Risk Management and Insurance Handout

UNIT FOUR: LEGAL PRINCIPLES OF INSURANCE

Learning objectives
At the end of this chapter you should be able to:
 Explain the fundamental legal principles that are reflected in insurance
 Explain how the legal concepts of representation, concealment and warranty support the
principle of utmost good faith
 Describe the various functions of insurance

4.1. THE PRINCIPLE OF INDEMNITY

Many insurance contracts are contracts of indemnity. Indemnity means the insurer agrees to pay
no more (and no less) than the actual loss suffered by the insured. 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.

4.1.1. Purposes of principle of indemnity

The indemnity principle has the following purposes

[1] To prevent the insured from profiting from insurance. For example, suppose your house is
insured for Br. 200,000 at the time it is totally destroyed by fire. If its value at that time is only Br.
180,000 that is the amount the insurance company will pay. You cannot collect Br. 200,000
because to do so would exceed the actual loss suffered. You would be better off after the loss than
you were before. The purpose of the insurance contract is—or should be—to restore the
insured to the same economic position as before the loss. An insurance contract that makes it
possible for the insured to profit by an event insured against violates the principle of indemnity and
may prove poor business to the insurer.

[2] To reduce moral hazard: If insured could gain by having an insured loss, some would
deliberately cause losses. It the loss payment does not exceed the actual amount of the loss; the
temptation to be dishonest is reduced.

1
Risk Management and Insurance Handout
The doctrine of indemnity is implemented and supported by the principles of insurable interest
and subrogation.

However, in case of life insurance, the principle of indemnity does not apply because the value of
human life cannot be measured in terms of money.

4.1. 2. Methods of indemnity

There are three methods of indemnity. These are, cash, replacement, and repairing.
 Cash Payment – This is the most popular method of setting clams, the payment in cash.
 Replacement – In case the insurance company prefers to replace the subject matter itself
rather than make cash payment of claims when the insured also so prefers.
 Repairing – Repairing of the subject matter to the satisfaction of the insured that constitutes
an indemnity.

4.1.3. Methods of Determining Actual Cash Value

This clause is included in many property insurance policies. An insured generally does not receive
an amount greater than the actual loss suffered because the policy limits payment to actual cash
value. A typical property insurance policy says, for example, that the company insures “to the
extent of actual cash value…but not exceeding the amount which it would cost to repair or
replace…and not in any event for more than the interest of the insured.”

Actual cash value is not defined in the policy, but a generally accepted notion of it is the
replacement cost at the time of the loss, less physical depreciation, including obsolescence.

Actual cash value = Replacement Cost - Depreciation

For example, if the roof on your house has an expected life of twenty years, roughly half of its
value is gone at the end of ten years. If it is damaged by an insured peril at that time, the insurer
will pay the cost of replacing the damaged portion, less depreciation. You must bear the burden of
the balance. If the replacement cost of the damaged portion is Br. 2,000 at the time of a loss, but the
depreciation is Br. 1000, the insurer will pay Br. 1,000 and you will bear a Br. 1000 expense.

Another definition of actual cash value is fair market value, which is the amount a willing buyer
would pay a willing seller. For auto insurance, where thousands of units of nearly identical property
exist, fair market value may be readily available. For other types of property, however, the
2
Risk Management and Insurance Handout
definition may be deceptively simple. How do you determine what a willing buyer would be
willing to pay a willing seller? The usual approach is to compare sales prices of similar property
and adjust for differences.

For example, if three houses similar to yours in your neighborhood have recently sold for Br.
190,000, then that is probably the fair market value of your home. You may, of course, believe your
house is worth far more because you think it has been better maintained than the other houses. Such
a process for determining fair market value may be time-consuming and unsatisfactory, so it is
seldom used for determining actual cash value. However, it may be used when obsolescence or
neighborhood deterioration causes fair market value to be much less than replacement cost minus
depreciation.

The actual value a damaged property can also be determined based on broad evidence rule; 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 sales of several
property, opinions of appraisers and numerous other factors.

4.1.4. Exceptions to the Principles of Indemnity

There are several exceptions to the principle of indemnity:

Valued policies: is the one that pays the face amount of insurance regardless of actual cash value 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 cash 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.

