Risk Management and Insurance

CHAPTER 4

LEGAL PRINCIPLES OF INSURANCE

CONTRACTS
 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 Utmost Good Faith

5. 4.1.5. Principles of Contribution

 4.1.1.PRINCIPLE OF INDEMNITY
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 Meaning of Indemnification : ?
Principle of indemnity

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

 Principle of indemnity ?
§ Principle of indemnity states that the insurer agrees to pay no more
than the actual amount of the loss; Or stated that 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. In this case;
 (A) what amount of dollars that the insurer obligated to pay to the insured?
 (B) what amount of dollars the insured should collect?
 Purposes of Indemnity
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 The principle of indemnity has two fundamental purposes. These are:
Principle of indemnity

1. To prevent the insured from profiting from loss

 Example: Alex's home is insured for $100,000, and a partial loss of
$20,000 occurs, the principle of indemnity would be violated if $100,000 were paid to
him. He would be profiting ($80,000) from insurance.

2. To prevent gambling and to reduce moral hazard

 Gambling ?

 Moral Hazard ?
 If dishonest insured 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 tendency to be
dishonest is reduced.
 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:
Determination of Actual cash value (ACV)

Determination of Actual Cash Value (ACV)

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1. Replacement Cost less Deprecation

ACV = Replacement Cost – Deprecation

2. Fair Market Value

3. Broad Evidence Rule

Determination of Actual cash value (ACV)

1. Replacement cost less deprecation : Meaning

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 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 here.

 Depreciation is a deduction for physical wear and tear, age, and

economic obsolescence.
Determination of Actual cash value (ACV)

1. Replacement cost less deprecation : Example

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ACV = Replacement Cost – Deprecation

For Example:
 Assume that 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 $1,000.
 Question
A. Under the actual cash value rule, how much will be
indemnified ?
B. What will happen if we paid him $1000?
 2. Fair Market Value: Meaning
11  Fair market value is the price which a potential buyer
would pay to a potential 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 rule.

 This difference might occur due to several reasons,

including:
 A Poor Location,
 Deteriorating Neighborhood, Or
 Economic Obsolescence of the Building.

There is also a chance for market value to be higher

 3. Broad Evidence Rule: Meaning
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 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.
Exceptions to the Principle of Indemnity

1. Valued Policy

2. Valued Policy Law

3. Replacement Cost Insurance

4. Life Insurance
 Exceptions to the Principle of Indemnity
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1. Valued Policy: It is a policy that pays the face

amount of insurance if a total loss occurs. This kind of
policy is issued for properties which are very difficult to
determine their values and for human life.

2. Valued Policy Law: The original purpose of a

valued policy law was to protect the insured from a
dispute with the insurer if an agent had deliberately over
insured property for a higher commission.
3. Replacement Cost Insurance: Means there is no deduction
for depreciation in determining the amount paid for a loss.

Example: Assume that the roof on your home is 5 years old and has a useful
life of 20 years. The roof is damaged by a tornado, and the current cost of
replacement is $10,000.

Under replacement cost policy, you would receive the full $10,000.

Under the actual cash value rule, How much you would receive?
4. Life Insurance: A life insurance is not a contract
of indemnity but is a valued policy that pays a
stated sum to the beneficiary upon the insured's
death.
 The actual cash value rule is meaningless in
determining the value of a human life.
 4.1.2. PRINCIPLE OF INSURABLE INTEREST
Principles of Insurable Interest

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 Meaning:
 It states that “the insured must be in a position to face
financial lose if a loss occurs”
 insurable interest is a crucial factor in determining
eligibility for insurance coverage.
 Example : You have insurable interest on:
 Your life, your spouses , children's (conditionally) life
 Your own properties
 Your own activities
For Example
Mr. X has an insurable interest in his car because he may
lose financially if the car is damaged or stolen.

He has also an insurable interest in his personal property,

such as a television set or computer, because he may lose
financially if the property is damaged or destroyed.
 Purposes of Insurable Interest
Principles of Insurable Interest

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 All insurance contracts must be supported by an insurable
interest for the following reasons:
1. TO PREVENT GAMBLING
 Otherwise: One person could insure the life of another person and
hope for an early death. Similarly, one could insure the property of
another and hope for a loss to occur.

