CHAPTER

FOUR

LEGAL PRINCIPLES OF
INSURANCE CONTRACT
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 The most important fundamental principles
insurance contracts are:
 Principles of Indemnity
 Principles of Insurable Interest
 Principles of Subrogation
 Principles of Utmost Good Faith
 Principles of Contribution
 Doctrine of Proximate Cause

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 Principle of Indemnity
 The principle of Indemnity states that the insurer is liable to
pay up to the amount of loss and not more than the actual
amount of the loss, which means the insured should not
profit from a loss.
 If the insured could profit from a loss, then the insured may
intentionally cause the loss to make a profit, or be
complacent in preventing a loss.
 Thus, allowing the insured to collect more than their losses
would create a moral hazard, which would be against public
policy, and would drive up premiums to unaffordable prices.
This principle has two fundamental purposes.
1. To prevent the insured from profiting from a loss, and
2. To reduce moral hazard.

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Techniques used to determine loss amount

Actual Cash Value

 In property insurance, the amount of the indemnity is

typically based on the actual cash value of the loss at

the time of the loss.
 Over the years, the courts have used three methods of

determining actual cash value. These are:

A. Replacement cost less depreciation,
B. Fair market value, and
c. The broad evidence rule

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 Replacement Cost Less Depreciation
 Replacement cost is the current price of a new item of like
kind and quality.
 Depreciation is the decrease in the market value of an item
because of wear and tear, age and economic obsolescence.
 If a 3-year-old car is totally demolished, the insurance
company is only going to pay what the car was worth at the
time of loss. If it paid the full value of a new car, this would
create a moral hazard by motivating some drivers to
intentionally destroy the car in an attempt to profit from
insurance.
 In many cases, the insurance company will determine the
actual cash value by subtracting depreciation from the
replacement value of the car.
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Depreciation = Replacement Cost x Age of Insured Property
Useful Age of Property

Actual Cash Value = Replacement Cost - Depreciation

Example 1: If a 5-year-old car with a useful life of 20
years suffers a total loss due to fire and a replacement
cost is $120,000. What would be the indemnification for
this loss?
Depreciation = 120,000 x 5
20
 Depreciation = 30,000
 Actual Cash Value = Replacement Cost - Depreciation
 Actual cash value = 120,000 – 30,000= 90,000

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 Class work

Example 2: If a new car costs $500,000, and the

estimated useful life of the car is 16 years. The car was
accidentally totally demolished at the end of 4 year.
What would be the indemnification for this loss? And
Why?

To pay more would violate the principle of

indemnification.

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 2. Fair Market Value
 Fair market value is the price that a property would get
in an open market.
3. Broad Evidence Rule
 The broad evidence rule uses all relevant factors in

determining the cash value for the loss, which can

include, appraisals, income generated by the property,
and anything else that could potentially affect the value
of the property.
 The factors used are what an expert would use to

determine the value of a property.

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 Exceptions to the Principle of Indemnity
 Sometimes, the principle of indemnity is not easily
applied or cannot be applied because of the nature of the
insurable interest, because of state law, or because the
insured wants greater protection than afforded by
indemnification.
a. Valued Insurance Policy
 A valued policy pays the face amount of the policy when

a total loss occurs. Valued policies are used because of

the difficulty of 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
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 b. Replacement Cost Insurance
 Replacement cost insurance pays for the replacement
value of the loss, without any deduction for
depreciation.
 Replacement cost insurance means there is no

deduction for depreciation in determining the amount

paid for a loss.
c. Life Insurance
 Life insurance is not a contract of indemnity and it is

only a valued policy. In life insurance, the amount paid

when the insured dies is the face value of the policy.

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 2.Principle of Insurable Interest
 It states that the insured must be in a position to lose
financially if a loss occurs, or to incur some other kind of
harm if the loss takes place. Insurable interest means the
policy holder must have a pecuniary or monetary interest
in the property, which he has insured.
 An insurable interest involves a relationship between the
person applying for the insurance and the subject matter
of the insurance.

