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Chapter 9

Fundamental Legal Principles
.1   Teaching Note

This chapter discusses several important legal principles that are reflected in insurance contracts. Emphasis should be placed on the principles of indemnity, insurable interest, subrogation, and utmost good faith. These principles are important in understanding individual insurance contracts discussed later in the text. How insurance contracts are formed is another area that merits some discussion if time permits.

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I.

  Outline
Fundamental Legal Principles A. Principle of Indemnity 1. Insurer agrees to pay no more than the actual amount of loss; the insured should not profit if a loss occurs. 2. Actual cash value rule a. Replacement cost less depreciation b. Fair market value c. Broad evidence rule 3. Exceptions to the principle of indemnity a. Valued policy b. Valued policy laws c. Replacement cost insurance d. Life insurance B. Principle of Insurable Interest 1. Insured stands to lose financially if a loss occurs. 2. Purposes of an insurable interest a. To prevent gambling b. To reduce moral hazard c. To measure the amount of the insured’s loss in property insurance 3. Examples of an insurable interest 4. Time that an insurable interest must be met

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53  Rejda • Principles of Risk Management and Insurance, Eleventh Edition

C. Principle of Subrogation 1. Insurer is entitled to recover from a negligent third party any loss payments made to the insured. 2. Purposes of subrogation a. To avoid collecting twice b. To hold the negligent person responsible c. To hold down rates D. Principle of Utmost Good Faith 1. Higher degree of honesty is imposed on both parties to an insurance contract 2. Areas of application—legal doctrines of misrepresentation, concealment, and breach of warranty II. Basic Requirements of an Insurance Contract A. Offer and Acceptance 1. The applicant usually makes the offer. 2. The insurer accepts or rejects the offer. 3. Agent’s authority to bind the insurer varies by type of insurance. a. Property and casualty insurance b. Life insurance B. Consideration 1. Insured’s consideration generally is payment of the first premium. 2. Insurer’s consideration is the promise to perform the contract. C. Competent Parties D. Legal Purpose III. Special Characteristics of an Insurance Contract A. Insurance Is an Aleatory Contract B. Insurance Is an Unilateral Contract C. Insurance Is a Conditional Contract 1. Conditions are provisions that qualify or place limitations on the insurer’s promise to perform. 2. The insurer does not have to pay the claim if the policy conditions are violated. For example, in property insurance the insured must give immediate written notice of a loss in order to collect. D. Insurance Is a Personal Contract 1. Consent of the insurer is required to assign a property or liability insurance policy to another person. 2. Since loss payments are usually money, they can be freely assigned without the insurer’s consent.

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E. Contract of Adhesion 1. Policy is offered on a “take-it-or-leave-it” basis with no bargaining over its terms. 2. The result is that any ambiguity is strictly construed against the insurer. IV. Law and the Insurance Agent A. General Rules of Agency 1. There is no presumption of an agency relationship. 2. Agents may bind the principal by express authority, by implied authority, or by apparent authority. 3. Principal is responsible for an agent’s torts and is charged with agent’s knowledge of notice. B. Doctrines of Waiver and Estoppel 1. Waiver—voluntary relinquishment of a known legal right 2. Estoppel—representation of fact made by one person to another person that 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 representation 3. Practical significance of these legal doctrines—insurer legally may be required to pay a claim that it ordinarily would not have to pay

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a.

  Answers to Case Application
(1) Jeff has an insurable interest equal to the full value of the building, since he would lose financially if a loss occurs. (2) Richard does not have an insurable interest, since the building was sold earlier. (3) Gateway Bank has an insurable interest equal to the unpaid balance of the loan. The mortgaged building serves as collateral for the loan. No. A property insurance contract is a personal contract between the property insurer and policyowner. Richard cannot validly assign the policy to Jeff without the insurer’s consent. Yes. A restaurant on the premises can substantially increase the probability of a fire or other loss. Premiums must be substantially higher if the restaurant was also covered. Since the physical hazard would be substantially increased and this fact was not disclosed, the insurer could attempt to deny coverage on the basis of a material concealment. Subrogation applies when the insurer makes a loss payment to the insured because of a loss caused by the negligence of a third party. In this case an electrician improperly wired an electrical outlet, which caused the fire. The insurer could attempt to recover the loss payment from the negligent electrician or from the firm employing the electrician.

b.

c.

d.

