CHAPTER FOUR:
4. LEGAL PRINCIPLES OF INSURANCE CONTRACT
4.1. What is Insurance Contract?
In fact, insurance contract ( policy) is a legal contract. It is similar to other civil legal contracts
i.e. lease contract. Since, the lease contract is written under terms of which you agree to pay rent
to the owner and the latter agrees to provide the apartment in turn. Moreover, the lease contract
includes provisions as the date when you can occupy the apartment, the date when the rent is
due, the term of rent and conditions under which, the lease contract can be cancelled … etc.
So, the insurance contract is like lease contract has indicated terms in the contract. By these
terms, both insurance company and policyholder can know their rights and their duties toward
each other. Hence, we can say "purchasing insurance policy is not much fun", but it gives you
financial security towards a risk, in spite of it is a piece of a paper.
Hence, insurance contract has the following elements:
 The first party is insurer or insurance company who pays or promises to pay the loss, if
the risk occurs.
 The second party is insured who pays the premium
 Sum insured is the payment that is paid by insurer, if the risk occurs.
 The premium is the payment that is paid by insured to the insurer in exchange of transfer
the risk to the latter.
 Period contract is the agreed period between insurer and insured through it, the insurance
still in force.
 Insurance policy is a written evidence for existing an agreement between insurer and
insured and it includes provisions and duties of each party toward the other,
The contract is an agreement enforceable by law. For any such agreement to be legally
enforceable, all contracts including insurance policy must have the following requirements:
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. The requirement of offer and acceptance can be examined in greater detail by
making a careful distinction between property and casualty insurance, and life insurance.
In property and casualty insurance, the offer, and acceptance can be oral or written. In the
absence of specific legislation to the contrary, oral insurance contracts are valid. As a practical
matter, most property and casualty insurance contracts are in written form. The applicant for
insurance fills out the application and pays the first premium (or promises to pay the first
premium). This step constitutes the offer. The agent then accepts the offer on behalf of the
insurance company. In property and casualty insurance, agents typically have the power to bind
their companies through use of a binder.
A binder is a temporary contract for insurance and can be either written or oral. The binder
obligates the company immediately prior to receipt of the application and issuance of the policy.
Thus, the insurance contract can be effective immediately, because the agent accepts the offer on
behalf of the company.
This procedure is usually followed in personal lines of property and casualty insurance, including
homeowners policies and auto insurance. However, in some cases, the agent is not authorized to
bind the company, and the application must be sent to the company for approval. The company
may then accept the offer and issue the policy or reject the application.
In life insurance, the procedures followed are different. A life insurance agent does not have the
power to bind the insurer. Therefore, the application for life insurance is always in writing, and
the applicant must be approved by the insurer before the life insurance is in force. The usual
procedure is for the applicant to fill out the application and pay the first premium.
A conditional premium receipt is then given to the applicant. The most common conditional
receipt is the “insurability premium receipt.” If the applicant is found insurable according to the
insurer’s normal underwriting standards, the life insurance becomes effective as of the date of
the application. Some insurability receipts make the life insurance effective on the date of the
application or the date of the medical exam, whichever is later.
For example, assume that Aaron applies for a Birr 100,000 life insurance policy on Monday. He
fills out the application, pays the first premium, and receives a conditional premium receipt from
the agent. On Tuesday morning, he takes a physical examination, and on Tuesday afternoon, he
is killed in a boating accident. The application and premium will still be forwarded to the insurer,
as if he were still alive. If he is found insurable according to the insurer’s underwriting rules, the
life insurance is in force, and Birr 100,000 will be paid to his beneficiary. However, if the
applicant for life insurance does not pay the first premium when the application is filled out, a
different set of rules applies. Before the life insurance is in force, the policy must be issued and
delivered to the applicant, the first premium must be paid, and the applicant must be in good
health when the policy is delivered. Insurers also require that there must be no interim medical
treatment between submission of the application and delivery of the policy. These requirements
are considered to be “conditions precedent”—in other words, they must be fulfilled before the
life insurance is in force.
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.
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.
Minors generally lack full legal capacity to enter into a binding insurance contract. Such
contracts usually are voidable by the minor, which means the minor can disaffirm the contract.
However, most states have enacted laws that allow minors to enter into a valid life insurance
contract at a specified age. Depending on the state, the age limit varies from ages 14 to 18; age
15 is the most common. The insurer must also be legally competent. Insurers generally must be
licensed to sell insurance in the state, and the insurance sold must be within the scope of its
charter or certificate of incorporation.
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.
4.2. Basic Parts of an Insurance Contract
Despite their complexities, insurance contracts generally can be divided into the following parts:
1. Declarations
2. Definitions
3. Insuring agreement
4. Exclusions
5. Conditions
6. Miscellaneous provisions
Although all insurance contracts do not necessarily contain all six parts in the order given here,
such a classification provides a simple and convenient framework for analyzing most insurance
contracts.
Declarations
The declarations section is the first part of an insurance contract. Declarations are statements
that provide information about the particular property or activity to be insured . Information
contained in the declarations section is used for underwriting and rating purposes and for
identification of the property or activity that is insured. The declarations section usually can be
found on the first page of the policy or on a policy insert.
