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Risk CH 4 PDF
Risk CH 4 PDF
CHAPTER 4
4.1.PRINCIPLE OF INDEMNITY
The principle of indemnity is one of the most important principles in insurance which applies to
only non-life insurance, (not applicable to life & personal accident insurance).
Indemnity means security, protection & compensation given against damage, loss or injury.
According to the principle of indemnity, an insurance contract is signed only for getting protection
against unpredicted financial losses arising due to future uncertainties. Insurance contract is not
made for making profit else its sole purpose is to give compensation in case of any damage or loss.
In an insurance contract, the amount of compensations paid is in proportion to the incurred losses.
The amount of compensations is limited to the amount assured or the actual losses, whichever is
less. The compensation must not be less or more than the actual damage. Compensation is not paid
if the specified loss does not happen due to a particular reason during a specific time period. Thus,
insurance is only for giving protection against losses and not for making profit.
However, in case of life insurance, the principle of indemnity does not apply because the value of
The principle of indemnity states that the insurer agrees to pay no more than the actual amount of the loss;
Most property and casualty insurance contracts are contracts of indemnity. If a covered loss occurs,
the insurer should not pay more than the actual amount of the loss. A contract of indemnity does
not mean that all covered losses are always paid in full. Because of deductibles, Birr limits on the
amount paid, and other contractual provisions, the amount paid is often less than the actual loss.
The first purpose is 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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The second purpose is to reduce moral hazard. If dishonest policyholders could profit from a loss,
they might deliberately cause losses with the intention of collecting the insurance. If the loss
payment does not exceed the actual amount of the loss, the temptation to be dishonest is reduced.
Indemnity can take different forms: cash payment, replacement of the property or reinstatement of
the property.
The concept of 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. Courts use three major methods to determine actual cash value:
Under this rule, actual cash value is defined as replacement cost less depreciation. This rule has
been traditionally used to determine the actual cash value of property in property insurance. It
takes in to consideration both inflation and depreciation of property values over time. Replacement
cost is the current cost of restoring the damaged property with new materials of like kind and
quality. Depreciation is a deduction for physical wear and tear, age and economic obsolescence.
For example, Sara has a favorite house that burns in a fire. Assume she bought the house five years
ago, the house is 50 percent depreciated, and a similar house today would cost $1000. Under the
actual cash value rule, Sarah will collect $500 for the loss because the replacement cost is $1000,
and depreciation is $500, or 50 percent. If she were paid the full replacement value of $1000, the
principle of indemnity would be violated. She would be receiving the value of a new house instead
of one that was five years old. In short, the $500 payment represents indemnification for the loss of
a five-year-old house.
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B. Fair market value
Fair market value is the price a willing buyer would pay a willing seller in a free market. The fair
market value of a building may be below its actual cash value based on replacement cost less
depreciation. This may be due to several reasons, including a poor location, deteriorating
This means that the determination of actual cash value 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, present value of expected income from the property, comparison
The principle of insurable interest states that the insured must be in a position to lose financially if a
For example, you have an insurable interest in your car because you may lose financially if the car
is damaged or stolen. You have an insurable interest in your personal property, such as a
computer, books, and clothes, because you may lose financially if the property is damaged or
destroyed.
To be legally enforceable, all insurance contracts must be supported by an insurable interest for the
To prevent gambling
First, an insurable interest is necessary to prevent gambling. If an insurable interest were not
required, the contract would be gambling contract and would be against the public interest.
For example, you could insure the property of another and hope for a loss to occur. You could
similarly insure the life of another person and hope for an early death. These contracts clearly
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Second, an 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. But if the insured stands to lose financially,
nothing is gained by causing the loss. Thus, moral hazard is reduced. In life insurance, an insurable
interest requirement reduces the incentive to murder the insured for the purpose of collecting the
proceeds
Finally, an insurable interest measures the amount of the insured’s 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.
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. Stated differently, the insurer is entitled to recover from a
For 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
However, to the extent that a loss payment is made, the insured gives to the insurer any legal
Purposes of Subrogation
Subrogation has three basic purposes. First, subrogation prevents the insured from collecting twice for
the same loss. In the absence of subrogation, the insured could collect from his or her insurer and
from the person who caused the loss. The principle of indemnity would be violated because the
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Second, subrogation is used to hold the negligent person responsible for the loss. By exercising its
subrogation rights, the insurer can collect from the negligent person who caused the loss.
