact,
and it turns out that the opinion was wrong, it is necessary for the insurer to demonstrate bad
faith or fraudulent intent on the part of the insured in order to avoid the contract. For example,
say one of your friends goes to Africa Insurance Company to purchase health insurance policy.
And on the application form he was asked whether he ever had cancer or not and he answers no.
Later he discovers that he actually had cancer. The court might well find that your friend has not
told the exact state of his health and thought that he had some other ailment. If the question had
been phrased, “Have you ever been told you had cancer?” a yes or no answer would clearly be a
fact, not an opinion. An honest opinion should not be a ground for rescinding an insurance
policy.

 Whether intentional or unintentional, a material misrepresentation of information by the

insured might give the insurer legitimate ground for cancellation of contracts.

2. Warranties:

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. For example, an insurance policy

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covering a ship may state “warranted free of capture or seizure.” This statement means that if the
ship is involved in a war skirmish, the insurance is void. Or a bank may be insured on condition
that a certain burglar alarm system be installed and maintained. Such a clause is a condition of
coverage and acts as a warranty. A warranty creates a condition of the 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 the insurance unless it is
material to the risk, whereas under common law any breach of warranty, whether it is material or
not, voids the contract.

 Unlike representations which need to be material enough to lead to cancellation of insurance

policies, any breach or warranty gives sufficient ground to the insurer to void insurance
contracts.

3. Concealments:

Concealment is defined as silence when obligated to speak. Concealment has approximately the
same legal effect as a misrepresentation of a material fact.

What difference do concealment and representation have?

Concealment is the failure of an applicant to reveal a fact that is material to the risk, while
misrepresentation refers to deliberate action of giving wrong information about the risk being
insured. As insurance is a contract of utmost good faith, it is not enough that the applicant
answers truthfully all questions asked by the insurer before the contract is effected. The applicant
must also volunteer material facts, even if the disclosure of such facts might result in rejection of
the application or the payment of a higher premium. The applicant is often in a position to know
material facts about the risk that the insurer does not. To allow these facts to be concealed would
be unfair to the insurer. After all, the insurer does not ask questions such as “ Is your building no
on fire?” or “Is your car now wrecked?” The most relentless opponent of an insurer’s defense
suit would not argue that an insured who obtained coverage under such circumstances would be
exercising even elementary fairness. The important, often crucial, question about concealment
lies in whether or not the applicant knew the fact withheld to be material.

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 What sort of questions would you use to test whether or not the insured is
concealing?

The following questions might be useful in testing concealment:

 Did the insured know of a certain fact?

 Was this fact material?

 Was the insurer ignorant of the fact?

 Did the insured know the insurer was ignorant of the fact?

The test of materiality is especially difficult because often the applicant is not an insurance
expert and is not expected to know the full significance of every fact that might be of vital
concern to the insurer. The final determination of materiality is the same as it is in the law of
representation, namely, would the contract be issued on the same terms if the concealed fact had
been known? There are two rules determining the standard of care required of the applicant. The
stricter rule, which usually applies only to ocean vessels and their cargoes, holds that
international concealment as well as innocent concealment can void the contract. In this case, the
fourth test for concealment is irrelevant. For most other risks, however, the rule is that a policy
cannot be avoided unless there is fraudulent intent to conceal material facts. Thus, the intentional
withholding of material facts with an intent to deceive constitutes fraud. In determining which
facts must be disclosed if known, it has been held that facts of general knowledge or facts known
by the insurer need not be disclosed. There is also the inference from past cases, though not a
final determination, that the insurer cannot void a contract on the grounds of concealment of
those facts that are embarrassing or self-disgracing to the applicant.

 In must cased insurance policies will be made void only incases of intentional concealments.

4. Mistakes:

When an honest mistake is made in a written contract of insurance, steps can 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, where no

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mention was made of it at the time the agreement was made was not the one stated in the
contract.

As an illustration of this, consider an insurer that issued a 1,000 Birr life insurance policy and, by
an error of one of its clerks, included an option at the end of 20 years to receive income
payments of 1,051 Birr per year, rather than 10.51 Birr per year. The mistake was discovered 18
years later. When the insurer tried to correct the error, the insured refused to accept payment of
the smaller amount. In a legal decision, the court held that the mistake was a mutual one that
should be corrected. The error of the insurer was in misplacing a decimal point, whereas the error
of the insured was either in not noticing the error or, if noticed, in failing to say anything. Thus,
the correct, smaller payment was substituted for the larger, incorrect one stated in the policy.

In contrast to the previous example, suppose Adam believes himself to be the owner of certain
property and insures it. He cannot later demand the entire premium back solely because he
discovers that, in fact, he was not the owner of the property. This was a mistake in judgment or
an erroneous supposition, and the courts will not relieve that kind of mistake.

Requirements of an insurance contract

Contract is an agreement embodying a set of promises that are legally enforceable.

To be legally enforceable, an insurance contract must meet four basic requirements:

1) Offer and Acceptance
2) Consideration – the value exchanged to the agreement
3) Competent parties – legal capacity to make a binding contract
4) Legal purpose

1. Offer and Acceptance of the terms:

In most cases the applicant for insurance makes the offer, and the company accepts or rejects the
offer.
In property and liability insurance, the offer and Acceptance can be oral or written. In the
absence of specific legislation to the contrary, oral contracts are valid. But, as a practical matter
most are in written form.

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2. Consideration: refers to the value that each party gives to the other.
The consideration requirement means something of value must be exchanged by each party to
the agreement.
3. Competent parties: Each party must be legally competent.
This means the parties must have legal capacity to enter in to a binding contract. E.g. minors and
mentally incompetent.
4. Legal purpose: The contract must be for a legal purpose.
The contract must neither violate the requirement of insurable interest nor protect or encourage
illegal ventures.

Distinguishing characteristics of insurance contracts

Insurance contracts have distinct legal characteristics that makes them different from other legal
contracts:

Aleatory contract:
An insurance contract is aleatory rather than commutative.
Aleatory contracts have a chance element and uneven exchange
Under aleatory contract, the performance of at least one of the parties is dependent on chance.
An aleatory contract also involves uneven exchange: one of the parties promises to do much
more than the other party.
In contrast, other commercial contracts are commutative. A commutative contract is one in
which the values exchanged by both parties are theoretically even. E.g. purchase of real estate
Unilateral Contract:
An insurance contract is 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.
In contrast most commercial contracts are bilateral

Conditional Contract:
An insurance contract is a conditional contract.
This means the insurer’s obligation to pay a claim depends on whether or not the insured or the
beneficiary has complied with all policy conditions.

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 Conditions are provisions inserted in the policy that qualify or place limitations on the insurer’s
promise to perform.
Personal Contract: An insurance contract is a personal contract.
4 Means the contract is between the insured and the insurer.

Contract of Adhesion:
The insurance contract is said to be a contract of adhesion.
This means that any ambiguities or uncertainties in the wording of the agreement will be
construed/interpreted against the drafter-the insurer. If the policy is ambiguous, the insured gets
the benefit of the doubt.

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