In property insurance, the declarations page typically contains information concerning the
identification of the insurer, name of the insured, location of the property, period of protection,
amount of insurance, amount of the premium, size of the deductible (if any), and other relevant
information. In life insurance, although the first page of the policy technically is not called a
declarations page, it contains the insured’s name, age, premium amount, issue date, and policy
number.
Definitions
Insurance contracts typically contain a page or section of definitions. Key words or phrases have
quotation marks (“. . .”) around them. For example, the insurer is frequently referred to as “we,”
“our,” or “us.” The named insured is referred to as “you” and “your.” The purpose of the various
definitions is to define clearly the meaning of key words or phrases so that coverage under the
policy can be determined more easily.
Insuring Agreement
The insuring agreement is the heart of an insurance contract. The insuring agreement
summarizes the major promises of the insurer . The insurer agrees to do certain things, such as
paying losses from covered perils, providing certain services (such as loss-prevention services),
or agreeing to defend the insured in a liability lawsuit.
There are two basic forms of an insuring agreement in property insurance: (1) named-perils
coverage and (2) open-perils coverage (formerly called “all-risks” coverage). Under a namedperils policy , only those perils specifically named in the policy are covered . If the peril is not
named, it is not covered. For example, in a homeowner’s policy, personal property is covered for
fire, lightning, windstorm, and certain other named perils. Only losses caused by these perils are
covered. Flood damage is not covered because flood is not a listed peril.
Under an open-perils policy , all losses are covered except those losses specifically excluded.
An open-perils policy is also called a special coverage policy. If the loss is not excluded, then it
is covered. For example, the physical damage section of the personal auto policy covers losses to
a covered auto. Thus, if a smoker burns a hole in the upholstery, or a bear in a national park
damages the vinyl top of a covered auto, the losses would be covered because they are not
excluded.
An open-perils policy generally is preferable to named-perils coverage, because the protection is
broader with fewer gaps in coverage. If the loss is not excluded, then it is covered. In addition, a
greater burden of proof is placed on the insurer to deny a claim. To deny payment, the insurer
must prove that the loss is excluded. In contrast, under a named-perils contract, the burden of
proof is on the insured to show that the loss was caused by a named peril .
Because the meaning of risk is ambiguous, rating organizations generally have deleted the words
“risk of” and “all risks” in their policy forms. In the latest edition of the homeowners forms, the
Insurance Services Office has deleted the words “risk of,” which appeared in earlier editions.
The deletion of any reference to “risk of” or “all-risks” is intended to avoid creating
unreasonable expectations among policyholders that the policy covers all losses, even those
losses that are specifically excluded.
Life insurance is another example of an open perils policy. Most life insurance contracts cover
all causes of death by accident or by disease except for certain exclusions. The major exclusions
are suicide during the first two years of the contract; certain aviation hazard exclusions, such as
military flying, crop dusting, or sports piloting; and in some contracts, death caused by war.
Exclusions
Exclusions are another basic part of any insurance contract. There are three major types of
exclusions
1. excluded perils,
2. excluded losses, and
3. Excluded property.
Excluded Perils The contract may exclude certain perils, or causes of loss. In a homeowners
policy, the perils of flood, earth movement, and nuclear radiation or radioactive contamination
are specifically excluded. In the physical damage section of the personal auto policy, loss to a
covered auto is specifically excluded if the car is used as a public taxi.
Excluded Losses Certain types of losses may be excluded. For example, in a homeowners
policy, failure of an insured to protect the property from further damage after a loss occurs is
excluded. In the personal liability section of a homeowners policy, a liability lawsuit arising out
of the operation of an automobile is excluded. Professional liability losses are also excluded; a
specific professional liability policy is needed to cover this exposure.
Excluded Property The contract may exclude or place limitations on the coverage of certain
property. For example, in a homeowner’s policy, certain types of personal property are excluded,
such as cars, planes, animals, birds, and fish.
Reasons for Exclusions: Exclusions are necessary for the following reasons:
Certain perils considered uninsurable
Presence of extraordinary hazards
Coverage provided by other contracts
Moral hazard problems
Attitudinal hazard problems
Coverage not needed by typical insured
Exclusions are necessary because the peril may be considered uninsurable by commercial
insurers; For example, most property and casualty insurance contracts exclude losses for
potential catastrophic events such as war or exposure to nuclear radiation. A health insurance
contract may exclude losses within the direct control of the insured, such as an intentional, selfinflicted injury. Finally, predictable declines in the value of property, such as wear and tear and
inherent vice, are not insurable. “Inherent vice” refers to the destruction or damage of property
without any tangible external force, such as the tendency of fruit to rot and the tendency
of diamonds to crack.
Exclusions are also used because extraordinary hazards are present; A hazard is a condition
that increases the chance of loss or severity of loss. Because of an extraordinary increase in
hazard, a loss may be excluded. For example, the premium for liability insurance under the
personal auto policy is based on the assumption that the car is used for personal and recreational
use and not as a taxi. The chance of an accident, and a resulting liability lawsuit, is much higher
if the car is used as a taxi for hire. Therefore, to provide coverage for a taxi at the same rate
charged for a family car could result in inadequate premiums for the insurer and unfair rate
discrimination against other insureds who do not use their vehicles as a taxi.