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 Purposes of an Insurable Interest
 To prevent gambling
 To reduce moral hazard
 To measure the amount of the insured’s loss in property
insurance

 What Constitutes Insurable Interest?

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 All insurance contracts must be supported by an insurable
interest. But, there is a difference between an insurable
interest in property and liability insurance and life insurance.
I. In Property and Liability Insurance
 A. Ownership of property can support an insurable interest

because he/she loses financially if his/her property is

damaged.
 B. Legal liability will also create an insurable interest.

Bailment commonly creates a legal liability for the bailee,

and, thus, creates an insurable interest in the property for the
bailee.
 For instance, an auto repair shop can have insurance on the

vehicles on its lot for possible damage or theft, even though

the shop does not own them.

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 C. Secured creditors have an insurable interest in the
property used as security for the property.
 D. A contractual right also can support an insurable

interest.
II. In Life Insurance
 There is no question of insurable interest if the life

insurance is purchased on their own life. Obviously, you

have an insurable interest in your own life, and you can
purchase any amount of life insurance up to the limits
imposed by the insurance company.

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 However, for anyone to purchase life insurance on
someone else's life, they must have an insurable interest
on that person's life, which is usually satisfied if they are
closely related, and, especially, if the beneficiary would
suffer financial loss from the insured's death.
 Therefore, close ties of blood or marriage or a pecuniary
interest will satisfy the insurable interest requirement in
life insurance. So, for instance, spouses can insure each
other.
 However, life insurance cannot be purchased on someone
who is more remotely related or unrelated, unless the
beneficiary would suffer a financial loss from the death.

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 Time that an insurable
interest must be exist

When should an insurable

interest exist?
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 In property insurance and Property, the insurable interest
must exist at the time of the loss. Because property and
liability insurance are contracts of indemnity, which only
covers losses, the insurable interest must exist at the time
of the loss
 In life Insurable interest requirement must be met only
at the inception of the policy and not at the time of
death.
 Because life insurance is a valued policy insurance that
pays a specified sum to the beneficiary at the time of the
insured's death, the beneficiary does not have to prove a
loss to collect the insurance.

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Principle of Subrogation
 The principle of subrogation strongly supports the
principle of indemnity.
 Subrogation means substitution of the insurer in place
of the insured for the purpose of claiming indemnity
from a third person for a loss covered by insurance.
 Example, in an accident the insured victim gives legal
rights to the insurer to collect damages from the
negligent third party instead of collecting himself
directly from the third party. Insurer must pay before it
claims subrogation.

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 The main purposes of subrogation are:

 To prevent the insured from collecting twice for the same

loss,
 To hold the negligent person responsible for the loss, and
 To hold down insurance rates.

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 Principle of Utmost Good Faith
 Utmost Good Faith mean higher degree of honesty is
imposed on both parties to an insurance contract.
 The practical effect of the principle of utmost good faith
today lies in the requirement that the applicant for insurance
must make full and fair disclosure of the risk to the agent and
the company.
 Any information about the risk that is known to one party
should be known to the other.
 If the insured intentionally fails to inform the insurer of any
facts that would influence the issue of the policy or the rate at
which it would be issued, the insurer may have grounds for
avoiding coverage.

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The principle of utmost good faith is supported by four important
legal doctrines
These are:
 Representations,
 Concealments,
 Warranties, and
 Mistake

A. Representations
 Representations are the statements made by the insured

on the insurance application. Many of these

representations are responses to questions to determine
whether the applicant is insurable and how much should
be charged.

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 For instance, for auto insurance, insurers will ask how
you travel to work, whether you had any accidents or
citations, and so on.
 Here both the parties are under an obligation not to
attempt to deceive or withhold material information
from the other. The insurance contract is voidable at the
insurer's option if the misrepresentation is:
1. Material,
2. Relied upon by the insurer, and
3. False

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 A material representation is one that was relied upon by
the insurer in issuing the policy. If the truth were known,
the insurer either would not have issued the policy, or
would have issued it with different terms, and probably
would have charged higher premiums.
 Any material misrepresentations after a loss can also void
an insurance contract.
 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.
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 For example, Kebede may apply for life insurance and
state in the application that he has not visited a doctor
within the last five years. However, he has undergone
surgery for lung cancer six months earlier.
 In this case, he has made a statement that is both false
and material and the policy is voidable at the insurer’s
option.
 If Kebede dies shortly after the policy is issued, the
company could contest the death claim on the basis of a
material misrepresentation.