Finally, subrogation helps to hold down insurance rates. Subrogation recoveries are reflected in the rate
making process, which tends to hold rates below where they would be in the absence of
subrogation. Although insurers pay for covered losses, subrogation recoveries reduce the loss
payments.
Importance of subrogation
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. The insured cannot do anything
after a loss that prejudices the insurer’s right to proceed against a negligent third party.
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
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
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.
Principle of Utmost Good Faith is a very basic and first primary principle of insurance. According
to this principle, the insurance contract must be signed by both parties (i.e insurer and insured) in
an absolute good faith or belief or trust. The person getting insured must willingly disclose and
surrender to the insurer his complete true information regarding the subject matter of insurance.
The insurer's liability gets void (i.e legally revoked or cancelled) if any facts, about the subject
matter of insurance are either omitted, hidden, falsified or presented in a wrong manner by the
insured. The principle of Utmost Good Faith applies to all types of insurance contracts.
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An insurance contract is based on the principle of utmost good faith. This means that a higher
degree of honesty is imposed on both parties to an insurance contract than is imposed on parties to
other contracts. The practical effect of the principle of utmost good faith today lies in the
requirement that the applicant for the insurance must make full and fair disclosure of the risk to
the agent and the company. The risk that the company thinks it is assuming must be the same risk
that the insured transfers. The application of the principle of utmost good faith may best be
I) Representations
Representations 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, state of health, family history, and other relevant questions. Your answers to
whether or not the applicant had been treated for any physical illness by a doctor with in the
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. 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 defense 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
II) 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
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withholds material information from the insurer. Concealment has approximately the same legal
effect as a misrepresentation of material fact. It is the failure of an applicant to reveal a fact that is
To deny a claim based on concealment, a non-marine insurer must prove two things: (1) the
concealed fact was known by the insured to be material and (2) the insured intended to defraud
the insurer.
III) Warranty
Is a statement of fact or a promise made by the insured, which is part of the insurance contract and
which must be true if the insurer is to be liable under the contract. A warranty is a clause in an
insurance contract holding that before the insurer is liable, a certain fact, condition or circumstance
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.
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
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.
IV) 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. Generally, a policy can be reformed if there is proof of a mutual mistake
or a mistake on one side that is known to be a mistake by the other party, when no mention was
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made of it at the time the agreement was made. 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
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. This also supports the principle of indemnity.
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. 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.
An insured party may have policies with two or more insurers covering the same risk, although
not necessarily with equal degrees of liability. Therefore, in the event of a claim, all of the insurers
should pay an equitable proportion of the claim payment. Contribution is the right of an insurer to
call upon the other insurers to share the costs of such a claim payment. The fundamental point is
that, if an insurer has paid a claim in full, it can recoup a proportion of the costs from the other
The doctrine of Proximate (i.e Nearest) Cause, means when a loss is caused by more than
one causes, the proximate or the nearest or the closest cause should be taken into consideration to
decide the liability of the insurer. It states that to find out whether the insurer is liable for the loss
or not, the proximate (closest) and not the remote (farest) must be looked into. “The active and
efficient cause that sets in motion a train of events which brings about a result, without the intervention of
any force started and working actively from a new and independent source”
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An insurance policy will define the perils or insured events that cover is provided for. For
example, a building insurance policy will provide various covers as standard – such as fire,
lightning strikes and earthquakes – and cover for additional risks, such as escape of water, storm
All contracts are subject to terms and conditions that will exclude certain causes of loss.
Therefore, in the event of a claim, it is important to ascertain the cause of the loss in order to
determine if that cause is insured or excluded. There may be multiple elements involved in a claim,
so it is the ‘proximate cause’ that is taken into account. The proximate cause is the dominant cause
that sets in play a chain of events. For example, if lightning damaged a building and weakened a
wall, following which the weakened wall was blown down by high winds, lightning would be
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.
contract must meet four basic requirements: offer and acceptance, consideration, competent
The first requirement of a binding insurance contract is that there must be an offer and acceptance
of its terms. In most cases, the applicant for insurance makes the offer, and the company accepts or
rejects the offer. An agent merely solicits or invites the prospective insured to make an offer.
2. Consideration
The second requirement of a valid insurance contract is consideration—the value that each party
gives to the other. The insured’s consideration is payment of the premium (or a promise to pay the
premium) plus an agreement to abide by the conditions specified in the policy. The insurer’s
consideration is the promise to do certain things as specified in the contract. This promise can
include paying for a loss from an insured peril, providing certain services, such as loss prevention
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3. Competent Parties
The third requirement of a valid insurance contract is that each party must be legally competent.