Replacement cost insurance: means no deduction is taken for depreciation in determining the
amount paid for loss. Property insurance is often written on a replacement cost basis, which
means that there is no deduction for depreciation of the property. With such coverage, the insurer
would pay Br. 2,000 for the roof loss mentioned above and you would not pay anything. This
coverage may or may not conflict with the principle of indemnity, depending on whether you are
better off after payment than you were before the loss. If Br. 2,000 provided your house with an
entirely new roof, you have gained. You now have a roof that will last twenty years, rather than ten
years. On the other hand, if the damaged portion that was repaired accounted for only 10 percent of
the roof area, having it repaired would not increase the expected life of the entire roof. You are not
3
Risk Management and Insurance Handout
really any better off after the loss and its repair than you were before the loss.

Life insurance: is an exception to the principle of indemnity.

4.2. THE PRINCIPLE OF INSURABLE INTEREST

The principle of insurable interest states that the person getting insured must have insurable
interest in the object of insurance. A person has an insurable interest when the physical existence
of the insured object gives him some gain but its non-existence will give him a loss. In simple
words, the insured person must suffer some financial loss by the damage of the insured object.

Under this principle an insured must demonstrate the existence of financial relationship to the
subject matter insured; otherwise the insured will be unable to collect amounts due when the
insured peril occurs. The principle applies to both life and non-life insurance. The subject matter
insured may include property of value, life of a person, or an event that may cause a legal liability.

For instance, in the case of a property, the owner has a financial interest in the safety of the
property for he will suffer a financial loss in the event of destruction of the property by accidental
misfortune. In the case of life insurance, a clear example is the insurable interest of a wife in the
life of a husband and the vice versa. In the business environment, a creditor has a financial
interest in the life of a debtor. Thus he has the right to purchase life insurance policy for the life of
the debtor to protect his financial interest. The doctrine of insurable interest is also necessary to
prevent insurance from becoming a gambling contract.

4.2.1. Purposes of insurable interest

The purposes of insurable interest are; [1] To prevent gambling. If insurable interest were 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. Suppose you are living in your
uncle's house, and you apply for homeowners' insurance because you believe that you may inherit
the house later. Insurers will decline your offer because you are not the owner of the house and,
therefore, you do not stand to suffer financially in the event of a loss. [2]To reduce moral hazard,
if an insurable interest were not required, a dishonest person could purchase a life insurance
contract on someone else’s life and then killed him/her to receive the proceeds. But, if the insured
stands to lose financially by causing the loss, nothing is gained. Thus, moral hazard is reduced.
[3]To measure the loss, most property insurance contracts are contracts of indemnity, and one

4
Risk Management and Insurance Handout
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.

4.2.2. When Insurable Interest Must Exist?

The time at which insurable interest must exist depends on the type of insurance. In property and
liability insurances, the interest must exist at the time of the loss. As the owner of a house, one
has an insurable interest in it. If the owner insures himself against loss to the house caused by fire
or other peril, that person can collect on such insurance only if he still has an insurable interest in
the house at the time the damage occurs. Thus, if one transfers unencumbered title to the house to
another person before the house is damaged, he cannot collect from the insurer, even though the
policy may still be in force. He no longer has an insurable interest. On the other hand, if the owner
has a mortgage on the house that was sold, he will continue to have an insurable interest in the
amount of the outstanding mortgage until the loan is paid.

In contrast, in Life insurance, requires an insurable interest must be presented only at the
inception of the contract. Such policies provide no cash surrender values; the insurer made
payment only if the person who was the subject of insurance died while the policy was in force. An
insured who was also the policy owner and unable to continue making premium payments simply
sacrificed all interest in the policy. Because the legal concept of requiring an insurable interest only
at the inception of the life insurance contract has continued, it is possible to collect on a policy in
which such interest has ceased. For example, if the life of a key person in a firm is insured, and the
firm has an insurable interest in that key person’s life because his or her death would cause a loss to
the firm, the policy may be continued in force by the firm even after the person leaves the firm. The
proceeds may be collected when he or she dies.

4.3. THE PRINCIPLE OF SUBROGATION

The principle of indemnity is also supported by the right of subrogation. Subrogation gives the
insurer whatever claim against third parties the insured may have as a result of the loss for which
the insurer paid. For example, if your house is damaged because a neighbor burned leaves and
negligently permitted the fire to get out of control, you have a right to collect damages from the
neighbor because a negligent wrongdoer is responsible to others for the damage or injury he or she
causes. If your house is insured against loss by fire, however, you cannot collect from both the
insurance company and the negligent party who caused the damage. Your insurance company
will pay for the damage and is then subrogated (that is, given) your right to collect damages.

5
Risk Management and Insurance Handout
The insurer may then sue the negligent party and collect from him or her. This prevents you from
making a profit by collecting twice for the same loss.