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 Avoiding the contract does not follow unless the
misrepresentation is material to the risk.
 If the misrepresentation is inconsequential, its falsity
will not affect the contract.
 Innocent or unintentional misrepresentation. An
insurance company can also void a contract if there was
an innocent misrepresentation of a material fact.

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B. Concealment
 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 insurer.
 However, before an insurance company can deny

payment for concealment it must prove:

 The insured knew that the fact was important in regard to

the insurance being applied for; &

 There was an intention to defraud the insurer.

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 C. Warranty
 Warranty is promise made by the insured in the contract.
 A warranty is a promise by the insurance applicant to
do certain things or to satisfy certain requirements, or, it
is a statement of fact that is attested by the insurance
applicant. The warranty becomes part of the insurance
contract.
 • Any breach of warranty, even if immaterial, will void
the contract.
 If the insured breaches the warranty, the insurer can void
the contract and deny payment of a claim.

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 Cont…
 Warranties may be either express or implied. Express
warranties are those stated in the contract, while implied
warranties are not found in the contract but are assumed by
the parties to the contract.
 Warranties also may be either promissory or affirmative.
 A promissory warranty is a condition, fact or circumstance
to which the insured agrees to be held during the life of the
contract. for example that an insured will ensure that all
fire extinguishers on the ship are serviced annually is an
example of a promissory warranty.
 An affirmative warranty is the one that must exist only at
the time the contract is first put into effect.
 For example, if someone sells a car and promises that it
has no problems, that is an affirmative warranty.
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 5. Principle of Contribution
 Some losses may be covered by more than 1 insurance
policy. Insurance companies have developed various
solutions to prevent the insured from profiting from multiple
insurance policies.
 These provisions apply when more than one policy covers

the same loss.

 The purpose of these provisions is to prevent profiting from

insurance and to support the principle of indemnity policies.

The conditions to satisfy the requirement of contribution are:
 All the insurance must relate to the same subject matter,
 They should cover the same interest of the same insured,
 They should cover same peril, and
 All of them should be in force at the time of loss.
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 Types of Contribution
 Pro-rata liability clause
 Contribution of equal shares, and
 Primary and excess insurance

1. Pro-rata Liability Clause

If a loss occurs that is covered by more than 1 insurance
policy that was purchased by the insured, then each
policy pays a portion of the loss that is proportional to
the amount of that policy over the total amount of all
policies for the loss―each policy pays its pro rata share.

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 Example- Pro-rata Liability
 You want to insure a building for $1,000,000, but, for
underwriting reasons, the maximum amount that you
can purchase from 3 insurance companies is $600,000;
$300,000, and $100,000, so you purchase the 3 policies
with the maximum limits.
 If you suffer a $200,000 loss, then the 1stcompany will
pay 60% of the loss, the 2nd, 30%, and the 3rd, 10%.

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 Contribution by Equal Shares
 According to contribution by equal shares, each
company pays an equal amount until the loss is covered,
or the policy limit of any policy is reached.
 If 1 or more of the policy limits are reached, then the
equal share principle applies to the remaining insurers.
 As each policy limit is reached, the remaining insurers
make equal payments with the remaining amount of
uncovered loss until the loss is covered or all policies are
maxed out.

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 Example- Contribution by Equal Shares
 Consider the same facts as in the 1st example.
 If you have a $150,000 loss, then each company
pays$50,000 for a total of $150,000.
 If your loss was $400,000, then each company pays
$100,000, and the 2 with higher coverage pay an
additional $50,000 for a total of $400,000.
 If your loss was$800,000, then the low-limit company
pays its policy limit of $100,000, the next company
pays its policy limit of $300,000, and the remaining
insurance company pays the remaining $400,000 to
cover the loss.

