Chapter 6

Analysis of
Insurance
Contracts
 Agenda

• Basic parts of an insurance contract

• Definition of “Insured”
• Endorsements and Riders
• Deductibles
• Other-insurance provisions

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 Basic parts of an Insurable Interest

• Declaration(D)
• Definition
• Insuring agreement(I)
• Exclusions(E)
• Conditions(C)
• Miscellaneous

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Basic Parts of an Insurance Contract

• Declarations are statements that provide

information about the particular property or
activity to be insured
– Can usually be found on the first page of the
policy
– In property insurance, it contains name of the
insured, location of property, period of
protection, amount of insurance, premium and
deductible information
• Insurance contracts typically contain a page
or section of definitions
– For example, the insured is referred to as “you”

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Basic Parts of an Insurance Contract

• The insuring agreement summarizes the

major promises of the insurer
• The two basic forms of an insuring
agreement in property insurance are:
– Named perils coverage, where only those
perils specifically named in the policy are
covered
Example: In homeowner policy , personal
property is covered for fire, lightening,
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.

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 All risks or Open-perils, or special coverage, where all
losses are covered except those losses specifically excluded.
“If the loss is not excluded, then it is covered”

Example: A bear in a national park damages the vinyl top of

a covered auto. The losses would be covered because they
are excluded.

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Which one is preferable? Named-peril
or all-risks coverage

• All-risks coverage is more preferable.

• In all-risks coverage the greater burden of proof is
placed on the insurer to deny a claim. 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.

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Basic Parts of an Insurance Contract

• Insurance contracts contain three major

types of exclusions
– Excluded perils, e.g., flood, intentional act
– Excluded losses, e.g., failure of an insured to
protect the property from further damage after
a loss in the homeowner policys
– Excluded property, e.g., pets are not covered as
personal property in the homeowners policy

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Why are Exclusions Necessary?

• Some perils are not commercially insurable

– e.g., catastrophic losses due to war
• Extraordinary hazards are present
– e.g., using the automobile for a taxi
• Coverage is provided by other contracts
– e.g., use of auto excluded on
homeowners policy

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Why are Exclusions Necessary?

• Moral hazard problems

– e.g., coverage of money limited to $200 in
homeowners policy
• Attitudinal hazard problems
– e.g., individuals are forced to bear losses that
result from their own carelessness
• Coverage not needed by typical insureds
– e.g., homeowners policy does not cover aircraft

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Basic Parts of an Insurance Contract

• Conditions are provisions in the policy that

qualify or place limitations on the insurer’s
promise to perform
– If policy conditions are not met, the insurer can
refuse to pay the claim
• Insurance policies contain a variety of
miscellaneous provisions
– e.g., cancellation, subrogation, grace period,
misstatement of age

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 Definition of “Insured”

• An insurance contract must identify the

persons or parties who are insured under the
policy
– The named insured is the person or persons named
in the declarations section of the policy
– The first named insured has certain additional
rights and responsibilities that do not apply to
other named insureds
– A policy may cover other parties even though they
are not specifically named
– Additional insureds may be added using an
endorsement

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Endorsements and Riders

• In property and liability insurance, an

endorsement is a written provision that
adds to, deletes from, or modifies the
provisions in the original contract
– e.g., an earthquake endorsement to a
homeowners policy
• In life and health insurance, a rider is a
provision that amends or changes the
original policy
– e.g., a waiver-of-premium rider on a life
insurance policy

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 Deductibles

• A deductible is a provision by which a

specified amount is subtracted from the
total loss payment that otherwise would be
payable
• The purpose of a deductible is to:
– Eliminate small claims that are expensive to
handle and process
Savings from reduced expenses and payments for small losses
are reflected in lower premium.
– Reduce premiums paid by the insured
– Reduce moral hazard and attitudinal (morale)
hazard

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 The Purpose of Deductible
• 1-Deductible eliminate small claims that are
expensive to handle and process.
Example:
an insurer can easily incur $500 or more for a $100
claim.

• Savings from reduced expenses and payments for

small losses are reflected in lower premium.

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• 2- Deductibles are used to reduce premiums
paid by the insured.
Eliminate of small claims reduce premiums
substantially
• Small claims can be better budgeted by personal and business
income.
• Insurance should be used to cover significant losses such as
medical expense of $500,000 or more from an extended
terminal illness.

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 Large-loss principle: using insurance
premiums to pay for large losses rather than
for small losses.
Purpose of large-loss principle:
To cover large losses that can be financially
ruin an individual and exclude small losses
than can be budgeted out of the person’s
income.

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• 3- Deductibles are used to reduce both moral
hazard and attitudinal (morale hazard).

 Deductibles reduces moral hazard because those

insured that may deliberately cause a loss they can
not profit form insurance.

 Deductibles reduce attitudinal hazard(morale

hazard) because they encourage people to be more
careful with respect to protection of their property
and prevention of loss.

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 Deductibles in Property Insurance
• With a straight deductible, the insured must
pay a certain number of dollars of loss before
the insurer is required to make a payment
– e.g., an auto insurance deductible

• The deductible applies to each loss and there is

no annual limit on the number of times the
deductibles applies.

Example: Ashely has collision insurance on her new

Toyota, with a $500 deductible. If a collision loss is
$7000, she would receive only $65000 and would have
to pay the remaining $500 herself.

