Definition of Insurance

From the viewpoint of the individual (Policyholder or insured or assured or

subscriber), insurance is defined as a mechanism of risk transfer or an
economic device whereby a person called the insured (subscriber of
policy) transfers the risk of financial loss resulting from unforeseeable
events affecting the property, life or body to a person named the Insurer for
consideration (payment of premiums).

On the other hand, from the perspective of the insurer (assurer), insurance
is a mechanism via which risk is distributed among the group of persons
(insured) who are exposed to the same type of risk, i.e., persons who bear
the risk of suffering a financial loss as a result of events affecting a
property, life or body.

From the definitions provided above, we can understand that insurance is a

cooperative economic device to spread the loss caused by a particular risk
over several persons exposed to it and agree to insure themselves against
it. This means that insurance provides a pool to which many persons
contribute a certain amount of money called the premium, and the insurer
compensates the few who suffer losses.

It should also be noted that via insurance, the risk is transferred from the
individual to the insurer, who considers the total or probability of loss in a
certain period and then fixes the premium to be paid by each person
insured.
An insurance does not and cannot prevent loss of property, incurring civil liability,
death, or injury or illness. Instead, it provides financial compensation for the effects
of misfortune. It provides financial compensation to the insured or the beneficiary
who has suffered financial losses as a result of loss or damage to property, or because
he has incurred a civil liability or illness or death of the insured. Therefore Insurance
is a curative (not preventive) remedy that provides financial compensation to alleviate
the effects of misfortune.

Nature of Insurance Contract

i. Insurance is a contingent or conditional contract: It is a contract in which the

performance of the obligation by the parties or one of them is dependent on the
condition or contingency agreed by the parties on the contract. Insurance
compensation will not be paid if the contingency or necessity does not materialize.

ii. An insurance contract is a mandatory contract rather than a Cumulative

Contract: Aleatory contracts have a chance element (not all subscribers would be
paid) and uneven exchange (not always win-win). Under such contracts, at least one
party‟s performance depends on chance.

iii. Insurance is a unilateral contract: Insurance is unilateral because only the

insurer makes a legally enforceable promise to pay a claim or provide other services
to the insured.

iv. Insurance is a Contract of Adhesion: it is in the nature of the contract of

insurance that not all the terms and conditions of the contract are the result of
negotiations between the parties. Hence, the insurance contract is mostly articulated
by the insurer, and all the insured has to do is agree (adhere to) the terms.
v. Insurance works by the Law of Large Numbers or pool of premiums:
Insurance spreads loss among a large pool of insured individuals who may not face
perils simultaneously.

Significance of Insurance

i. Indemnification of losses: payment of compensation by the insurer for losses

permits individuals and their families to be restored to their original financial position
after a loss has occurred. Hence, businesses will remain in business, employees
continue to keep their jobs or families intact, and so on.

ii. Reduction of worry and fear: it reduces or eradicates worry and anxiety before or
after the loss. A person insured for a long-term disability does not have to worry
about losing earnings if a severe illness or accident occurs.

iii. Source of investment funds: the insurance industry is an essential source of

capital investment and accumulation funds. The premiums collected by the insurer
and other funds not needed for immediate losses and expenses can be loaned to
businesses or invested in manufacturing or real estate.

iv. Means of loss control: if no effort were made to prevent or minimize the
occurrence of insured risks or losses, the premiums would tend to rise. Hence,
insurers should participate in various programs and sponsorship schemes to mitigate
or reduce the chance of risk, such as road building, fire safety standards, and so on. In
this sense, insurance can be taken as a risk management mechanism.

v. Enhancing credit: when a person is insured, the fact that s/he is insured enhances
a person’s honor. i.e., it makes them as a borrower a better credit risk to the lender
because it guarantees the value of the borrower’s collateral and gives the lender (the
creditor) a greater assurance that the loan will be paid.
The Major Principles of Law of Insurance

1. Principle of Insurable Interest

The word “interest” can have several meanings. In the present context, it means a
financial relationship with something or someone. The following important features
of an “insurable interest‟ are considered. (Refer to articles 675-684 of the
Commercial Code of Ethiopia 1960)

Insurable interest is a person’s legally recognized relationship to the subject matter of

insurance that gives them the right to subscribe to insurance for it. Since the
relationship must be legal, a thief possessing stolen goods has no right to insure them.
(Refer to articles 654, 675-676 of the Commercial Code of Ethiopia 1960)

Why Insurable Interest after all? An insurance agreement is void without insurable
interest. The rules relating to the return of premiums under such an agreement vary
between the different classes of insurance. These are the general rules on the illegality
of contracts and the relevant provisions of the Insurance Companies Ordinance.