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55  Rejda • Principles of Risk Management and Insurance, Eleventh Edition

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  Answers to Review Questions

1. (a) 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. (b) The normal rule for determining actual cash value is replacement cost less depreciation. However, some courts have ruled that fair market value should be used to determine the actual cash value. Finally, some states use the broad evidence rule to determine the actual cash value. 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. (c) Insureds are indemnified when they are restored to approximately the same financial position they were in before the loss occurred. Actual cash value, which is defined as replacement cost less depreciation, supports the principle of indemnity because it is designed to prevent profiting from insurance. 2. (a) A valued policy pays the face amount of insurance in the event of a total loss. Valued policies are used to insure valuable property, such as antiques, fine arts, rare paintings, and family heirlooms. Because of the difficulty of 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. (b) A valued policy law requires payment of the face amount of insurance if a total loss to real property occurs from a peril specified in the law. (c) Replacement cost insurance means there is no deduction for depreciation in determining the amount paid for a loss. 3. (a) The principle of insurable interest means that the insured must stand to lose financially if a loss occurs. (b) An insurable interest is required in every insurance contract in order to prevent gambling, to reduce moral hazard, and to measure the amount of the insured’s loss in property insurance. 4. (a) Subrogation is taking over another person’s right to recover in a legal action against a negligent third party. (b) It is used to support the principle of indemnity by preventing an insured from collecting twice, once from the insured and a second time from the negligent party. 5. (a) Representations are statements made by the applicant for insurance. A misrepresentation is a statement that is material, false, and relied on by the insurer. A material misrepresentation allows the insurer to void the policy. (b) Concealment is the intentional failure of the applicant for insurance to reveal a material fact to the insurer. The legal effect of a material concealment is the same as a misrepresentation—the contract is voidable at the insurer’s option. (c) 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, a bank may warrant that a guard will be on the premises 24 hours a day. In the past, under the common law, any breach of the warranty, even if slight, permitted the insurer to deny liability for the claim. However, this harsh doctrine has been substantially modified by court decisions and legislation.

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6. Four requirements must be met for a valid insurance contract: (a) There must be an offer and acceptance. (b) There must be consideration to support the contract. (c) There must be competent parties. (d) To be enforced, the contract must be for a lawful purpose. 7. (a) The insurance contract is aleatory. The values exchanged are not equal. If a loss occurs, the insured may recover an amount in excess of the premiums paid. In a commutative contract, theoretically, there is an equal exchange of values. (b) The insurance contract is unilateral since only the insurer makes a legally binding promise. Most ordinary contracts are bilateral, and either party may be sued for breach of contract. (c) A property insurance contract is personal. Personal characteristics of the insured influence the insurer’s willingness to issue a policy. Accordingly, these contracts can be validly assigned only with the consent of the insurer. A life insurance policy is not a personal contract and can be freely assigned. (d) The contract is conditional. In order to collect, a number of duties must be complied with, such as giving prompt notice of loss and submitting proof of loss. (e) Insurance is a contract of adhesion in that it is not bargained. Rather, the policy is offered on a “take-it-or-leave-it” basis, and any ambiguity is construed against the insurer. 8. The general rules are: (a) There is no presumption of agency. There must be evidence sufficient to establish that a person has authorized someone to act on his or her behalf. (b) The agent must have authority to bind the principal. There are three sources of such authority: (1) Expressed authority (2) Implied authority (3) Apparent authority (c) The principal is responsible for acts of an agent who is acting within the scope of his or her authority. Accordingly, the principal can be bound by contracts that the agent has entered into and is also liable for the agent’s torts. 9. See 8(b) above. 10. Waiver is defined as the voluntary relinquishment of a known legal right. The insurer voluntarily waives a legal right under the contract, and in so doing cannot later deny payment of a claim by the insured. Estoppel is a representation of fact made by one person to a second person that is reasonably relied upon by that second person to such an extent that it would be inequitable to allow the first person to deny the truth of the representation. Based on the legal doctrine of estoppel, an insurer legally may be required to pay a claim that it ordinarily would not have to pay.