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 An aggregate deductible means that all losses that occur
during a specified time period, usually a year, are
accumulated to satisfy the deductible amount.
• Once the deductible is satisfied , the insurer pays all future
losses in full.
Example :
Assume that a policy contains an aggregate deductible of $10,000.
Also assume that losses of $1000 and $2000 occur, respectively,
during, the policy year.
 The insurer pays nothing because the deductible is not met.
 If the third loss of $8000 occurs during the same time period ,
the insurer would pay $1000( $11,000 losses – $10,000
deductible)
 Any other losses occurring during the policy year would be paid in
full.

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 Example:
A manufacturing firm incurred the following
insured losses, in the order given, during the
current policy year.
Loss Amount of Loss
A $2,500
B $3,500
C $10,000
How much would the company’s insurer pay
for each loss if the policy contained the
following type of deductible?
1- $1,000 straight deductible
2- $15,000 annual aggregate deductible

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 Other-insurance Provisions

• These provisions apply when more than one

contract covers the same loss.
• The purpose of other-insurance provisions is
to prevent profiting from insurance and
violation of the principle of indemnity.
1-Under a pro rata liability provision, each
insurer’s share of the loss is based on the
proportion that its insurance bears to the total
amount of insurance on the property

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 Example:
Jacob owns a building and wishes to insure it for
$500,000. Assume that an agent places $300,000 of
insurance with company A,$100,000 with company
B, and $100,000 with company C, for a total of
$500,000. If $100,000 loss occurs , each company
will pay only its pro rata share of the loss(Exhibit
6.3)

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Exhibit 6.3 Pro Rata Liability Example

IF pro rata clause were not present, the insured would collect $100,000
from each insured or a total of $300,000 for a $100,000 loss.

The basic purpose of the pro rate liability clause

is to preserve the principle of indemnity and to
prevent profiting from insurance.
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 2-Under contribution by equal shares, each insurer
shares equally in the loss until the share paid by each
insurer equals the lowest limit of liability under any
policy, or until the full amount of the loss is paid.

See example 1 & 2

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Example1: Assume that the amount of insurance provided by
companies A,B,C is $100,000, $200,000, and $300,000,
respectively.

Case 1 : If the loss is $150,000 each insurer pays an equal

share , or $50,000(Exhibit 6.4).

Exhibit 6.4 Contribution by Equal Shares(Example 1)

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 Example2 Assume that the amount of insurance
provided by companies A,B,C is $100,000, $200,000,
and $300,000, respectively.

Case 2 : If the loss is $500,000 each insurer would pay

equal amounts until its policy limits are exhausted. The
remaining insurers then continue to share equally in the
remaining amount of the loss until each insurer has
paid its policy limit in full, or the full amount of the loss
is paid.
Exhibit 6.5 Contribution by Equal Shares (Example 2)

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 Other-insurance Provisions

3-Under a primary and excess insurance

provision, the primary insurer pays first, and the
excess insurer pays only after the policy limits
under the primary policy are exhausted.
 Auto insurance is an example of primary and
excess insurance.

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 Example: Bob occasionally drives Jill’s car. Bob’s policy
has a liability insurance limit of $100,000 per person for
bodily injury liability. Jill’s policy has a limit of $50,000
per person for bodily injury liability.
If Bob negligently injures another motorist while driving

Jill’s car, both policies will cover the loss. How?

The rule is that liability insurance on the borrowed car is
primary and any other insurance is considered excess
insurance.
If a court orders Bob to pay damages of $75,000, Jill’s
policy is primary and pays the first $50,000. Bob’s policy
is excess and pays the remaining $25,000.

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 Application question #4 pg.124 Chapter 6

Andrew owns a commercial office building that is insured

under three property insurance contracts. He has
$100,000 of insurance from Company A $200,000 from
Company B, and $200,000 From Company C.

a. Assume that the pro rata liability provision appears in

each contract. If a $100,000 loss occurs, how much will
Andrew collect from each insurer? Explain your answer.
b. What is the purpose of the other-insurance provisions
that are frequently found in insurance contracts?

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 Answer:
(a) Company A has one-fifth of the total amount of
insurance. Thus, based on the pro rata liability clause, it
will pay one-fifth of the $100,000 loss or $20,000.
Company B and Company C will each pay $40,000.

(b) The purpose is to reduce profiting from

insurance and violation of the principle of indemnity.

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 Application question #5 pg.124 Chapter 6
Assume that a $300,000 liability claim is covered
under two liability insurance contracts. Policy A has
a $500,000 limit of liability for the claim, while
policy B has a $125,000 limit of liability. Both
contracts provide for contribution by equal shares.

a. How much will each insurer contribute toward

this claim? Explain your answer.
b. If the claim were only $50,000, how much would
each insurer pay?

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 Answer:
(a) Based on contribution by equal shares, each company
shares equally in the loss until the share of each insurer
equals the lowest limit of liability under any policy, or until
the full amount of the loss is paid. Company A and Company
B will each contribute $125,000 toward the loss.
At that point, the limit of liability under Company B’s policy
is exhausted. Therefore Company A will pay the remaining
$50,000. Thus Company A pays a total of $175,000 and
Company B pays $125,000.

(b) $25,000

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