Chapter 4

LEGAL PRINCIPLE OF
INSURANCE CONTRACT
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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

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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

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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.

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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.

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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.

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

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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 - Deprn

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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

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II-Fair market value

 The price a willing buyer would pay a willing
seller in a free market.
 The fair market value of a building may be
below it actual cash value based on replacement
cost less depreciation.
 This may be due to several reasons, including a
poor location, deteriorating neighborhood or
economic obsolescence of the building

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Cont,d
 If a loss occurs, the fair market value may
reflect more accurately the value of the loss. In
one case, a building valued at $170,000 based
on the actual cash value rule had a market
value of only $65,000 when a loss occurred.
The court ruled that the actual cash value of
the property should be based on the fair market
value of $65,000 rather than on $170,000.

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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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 Exceptions to the Principle of Indemnity

 There are several important exceptions to the
principle of indemnity. They include the
following:
 Valued policy
 Valued policy laws
 Replacement cost insurance
 Life insurance
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Valued Policy
 A valued policy is a policy that pays the face amount of
insurance if a total loss occurs. Valued policies typically
are used to insure antiques, fine arts, rare paintings,
and 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

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 For example, you may have a valuable

antique clock that was owned by your
grandmother.
 You may feel that the clock is worth $10,000
and have it insured for that amount. If the
clock is totally destroyed in a fire, you would
be paid $10,000 regardless of the actual cash
value of the clock at the time of loss.
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Valued Policy Laws

 Valued policy laws are another exception to the
principle of indemnity.
 A valued policy law is a law that exists in some states
that requires payment of the face amount of insurance
to the insured if a total loss to real property occurs
from a peril specified in the law .
 The specified perils to which a valued policy law
applies vary among the states.

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 Laws in some states cover only fire; other

states cover fire, lightning, windstorm, and
tornado; and some states include all insured
perils.
 In addition, the laws generally apply only to
real property, and the loss must be total.

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 For example, a building insured for $200,000

may have an actual cash value of $175,000. If
a total loss from a fire occurs, the face amount
of $200,000 would be paid. Because the
insured would be paid more than the actual
cash value, the principle of indemnity would be
violated.

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Replacement Cost Insurance

 Replacement cost insurance is a third exception
to the principle of indemnity. Replacement cost
insurance means there is no deduction for
physical depreciation in determining the amount
paid for a loss. For example, assume that the
roof on your home is 5 years old and has a
useful life of 20 years

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Cont,d
 The roof is damaged by a tornado, and the current
cost of replacement is $10,000. Under the actual cash
value rule, you would receive only $7500 ($10,000 -
$2500 = $7500).
 Under a replacement cost policy, you would receive
the full $10,000 (less any applicable deductible).
Because you receive the value of a brand-new roof
instead of one that is 5 years old, the principle of
indemnity is technically violated.

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Life Insurance
 Life insurance is another exception to the principle of
indemnity. A life insurance contract is not a contract of
indemnity but is a valued policy that pays a stated
amount to the beneficiary upon the insured’s death.
 The indemnity principle is difficult to apply to life
insurance because the actual cash value rule
(replacement cost less depreciation) is meaningless in
determining the value of a human life.

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Cont,d
 Moreover, to plan for personal and business
purposes, such as the need to provide a
specific amount of monthly income to the
deceased’s dependents, a certain amount of
life insurance must be purchased before death
occurs. For these reasons, a life insurance
policy is another exception to the principle of
indemnity.

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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.

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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.

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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.

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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.

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Cont,
 If a pecuniary 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.

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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.

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

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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.

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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.

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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.

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

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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.
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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.

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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.

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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

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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 non

disclosure;that is, the applicant for insurance

deliberately withholds material information from
the insurer

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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 .

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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.

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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.

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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.
 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.

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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.

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Con,d

 E.g. Assume that [Link] has insured his house,

which is worth 80,000 Birr against fire with three
insurers namely A, B & C for 60,000 Birr, 40,000
Birr, and 20,000 Birr respectively. [Link]’s
house was completely destroyed by a fire caused
by [Link]’s negligence. The amount of
indemnity that [Link] will be entitled to receive
would be 80,000 Birr, the value of the actual loss or
the amount of insurance covered.

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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.

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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.

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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

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Cont,
Personal: In property insurance, insurance is a
personal contract, which means the contract is
between the insured and the insurer.
Strictly speaking, a property insurance contract does
not insure property, but insures the owner of
property against loss.
The owner of the insured property is indemnified if
the property is damaged or destroyed.

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 Contract of adhesion: (Take it or Leave it)the

insured must accept the entire contract, with all of its
terms and conditions

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quiz(5%)
 A corporation purchased 1 million birr life insurance
policy on an officer who was 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?

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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

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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.

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THE END

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