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 3. Primary and Excess Insurance
 This method of determining insurance payouts is
commonly used where insurance by different people's
policies cover the same loss.
 Sometimes the amount that each company pays is
determined by which insurance company is considered
primary and which is excess.
 The primary insurer pays first, and the excess insurer
pays only after the policy limits under the primary policy
are exhausted.
 Many liability insurance policies are set upon an excess
basis.

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 For example, suppose that Kombolcha Textile Factory
has Birr 500, 000 in liability insurance from X, with a
Birr 1 million excess liability policy from insurer Y. If
Kombolcha Textile Factory incurs a Birr 750, 000
liability risk, insurer X will pay up to its limit of Birr
500,000.
 Then the excess insurance provided by insurer Y

becomes payable,
In this case, insurer Y will pay Birr Birr 250,000.

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 6. Doctrine of Proximate Cause
 The term proximate cause refers to the nearest cause
leading to the loss. It is the direct cause of a loss event. The
principle of proximate cause is the cause that is primary
to the occurred event.
 The legal doctrine of proximate cause is based on the
principle of cause and effect.
 And it does not concern itself with the cause of causes. The
law provides the rule "cause proximate non remote
spectator" which means to be proximate; a cause must be
immediate cause, which is effectual in producing that result
but not the remote or distant one.
 And this cause has to be selected by applying common
sense standards i.e., the standards of 05/20/2024
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 An insurance policy is designed to provide compensation
only for insured perils i.e., Named in the policy as
insured ex. Fire, theft etc. but not for uninsured (not
mentioned in the policy).
 And the liability of the insurer arises only if the loss is
caused by an insured.
 The selection of proximate cause is not an easy and
simple task because loss may be caused by several events
acting simultaneously or one after the other.
 It is necessary to differentiate between the insured peril,
the excepted peril and the uninsured peril.

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 Example (class work)

 Ato Abebe insured his car worth of Br. 500,000 in two

insurance companies: Ethiopian insurance and Awash
insurance company for birr 300,000 and Br. 200,000
respectively. While the policy is in force the car was
damaged due to collusion done intentionally by kebede.
The loss is estimated to be birr 200,000
 Required

A. How much each insurance is going to pay to ato

Abebe? Why?

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B. How much Ato Abebe is going to claim? Why?
c. Ato Abebe has an intention to claim compensation from
the two insurance companies and kebede at the same
time. Advice him. What he/she does?

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A. The insured has the right to claim compensation from
the insurer as far as the policy is in force an equal
amount to the loss or face value of the policy.
(indemnity principle).
Due to contribution principle, Abebe can claim the
amount of loss br 200,000 from the two companies.
They contribute to the loss based on the proportion
insured.
The proportion is calculated as
For EIC = 300,000/500,000 = 0.6 or 60%
For AwIC = 200,000/500,000 = 0.4 or 40%

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B. Ato Abebe can collect a total of Birr. 200,000 an
amount of the loss and 120,000 br. (0.6*200,000) from
EIC and 80,000 br. (0.4*200,000) from AIC
C. Ato Abebe cannot collect from the insurance companies
and the wrong doer Ato Kebede because of the principle
of indemnity and subrogation.

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 INSURANCE CONTRACTS
 Understanding of the legal interpretation of insurance
contracts can be important to a risk manager, for several
reasons.
 One reason in fundamental in deciding whether to use
insurance or some other risk management tools, the
insured or the risk manager should know what the
insurer promises to do under the contract.
 The risk manager also should understand the rights and
responsibilities of the insurer and the insured under the
contract.

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 INSURANCE CONTRACTS
 Insurance contracts are agreements between the
insurance companies and the insured for the purpose of
transferring from the insured to the insurer part of risk or
loss arising out of contingent events. The contract serves
the following functions:
 Define the risk to be transferred
 State the condition under which the contract parties
should know such as premium and performance of
certain acts.
 Explain the procedure for selling loss claims.

