Risk Management & Insurance

Chapter Four
Legal Principle of Insurance Contract
The legal or fundamental principles are common to all types of insurance contracts with the
exception of indemnity, which is not applicable to personal insurance contracts. These principles
are discussed briefly as follows:
4.1 Principle of indemnity
The principle of indemnity states that the insured, in the event or loss, receives financial
compensation equal to the amount of the loss or the face value of the policy, whichever is lower.
The whole purpose is to restore the insured to his/her former financial position. Thus, the
principle eliminates the intention of gambling, which incorporates profit motive. It is the
controlling principle in insurance contract that limits compensation. This principle is not
applicable to personal insurances because the loss due to risk cannot be calculated and so a
previous agreement regarding the amount payable on the happening of risk is made between the
insurer and the insured.

Indemnity implies that:

- There must be an actual loss
- The loss should have occurred through the risk insured
- The loss must be capable of calculation in terms of money
- The payment made by another person (third party) should not exceed the actual loss
suffered.

Indemnity can take different forms: cash payment, replacement of property or reinstatement of
the property or repair.
4.2 Principle of insurable Interest
For an insurance contract to be valid, the insured must possess an insurable interest in the subject
matter of insurance. Insurable interest refers to the existence of financial relationship to the
subject matter insured. The subject matter of insurance may be a property, life or legal liability.

The insurable interest to be valid must be recognized as such under the law and must satisfy the
following conditions:

1|Page
 Risk Management & Insurance

i) There must be some subject matter of insurance such as physical object or potential
liability;
ii) There must be risk to which the subject matter is exposed
iii) The insured must have some legally recognized relationship with the subject matter
insured.
iv) The insured should stand to benefit by the safety of the subject matter and should
incur loss by its destruction or damage; and
v) The subject matter should be measurable in terms of money.

Generally in the case of life insurance insurable interest must exist at the inception of the policy.
In the case of property insurance, with few exceptions, insurable interest must exist both at the
time of effecting insurance and at the time of loss.

The doctrine of insurable interest in property insurance is to prevent insurance from becoming
gambling contract and in life insurance it is required in order to prevent acts of murder. Insurable
interest may take the following ways, i.e., ownership, lawful possession, contract or insurer.
4.3 Principle of subrogation
Subrogation is the right to an insurer who has paid a claim under a policy issued by him to
receive the benefit of all rights and remedies of the insured will extinguish or diminish the
ultimate loss sustained. It is the right of one person (the insurer) to stand in the place of another
(the insured) to avail himself on the latter's rights and remedies.

Principle of subrogation is a supplement to the principle of indemnity. The reason behind this
principle is to eliminate the profit motive of the insured. That means, the insured cannot claim
both from the insurer and the wrong doer for single accident, which would enable him/her collect
more than what was actually lost.

Subrogation implies that:

- The insurer makes payment to the insured for his actual loss
- The insurer after making good the loss, places himself in the position of the insured and
has all the rights and remedies of the insured
- The insurer cannot recover anything more than he has paid to the insured
Like principle of indemnity, principle of subrogation is not applicable to life insurances.

2|Page
 Risk Management & Insurance

4.4 Principle of utmost good-faith

Insurance contracts are based upon mutual trust and confidence between the insurer and the
insured. This principle requires each party to tell the other "the truth, the whole truth and nothing
but the truth". It means that both the insured and insurer must make full disclosure of material
facts and information relating to the contract or facts that have a bearing on the assessment of the
risk. Material facts are of the following types:
1. those which affect the nature or incidence of risk; and
2. those which affect the character of insured.

Non-disclosure, concealment, innocent misrepresentation, and fraud may lead to avoidance or

cancellation of the insurance contract by one of the parties to the contract.
4.5 Principle of contribution
Contribution is also corollary of /or supplement of the principle of indemnity. The doctrine of
this principle preaches for an "equitable distribution" of any loss among insurers. In other words
it applies that when there is more than one policy covering the same subject matter against the
same peril for the same period and for the same insured. In this case, the insured can make
claims under all policies with different insurers and recover pro rata from each. Contribution is
the right of an insurer who has paid a loss under a policy to recover a proportionate amount from
other insurers who are liable for the same loss.

The principle of contribution is enforceable only under the following conditions:

1) The policies must cover the same period
2) The policies must have been enforce at the time of loss
3) They must protect the same interest
4) The subject matter of insurance must be the same, and
5) The insured must be the same person.

Note: The principle of contribution is not applicable to life insurances.

4.6 Principle of proximate cause
The maxim 'causa proxima non remota spectature' means that proximate (nearest) causa and not
the remote one is to be taken notice of at the time of determining the liability of the insurer. The
insurer is not liable for remote cause even if it is one of the insured risk for the occurrence of

3|Page
 Risk Management & Insurance

which the insured is to be compensated the insurer is liable to make the payment of loss under
the policy, otherwise not. The insured may recover the loss from the insurer only when:
- The loss has been caused by the insured peril; and
- The cause has been proximate to the loss.

Therefore, the insurer is not liable for the loss due to a proximate cause, which is not an insured
peril.

Example
Ato Abebe insured his car worth of Br. 500,000 in two insurance companies: Ethiopian
Insurance Corporation and Awash Insurance Company for Br 300,000 and 200,000 Birr
respectively. While the policy is in force the car was damaged due to collusion done intentionally
by Kebede. The loss is estimated to be Br. 200,000.

Required:
a) How much each insurance company is going to pay to Ato Abebe? Why?
b) How much Ato Abebe is going to claim? Why?
c) Abebe has an intention to claim compensation from the two insurance companies and
Kebede at the same time. Advice him. What he/she should does?

Answers
a) The insured has the right to claim compensation from the insurer as far as the policy is in
force an amount equal to the loss or face value of the policy. (Indemnity principle). Due to
contribution principle, Abebe can 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:
b) Ato Abebe can collect a total of Br. 200,000 an amount of the loss; and 120,000 Br from EIC
and 80,000 BR from Awash.
c) Ato Abebe cannot collect claim from the insurance companies and the wrong doers because
of the principle of indemnity and subrogation.

4|Page