This means the parties must have legal capacity to enter into a binding contract. Most adults are
legally competent to enter into insurance contracts, but there are some exceptions. Insane persons,
intoxicated persons, and corporations that act outside the scope of their authority cannot enter into
4. Legal Purpose
A final requirement is that the contract must be for a legal purpose. An insurance contract that
encourages or promotes something illegal or immoral is contrary to the public interest and cannot
be enforced. For example, a drug dealer who sells heroin and other illegal drugs cannot purchase a
property insurance policy that would cover seizure of the drugs by the police. This type of contract
obviously is not enforceable because it would promote illegal activities that are contrary to the
public interest.
Insurance contracts have distinct legal characteristics that make them different from other legal
contracts. Most property insurance contracts are contracts of indemnity; all insurance contracts
must be supported by an insurable interest; and insurance contracts are based on utmost good
A. Aleatory Contract
B. Unilateral Contract
C. Conditional Contract
D. Personal Contract
E. Contract of Adhesion
A) Aleatory Contract
An insurance contract is aleatory rather than commutative. An aleatory contract is a contract where
the values exchanged may not be equal but depend on an uncertain event. Depending on chance,
one party may receive a value out of proportion to the value that is given. For example, assume
that Jessica pays a premium of $600 for a $200,000 homeowner’s policy. If the home were totally
destroyed by fire shortly thereafter, she would collect an amount that greatly exceeds the premium
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paid. On the other hand, a homeowner may faithfully pay premiums for many years and never
have a loss.
In contrast, other commercial contracts are commutative. A commutative contract is one in which
the values exchanged by both parties are theoretically equal. For example, the purchaser of real
estate normally pays a price that is viewed to be equal to the value of the property.
Although the essence of an aleatory contract is chance, or the occurrence of some fortuitous event,
an insurance contract is not a gambling contract. Gambling creates a new speculative risk that did
not exist before the transaction. Insurance, however, is a technique for handling an already existing
pure risk. Thus, although both gambling and insurance are aleatory in nature, an insurance
B) Unilateral Contract
An insurance contract is a unilateral contract. A unilateral contract means that only one party
makes a legally enforceable promise. In this case, only the insurer makes a legally enforceable
After the first premium is paid, and the insurance is in force, the insured cannot be legally forced
to pay the premiums or to comply with the policy provisions. Although the insured must continue
to pay the premiums to receive payment for a loss, he or she cannot be legally forced to do so.
However, if the premiums are paid, the insurer must accept them and must continue to provide
In contrast, most commercial contracts are bilateral in nature. Each party makes a legally
enforceable promise to the other party. If one party fails to perform, the other party can insist on
C) Conditional Contract
An insurance contract is a conditional contract. That is, the insurer’s obligation to pay a claim
depends on whether the insured or the beneficiary has complied with all policy conditions.
Conditions are provisions inserted in the policy that qualify or place limitations on the insurer’s
promise to perform. The conditions section imposes certain duties on the insured if he or she
wishes to collect for a loss. Although the insured is not compelled to abide by the policy
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The insurer is not obligated to pay a claim if the policy conditions are not met. For example, under
a homeowner’s policy, the insured must give immediate notice of a loss. If the insured delays for
an unreasonable period in reporting the loss, the insurer can refuse to pay the claim on the
D) Personal Contract
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. Because the contract is personal, the applicant for insurance
must be acceptable to the insurer and must meet certain underwriting standards regarding
A property insurance contract normally cannot be assigned to another party without the insurer’s
consent. If property is sold to another person, the new owner may not be acceptable to the insurer.
Thus, the insurer’s consent is required before a property insurance policy can be validly assigned
to another party. In practice, new property owners get their own insurance, so consent of the
previous insurer is not required. In contrast, a life insurance policy can be freely assigned to
anyone without the insurer’s consent because the assignment does not usually alter the risk or
E) Contract of Adhesion
A contract of adhesion means the insured must accept the entire contract, with all of its terms and
conditions. The insurer drafts and prints the policy, and the insured generally must accept the
entire document and cannot insist that certain provisions be added or deleted or the contract
rewritten to suit the insured. Although the contract can be altered by the addition of endorsements
and riders or other forms, the contract is drafted by the insurer. To redress the imbalance that
exists in such a situation, the courts have ruled that any ambiguities or uncertainties in the contract
are construed against the insurer. If the policy is ambiguous, the insured gets the benefit of the
doubt.
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