Exclusions are also necessary because coverage can be better provided by other contracts;
Exclusions are used to avoid duplication of coverage and to limit coverage to the policy best
designed to provide it. For example, a car is excluded under a homeowners policy because it is
covered under the personal auto policy and other auto insurance contracts. If both policies
covered the loss, there would be unnecessary duplication.
In addition, certain property is excluded because of moral hazard or difficulty in determining
and measuring the amount of loss; For example, homeowners insurance policies drafted by the
Insurance Services Office limit the coverage of money to Birr200. If unlimited amounts of
money were covered, fraudulent claims would increase. Also, loss-adjustment problems in
determining the exact amount of the loss would also increase. Thus, because of moral hazard,
exclusions are used.
Exclusions are also used to deal with attitudinal hazard (morale hazard); Attitudinal hazard is
carelessness or indifference to a loss, which increases the frequency or severity of loss.
Exclusions force individuals to bear losses that result from their own carelessness.
Finally, exclusions are used because the coverage is not needed by the typical insured; For
example, most homeowners do not own private planes. To cover aircraft as personal property
under a homeowners policy would be grossly unfair to the most insureds who do not own planes
because premiums would be substantially higher.
Conditions
Conditions are another important part of an insurance contract. Conditions are provisions in the
policy that qualify or place limitations on the insurer’s promise to perform . In effect, the
conditions section imposes certain duties on the insured. If the policy conditions are not met, the
insurer can refuse to pay the claim. Common policy conditions include notifying the insurer if a
loss occurs, protecting the property after a loss, preparing an inventory of damaged personal
property, and cooperating with the insurer in the event of a liability suit.
Miscellaneous Provisions
Insurance contracts also contain a number of miscellaneous provisions. In property and casualty
insurance, miscellaneous provisions include cancellation, subrogation, and requirements if a loss
occurs, assignment of the policy, and other-insurance provisions. In life and health insurance,
typical miscellaneous provisions include the grace period, reinstatement of a lapsed policy, and
misstatement of age.
Definition of “Insured”
An insurance contract must identify the person or parties who are insured under the policy. For
ease in understanding, the meaning of “insured” can be grouped into the following categories:
Named insured
First named insured
Other insureds
Additional insureds
Named Insured
The named insured is the person or party named on the declarations page of the policy. The
named insured can be one or more persons or parties. For example, Ron and Kay Lukens may be
specifically listed as named insured on the declaration page of their homeowners’ policy. The
words “you” and “your” appear in many policies and refer to the named insured shown in the
declarations. Thus, throughout the entire policy, “you” or “your” refers to the named insured.
First Named Insured
When more than one person or party is named on the declarations page, the order of names is
important. The first named insured is the first name that appears on the declarations page of
the policy as an insured. For example, Tim Jones and Bob Brown own a bookstore and are listed
as named insureds under a commercial property policy. Tim is the first named insured. The first
named insured has certain additional rights and responsibilities that do not apply to other named
insureds. Additional rights include the right to a premium refund and the receipt of a cancellation
notice. However, the first named insured is responsible for the payment of premiums and for
complying with notice-of-loss requirements.
Other Insureds
Other insureds are persons or parties who are insured under the named insured’s policy even
though they are not specifically named in the policy . For example, a homeowners policy covers
resident relatives of the named insured or any person under age 21 who is in the care of an
insured. A homeowners policy also covers resident relatives under age 24 who are full-time
students and away from home. Likewise, in addition to the named insured, the personal auto
policy also covers the named insured’s resident relatives and any other person using the auto
with the permission of the named insured
Additional Insureds
An additional insured is a person or party who is added to the named insured’s policy by an
endorsement. As a result, an additional insured acquires coverage under the named insured’s
policy. For example, Ken owns farmland that is leased to a tenant. Ken is concerned about
possible legal liability if the tenant injures someone. Ken can request to be added to the tenant’s
farm liability policy as an additional insured.
Endorsements and Riders
Insurance contracts frequently contain endorsements and riders. The terms endorsements and
riders are often used interchangeably and mean the same thing. In property and casualty
insurance, an endorsement is a written provision that adds to, deletes from, or modifies the
provisions in the original contract. In life and health insurance, a rider is a provision that
amends or changes the original policy.
There are numerous endorsements in property and casualty insurance that modify, extend, or
delete provisions found in the original policy. For example, a homeowners policy excludes
coverage for earthquakes. However, an earthquake endorsement can be added that covers
damage from an earthquake or from earth movement.
In life and health insurance, numerous riders can be added that increase or decrease benefits,
waive a condition of coverage present in the original policy, or amend the basic policy. For
example, a waiver-of premium rider can be added to a life insurance policy.
If the insured becomes totally disabled, all future premiums are waived after an elimination
period of six months, as long as the insured remains disabled according to the terms of the rider.
An endorsement attached to a policy generally takes precedence over any conflicting terms in the
policy. Also, many policies have endorsements that amend the policy to conform to a given
state’s law.
