Chapter 4

LEGAL PRINCIPLE OF
INSURANCE CONTRACT

03/03/24
2

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

 2003 BISYS Education Services

3

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

 2003 BISYS Education Services

4

Purpose:
1. To prevent the insured from profiting from a
loss
 For example, if Mr. X’s home is insured for Br.

200,000, and a partial loss of Br. 50,000 occurs,

the principle of indemnity would be violated if
Br.200,000 were paid to him. He would be
profiting from insurance.

 2003 BISYS Education Services

5

Cont,
2. To reduce moral hazard (the likelihood of
intentional loss will reduce)
 If dishonest insured's can profit from a loss,

they may deliberately cause a loss with the

intention of collecting the insurance.

 2003 BISYS Education Services

6

Actual cash Value

 Actual cash value underlies the principle of

indemnity.
 In property insurance, the standard method of
indemnifying the insured is based on the actual
cash value of the damaged property at the
time of loss.

 2003 BISYS Education Services

7

Cont,
 Courts have used three major methods to
determine actual cash value:
 Replacement cost less depreciation
 Fair market value
 Broad evidence rule

 2003 BISYS Education Services

8

I-Replacement cost less depreciation

 Replacement cost is the current cost of restoring
the damaged property with new materials of like
kind and quality.
 It takes into consideration both inflation and

depreciation of property values over time.

Actual cash value = Replacement cost - Depr

 2003 BISYS Education Services

9

Example
 Samʹs furniture was destroyed by a fire. The furniture c
ost 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

 2003 BISYS Education Services

10

II-Fair market value

 The price a willing buyer would pay for 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

 2003 BISYS Education Services

11

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.

 2003 BISYS Education Services

12

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.

 2003 BISYS Education Services

13

Purpose:
 To prevent Gambling
 If an insurable interest were not required, the contract would
be gambling contract and would be against the public
interest.
 To reduce Moral Hazard
 Insurable interest reduces moral hazard. If an insurable
interest is not required, a dishonest person could purchase a
property insurance contract on someone else’s property and
then deliberately cause a loss to receive the proceeds.

 2003 BISYS Education Services

14

Cont,
 To measure the amount of loss
 In property insurance, most contracts are contracts
of indemnity and one measure of recovery is the
insurable interest of the insured. If the loss payment
cannot exceed the amount of one’s insurable interest,
the principle of indemnity is supported .
 In life insurance, the insurable interest requirement must be met
only at the inception of the policy, not at the time of death.
 Life insurance is not a contract of indemnity but it is a valued
policy that pays a stated sum upon the insured’s death.
 2003 BISYS Education Services
15

Cont,
 The question of an insurable interest does not arise when you
purchase life insurance on your own life.
 When you apply for life insurance on own life you can name
anyone as beneficiary.
 The beneficiary(the one who receives the insurance proceeds
when death occurs) is not required to have insurable interest in
your life.
 If you wish to purchase a life insurance policy on the life of
another person, however, you must have an insurable interest in
that person’s life. Close ties of blood or marriage will satisfy the
insurable interest requirement in life insurance.

 2003 BISYS Education Services

16

Cont,
 If a pecuniary or Financial interest is involved, the
insurable interest requirement in life insurance can be met.
 Even when there is no relationship by blood or marriage,
one person may be financially harmed by the death of
another.
 In other relationships, particularly those of a business
nature, the death of the insured must give rise to the
definite and measurable financial loss if insurable interest
is to exist.

 2003 BISYS Education Services

17

Exercise
 If wazira takes out a life insurance policy on her
husbands life and later get divorce. Required:
 Does she collect policy amount upon death of her
former husband ? Explain your justification.

 2003 BISYS Education Services

18

Answer
 Yes she entitled policy amount upon death of
her for husband if kept insurance in force.
 Because insurable interest requirement must be
met only at the inception of the contract.

 2003 BISYS Education Services

19

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.

 2003 BISYS Education Services

20

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

 2003 BISYS Education Services

21

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.

 2003 BISYS Education Services

22

Cont,
4. Subrogation does not apply to life insurance and to most
individual health insurance contracts. Life insurance is
not a contract of indemnity, and subrogation has
relevance only for contracts of indemnity. The same
principles are true for health insurance.
5. The insurer cannot subrogate against its own insured. . If
the insurer could recover a loss payment for a covered
loss, the basic purpose of purchasing the insurance
would be defeated.

 2003 BISYS Education Services

23

Example
 Assume that a negligent motorist fails to stop at a red light and
smashes into Meaza’s car, causing damage in the amount of $5000.
 If she has collision insurance on her car, her insurer will pay the
physical damage loss to the car (less any deductible) and then
attempt to collect from the negligent motorist who caused the
accident.
 Alternatively, Meaza could attempt to collect directly from the
negligent motorist for the damage to her car. Subrogation does not
apply unless the insurer makes a loss payment.
 However, to the extent that a loss payment is made, the insured
gives to the insurer any legal rights to collect damages from the
negligent third party.
 2003 BISYS Education Services
24

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
 The risk that the company thinks it is assuming must be the same
risk that the insured transfers.

