Risk Management and Insurance

BAIS 2024

Chapter 4
Fundamentals of Insurance Contracts
November 3, 2024

Shambachew O. Hussen
 Chapter 4: Agenda
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Chapter four:
Fundamentals of Insurance contracts

4.1. Legal principles of insurance contract.

4.2. Requirements of an insurance contract.

4.3. Unique characteristics of insurance.

 After studying this chapter, you should be able to:
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1. Describe the legal principles of insurance contract.

2. Appreciate the purposes of each legal principles of insurance

3. Realize the legal requirements of insurance contract.

4. List and explain the unique characteristics of insurance

 4.1. Legal principles of insurance contract.
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List of Legal principles

1. 4.1.1.Principle of indemnity.

2. 4.1.2.Principle of insurable interest.

3. 4.1.3.Principle of subrogation

4. 4.1.4.Principle of Ut most good faith

 4.1.1. PRINCIPLE OF INDEMNITY (2 of 12)
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 Indemnification : Meaning
Principle of indemnity

 ?

 Principle of indemnity ?
 The most fundamental legal principles in insurance.
 Mostly in property insurance but also in liability insurance
contracts.
 Why?

 Principle of indemnity ? Meaning

 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.
 Example : Alex's home is insured for $100,000, and a partial loss of
$20,000 occurs,
 4.1.1. PRINCIPLE OF INDEMNITY (3 of 12)
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Purpose of principle of Indemnity

Principle of indemnity

1. To prevent the insured from profiting from loss

◼ Example

2. To prevent gambling and moral hazard

◼ Gambling ?

◼ Moral Hazard ?
 4.1.1. P R I N C I P L E O F INDEMNITY (4 of 12)

Determination of actual cash value (ACV)

Actual Cash Value
 The concept of actual cash value underlies the principle of
indemnity.

 In property insurance, the basic method for indemnifying the

insured is based on the actual cash value of the damaged
property at the time of loss.

 The courts have used three major methods to determine

actual cash value:
 4.1.1. PRINCIPLE OF INDEMNITY (5 of 12)
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1. Replacement cost less deprecation

ACV = Replacement cost – deprecation

2. Fair market value

3. Broad evidence rule

 4.1.1. P R I N C I P L E O F INDEMNITY (6 of 12)
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1. Replacement cost less deprecation : Meaning

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

ACV = Replacement cost – deprecation

 Replacement cost is the current cost of restoring the damaged

property with new materials of like kind and quality.

 Both inflation and depreciation are considered

 Depreciation is a deduction for physical wear and tear, age, and
economic obsolescence.
 4.1.1. P R I N C I P L E O F INDEMNITY (7 of 12)
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1. Replacement cost less deprecation : Example

ACV = Replacement cost – deprecation

For example:
 Assume Alex has a favorite couch that burns in a fire.
Assume he bought the couch five years ago; the couch
is 50 percent depreciated, and a similar couch today
would cost $1000.
 Q= Under the actual cash value rule, how much will
be indemnified ?
◼ Answer= $ 500
◼ What would happen if we paid him $1000?
 4.1.1. PRINCIPLE OF INDEMNITY (8 of 12)

 Almaz purchased a living room set for $1,000 and insured this
furniture on an actual cash value basis. Two years later the living
room set was destroyed by a covered peril. At the time of loss,
the property had depreciated in value by 25 percent. The
replacement cost of the furniture at the time of loss was $1,200.
Assuming no deductible, how much will Almaz receive from her
insurer?
A) $900
B) $950
C) $1,000
D) $1,200
 4.1.1. P R I N C I P L E O F INDEMNITY (9 of 12)
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2. Fair market value: Meaning

 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 difference might br due to several reasons,

including:
◼ A Poor Location,
◼ Deteriorating Neighborhood, Or
◼ Economic Obsolescence Of The Building.
 4.1.1. P R I N C I P L E O F INDEMNITY (10 of 12)
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3. Broad evidence rule: Meaning

 Determination of actual cash value should include
all relevant factors an expert would use to
determine the value of the property. Including:
◼ Replacement cost less depreciation,
◼ Fair market value, and
◼ Present value of expected income from the property,
◼ Comparison sales of similar property,
◼ Opinions of appraisers, and
◼ Numerous other factors.
 4.1.1. P R I N C I P L E O F INDEMNITY (11 of 12)
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Exceptions to the principle of Indemnity

1. Valued policy

2. Valued policy law

3. Replacement cost insurance

4. Life Insurance
 4.1.2. PRINCIPLE OF INSURABLE INTEREST (1 0f 2)
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❑ Meaning:
 It states that “the insured must be in a position to lose
financially if a loss occurs”
❑ Example : You have insurable interest on:
◼ Your life, your spouses , children's (conditionally) life
◼ Your own properties
◼ Your own activities
◼ Etc
 4.1.2. PRINCIPLE OF INSURABLE INTEREST (2 0f 2)
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 PURPOSES of insurable interest

1. TO PREVENT GAMBLING
◼ Otherwise: One person could similarly insure the life of another
person and hope for an early death.

2. TO REDUCE MORAL HAZARD

◼ Otherwise: a dishonest person could purchase a property insurance
contract on someone else's property and then deliberately cause a loss
to receive the proceeds.

3. To MEASURE THE AMOUNT of the insured's loss

 4.1.3. PRINCIPLE OF SUBROGATION ( 1 of 2)
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Meaning :
 Means “Substitution of the insurer in place of the insured
for claiming indemnity from a third person for a loss covered by
insurance”

 The insurer is entitled to recover from a negligent

third party and loss payments made to the insured.