Deductibles
A deductible is a common policy provision that requires the insured to pay part of the loss. A
deductible is a provision by which a specified amount is subtracted from the total loss payment
that otherwise would be payable. Deductibles typically are found in property, health, and auto
insurance contracts. A deductible is not used in life insurance because the insured’s death is
always a total loss, and a deductible would simply reduce the face amount of insurance. Also, a
deductible generally is not used in personal liability insurance because the insurer must provide a
legal defense, even for a small claim. The insurer wants to be involved from the first dollar of
loss so as to minimize its ultimate liability for a claim. Also, the premium reduction that would
result from a small deductible in personal types of third-party liability coverage would be
relatively small.
Purposes of Deductibles
Deductibles have several important purposes. They include the following:
To eliminate small claims
To reduce premiums
To reduce moral hazard and attitudinal hazard
A deductible eliminates small claims that are expensive to handle and process . For each large
claim processed, there are numerous small claims, which can be expensive to process. For
example, an insurer may incur expenses of Birr100 or more in processing a Birr100 claim.
Because a deductible eliminates small claims, the insurer’s loss-adjustment expenses are
reduced.
Deductibles are also used to reduce premiums paid by the insured. Because deductibles
eliminate small claims, premiums can be substantially reduced. Insurance is not an appropriate
technique for paying small losses that can be better budgeted out of personal or business income.
Insurance should be used to cover large catastrophic events, such as medical expenses of Birr
500,000 or more from an extended terminal illness. Insurance that protects against a catastrophic
loss can be purchased more economically if deductibles are used. This concept of using
insurance premiums to pay for large losses rather than for small losses is often called the largeloss principle. The objective is to cover large losses that can financially ruin an individual and
exclude small losses that can be budgeted out of the person’s income.
Other factors being equal, a large deductible is preferable to a small one. For example, some
motorists with auto insurance have policies that contain a Birr 250 deductible for collision losses
instead of a Birr 500 or larger deductible. They may not be aware of how expensive the extra
insurance really is. For example, assume you can purchase collision insurance on your car with a
Birr 250 deductible with an annual premium of Birr 900, while a policy with a Birr 500
deductible has an annual premium of Birr 800. If you select the Birr 250 deductible over the Birr
500 deductible, you have an additional Birr 250 of collision insurance, but you must pay an
additional Birr 100 in annual premiums. Using a simple cost-benefit analysis, you are paying an
additional Birr 100 for an additional Birr 250 of insurance, which is a relatively expensive
increment of insurance. When analyzed in this manner, larger deductibles are preferable to
smaller deductibles.
Finally, deductibles are used by insurers to reduce both moral hazard and attitudinal (morale)
hazard. Some dishonest policyholders may deliberately cause a loss in order to profit from
insurance.
Deductibles reduce moral hazard because the insured may not profit if a loss occurs. Deductibles
are also used to reduce attitudinal (morale) hazard. Attitudinal hazard is carelessness or
indifference to a loss, which increases the chance of loss. Deductibles encourage people to be
more careful with respect to the protection of their property and prevention of a loss because the
insured must bear a part of the loss.
Deductibles in Property Insurance
The following deductibles are commonly found in property insurance contracts:
■ Straight deductible
■ Aggregate deductible
Straight Deductible With a straight deductible, the insured must pay a certain number of
dollars of loss before the insurer is required to make a payment. Such a deductible typically
applies to each loss. An example can be found in auto collision insurance.
For instance, assume that Ashley has collision insurance on her new Toyota, with a Birr 500
deductible. If a collision loss is Birr 7000, she would receive only Birr 6500 and would have to
pay the remaining Birr 500 herself.
Aggregate Deductible Commercial insurance contracts sometimes contain an aggregate
deductible. An aggregate deductible means that all losses that occur during a specified time
period, usually a policy year, are accumulated to satisfy the deductible amount.
Once the deductible is satisfied, the insurer pays all future losses in full. For example, assume
that the policy contains an aggregate deductible of Birr 10,000. Also assume that losses of Birr
1000 and Birr 2000 occur, respectively, during the policy year. The insurer pays nothing because
the deductible is not met. If a third loss of Birr 8000 occurs during the same time period, the
insurer would pay Birr 1000. Any other losses occurring during the policy year would be paid in
full.
Deductibles in Health Insurance
In health insurance, the deductible can be stated in terms of dollars or time, such as a calendaryear deductible or an elimination (waiting) period.
Calendar-Year Deductible A calendar-year deductible is a type of aggregate deductible that
is found in individual and group medical expense policies. Eligible medical expenses are
accumulated during the calendar year, and once they exceed the deductible amount, the insurer
must then pay the benefits promised under the contract. Once the deductible is satisfied during
the calendar year, no additional deductibles are imposed on the insured.
Elimination (Waiting) Period A deductible can also be expressed as an elimination period. An
elimination (waiting) period is a stated period of time at the beginning of a loss during which
no insurance benefits are paid.
An elimination period is appropriate for a single loss that occurs over some time period, such as
the loss of work earnings. Elimination periods are commonly used in disability-income contracts.
For example, disability-income insurance contracts that replace part of a disabled worker’s
earnings typically have elimination periods of 30, 60, or 90 days, or longer periods.
4.3. Essential Requirements of Insurance Contract
A contract is an agreement embodying a set of promises that are enforceable at law, or for breach
of which the law provides a remedy. These promises must have been made under certain
conditions before they can be enforced by law. In general, there are four such conditions, or
requirements, that maybe stated as follows:
1.