 2003 BISYS Education Services

25

Cont,
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.
 2003 BISYS Education Services
26

Cont,
 The legal significance of a representation is that the insurance
contract is voidable at the insurer’s option 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.
 False means that the statement is not true or is misleading.
 Reliance means that the insurer relies on the misrepresentation in
issuing the policy at a specified premium.

 2003 BISYS Education Services

27

Cont,
 An innocent (unintentional) misrepresentation of a material
fact, if relied on by the insurer also makes the contract voidable.
 An innocent misrepresentation of a material fact is no defence for
the insured if the insurer elects to avoid the contract.
 Applicants for insurance speak at their own risk and if they make
an innocent mistake about a fact they believe to be true, they are
held accountable for their carelessness.

 2003 BISYS Education Services

28

Example
 John applies for life insurance and state in the
application that he has not visited a doctor within
the last five years.
 However six month earlier, he had surgery for
lung cancer. In this case he has made a statement
that is false, material, and relied on by the insurer.
 Therefore the policy is voidable at the insurer
option

 2003 BISYS Education Services

29

concealment:
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

 2003 BISYS Education Services

30

Example
 Joseph De Bellis applied for a life insurance policy on his life.
Five month after the policy was issued, he murdered. The death
certificate named the deceased as Joseph de luca, his true name.
The insurer denied payment on the grounds that joseph had
concealed a material fact by not reveling his true identity and that
he had an extensive criminal record.
 In finding for the insurer, the court held that intentional
concealment of his true identity was material and breached the
obligation of good faith .

 2003 BISYS Education Services

31

Warranty:
 A warranty: is a statement that becomes
part of the insurance contract and is
guaranteed by the maker to be true in all
respects
 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.

 2003 BISYS Education Services

32

cont,
 Warranties may be either express or implied.
 Express warranties are those stated in the contract, whereas
implied warranties are not found in the contract but are assumed
by the parties to the contract.
 A warranty also may be either promissory or affirmative.
 A promissory warranty describes a condition, fact, or
circumstance to which the insured agrees to be held during the life
of the contract.
 An affirmative warranty is one that must exist only at the time
the contract is first put into effect.

 2003 BISYS Education Services

33

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.

 2003 BISYS Education Services

34

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.
 Contribution is the right of an insurer to call upon the
other insurers to share the costs of such a claim payment
 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.

 2003 BISYS Education Services

35

cont,
 Under such circumstance, the insured cannot collect
compensation from each insurer. If this happens,
insurance becomes profit-making mechanism. So, the
insured is paid only to the extent of the loss he has
suffered.
 But, each insurer will make contribution to settle the
claim.
 The contribution may be a proportional amount based on
the sum insured under the respective insurers.

 2003 BISYS Education Services

36

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.
 2003 BISYS Education Services
37

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.

 2003 BISYS Education Services

38

cont,
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.

 2003 BISYS Education Services

39

Distinct Legal Characteristics of

Insurance Contracts
Aleatory: Unequal Money Exchange 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: Conditioned on Paying the Premium)
policy owner must comply with all policy provisions to
collect for a covered loss

 2003 BISYS Education Services

40

Cont,
Personal: A property insurance contract does not
insure property, but insures the owner of property
against loss.
Contract of adhesion: (Take it or Leave it) the
insured must accept the entire contract, with all of
its terms and conditions

 2003 BISYS Education Services

41

quiz(5%)
 A corporation purchased 1 million birr life insurance
policy on an officer who has 20% stockholder in the
company.
 Shortly thereafter, the officer sold his stock and resigned.
Two years later he died. Some argue that insurable
interest was temporary and must continue until death
 Req. is cor. entitled to the policy even though it had no
insurable interest at the time of death?

 2003 BISYS Education Services

42

Answer
 Court decision
 Court rejected the argument that insurable
interest must continue until death.
 And reflect that termination of an insurable
interest before the policy mature, doesn’t affect
policy holder’s right of recovery coz the policy is
valid at its inception

 2003 BISYS Education Services

43

Exercise
 Alex has $200,000 home insured for only $150,000
under homeowner policy. Assume that the house is
totally destroyed by fire because of faulty wiring by an
electrician.
 Req. Can Alex collect from both the negligent
electrician and his own insurer? Explain your answer.
 Which principle is affected if Alex collected from both
parties ? Explain your justification.

 2003 BISYS Education Services

44

THE END

44
 2003 BISYS Education Services