Chapter 9
Fundamental Legal Principles
• Principle of Indemnity
• Principle of Insurable Interest
• Principle of Subrogation
• Principle of Utmost Good Faith
The principles 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.
The principles of indemnity has two
fundamental purposes.
• The first purpose is to prevent from profiting
from a loss.
E.g., if Kristin’s home is insured for $200,000, and a
partial loss of $50,000 occurs, the principle of
indemnity would be violated if $200,000 were
paid to her. She would be profiting from
• The second purpose is to reduce moral
hazard. If dishonest insureds could profit
from a loss, they might deliberately cause
losses with the of collecting the
• If the loss payment does not exceed the
actual amount of the loss, the
temptation to be dishonest is reduced.
Actual Cash Value
• The concepts 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 damage property at
the time of loss.
Determinants of Actual Cash Value
• 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.
• 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.
Fair Market Value
• 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.
• The difference due to several factors;
– Poor location
– Deteriorating neighborhood
– Economic obsolescence of the building.
Broad Evidence Rule
• 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
Exception to the Principle of Indemnity
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,
– Family heirlooms etc.
Valued Policy Laws
• 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.
 Example 
Replacement Cost Insurance
• Replacement cost insurance means there is
no deduction for physical depreciation in
determining the amount paid for a loss.
 Example 
Life Insurance
• A life insurance contract 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 indemnity principle is difficult to apply to
life insurance for the obvious reason that the
actual cash value rule (replacement cost less
depreciation) is meaningless in determining
the value of a human life.
• The principle of insurable interest states that
the insured must be in a position to lose
financially if a covered loss occurs.
• E.g., you have an insurable interest in your car
because you may lose financially if the car is
damaged or stolen.
• Same as for personal property such as;
– Television
– computer
Purposes of Insurable Interest
• To be legally enforceable, all insurance
contract must be supported by an insurable
• And for the following reasons;
– To prevent gambling
– To reduce morale hazard
– To measure the amount of the insured’s loss in
property insurance
Property and Casualty Insurance
• In property and casualty insurance, the
ownership of property, potential legal liability,
secured creditors, and contractual rights can
support the insurable interest requirement.
Life Insurance
• In life insurance, the question of an insurable
interest does not arise when a person
purchase life insurance on his or her own life.
• If life insurance is purchased on the life of
another person, there must be an insurable
interest in that person’s life.
• E.g., a husband can purchase a life insurance
policy on his wife or vice versa.
When Must an Insurable interest
• In property insurance, the insurable interest
requirement must be met at the time of loss.
• In life insurance, the insurable interest
requirement must be met only at the
inception of the policy.
• Subrogation means substitution of the insurer
in place of the insured for the purpose of
claiming indemnity from a third person for a
loss covered by insurance.
• The insurer is entitled to recover from a
negligent third party any loss payments made
to the insured.
 Example 
Purposes of Subrogation
• The purposes of subrogation are to;
– Prevent the insured from collecting twice for the
same loss.
– To hold the negligent person responsible for the
loss and
– To hold down insurance rates.
Importance of Subrogation
• The general rule is that by exercising its
subrogation rights, the insurer is entitled only to
the amount it has paid under the policy.
• The insured cannot do anything that might impair
the insurer’s subrogation rights.
• The insurer cannot subrogate against its own
• Finally subrogation does not apply to life
insurance and to most individual health
• The principle of utmost good faith means that
a higher degree of honesty is imposed on both
parties to an insurance contract than is
imposed on parties on other contracts.
Representation, Concealment,
• Representations are statements made by the
applicants for insurance.
• The insurer can deny payment for a claim if
the representation is material and false, and is
relied on by the insurer in issuing the policy at
a specified premium.
• In the case of statement of belief or opinion,
the misrepresentation must also be fraudulent
before the insurer can deny a claim.
• 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.
• A warranty is a statement that becomes part
of the insurance contract and is guaranteed by
the maker to be true in all respects.
• E.g., a bank may warrant that a guard will be
on the premises 24 hours a day.
• Any breach of the warranty, even if slight,
allows the insurer to deny payment of a claim.
• To have a valid insurance contract, four
requirements must be met;
– There must be an offer and acceptance.
– Consideration must be exchanged.
– The parties to the contract must be legally
– The contract must be for a legal purpose.