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57  Rejda • Principles of Risk Management and Insurance, Eleventh Edition

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1.

  Answers to Application Questions
(a) (1) The Gateway Bank has an insurable interest in the boat because it serves as collateral for the loan. Thus the Gateway Bank has an insurable interest in the amount of $800,000. (2) The Harbor Company also has an insurable interest in the property. The Harbor Company is a bailee, and there may be possible legal liability if Jake is negligent while docking the boat and using the facilities. Also, the Harbor Company would lose rental income if the boat is damaged. The loss of rental income will support an insurable interest. (3) The White Shark Fishing Company also has an insurable interest in the property. Jake is acting as the company’s agent, and his negligence can be imputed to the White Shark Fishing Company. Thus potential legal liability for a negligent act by Jake would support an insurable interest. (b) Yes. Jake is using the boat and has a potential legal liability as a bailee if he should damage the boat. In addition, if the boat is damaged there may be a business income loss and the loss of earnings, which would also support an insurable interest.

2. Actual cash value (ACV) is replacement cost less depreciation. Replacement cost is $6000. Depreciation is $3000 because the dining room set is 50 percent depreciated. Ashley would collect $3000 as shown by the following: ACV = Replacement cost − depreciation = $6000 − $3000 = $3000 3. ACV is replacement cost less depreciation. Replacement cost of a new computer is $1800. Depreciation is $900 because the laptop is 50 percent depreciated. Nicholas would collect $900. ACV = Replacement cost − depreciation = $1800 − $900 = $900 4. Under a valued policy, the face amount of insurance is paid if a total loss occurs. Megan would collect $12,000. 5. (a) No. If Kristen collects from her own insurer, she gives her insurer the right to subrogate against the negligent driver who caused the accident. Her insurer then has the legal right to collect damages from the negligent driver or negligent driver’s insurance company. (b) Subrogation supports the principle of indemnity since the insured does not profit from the loss. By giving up subrogation rights, the insured does not collect twice for the same loss, which supports the principle of indemnity.

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6. (a) Three additional factors are (1) offer and acceptance, (2) consideration, and (3) competent parties. (b) The applicant for an auto insurance policy fills out the application for insurance. This constitutes the offer. The insurer then accepts or rejects the offer. Consideration by the applicant 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, which can include payment of a loss from an insured peril, providing certain services, or defending the insured. Each party must be legally competent and have legal capacity to enter into a binding contract. The applicant for auto liability insurance must not be a minor, insane, or intoxicated when he or she applies for insurance. Also, the liability insurer must have legal authorization to sell auto liability insurance. 7. (a) The insurer could attempt to deny payment of the claim on the basis of a material concealment. (b) The principal is responsible for all acts of the agents when they are acting within the scope of their authority. Also, knowledge of the agent is presumed to be knowledge of the principal with respect to matters within the scope of the agency. In this case, the agent knew that Nicole had a health problem and deliberately omitted this information from the application. This knowledge is imputed to the insurer. Thus if the insurer issues the policy, it cannot later attack the validity of the policy on the grounds that Nicole concealed a material fact. Based on the doctrine of estoppel, the company could not deny liability for the claim. The agent told Nicole the health information would be given to the underwriters. Nicole relied on the agent’s statement and believed she had coverage. Since the insurer is responsible for the acts of agents, including acts of omission and fraud, the company cannot deny liability for the claim.

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