Characteristics of an Insurable Interest

For insurable interest to exist, the following criteria must be satisfied:

i. There must be some person (i.e., life, limbs, etc.), property, liability, or legal right
(e.g., the right to repayment by a debtor) capable of being insured;

ii. That person, etc., must be the subject matter of the insurance (that is to say, claim
payment is made contingent on a mishap to such person, etc.);

iii. The proposer must have a legally recognized relationship (such as a right of
ownership) to the subject matter of insurance so that financial loss may result for him
if the insured event happens. However, remember that insurable interest is sometimes
legally presumed without showing a financial relationship. For example, any person
is regarded as having an insurable interest in their spouse’s life.

It would help to remember that a financial relationship alone is insufficient to give

rise to insurable interest. For instance, a creditor is legally recognized to have an
insurable interest in the life of his debtor. Still, the creditor cannot insure the debtor’s
property despite his financial relationship to it unless the property has been
mortgaged to him. (Refer to article 654 of the Commercial Code of Ethiopia 1960)

2. Principle of Utmost Good Faith

Insurance is subject to a more stringent principle of good faith, often called the
doctrine of utmost good faith. It means that each party must reveal all vital
information (called material facts) to the other party, whether or not that other party
asks for it. For example, a proposer of fire insurance is obliged to reveal the relevant
loss record to the insurer, even where there is no question of this on the application
form.

3. The Principle of Proximate Cause

The proximate cause of a loss is its effective or dominant cause. Dear student, why is
it essential to find out which of the causes involved in an accident is the proximate
cause? That is because a loss might be the combined effect of many causes.
Accordingly, for the purposes of an insurance claim, one dominant cause must be
singled out in each case because not every cause of loss will be covered.

On the contrary, the insurance policy shall terminate as of right where the object
insured is lost for a reason not specified in the policy. Similarly, the insurance policy
shall be of no effect where, when made, the thing is already lost or no longer exposed
to risk. Moreover, the premiums paid shall be refunded to the beneficiary in such
cases. (Refer to articles 676-677, 682 of the Commercial Code of Ethiopia 1960). The
conclusion of such an analysis depends very much on identifying the perils (i.e., the
causes of the loss) and their nature.

All perils can be classified into the following three types:

i. Insured peril: It is not common that a policy will cover all possible perils. Those
covered are known as the „insured perils‟ of that policy, e.g., „fire‟ under a fire
policy and „stranding‟ under a marine policy.

ii. Excepted (or excluded) peril: This peril would be covered but for its removal
from cover by exclusion, e.g., fire damage caused by war is irrecoverable under a fire
policy because war is an excepted peril of the policy.

iii. Uninsured peril: This peril is neither insured nor excluded. A loss caused by an
uninsured risk is irrecoverable unless it is an insured peril that has led to the
happening of the uninsured peril. For example, rain and theft are among the
uninsured perils of the standard fire policy. (Refer to articles 676-677 of the
Commercial Code of Ethiopia 1960)

4. The Principle of Indemnity

Indemnity means an exact financial compensation paid by the insurer for an insured
loss to the insured. Accordingly, a contract for the insurance of an object is a contract
for compensation. Therefore, the insurance compensation shall not exceed the value
of the thing insured on the day of the occurrence.

As discussed above, the purpose of insurance is to compensate for the insured’s

losses. This principle prohibits the insured from exploiting the indemnity payment
opportunistically to make additional profits. Accordingly, the insurer shall pay the
agreed sum of indemnity within the time specified in the insurance policy, when the
risk insured against occurs, or at the time specified in the policy. Moreover, the
insurer’s liability to pay compensation shall not exceed the amount specified in the
policy.

5. The Principle of Contribution

This is a claims-related doctrine of equity that applies between insurers in the event
of double (cumulative) insurance, a situation where two or more policies have been
bought by or on behalf of the insured on the same interest or any part thereof, and the
aggregate of the sums insured exceeds the indemnity legally allowed.

6. The Principle of Subrogation

Subrogation is the exercise, for one’s benefit, of rights or remedies possessed by

another against third parties. As a corollary (i.e., a natural consequence of an
established principle) of indemnity, subrogation allows proceeds of claim against a
third party to be passed to insurers to the extent of their insurance payments. As per
the law, an insurer’s subrogation action must be conducted in the insured’s name.

The law guarantees the rights of an insurer who has paid the agreed compensation to
substitute (subrogate) himself to the extent of the amount he paid for the beneficiary
for claiming against third parties who caused the damage. However, where the
beneficiary makes the substitution (subrogation) by the insurer impossible, the insurer
may be relieved totally or partly of his liabilities to the beneficiary.