Offer and Acceptance
• The applicant for insurance makes the offer,
and the company accepts or rejects the offer.
• An agent 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.
Offer and Acceptance ….
• Most property and casualty insurance
contracts are written form.
• The applicant for insurance fills out the
application and pays the first premium (or
promises to pay the first premium).
• In property and casualty insurance, agents
typically have the power to bind their
companies through use of a binder.
Offer and Acceptance ….
• 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.
Offer and Acceptance ….
• In life insurance, the procedures followed are
• 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.
Offer and Acceptance ….
• A conditional premium receipt is then given
to the applicant.
• The most common conditional receipt is the
“insurable 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.
Offer and Acceptance ….
• Some insurability receipts make the life insurance
effective on the date of the application or the
date of the medical exam, whichever is later.
Example 
• 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
• The second requirement of a valid insurance
contract is consideration – the value that each
party gives to other.
• The insured’s consideration is payment of the
premium ( or a promise to pay the premium)
plus and 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
• 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
– Insane person,
– Intoxicated person, and
– Corporation that act outside the scope of their
authority cannot enter into enforceable insurance
Competent Parties
• Age restriction for minors under 18.
• 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
• 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
Legal Purpose….
• E.g., a street pusher of 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
Aleatory contract.
Unilateral contract
Conditional contract
Personal contract
Contract of adhesion
Aleatory (dependent on chance)
• An aleatory contract is a contract where the
values exchanged may not be equal but
depend on an uncertain event.
• Depending on the chance, one party may
receive a value out of proportion to the value
that is given.
Aleatory (dependent on chance)
• Assume that Jessica pays a premium of $600 for
$200,000 of homeowners insurance.
• If the home were totally destroyed by fire shortly
thereafter, she would collect an amount that
greatly exceeds the premium paid.
• On the other hand, a homeowner may faithfully
pay premiums for many years and never have a
 remember… pooling of fortuitous losses!!
• A commutative contract is one in which the
values exchanged by both parties are
theoretically equal.
• E.g., the purchase of real estate normally pays
a price that is viewed to be equal to the value
of the property.
Unilateral Contract
• A unilateral contract means that only one
party makes a legally enforceable promise.
• In this case, only the insurer makes a legally
enforceable promise to pay a claim or provide
other services to the insured.
• After the first premium is paid, and the
insurance is in force, the insured cannot be
legally forced to pay the premiums or to
comply with the policy provisions.
Unilateral Contract….
• Although the insured must continue to pay
the premiums to receive payment for a loss,
he or she cannot be legally forced to do so.
• However, if the premiums are paid, the insurer
must accept them and must continue to
provide the protection promised under the
Conditional Contract
• An insurer contract is a conditional contract.
That is, the insurer’s obligation to pay a claim
depends on whether the insured or the
beneficiary has complied with all policy
• Conditions are provisions inserted in the policy
that qualify or place limitations on the
insurer’s promise to perform.
Conditional Contract….
• For example, under a homeowners policy, the
insured must give immediate notice of a loss.
• If the insured delays for an unreasonable
period in reporting the loss, the insurer can
refuse to pay the claim on the grounds that a
policy condition has been violated.
Personal Contract
• In property insurance, insurance is a personal
contract, which means the contract is between
the insured and the insurer.
• A property insurance contract does insure a
property, but insures the owner of the
property against loss. The owner of the
property is indemnified if the property is
damaged or destroyed.
Personal Contract….
• A property insurance contract normally
cannot be assigned to another party without
the insurer’s consent.
• If property is sold to another person, the new
owner may not be acceptable to the insurer.
• Thus, the insurer’s consent is required before a
property insurance policy can be validly
assigned to another party.
Contract of Adhesion
• A contract of adhesion means the insured
must accept the entire contract, with all of its
terms and conditions.
• The insurer drafts and prints the policy, and
the insured generally must accept the entire
document and cannot insist that certain
provisions be added or deleted or the contract
rewritten to suit the insured.
Contract of Adhesion….
• Although a policy can be altered by the
addition of endorsement and riders or other
forms, the contract is drafted by the insurer.
• If the policy is ambiguous, the insured gets the
benefit of doubt.
• The general rule that ambiguities in insurance
contracts are construed against the insurer is
reinforced by the principle of reasonable
• An insurance contract normally is sold by an
agent who represent the principal (the
• An agent is someone who has the authority to
act on behalf of someone else.
