Topic 10.
Legal Principles in
Insurance Contracts
BUS 200
Introduction to Risk Management and Insurance
Jin Park
Overview
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Distribution of Insurance Contracts
Insurance as contracts
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legally enforceable agreements
Characteristics of Insurance Contracts
Fundamental Principles of Insurance
Contracts
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Principle of indemnity
Principle of insurable interest
Principle of utmost good faith
Principle of subrogation
Distribution of Insurance
Contracts
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Direct Marketing
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Exclusive Agent
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No outside agent is involved
Mail marketing, internet based marketing
represents one insurer
Independent Agent
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represents more than one insurer
Distribution of Insurance
Contracts
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Agent versus Broker
Binding Authority by Agent
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Property/Liability Insurance
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Binder
Life/Health Insurance
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Conditional premium receipt
Insurance as Contracts
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Elements of contract
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Agreement
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Consideration
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Offer and Acceptance
Insured – premium payment and fulfillment of policy conditions
Insurer – promise to do certain things as specified in the
contract (insurance policy)
Legally competent parties
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Parties must have legal capacity to enter into a binding contract
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Contract must be for a legal purpose
Legal Purpose
Legal Form
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Contract may be oral or written
Some insurance policy provisions and attachments must be
approved by regulator before being marketed
Insurance as Contracts
Property - Casualty
 Offer
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Life
 Offer
Submission of application
with a down payment
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Acceptance
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Binder
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Submission of application
with a down payment
Issuance of a life
insurance policy
Acceptance

Conditional premium
receipt
Note: Giving a quotation to a prospective insured is deemed
as mere solicitation or invitation to make an offer.
Characteristics of
Insurance Contracts
1. Personal Contracts
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Insurance protects insured, not the
property or liability subject to loss.
Assignment provision
In property insurance, if ownership of a
property changes, insurance contracts (policies)
cannot be transferred to another party (buyer)
without the insurer’s written consent.
 In life insurance, the beneficiary or ownership
of policy may be freely reassigned.

Characteristics of
Insurance Contracts
2. Aleatory Contracts
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A contract whose value to either or both of
the parties depends on chance or future
events, or where the monetary values of
the parties' performance are unequal.
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The insurer's obligation to pay a loss depends on
uncertain events
Premium paid by Insured
< Claim paid by Insurer
cf: commutative contract
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The values exchanged are theoretically equal.
Characteristics of
Insurance Contracts
3. Contracts of adhesion
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Insurance contracts are drafted by an insurer and
an insured must accept or reject all the terms and
conditions.
Insured gets the benefit of the doubt.
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Contracts may be altered by the addition of riders
or endorsements
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Courts tend to construe an ambiguous term in an
insurance policy in favor of an insured.
Rider or endorsement – a document that amends or
changes the original policy.
cf: Contracts of cohesion
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Contracts are drafted by both parties.
Characteristics of
Insurance Contracts
4. Conditional contracts
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An insurer’s obligation to pay a claim
depends on whether the insured or the
beneficiary has complied with all policy
conditions.
The insurer may not pay a claim if one or
more of policy conditions are not complied.
Duties after loss – Homeowners (p. 562)
 Duties after an accident or loss – Automobile (p.
585)
 Duties after in the event of loss or damage – CP
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Characteristics of
Insurance Contracts
5. Unilateral contracts
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Only one party makes a legally enforceable
promise.
Insured are not legally forced to pay
premium or renew the policy.
Fundamental Legal Principles of
Insurance Contracts
1. Principle of indemnity
2. Principle of insurable interest
3. Principle of utmost good faith
4. Principle of subrogation
Principle of Indemnity
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The insurer agrees to pay no more than
the actual amount of the loss suffered
by the insured.
Why?
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The purpose of the insurance contract is to
restore the insured to the same economic
position as before the loss.
The insured should not profit from a loss.
It reduces the moral hazard by eliminating
the profit incentive.
Principle of Indemnity
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To support the principal of indemnity an
insurance contact uses Actual Cash Value
(ACV) method
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Replacement cost (RC) less depreciation
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Fair market value
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RC – current cost of restoring the damaged property with
new materials of like kind and quality.
The price of a wiling buyer would pay a willing seller in a
free market.
Broad evidence rule
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The determination of ACV should include all relevant
factors an expert would use to determine the value of the
property.
Principle of Indemnity
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To support the principal of indemnity
insurance contact includes “Other Insurance
Provisions”.
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Escape clause
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Primary-Excess
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It (or This insurance) is excess insurance over any other
valid and collectible insurance.
Pro-rata provision
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The policy (or insurance) would not apply if the insured
was covered by another policy.
Proration by face amounts
Proration by amounts otherwise payable
Contribution by equal shares
Principle of Indemnity
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Primary-Excess
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Accident while test driving a dealer’s car.
