Chapter 3

Legal principles in risk and

insurance
Fundamental legal principles in insurance
contracts

Insurance contracts are legal documents that

reflect both general rules of law and insurance law

Basic legal principles that underlie insurance

contracts:
• Principle of indemnity
• Principle of insurable interest
• Principle of subrogation
• Principle of utmost good faith

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Principle of Indemnity
 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 (Source:
Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.)

 Brett LJ in Castellain - v - Preston (1883) 11 QBD 380:

“The very foundation, in my opinion, of every rule which has been applied to insurance law is
this, namely, that the contract of insurance contained in a marine or fire policy is a contract of
indemnity, and of indemnity only, and that this contract means that the assured, in case of a loss
against which the policy has been made, shall be fully indemnified, but shall never be more than
fully indemnified. That is the fundamental principle of insurance, and if ever a proposition is
brought forward which is at variance with it, that is to say, which either will prevent the assured
from obtaining a full indemnity, or which will give to the assured more than a full indemnity, that
proposition must certainly be wrong.”
Principle of Indemnity
 This principle has two purposes:
 To prevent the insured from profiting from a loss
 To reduce moral hazard

 Most property and casualty insurance contracts are contracts of indemnity

 In property insurance, the basic method for indemnifying the insured is based on the
actual cash value of the damaged property at the time of loss

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Exceptions to the Principle of Indemnity
 Valued policy
 Valued policy pays the face amount of insurance if a total loss occurs
 Usually used to insure antiques, fine arts, family heirlooms
 Because of difficulty in 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

 Life insurance
 Not a contract of indemnity but is a valued policy that pays a stated amount to the
beneficiary upon the insured’s death
 The actual cash value concept is meaningless in determining the value of a human life
 The amount of life insurance depends on the insured’s plan for personal and business
purposes, such as the need to provide a specific amount of monthly income to his
dependents Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 Edition. Pearson.
th

Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 Edition. McGrawHill.
nd
Case Study

If the shop owner has $10 million of clothes, which are expected to be
sold at $13 million, then what is the maximum insurance coverage she
can get for the insurance policy?
How indemnity is provided

 Cash payment
 Repair
 Replacement
 Reinstatement

Source: https://www.ia.org.hk/en/supervision/reg_ins_intermediaries/files/P1_SN_eng_2017ver_2018update.pdf
Principle of insurable interest
 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 on your computer because you may lose
financially if the computer is damaged

 Insurance contracts must be supported by an insurable interest as

 To prevent gambling
 To reduce moral hazard

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Principle of insurable interest
 In Lucena -v - Craufurd (1806) 127 ER:
“A man is interested in a thing to whom advantage may arise of prejudice happen
from the circumstances which may attend it…and whom it important that its
condition as to safety or other quality should continue; interest does not
necessarily imply a right to the whole or a part of the thing, nor necessarily and
exclusively that which may be the subject of privation, but the having some
relation to, or concern in the subject of insurance, which relation or concern by
the happening of the perils insured against may be so affected as to produce a
damage, detriment, or prejudice to the person insuring; and where a man is so
circumstanced with respect to matters exposed to certain risks or dangers, he
may be said to be interested in the safety of the thing.”
Examples of insurable interest
 Property and casualty insurance
 Ownership of property
 Potential legal liability
 Secured creditors
 Contractual right

 Life insurance
 Policyowner’s own life
 Between spouses
 Between parents and children

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
 Case Study

Jess purchased a life insurance policy insuring her husband, Mike.

Jess and Mike divorced several years later.
Is the life insurance policy still valid after the divorce?
Principle of subrogation
 Subrogation means that the insurer is entitled to recover from a negligent third party any
loss payments made to the insured
 Example: a negligent motorist fails to stop at a red light and smashes into Megan’s car, causing
damage in the amount of $5000. There are two ways for Megan to claim indemnity:
 Megan could collect directly from the negligent motorist for the damage to her car; or
 If Megan has collision insurance on her car, her insurer will pay the physical damage loss to
the car. Her insurer then collect from the negligent motorist who caused the accident
(subrogation)
 Subrogation
 Prevents the insured from collecting twice for the same loss (supports the principle of
indemnity)
 Holds the negligent person responsible for the loss
 Helps to hold down insurance Sources:
ratesRejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th
Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Principle of utmost good faith
 An insurance contract is based on the principle of utmost good faith, that is, a higher
degree of honesty is imposed on both parties to an insurance contract than is imposed
on parties to other contracts

 Insurance contracts require that both the policyholder and the insurer disclose all
relevant information; that is, the two parties must negotiate with utmost good faith

 IIQE Paper I Study notes (Section 3.2.5)

 Misrepresentation
 Non-disclosure

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Principle of utmost good faith
 If an insurer asks whether you smoke, your answer is called a representation, and it
must be truthful. If incorrect, it is known as a misrepresentation.