• The principal (insurer) is the party for whom
action is to be taken.
General Rules of Agency
• Important rules of law govern the actions of
agents and their relationship to insureds. They
include the following;
– There is no presumption of an agency
– An agent must have authority to represent the
– A principal is responsible for the acts of agents
acting within the scope of their authority.
No Presumption Of An Agency
• There is no automatic presumption that one
person legally can act as an agent for another.
• Some visible evidence of an agency
relationship must exist.
• For example, a person who claims to be an
agent for an auto insurer may collect
premiums and then abscond with the funds.
No Presumption Of An Agency
• The auto insurer is not legally responsible for
the person’s actions if it has done nothing to
create the impression that an agency
relationship exists.
• However, if the person has a business card,
rate data, and application blanks supplied by
the insurer, then it can be presumed that a
legitimate agent is acting on behalf of the
Authority to Represent the Principal
• The agent must be authorized to represent
the principal.
• An agent’s authority is derived from three
1. Express authority,
2. Implied authority, and
3. Apparent authority.
Express Authority
• Express authority refers to powers specifically
conferred on the agent.
• The powers are normally stated in the agency
agreement between the agent and the
Express Authority….
• The agency agreement may also withhold
certain powers.
• E.g., a life insurance agent may be given the
power to solicit applicants and arrange for
physical examinations.
• Certain powers, however, such as the right to
extend the time for payment of premiums or
the right to alter contractual provisions in the
policy, may be denied.
Implied Authority
• Implied authority refers to the authority of an
agent to perform all incidental acts necessary
to fulfill the purpose of the agency agreement.
• e.g., an agent may have the express authority
to deliver a life insurance policy to the client.
• It follows that the agent also has the implied
power to collect the first premium.
Apparent Authority
• An agent may bind the principal by apparent
• If an agent acts with apparent authority to do
certain things, and a third party is led to
believe that the agent is acting within the
scope of reasonable and appropriate
authority., the principal can be bound by the
agent’s action.
Apparent Authority
• E.g., an agent for an auto insurer may
frequently grant his or her clients an extension
of time to pay overdue premiums.
• If the insurer has not expressly granted this
right to the agent and has not taken any
action to deal with the violation of company
policy, it could not later deny liability for a loss
on the grounds that the agent lacked
authority to grant the time extension.
Principal Responsible for Acts of
• A final rule of agency law is that the principal
is responsible for all acts of agents when they
are acting within the scope of their authority.
• This responsibility also includes fraudulent
acts, omission, and misrepresentation.
• In addition, knowledge of the agent is
presumed to be the knowledge of the
principal with respect to matters within the
scope of the agency relationship.
Principal Responsible for Acts of
• E.g., if a life insurance agent knows that an
applicant for life insurance is addicted to
alcohol, this knowledge is imputed to the
insurer even though the agent deliberately
omits this information from the application.
• Thus, if the insurer issues the policy, it cannot
later attack the validity of the policy on the
grounds of alcohol addiction and the
concealment of the material fact.
Waiver and Estoppel
• Waiver is defined as the voluntary
relinquishment of a known legal right or giving
up a known contractual right.
• If the insurer voluntarily waives a legal right
under the contract, it cannot later deny
payment of a claim by the insured on the
grounds that such a legal right was violated.
• E.g., assume that an insurer receives an application
for insurance at its home office, and that the
application contains an incomplete or missing
• Assume that the insurer does not contact the
applicant for additional information, and the policy is
• The insurer could not deny payment of a claim on
the basis of an incomplete application.
• In effect, the insurer has waived its requirement that
the application be complete by issuing the policy.
• Estoppel occurs when a representation of fact
made by one person to another person is
reasonably relied on by that person to such an
extent that it would be inequitable to allow the
first person to deny the truth of the
• Simply if one person makes a statement of fact to
another person who then reasonably relies on
the statement to his or her detriment, the first
person cannot later deny the statement was
• The law of estoppel is designed to prevent
persons from changing their minds to the
detriment of another party.
• E.g., assume that an applicant for health
insurance tells the agent of a health problem, and
the agent assures the applicant that the health
problem does not have to be stated in the
• The insurer could be estopped from denying
benefits on the grounds that this information was
not include.
Detriment= a damage or