Health insurance between a couple working
for different employers.
Own insurance – primary
 Spouse insurance – excess
 Birthday rule for dependents’ coverage
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Principle of Indemnity
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Pro-ration by Face Amounts
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It limits an insurer’s maximum obligation to the
proportion of the loss that the insurer’s policy
limit bears to the sum of all applicable policy
limits.
Assume that there are three polices covering the
same loss and the loss amount is $150,000.
Policy Limit
Share
Payment
Insurer A
Insurer B
Insurer C
$100,000
$200,000
$300,000
1/6
2/6
3/6
$25,000
$50,000
$75,000
Principle of Indemnity
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Pro-ration by Amounts Otherwise Payable
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The amount what would be payable under each
policy in the absence of other insurance
Assume that there are three polices covering the
same loss and the loss amount is $150,000.
Insurer A
Insurer B
Insurer C
Policy Limit
$100,000
$200,000
$300,000
Payable
$100,000
$150,000
$150,000
1/4
1.5/4
1.5/4
$37,500
$56,250
$56,250
Share
Payment
Principle of Indemnity
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Pro-ration by Amounts Otherwise Payable
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What if the loss amount is $60,000?
Insurer A
Insurer B
Insurer C
Policy Limit
$100,000
$200,000
$300,000
Payable
$60,000
$60,000
$60,000
1/3
1/3
1/3
$20,000
$20,000
$20,000
Share
Payment
Principle of Indemnity
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Contribution by Equal Shares
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Each insurer contributes equal amount until it has
paid its applicable limit of insurance or none of
the loss remains, whichever comes first.
Assume that there are three polices covering the
same loss and the loss amount is $150,000
Insurer A
Insurer B
Insurer C
Policy Limit
$100,000
$200,000
$300,000
Equal Share
$50,000
$50,000
$50,000
Payment
$50,000
$50,000
$50,000
Principle of Indemnity
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Contribution by Equal Shares
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What is the loss amount is $400,000?
Insurer A
Insurer B
Insurer C
Policy Limit
$100,000
$200,000
$300,000
Equal Share 1
$100,000
$100,000
$100,000
Equal Share 2
N/A
$50,000
$50,000
$100,000
$150,000
$150,000
Payment
Principle of Indemnity
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Exceptions to the Principle of Indemnity
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Valued policy (or agreed value)
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Pays face value of insurance if a total loss occurs
Life insurance, disability insurance, fine arts, antiques
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Valued policy law
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Ex.) Value of a fine art is agreed at $250,000.
A law that requires payment of the face amount of
insurance to the insured if a total loss to real property
occurs from a covered peril, regardless of the property’s
ACV.
Replacement cost
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No deduction for depreciation in determining the amount
paid for a loss.
Principle of Insurable Interest
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The insured must be in a position to
financially suffer if a loss occurs.
Why?
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To prevent gambling
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To reduce moral hazard
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Insurance on a property and wait for a loss occur.
Life insurance on a person and pray for his/her death for
insurance proceeds.
In order not to indemnify more than an insured’s
financial interest
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It supports the principle of indemnity.
Principle of Insurable Interest
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Property-Casualty insurance
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At the time of a loss, an insured must have
insurable interest.
No insurable interest
no financial loss
no indemnity
support Prin. of
indemnity
Life Insurance
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Insurable interest must exist at the time
of a policy inception, but not at the time of
a loss (death)
Principle of Utmost Good Faith
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A higher degree of honesty is imposed
on an insurance contract than is imposed
on other contracts
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Honesty is mainly imposed on the insurance
applicants.
It is supported by three legal doctrines
Representation
 Concealment
 Warranty
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Principle of Utmost Good Faith
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Representation
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Statements made by an applicant
Insurance is voidable at the insurer’s option.
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cf: Innocent misrepresentation
Concealment
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Material
False
Reliance
Intentional failure to disclose a material fact
Warranty
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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.
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In exchange for a reduced premium, a store owner warrants
that a burglar alarm will be always on.
Principle of Subrogation
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Substitution of the insurer in place of
the insured for the purpose of claiming
indemnity from a third party wrongdoer
for a loss paid by the insurer.
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Why?
To prevent collecting twice
 To hold the negligent party responsible
 To hold down insurance rates
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Principle of Subrogation
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The insurer is entitled only to the amount it
has paid under the policy.
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What if the insurer collects more, from the
negligent party, than the amount the insurer paid
to its insured?
The insured cannot impair the insurer’s
subrogation rights.
Subrogation does not apply to life insurance
and to individual health insurance contracts.
The insurer cannot subrogate against its own
insured.
Additional Reading Assignments
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Two insurers seek to void Enron
policies
Coming Clean on Insurance Applications
Rescission of Life Insurance Policy
Upheld on Finding of Intent to Deceive
in Application