Chapter 2

Legal Principles of Insurance

 Topics
• Characteristics of Insurable risks
• Legal principles affecting insurance
– Principle of Indemnity
– Principle of Insurable Interest
– Principle of Subrogation
– Principle of Utmost Good Faith
• Insurance regulation
 Characteristics of Insurable risks
• Large number of exposure units
– to predict average loss
• Accidental and unintentional loss
– to control moral hazard and to assure randomness
• Determinable and measurable loss
– to facilitate loss adjustment insurer must be able to
determine if the loss is covered and if so, how
much should be paid.
• No catastrophic loss
– to allow the pooling technique to work
• Calculable chance of loss
– to establish an adequate premium
• Economically feasible premium
– so people can afford to buy
– Premium must be substantially less than the face value of
the policy
 Fundamental legal principles
•Principle of Indemnity
•The insurer agrees to pay no more than the actual amount of the
loss
• Purpose:
– To prevent the insured from profiting from a loss
– To reduce moral hazard
• In property insurance, indemnification is based on the actual cash
value (ACV) of the property at the time of loss
• Methods to determine actual cash value:
– Replacement cost less depreciation
– Fair market value
– Broad evidence rule
• Methods to determine actual cash value:
– Replacement cost less depreciation
– Fair market value is the price a willing buyer would pay a
willing seller in a free market
– Broad evidence rule means that the determination of ACV
should include all relevant factors an expert would use to
determine the value of the property
• There are some exceptions to the principle of indemnity:
– A valued policy
– Replacement cost insurance
– A life insurance contract
 Principle of Insurable Interest
•The insured must be in a position to lose financially if a covered
loss occurs
•Purposes:
– To prevent gambling
– To reduce moral hazard
– To measure the amount of the insured’s loss
•An insurable interest can be supported by:
– Ownership of property
– Potential legal liability
– Serving as a secured creditor
– Contractual rights
• When must insurable interest exist?
– Property insurance: at the time of the loss
– Life insurance: only at inception of the policy
 Principle of Subrogation
•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.
• Purpose:
– To prevent the insured from collecting twice for the same
loss
– To hold the negligent person responsible for the loss
– To hold down insurance rates
 Principle of Utmost Good Faith
•A higher degree of honesty is imposed on both parties
to an insurance contract than is imposed on parties to
other contracts
•Supported by three legal doctrines:
– Representations
– Concealment
– Warranty
 Representations
• are statements made by the applicant for
insurance
• A contract is voidable if the representation is
material, false, and relied on by the insurer
• Material means that if the insurer knew the
true facts, the policy would not have been
issued, or would have been issued on different
terms
• A concealment is intentional failure of the
applicant for insurance to reveal a material
fact to 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
– Statements made by applicants are considered
representations, not warranties
 Requirements of an Insurance Contract

• To be legally enforceable, an insurance

contract must meet four requirements:
– Offer and acceptance of the terms of the contract
– Consideration – the value that each party gives to
the other
– Competent parties, with legal capacity to enter
into a binding contract
– The contract must exist for a legal purpose
 Distinct Legal Characteristics of Insurance
Contracts
• An insurance contracts is:
– Aleatory: values exchanged are not equal
– Unilateral: only the insurer makes a legally enforceable
promise
– Conditional: policy owner must comply with all policy
provisions to collect for a covered loss
– Personal: property insurance policy cannot be validly
assigned to another party without the insurer's consent
– A contract of adhesion: the insured must accept the entire
contract with all of its terms and conditions
 Insurance regulation
• Reasons for Insurance Regulation
– Maintain insurer solvency
– Compensate for inadequate consumer knowledge
– Ensure reasonable rates
– Make insurance available
 Maintain Insurer Solvency
• Insurance regulation is necessary to maintain the solvency of
insurers.
• Solvency is important for several reasons.
– First, premiums are paid in advance, but the period of
protection extends into the future.
– A second reason for stressing solvency is that individuals
can be exposed to great economic insecurity if insurers fail
and claims are not paid.
– Finally, when insurers become insolvent, certain social and
economic costs are incurred.
 Methods of Ensuring Solvency
• The principal methods of ensuring insurer solvency are:
– Financial requirements.
• minimum capital and surplus requirements,
restrictions on investments, and valuation of loss
reserves.
– Risk-based capital standards
– Annual financial statements
– Field Examinations
Compensate for Inadequate Consumer Knowledge