The agreement must be for a legal purpose; it must be not against public policy or be
otherwise illegal. For example, a contract of insurance that covers a risk promoting a
business or venture prohibited by a law is void. Similarly a gambling contract will not be
enforced by law.
2.
The parties must have legal capacity to contract. This requirement excludes persons
who have been deemed incapable of contracting, such as those who have been judicially
declared insane; and persons who are legally incompetent such as infants, drunken
(alcohol addicted) persons etc.
3.
There must be evidence of agreement of the parties to the promises. In general this is
shown by an offer by one party and acceptance of that offer by the other.
4.
The promises must be supported by some consideration, which may take the form of
money or by some action by the parties that would not have been required had it not been
for agreement.
Contract of Adhesion:
A contract of adhesion is a contract prepared by one of the parties (the insurer) and accepted or
rejected by the other (the insured). The insurance contract is not drawn up through negotiation,
unlike general contracts where both parties to the contract have a say on the terms of contract.
The insured who does not like certain terms of the contract may choose not to go in for the
contract. But if he or she decides to go in for the contract, it must be accepted as it is.
Insurance is a Personal Contract:
The personal characteristics of the insured and the circumstances surrounding the subject matter
of the coverage are important to the insurance company in determining whether it will issue the
policy. Since the insurer has a right to decide with whom it will or will not do business, the
insured cannot transfer the contract to someone else without the written consent of the insurer.
Insurance is a Unilateral Contract:
In Insurance, only one party (viz. the insurer) to the contract is legally bound to do anything.
The insured makes no promises that can be legally enforced.
Insurance is a Conditional Contract:
An insurance contract is said to be a conditional contract, which means that the conditions of the
contract are not considered a part of the consideration by the insured. The insurer is obligated to
fulfill its promises only if the insured has fulfilled his or her promises. If the conditions are not
met, the insured may be prevented from collecting in the event of a loss.
Insurance is an Aleatory Contract:
“Aleatory” means that the outcome is affected by chance and that the amount given by the
contracting parties will be unequal. The insured pays the required premium, and if no loss
occurs, the insurance company pays nothing. If a loss does occur, the insured’s premium is small
in relation to the amount the insurer will be required to pay. The aleatory feature of insurance
contract signifies that the parties know in advance that the amount they will exchange will be
unequal.
4.4. Principles of Insurance Contracts
4.4.1. Principle of Indemnity
The principle of indemnity is one of the most important principles in insurance. 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, dollar 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 Keneni’s home is insured for Birr 200,000,
and a partial loss of Birr 50,000 occurs, the principle of indemnity would be violated if Birr
200,000 were paid to her. She would be profiting from insurance.
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.
Actual Cash Value
The concept of actual cash value supports 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 a number of methods to determine actual cash
value, including the following:
Replacement cost less depreciation
Fair market value
Broad evidence rule
Replacement Cost Less Depreciation Under this rule, actual cash value is defined as
replacement cost less depreciation. This rule has been used traditionally to determine the actual
cash value of property in property insurance. It takes into 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.
For example, Sarah has a favorite couch that burns in a fire. Assume she bought the couch five
years ago; the couch is 50 percent depreciated, and a similar couch today would cost Birr 1000.
Under the actual cash value rule, Sarah will collect Birr 500 for the loss because the replacement
cost is Birr 1000, and depreciation is Birr 500, or 50 percent. If she were paid the full
replacement value of Birr 1000, the principle of indemnity would be violated. She would be
receiving the value of a new couch instead of one that was five years old. In short, the Birr 500
payment represents indemnification for the loss of a five-year-old couch.
This calculation can be summarized as follows:
Replacement cost = Birr 1000
Depreciation = Birr 500 (couch is 50 percent depreciated)
Replacement cost – Depreciation = Actual cash value
Birr 1000 – Birr 500 = Birr 500
Fair Market Value Some courts have ruled that fair market value should be used to determine
actual cash value of a loss. 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 is due to several factors, including a poor location,
deteriorating neighborhood, or economic obsolescence of the building. For example, in major
cities, large homes in older residential areas often have a market value well below replacement
cost less depreciation. If a loss occurs, the fair market value may reflect more accurately the
value of the loss. In one case, a building valued at Birr 170,000 based on the actual cash value
rule had a market value of only Birr 65,000 when a loss occurred. The court ruled that the actual
cash value of the property should be based on the fair market value of Birr 65,000 rather than on
Birr 170,000.
Broad Evidence Rule Many states use the broad evidence rule to determine the actual cash
value of a loss. The broad evidence rule 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.
Although the actual cash value rule is used in property insurance, different methods are
employed in other types of insurance. In liability insurance, the insurer pays up to the policy
limit the amount of damages that the insured is legally obligated to pay because of bodily injury
or property damage to another. In business income insurance, the amount paid is usually based
on the loss of profits plus continuing expenses when the business is shut down because of a loss
from a covered peril. In life insurance, the amount paid when the insured dies is generally the
face value of the policy.
