CHAPTER 4

LEGAL
PRINCIPLE OF
INSURANCE
CONTRACT
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 Chapter Outlines
 Legal Principle of Insurance
1. Principle of Indemnity

2. Principle of Insurable Interest

3. Principle of Subrogation

4. Principle of Utmost Good Faith

5. Principle of Contribution

6. Doctrine of Proximate cause

 Requirements of an Insurance Contract

03:58Distinct
PM
Legal Characteristics of Insurance Contracts 2
 1. Principle of Indemnity
The insured should not profit from a covered loss but
should be restored to approximately the same
financial position that existed prior to the loss.
The insurer agrees to pay no more than the actual
amount of the loss
It is applicable to only non-life insurance

Purpose:
– To prevent the insured from profiting from a loss
– To reduce moral hazard (the likelihood of intentional
loss will reduce)
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In property insurance, indemnification is
based on the actual cash value of the property
at the time of loss.
There are three main methods to determine
actual cash value:
I-Replacement cost less depreciation
It takes in to consideration both inflation and
depreciation of property values over time.
Actual cash value = Replacement cost - Deprn
Q. Samʹs furniture was destroyed by a fire. The furniture cost Br
1,200 when it was purchased, but similar new furniture now costs Br
1,800. Assuming the furniture was 50 percent depreciated,
what is the actual cash value of Samʹs loss?
A) Br 600 B) Br 900 C) Br 1,200 D) Br 1,800 4
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II-Fair market value
• The price a willing buyer would pay a willing
seller in a free market.
• This may be due to several reasons, including a
poor location, deteriorating neighborhood or
economic obsolescence of the building
III-Broad evidence rule:
• The determination of ACV 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, PV of expected
income from the property, comparison sales of
similar property and other related factors as
well.
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 2. Principle of Insurable Interest
• States that the insured must be in a position to lose
financially if a covered loss occurs.
• For example, you have an insurable interest in your car
because you may lose financially if the car is damaged or
stolen.
• Purpose:
– To prevent Gambling
– To reduce Moral Hazard
– To measure the amount of loss
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 3. Principle of Subrogation
• Subrogation means 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.
The insurer is entitled to recover from a negligent third
party any loss payments made to the insured.
 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
– To reduce moral hazard

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 Generally, Subrogation has the following major characteristics:
1. By exercising its subrogation rights, the insurer is entitled only
to the amount it has paid under the policy.
2. The insured cannot impair the insurers’ subrogation right.
3. The insurer can waive its subrogation rights in the contract. To
meet the special needs of some insured, the insurance company
may waive its subrogation rights by a contractual provision for
losses that have not yet occurred.
4. Subrogation does not apply to life insurance and to most
individual health insurance contracts.
5. The insurer cannot subrogate against its own insured.

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 4. Principle of Utmost Good Faith
• The insurance contract must be signed by both
parties (i.e insurer and insured) in an absolute
good faith or belief or trust
• A higher degree of honesty is imposed on both
parties to an insurance contract than is imposed
on parties to other contracts

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It can be supported by the following four legal doctrines:
1. Representations:

They are statements made by the applicant for insurance

before the policy is issued.
– For example, if you apply for life insurance, you may be
asked questions concerning your age, weight, height,
occupation, family history, and other relevant questions.
Your answers are called representations.
• A contract is voidable if the representation is material,

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false, and relied on by the insurer. 10
2. 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
3. A warranty: is a statement that becomes
part of the insurance contract and is
guaranteed by the maker to be true in all
respects

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• A warranty creates a condition of contract and
any breach of warranty even if immaterial, will
void the contract. This is the central distinction
between a warranty and a representation.
• A misrepresentation does not void insurance
unless it is material to the risk, whereas under
common law any breach of warranty even if held
to be minor, voids the contract.

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4. Mistake

When an honest mistake is made in a written contract

of insurance, steps can be taken to correct it after the
policy is issued.

A mistake in the sense used here does not mean an

error in judgment by one party but refers to a
situation where it can be shown that the actual
agreement made was not the one stated in the contract.
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 5. Principle of Contribution
• It is the right of insurers who have paid a loss
under a policy to recover a proportionate
amount from other insurers, who are liable for
the same loss.
• It is applied in a situation where a person or firm,
for some reasons, purchase insurance from two or
more insurers to cover the same subject matter
against loss or damage.
• Under such circumstance, the insured cannot
collect compensation from each insurer.
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 6. Doctrine of Proximate Cause
• Means that, when a loss is caused by more than one
causes, the proximate (nearest) cause should be taken
into consideration to decide the liability of the insurer.
• However, in case of life insurance, the proximate cause
doctrine does not apply.
• Whatever may be the reason of death (whether a natural
death or an unnatural death) the insurer is liable to pay
the amount of insurance.
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 Requirements of an Insurance Contract
• To be legally enforceable, an insurance contract must meet four
requirements:
1. Offer and acceptance of the terms of the contract
 The applicant for insurance makes the offer, and the company
accepts or rejects the offer.
2. Consideration – the values that each party gives to the other
 The insured’s consideration is payment of the premium and
the insurer’s consideration is the promise to do certain things
as specified in the contract.
3. Legally competent parties, parties must have legal capacity to
enter into a binding contract
4. The contract must exist for a legal purpose:
o An insurance contract that encourages something illegal is
contrary to the public interest and cannot be enforced.

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Distinct Legal Characteristics of Insurance Contracts
Aleatory: contract where the values exchanged may not
be equal but depend on an uncertain event.
Unilateral: only one party (the insurer) makes a legally
enforceable promise
Conditional: policy owner must comply with all policy
provisions to collect for a covered loss
Personal: A property insurance contract does not insure
property, but insures the owner of property against loss.
Contract of adhesion: the insured must accept the entire
contract, with all of its terms and conditions

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Question 2:
A drunk driver ran a red light and smashed into
Solomon’s car. The cost to repair the car is Br
8,000. He has collision insurance on his car.
A. Can Solomon collect from both the negligent
driver’s insurer and his own insurer? Explain
your answer.
B. Do you think that Subrogation supports the
principle of indemnity??
Yes: Give Explanation
No: Give Explanation
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Ans:
a) No. If Solomon collects from his own insurer, he
gives his insurer the right to subrogate against the
negligent driver who caused the accident.
– His 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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 End of chapter 4

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