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 Distinguishing Features of insurance contracts

A. Personal contract
 Insurance contracts are personal contracts. Although the

subject of a property insurance contract is an item of

property, the contract insures the legal interest of a
person or an entity not the property itself.
 If the owner of a car (Mr. Y) sells the car to Mr. X, the

new owner Mr. X is not insured under the contract unless

the insurer agrees to an assignment of the insured’s (Mr.
Y) rights to the new owner (Mr. X)

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 B. Unilateral contract
 Insurance contracts are commonly unilateral contract.
 After the insured has paid the premium and the contracts
has gone into effect, only the insurer can be forced to
perform, because the insured has fulfilled his/her
promise to pay the premium.
 The term “unilateral” mean; in this case the insurer. A
typical contract other than insurance is bilateral.

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 C. Conditional contract
 Insurance contract are conditional contract. Although
only the insurer can be forced to perform after the
contract is effective, the insurer can refuse to perform if
the insured does not satisfy conditions in the contract.
For instance, the insurer need not pay a claim if the
insured has increased the chance of loss in some manner
prohibited under the contract or has failed to submit a
proof of loss within a specified period.

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 D. Aleatory contract
 Insurance contracts are Aleatory contracts, i.e the
obligation of at least one of the parties to perform is
dependent upon chance.
 If the event insured against occurs, the insurer will
probably pay the insured a sum of money much larger
than the premium.
 If the event does not occur, the insurer will pay nothing.

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 E. Contract of adhesion
 Insurance contract is usually contract of adhesion.
 The insured seldom participate in the drafting of
the contract.
 Usually the insurer offers the insured a printed
document on a take it or leave it basis.
 Courts frequently refer to this characteristic of
insurance contracts when they interpret
ambiguous provision in the favor of the insured
and interpreted for the benefit of the insured.

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F. Contracts of uberrimae Fidei
 The literal meaning of “uberrimae Fidei” is utmost good
faith that can be restated as the highest standards of
honesty.
 Insurance contract are contracts of utmost good faith.
 Both parties to the contract are bound to disclose all the
fact relevant to the transaction.
 Neither party is advantage of the others lack of
information.

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 G. Contracts of indemnity
 Property and liability insurance contracts are contracts of
indemnity.
 The person insured should not benefit financially from
the happening of the even insured against. Because
insured do not allow insured’s to make profit from
happening of a particular risk, life and frequently health
insurance contracts of indemnity.

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 Requirement for a valid contract

According to the law of contracts, a contract must

satisfy some conditions before it is legally enforceable
some of these are:
 The contract must serve a legal purpose
 One party must make a definite offer and a second party
must accept the offer.
 Each party to the contract must be required to make
some consideration on behalf of the other party.
 The contract is not enforceable unless one part gives up a
right power , or privilege that he/she already has in
exchange for an equivalent renouncement by the other.
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 The parties to the contract must be legally competent .
insane, minors or intoxicated persons are not considered
competent .
 The purpose of the contract should not be contrary to
public interest.
 Valid elements common to insurance contracts
 A valid insurance contract includes the following
documents and conditions. They are:
 application
 binders
 policy forms
 endorsement

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 Application: is an offer to enter into a contract. The
prospective insured sets forth the facts and figures
required by the insurance company. Application may
take oral or written form.
 Binders: are temporary documents, which remain in
force for few days for not more than 10 days.
 Policy forms: policy form is a formal written contract of
insurance. the common provisions included in this
document are:

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 Declarations: This identifies the insured, describes the
property, activity or life being insured, states the types of
coverage purchased, terms of coverage, and indicates the
premium paid.
The purpose of declaration is to give sufficient information
needed for the insured.
 Insuring agreement: this part states what the insurer

promise to do.
 Exclusions: the contract may exclude certain perils,

property sources of liability, persons, losses, location or

time periods.
 Conditions: this prescribes certain conditions that should

be meeting by the insured.

 Endorsement: is a form that is used to modify the policy

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