Exceptions to the Principle of Indemnity
There are several important exceptions to the principle of indemnity. They include the following:
 Valued policy
 Valued policy laws
 Replacement cost insurance
 Life insurance
Valued Policy A valued policy is a policy that pays the face amount of insurance if a total loss
occurs. Valued policies typically are used to insure antiques, fine arts, rare paintings, and family
heirlooms. Because of difficulty in determining the actual value of the property at the time of
loss, the insured and insurer both agree on the value of the property when the policy is first
issued. For example, you may have a valuable antique clock that was owned by your greatgrandmother. You may feel that the clock is worth Birr 10,000 and have it insured for that
amount. If the clock is totally destroyed in a fire, you would be paid Birr 10,000 regardless of the
actual cash value of the clock at the time of loss.
Valued Policy Laws Valued policy laws are another exception to the principle of indemnity. A
valued policy law is a law that exists in some states that requires payment of the face amount of
insurance to the insured if a total loss to real property occurs from a peril specified in the law .
The specified perils to which a valued policy law applies vary among the states. Laws in some
states cover only fire; other states cover fire, lightning, windstorm, and tornado; and some states
include all insured perils. In addition, the laws generally apply only to real property, and the loss
must be total. For example, a building insured for Birr 200,000 may have an actual cash value of
Birr 175,000. If a total loss from a fire occurs, the face amount of Birr 200,000 would be paid.
Because the insured would be paid more than the actual cash value, the principle of indemnity
would be violated.
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. After a total
loss, the insurer might offer less than the face amount for which the policyholder had paid
premiums on the grounds that the building was over insured. However, the importance of a
valued policy law has declined over time because inflation in property values has made over
insurance less of a problem. Underinsurance is now the greater problem, because it results in
both inadequate premiums for the insurer and inadequate protection for the insured.
Despite their reduced importance, however, valued policy laws can lead to over insurance and an
increase in moral hazard. Most buildings are not physically inspected before they are insured.
If an insurer fails to inspect a building for valuation purposes, over insurance and possible moral
hazard may result. The insured may not be concerned about loss prevention, or may even
deliberately cause a loss to collect the insurance proceeds. Although valued policy laws provide
a defense for the insurer when fraud is suspected, the burden of proof is on the insurer to prove
fraudulent intent. Proving fraud is often difficult. For example, in an older case, a house
advertised for sale at Birr 1800 was insured for Birr 10,000 under a fire insurance policy. About
six months later, the house was totally destroyed by a fire. The insurer denied liability on the
grounds of misrepresentation and fraud. An appeals court ordered the face amount of insurance
to be paid, holding that nothing prevented the company from inspecting the property to
determine its value. The insured’s statement concerning the value of the house was deemed to be
an expression of opinion, not a representation of fact.
Replacement Cost Insurance Replacement cost insurance is a third exception to the principle of
indemnity. Replacement cost insurance means there is no deduction for physical depreciation
in determining the amount paid for a loss. For 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 Birr 10,000. Under the actual cash value rule, you would receive only Birr
7500 (Birr 10,000 – Birr 2500 = Birr 7500). Under a replacement cost policy, you would receive
the full Birr 10,000 (less any applicable deductible). Because you receive the value of a brandnew roof instead of one that is 5 years old, the principle of indemnity is technically violated.
Replacement cost insurance is based on the recognition that payment of the actual cash value can
still result in a substantial loss to the insured, because few persons budget for depreciation. In our
example, you would have had to pay Birr 2500 to restore the damaged roof, since it was onefourth depreciated. To deal with this problem, replacement cost insurance can be purchased to
insure homes, buildings, and business and personal property.
Life Insurance Life insurance is another exception to the principle of indemnity. A life
insurance contract is not a contract of indemnity but is a valued policy that pays a stated amount
to the beneficiary upon the insured’s death. The indemnity principle is difficult to apply to life
insurance because the actual cash value rule (replacement cost less depreciation) is meaningless
in determining the value of a human life. Moreover, to plan for personal and business purposes,
such as the need to provide a specific amount of monthly income to the deceased’s dependents, a
certain amount of life insurance must be purchased before death occurs. For these reasons, a life
insurance policy is another exception to the principle of indemnity.
4.4.2. 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.
Insurance contracts must be supported by an insurable interest for the following reasons.
■ To prevent gambling
■ To reduce moral hazard
■ To measure the amount of the insured’s loss in property insurance
First, an insurable interest is necessary to prevent gambling. If an insurable interest were not
required, the contract would be a 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.
Second, an insurable interest reduces moral hazard. If an insurable interest were not required, a
dishonest person could purchase property insurance 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, in property insurance, an insurable interest measures the amount of the insured’s loss.
Most property insurance 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.
Examples of an Insurable Interest
Several examples of an insurable interest are discussed in this section. However, it is helpful at
this point to distinguish between an insurable interest in property and casualty insurance and in
life insurance.
Property and Casualty Insurance Ownership of property can support an insurable interest
because owners of property will lose financially if their property is damaged or destroyed.
Potential legal liability can also support an insurable interest. For example, a dry-cleaning firm
has an insurable interest in the property of the customers. The firm may be legally liable for
damage to the customers’ goods caused by the firm’s negligence.
Secured creditors have an insurable interest as well. A commercial bank or mortgage company
that lends money to buy a house has an insurable interest in the property. The property serves as
collateral for the mortgage, so if the building is damaged, the collateral behind the loan is
impaired. A bank that makes an inventory loan to a business firm has an insurable interest in the
stock of goods, because the goods are collateral for the loan. However, the courts have ruled that
unsecured or general creditors normally do not have an insurable interest in the debtor’s
property.