 The legal remedy for misrepresentation or concealment of a material fact is that the
insurer can void the contract. Material means that the information is relevant to the
insurer’s decision to sell or price the policy.

 An innocent misrepresentation (an unintentional misrepresentation) of a material fact,

if relied on by the insurer, also makes the contract voidable.

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Your duty of disclosure
Source: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Common terms in insurance contracts
 Declarations are statements that provide information about the particular property or
activity to be insured
 Usually on the first page of the insurance policy
 For example, in property insurance, the declarations page typically contains
information concerning the identification of the insurer, name of the insured, location
of the property, period of protection, amount of insurance, amount of the premium,
size of the deductible
 Insuring agreement summarizes the major promises of the insurer
 Named-perils policy: only those perils specifically named in the policy are covered; if
the peril is not named, it is not covered
 Open-perils policy: all losses are covered except those losses specifically excluded; if
the loss is not excluded, then it is covered (Exclusions are another basic part of an
insurance policy)
Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Common Policy Provisions
 Deductible: a specified amount which is subtracted from the total loss payment before the
insurer makes a claim to the insured
 Annie buys a six-month automobile insurance policy that covers damage to her car from
events other than collisions and that her policy has a $250 deductible per occurrence.
 If the loss is less than $250, then Annie will pay the entire loss. If the loss is $1000, Annie
will pay $250 and the insurer will pay $750.
 Deductibles have several important purposes:
 Reduce the costs of processing small claims. For example, an insurer may need to incur
expenses of more than $250 in processing a $250 claim
 Reduce premiums
 Reduce moral hazard. For example, with the $250 deductible, Annie has a greater
incentive to park her car in safe places where the possibility of damage is lower.
 Deductible (墊底費) Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
Common Policy Provisions
 Coinsurance: the insured pays a specified proportion of the loss
 The insured shares some of the loss as a coinsurer
 Annie has an individual medical expense insurance policy with a 20 ％ coinsurance
clause. Annie had just incurred a medical bill of $10,000. Then Annie’s insurer will pay
$10,000 × 80% = $8,000 for this loss.
 Coinsurance also reduces moral hazard. Since the insured pays part of any loss with a
coinsurance provision, the insured has a greater incentive to reduce losses with the
coinsurance provision.

 Policy Limit: Limit the amount of coverage by placing an upper limit

 For example, an automobile liability insurance policy may state that the insurer will pay
up to $20,000 in physical damage to another person’s car
Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
 Question: Annie has an individual medical expense insurance policy with a $1,000 calendar-
year deductible, a 20 ％ coinsurance clause, and a $9,000 policy limit. Annie had just
incurred a medical bill of $10,000.
(a) How much Annie’s insurer will need to pay for the loss?
(b) Suppose that Annie incurred another medical bill of $5,000 in the same year. How much
Annie’s insurer will pay for the loss this time?

 Answer:
(a) First, Annie herself is responsible for the $1,000 deductible. Then the insurer pays 80 ％
of the remaining $9,000 of medical expenses, i.e. $9,000× 80% = $7,200.
(b) $1,000 calendar-year deductible means that in the same year, the maximum amount of
deductible is $1000. Therefore, there will be no deductible this time. 80 ％ of the $5,000 is
$5,000×80% = $4,000. However, the policy at most pays $9,000 during the calendar year.
Therefore, the insurer will pay $9,000 - $7,200 = $1,800 this time instead of $4,000.

Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.
 Exercise: Captain Mack’s, a seafood restaurant, offers medical cost coverage for its
employees. Its probability distribution for medical costs for the coming year is as follows:

Medical cost Probability

$0 0.9335
$2,000 0.05
$5,000 0.01
$10,000 0.005
$50,000 0.001
$500,000 0.0005

Calculate Captain Mack’s expected claim costs for each of the following policies:
(a) Full insurance
(b) $5,000 deductible and a $200,000 limit
(c) 20% coinsurance and a $200,000 limit
(d) $5,000 deductible, 20% coinsurance, and a $200,000 limit
Sources: Rejda, G. E., McNamara, M. (2017). Principles of Risk Management and Insurance, 13 th Edition. Pearson.
Harrington, S. E., Niehaus, G. R. (2004). Risk Management and Insurance, 2 nd Edition. McGrawHill.