• Regulation is also necessary because of inadequate consumer

knowledge.
• Insurance contracts are technical, legal documents that
contain complex clauses and provisions.
• Without regulation, an unscrupulous insurer could draft a
contract so restrictive and legalistic that it would be
worthless.
 Ensure Reasonable Rates
• Regulation is also necessary to ensure reasonable rates.
• Rates should not be so high that consumers are being
charged excessive prices.
• Nor should they be so low that the solvency of insurers is
threatened.
• In most insurance markets, competition among insurers
results in rates that are not excessive.
 Make Insurance Available
• Another regulatory goal is to make insurance available to all
persons who need it.
• Insurers are often unwilling to insure all applicants for a given
type of insurance because of
– underwriting losses
– inadequate rates
– adverse selection and
– host of additional factors.
 Methods for Regulating Insurers
• The three principal methods used to regulate
insurers are:
– Legislation, through both state and federal laws
– Court decisions, e.g., interpreting policy provisions
– State insurance departments
 Legislation
• All states have insurance laws that regulate the operations of
insurers.
• These laws regulate
– formation and licensing of insurance companies,
– licensing of agents and brokers,
– financial requirements for maintaining solvency,
– insurance rates,
– sales and claim practices,
– taxation, and
– rehabilitation or liquidation of insurers.
 Courts
• courts periodically hand down decisions concerning the
– constitutionality of state insurance laws
– the interpretation of policy clauses and provisions, and
– the legality of administrative actions by state insurance
departments.
• As such, the court decisions can affect the market conduct
and operations of insurers in an important way
 What are regulated?
• Insurers are subject to numerous laws and regulations.
• The principal areas regulated include the following:
– Formation and licensing of insurers
– Solvency regulation
– Rate regulation
– Policy forms
– Sales practices and consumer protection
– Taxation of insurers
 Formation and Licensing of Insurers
• The requirements for the formation and licensing of insurers
• Licensing includes minimum capital and surplus requirements
• A license can be issued to a domestic, foreign, or alien insurer
– A domestic insurer is domiciled in the state
– A foreign insurer is an out-of-state insurer that is chartered
by another state, but licensed to operate in the state
– An alien insurer is an insurer that is chartered by a foreign
country, but is licensed to operate in the state
 Solvency Regulation
• Insurers are subject to financial regulations designed to
maintain solvency
• Assets must be sufficient to offset liabilities
– Admitted assets are assets that an insurer can show on its
statutory balance sheet in determining its financial
condition
– Reserves are liability items on an insurer’s balance sheet
and reflect obligations that must be met in the future
– Policyholders’ surplus is the difference between an
insurer’s assets and its liabilities .
– Investment
 Rate Regulation
• Rate regulation takes a variety of forms across states
• Forms of rate regulation for property and casualty insurance
include
• Many states exempt insurers from filing rates for large
commercial accounts
• Life insurance rates are not directly regulated by the states
 Policy Forms
• State insurance commissioners have the authority to approve
or disapprove new policy forms before the contracts are sold
to the public
– Insurance contracts are technical and complex
– Purpose is to protect the public from misleading,
deceptive, and unfair provisions
 Sales Practices and Consumer Protection

• Sales practices are regulated by the laws concerning the

licensing of agents and brokers
– All states require agents and brokers to be licensed
– All states require agents to obtain continuing education to
upgrade their knowledge and skills