Finally, a contractual right can support an insurable interest. Thus, a business firm that contracts
to purchase goods from abroad on the condition that they arrive safely in the United States has an
insurable interest in the goods because of the loss of profits if the merchandise does not arrive.
Life Insurance The question of an insurable interest does not arise when you purchase life
insurance on your own life. The law considers the insurable interest requirement to be met
whenever a person voluntarily purchases life insurance on his or her life.
Thus, you can purchase as much life insurance as you can afford, subject of course to the
insurer’s underwriting rules concerning the maximum amount of insurance that can be written on
any single life. Also, when you apply for life insurance on your own life, you can name anyone
as beneficiary. The beneficiary is not required to have an insurable interest, either at the
inception of the policy or time of death, when you purchase life insurance on your own life.
However, if you wish to purchase a life insurance policy on the life of another person, you must
have an insurable interest in that person’s life. Close family ties or marriage will satisfy the
insurable interest requirement in life insurance. For example, a husband can purchase a life
insurance policy on his wife and be named as beneficiary. Likewise, a wife can insure her
husband and be named as beneficiary.
A grandparent can purchase a life insurance policy on the life of a grandchild. However, remote
family relationships will not support an insurable interest. For example, cousins cannot insure
each other unless a pecuniary relationship is present.
If there is a pecuniary (financial) interest , the insurable interest requirement in life insurance
can be met. Even when there is no relationship by blood or marriage, one person may be
financially harmed by the death of another. For example, a corporation can insure the life of an
outstanding salesperson, because the firm’s profit may decline if the salesperson dies. One
business partner can insure the life of the other partner and use the life insurance proceeds to
purchase the deceased partner’s interest if he or she dies.
When Must an Insurable Interest Exist?
In property insurance, the insurable interest must exist at the time of the loss . There are two
reasons for this requirement. First, most property insurance contracts are contracts of indemnity.
If an insurable interest does not exist at the time of loss, the insured would not incur any
financial loss. Hence, the principle of indemnity would be violated if payment were made. For
example, if Mark sells his home to Susan, and a fire occurs before the insurance on the home is
cancelled, Mark cannot collect because he no longer has an insurable interest in the property.
Susan cannot collect either under Mark’s policy because she is not named as an insured under his
policy.
Second, you may not have an insurable interest in the property when the contract is first written
but may expect to have an insurable interest in the future, at the time of possible loss. For
example, in ocean marine insurance, it is common to insure a return cargo by a contract entered
into prior to the ship’s departure. However, the policy may not cover the goods until they are on
board the ship as the insured’s property. Although an insurable interest does not exist when the
contract is first written, you can still collect to the extent of your interest if you have an insurable
interest in the goods at the time of loss.
In contrast, in life insurance, the insurable interest requirement must be met only at the inception
of the policy, not at the time of death. Life insurance is not a contract of indemnity but is a valued
policy that pays a stated sum upon the insured’s death. Because the beneficiary has only a legal
claim to receive the policy proceeds, the beneficiary does not have to show that a financial loss
has been incurred by the insured’s death. For example, if Michelle takes out a policy on her
husband’s life and later gets a divorce, she is entitled to the policy proceeds upon the death of her
former husband if she has kept the insurance in force. The insurable interest requirement must be
met only at the inception of the contract.
4.4.3. 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
Megan’s car, causing damage in the amount of Birr 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, Megan
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. 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 ratemaking 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
You should keep in mind several important corollaries of the principle of subrogation.
1. The general rule is that by exercising its subrogation rights, the insurer is entitled only to
the amount it has paid under the policy .8 Some insureds may not be fully indemnified
after a loss because of
insufficient insurance, satisfaction of a deductible, or legal
expenses in trying to recover from a negligent third party. Many policies, however, now
have a provision that states how a subrogation recovery is to be shared between the
insured and insurer.
In the absence of any policy provision, the courts have used different rules in determining how a
subrogation recovery is to be shared. One view is that the insured must be reimbursed in full for
the loss; the insurer is then entitled to any remaining balance up to the insurer’s interest, with
any remainder going to the insured. For example, Andrew has a Birr 200,000 home insured for
only Birr 160,000 under a homeowner’s policy. Assume that the house is totally destroyed in a
fire because of faulty wiring by an electrician. The insurer would pay Birr 160,000 to Andrew
and then attempt to collect from the negligent electrician. After exercising its subrogation rights
against the negligent electrician, assume that the insurer has a net recovery of Birr 100,000 (after
deduction of legal expenses). Andrew would receive Birr 40,000, and the insurer can retain the
balance of Birr 60,000.
2. After a loss, the insured cannot impair or interfere with the insurer’s subrogation rights.
The insured cannot do anything after a loss that interferes with the insurer’s right to
proceed against a negligent third party. For example, if the insured waives the right to sue
the negligent party, the right to collect from the for the loss is also waived. This could
happen if the insured admits fault in an auto accident or attempts to settle a collision loss
with the negligent driver without the insurer’s consent. If the insurer’s right to subrogate
against the negligent motorist is adversely affected, the insured’s right to collect from the
insurer is forfeited.