 Strongly support the principle of indemnity

 Example:
 4.1.3. PRINCIPLE OF SUBROGATION ( 2 of 2)
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• Purposes of subrogation
 To prevents the insured from double collection

 To hold the guilty person responsible for the loss

 To hold down insurance rates (premium)

 4.1.4. PRINCIPLE OF UT MOST GOOD FAITH
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 A higher degree of honesty is imposed on both

parties to an insurance contract than is imposed on
parties to other contracts.

 Thus, the principle of utmost good faith imposed a

high degree of honesty on the applicant for insurance.

 The principle of utmost good faith is supported by

three important legal doctrines:
♥ representations,
♥ concealment, and
♥ Warranty.
 1. Representation
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 Representations are “statements made by the applicant for

insurance“
For example:
 If you apply for life insurance, you may be asked questions
concerning you age, weight, height, occupation, state of
health, family history, and other relevant questions. Your
answers to these questions are called representations.
 Usually embodied in a written application
 The legal significance of a representation is that the
insurance contract is avoidable at the insurer's option if the
representation is material, false, and relied on by the
insurer.
 2. Concealment /Non-Disclosure/
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 Concealment is intentional failure of the

applicant for insurance to reveal a material
fact to the insurer.

 The legal effect of a material concealment is

the same as a misrepresentation the contract is
voidable at the insurer's option.
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3. Warranty

 A warranty is a statement of fact or a promise made

by the insured, which is part of the insurance contract
and must be true if the insurer is to be liable under the
contract.
 For example:

 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.
Minilik's office building was damaged by a fire
caused by a careless tenant. After paying
Minilik for his loss, the insurance company
sued the tenant to recover its loss. This suit is
based on the principle of
A) Warranty.
B) Insurable Interest.
C) Utmost Good Faith.
D) Subrogation.
Dani owns a liquor store in a high-crime area. In order
to obtain a reduced insurance premium, Dani
promised to have a burglar alarm operating at the
store when the store was closed. This agreement,
which was incorporated into the insurance contract,
is an example of a
A) Representation.
B) Concealment.
C) Contract Of Adhesion.
D) Warranty.
 4.2 Legal requirements of insurance contract
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Also known as a legal elements.

Elements/requirements

It includes:
Elements
1. Offer and acceptance
of VALID
2. Considerations Insurance
3. Competent parties CONTRACT
4. Legal purpose
URPOSE
 Element # 1. Offer & Acceptance
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 Offer constitutes filling the application form and

paying (promising to pay) the first premium.
Elements/requirements

Offer in Property Offer in

and liability
insurance Life insurance
• Written or oral offer • Only written offer
• Agents have binding • Agents have no
power binding power
 Element # 2. Considerations /Value
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 The value that each party gives to the other
Elements/requirements

 The value agreed to be exchanged should be clear and

precise

Insured Insurer
• Promise to pay
• Pay premium
indemnification
• Obey the rules,
• Obey the rules
conditions etc
 Element # 3: COMPETENT PARTIES
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 Parties in insurance contract should be legally

Elements/requirements

competent to enter in to insurance contract

I. Insured
 Mad
 Insane
 Intoxicated persons
 Minor child are not competent to get in to
contract.
II. Insurer
◼ Having no legal licence
 Element # 4 LEGAL PURPOSE
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 An insurance contract that encourages or

Elements/requirements

promotes something illegal or immoral is

contrary to the public interest and cannot be
enforced

 The contract should not be

 Illegal
 Immoral
 Against the society interest
 Example : a contract made for
◼ Contraband
◼ Killer
◼ Terrorist have no legal ground
4.3. Unique Characteristics Of Insurance

❖ Insurance contracts have distinct legal characteristics

that make them different from other legal contract.
1. Aletory contract

2. Conditional contract

3. Unilateral contract

4. A personal contract

5. Contract of adhesion
1. Insurance is an ALETORY Contract

INSURANCE OTHERS contracts

❖ Is just like a lotter ❖ Commutative contracts

❖ Value exchanged is not equal ❖ Equal value exchange

❖ It depends on chance ❖ Example:

❖ Example : sales contract

2. Insurance is a UNILATERAL contract

Insurance Other contracts

❖ Means that only one party ❖ They are Bilateral Contract.
(insurer) makes a legally ❖ Most commercial contract
enforceable promise are bilateral contract in
❖ Only the insurer nature.

❖ Insured have no legally ❖ Each party makes a legally

enforceable promise enforceable promise to the
other party.

❖ Example . Sales contract

 3. Insurance is a PERSONAL contract
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 The contract will be made between persons (i.e

the manager (employee) of the insurance and the
Unique characters

customer, the insured)

 Property insurance did not insure property, but

the property owner

 Property insurance is not assignable with out the

consent of insurer

 Life insurance is assignable (transferable benefit)

 4. Insurance is a CONDITIONAL contract
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 Conditions are provisions which makes the insurers

obligation to pay insured qualified or disqualified,
Unique characters

 Payment of premium is not a guarantee for insured to

insure indemnification
 Insurers obligation to pay the insured depends on
weather the insured discharges his duties or not
Common conditions of property insurance
 To protect damaged property from further damage
 To file a proof of loss with in due time
 Co work with insurer while determining the amount
of loss and legal low suit
 5. Insurance is a contract of ADHESION
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 The contract made on mutual trust ad agreement

Unique characters

 The insured must accept the entire contract, with all its terms
and conditions.

 If there is any doubt or ambiguity on the contract the

advantage will go to the insured

 Under a clear contract the legal effete is as it is written on the

contract.
End !