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 in

property insurance
 4.1.3. PRINCIPLE OF SUBROGATION
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Principles of Subrogation

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: A negligent motorist fails to stop at a red light and
smashes into Mr. X's car, causing damage in the amount of 5000
Br.

 Based on this principle;

A. How much amount of birr Mr X should receive and from

whom?

B. Could Mr X receive from the negligent motorist and from his

insurer? If no why?

C. If so, which legal principle of insurance contract is violated?

How?
 Purposes of Subrogation
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Principles of Subrogation

Subrogation has three basic purposes:

 To prevents the insured from double collection

 To hold the guilty person responsible for the loss

 To hold down insurance rates (premium)

 Importance of Subrogation
1. Exercising its subrogation rights, the insurer is entitled
only to the amount it has paid under the policy.
2. After a loss, the insured cannot impair or interfere with
the insurer’s subrogation rights.
3. Subrogation does not apply to life insurance contracts.
4. The insurer cannot subrogate against its own insured.
Principles of Utmost Good Faith
4.1.4. PRINCIPLE OF UTMOST GOOD FAITH
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 A higher degree of honesty is imposed on both parties

to an insurance contract than it 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.
Principles of Utmost Good Faith
1. Representation
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 Representations are “statements made by the applicant for

insurance“
For example:
 If you apply for a life insurance, you may be asked
questions concerning your age, weight, height, occupation,
status 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.

For Example, Alex applies for life insurance and states in the application that
he has not visited a doctor within the last five years. However, six months earlier, he
had surgery for lung cancer. In this case, he has made a statement that is false,
material, and relied on by the insurer. Therefore, the policy is voidable at the insurer's
option. If Alex dies shortly after the policy is issued, say three months, the insurance
company could contest the death claim on the basis of a material misrepresentation.
Principles of Utmost Good Faith
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 applicant for insurance deliberately

withholds material information from the insurer.

 The legal effect of a material concealment is the

same as a misrepresentation the contract is
voidable at the insurer's option.
For Example:
 Assefa Bekele is applied for a life insurance policy on his life. Five
months after the policy was issued, he was murdered. The death
certificate named the deceased as Assefa Alemu, his true name. The
insurer denied payment on the grounds that Assefa had concealed a
material fact by not revealing his true identity and that he had an
extensive criminal record.
Principles of Utmost Good Faith
3. Warranty
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 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:

 In exchange for a reduced premium, the owner of a liquor

store may warrant that an approved burglary and robbery
alarm system will be operational at all time.
 4.1.5 Principles of Contribution
Principles of Contribution

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 Contribution is the right of an insurer who has paid under

a policy, to call upon other insurers equally.

 Here the principle of indemnity still applies. Like

subrogation, contribution supports the principle of
indemnity.

 The insured will only be entitled to recover the full

amount of his loss and

 If one insurer has paid out full amount of loss, he will be

not entitled to the other insurers.
 Basis of Contribution
Principles of Contribution

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This term allows two constructions, both of which are
found in insurance:
1. Contribution According to Independent Liability.
This means that the amount payable by each insurer
is assessed as if the other insurances do not exist.
If the aggregate of the amounts so calculated exceeds
the loss, each insurer’s contribution is scaled down
proportionally.
 32
Principles of Contribution
Basis of Contribution
 Example
Principles of Contribution

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Assume that Mr X has insured his house, which is worth 80,000

birr against fire insurers X, Y, and Z for Birr 60,000, 40,000, and
20,000 respectively. Mr X’s house was completely destroyed by
a fire caused by Mr Y’s negligence. The amount of indemnity
that Mr X will be entitled to receive would be Birr 80,000, the
value of the actual loss or the amount of insurance carried.
Required: Calculate the amount that Mr X will collect from
each insurers? And compute the total amount of indemnity?
 34
Principles of Contribution
Solution
End of the
Chapter
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