3. Subrogation does not apply to life insurance contracts. Life insurance is not a contract of
indemnity, and subrogation has relevance only for contracts of indemnity.
4. The insurer cannot subrogate against its own insureds . If the insurer could recover a loss
payment for a covered loss from an insured, the basic purpose of purchasing the
insurance would be defeated.
4.4.4. Principle of Utmost Good Faith
An insurance contract is based on the principle of utmost good faith: that is, a higher degree
of honesty is imposed on both parties to an insurance contract than is imposed on parties to
other contracts. This principle has its historical roots in ocean marine insurance. An ocean
marine underwriter had to place great faith in statements made by the applicant for insurance
concerning the cargo to be shipped. The property to be insured may not have been visually
inspected, and the contract may have been formed in a location far removed from the cargo and
ship. 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.
Representations
Representations are statements made by the applicant for insurance. 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.
The legal significance of a representation is that the insurance contract is voidable at the
insurer’s option if the representation is (1) material, (2) false, and (3) relied on by the insurer.
Material means that if the insurer knew the true facts, the policy would not have been issued, or
it 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.
For example, Joseph 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 Joseph dies shortly after the policy is
issued, say three months, the company could contest the death claim on the basis of a
material misrepresentation.
If an applicant for insurance states an opinion or belief that later turns out to be wrong, the
insurer must prove that the applicant spoke fraudulently and intended to deceive the company
before it can deny payment of a claim. For example, assume that you are asked if you have high
blood pressure when you apply for health insurance, and you answer “no” to the question. If the
insurer later discovers you have high blood pressure, to deny payment of a claim, it must prove
that you intended to deceive the company. Thus, a statement of opinion or belief must also be
fraudulent before the insurer can refuse to pay a claim.
An innocent misrepresentation of a material fact, if relied on by the insurer, also makes the
contract voidable. An innocent misrepresentation is one that is unintentional. A majority of court
opinions have ruled that an innocent misrepresentation of a material fact makes the contract
voidable.
Finally, the doctrine of material misrepresentations also applies to statements made by the
insured after a loss occurs. If the insured submits a fraudulent proof of loss or misrepresents the
value of the items damaged, the insurer has the right to void the coverage
Concealment
The doctrine of concealment also supports the principle of utmost good faith. A 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
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.
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. For example, Joseph DeBellis applied for a life insurance policy on his life. He had
an extensive criminal record. Five months after the policy was issued, he was murdered. The
death certificate named the deceased as Joseph DeLuca, his true name. The insurer denied
payment on the grounds that Joseph had concealed a material fact by not revealing his true
identity and that he had an extensive criminal record. In finding for the insurer, the court held
that intentional concealment of his true identity was material and breached the obligation of good
faith.
Warranty
The doctrine of warranty also reflects the principle of utmost good faith. A warranty is a
statement that becomes part of the insurance contract and is guaranteed by the maker to be true
in all respects. For example, in exchange for a reduced premium, a liquor store owner may
warrant that an approved burglar alarm system will be operational at all times.
A bank may warrant that a guard will be on the premises twenty-four hours a day. Likewise, a
business firm may warrant that an automatic sprinkler system will be in working order
throughout the term of the policy. A clause describing the warranty becomes part of the contract.
Based on common law, in its strictest form, warranty is a harsh legal doctrine. Any breach of the
warranty, even if minor or not material, allowed the insurer to deny payment of a claim. During
the early days of insurance, statements made by the applicant for insurance were considered to be
warranties. If the statement were untrue in any respect, even if not material, the insurer could
deny payment of a claim based on a breach of warranty.
Because strict application of the warranty doctrine harmed many insureds, state legislatures and
the courts have softened and modified the harsh common law doctrine of warranty over time.
Some modifications of the warranty doctrine are summarized as follows:
■ Statements made by applicants for insurance are considered to be representations and not
warranties. Thus, the insurer cannot deny liability for a claim if a misrepresentation is not
material.
■ Most courts will interpret a breach of warranty liberally in those cases where a minor breach
affects the risk only temporarily or insignificantly.
■ Statutes have been passed that allow the insured to recover for a loss unless the breach of
warranty actually contributed to the loss.
4.4.5. Principle of Contribution
Contribution is the right of an insurer who has paid under a policy, to call upon other insurers
equally or otherwise liable for the same loss to contribute to the payment. Where there is over
insurance because a loss is covered by policies affected with two or more insurers, the principle
of indemnity still applies. In these circumstances, the insured will only be entitled to recover the
full amount of his loss and if one insurer has paid out in full, he will be entitled to nothing more.
Like subrogation, contribution supports to principle of indemnity and applies only to contracts of
indemnity. There is, therefore, no contribution in personal accident and life policies under which
insurers contract to pay specific sums on the happening of certain events. Such policies are not
contracts of indemnity, except to the extent that they may be important in a benefit by way of
indemnity. Example, for payment of medical expenses incurred the contribution would apply.
It is important to understand the difference between contribution and subrogation. Subrogation is
concerned with rights of recovery against third parties or elsewhere in respect of payment of an
indemnity, and need not involved any other insurance, although it frequently does. Contribution
necessarily involves more than one insurer each covering the interest of the same insured.