The insurer can benefit out of subrogation rights only to the extent of the amount it has paid to
the insured as compensation.

For example: - Mr. Samuel insures his house for Br. 1 million. The house is totally destroyed by
the negligence of his neighbor Mr. Assefa. The insurance company shall settle the claim of Mr.
Samuel for Br. 1 million. At the same time, it can file a law suit against Mr. Assefa for 1.2 million,
the market value of the house. If insurance company wins the case and collects Br. 1.2 million from
Mr. Assefa, then the insurance company will retain Br. 1 million (which it has already paid to Mr.
Samuel) plus other expenses such as court fees. The balance amount, if any will be given to Mr.
Samuel, the insured.

4.3.1. Purposes of subrogation

Subrogation has the following three purposes: [1] Subrogation prevents the insured from collecting
twice for the same loss. [2] Subrogation is used to hold the guilty person responsible for loss.[3]
Subrogation tends to hold down insurance rates.

4.3.2. Importance of subrogation

You should keep in mind several important corollaries of the principle of subrogation. [1] The
insurer is entitled only to the amount it has paid under the policy. [2] The insured cannot impair the
insurer’s subrogation right. [3] The insurer can waive its subrogation right in the contract. [4]
Subrogation does not apply to life and health insurance. [5]The insurer cannot subrogate against its
own insured.[6]Subrogation is supplementary (corollary)to principle of indemnity.

4.4. THE PRINCIPLE OF UTMOST GOOD FAITH

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. The penalty for departing from utmost good faith was having no coverage when a loss
occurred.

6
Risk Management and Insurance Handout
The concept of utmost good faith is implemented (supported) by the doctrines of (1) representations
and (2) concealment and (3) warranty.

Representations

When people are negotiating with insurers for coverage, they make statements concerning their
exposures, and these statements are called representations. They are made for the purpose of
inducing insurers to enter into contracts; that is, provide insurance. If people misrepresent material
facts—information that influences a party’s decision to accept the contract—insurers can void their
contracts and they will have no coverage, even though they do have insurance policies. In essence,
the contracts never existed.

Note that “material” has been specified. If an insurer wants to void a contract it has issued to a
person in reliance upon the information he/she provided, it must prove that what she
misrepresented was material. That is, the insurer must prove that the information was so
important that if the truth had been known, the underwriter would not have made the contract or
would have done so only on different terms.

If, for example, you stated in an application for life insurance that you were born on March 2 when
in fact you were born on March 12, such a misrepresentation would not be material. A correct
statement would not alter the underwriter’s decision made on the incorrect information. The policy
is not voidable under these circumstances. On the other hand, suppose you apply for life insurance
and state that you are in good health, even though you’ve just been diagnosed with a severe heart
ailment. This fact likely would cause the insurer to charge a higher premium or not to sell the
coverage at all. The significance of this fact is that the insurer may contend that the policy never
existed (it was void), so loss by any cause (whether related to the misrepresentation or not) is not
covered.

Concealment

Telling the truth in response to explicit application questions may seem to be enough, but it is not.
One must also reveal those material facts about the exposure that only he or she knows and
that he or she should realize are relevant. Suppose, for example, that you have no insurance on
your home because you “don’t believe in insurance.” Upon your arrival home one afternoon, you
discover that the neighbor’s house—only thirty feet from yours—is on fire. You promptly
telephone the agency where you buy your auto insurance and apply for a homeowner’s policy,
asking that it be put into effect immediately. You answer all the questions the agent asks but fail to
7
Risk Management and Insurance Handout
mention the fire next door. You have intentionally concealed a material fact you obviously realize
is relevant. You are guilty of concealment (intentionally withholding a material fact), and the
insurer has the right to void the contract.

If the insurance company requires the completion of a long, detailed application, an insured who
fails to provide information the insurer neglected to ask about cannot be proven guilty of
concealment unless it is obvious that certain information should have been volunteered. Clearly, no
insurance agent is going to ask you when you apply for insurance if the neighbor’s house is on fire.
The fact that the agent does not ask does not relieve you of the responsibility.

Warranty
Warranty refers to a statement of fact or promise made by the insured, which is part of the
insurance contract and which must be true if the insurer is to be liable. If the warranted conditions
are not in effect at the time of a loss, the insurer may not be liable.

4.5. THE PRINCIPLE OF CONTRIBUTION

Principle of Contribution is a corollary of the principle of indemnity. It applies to all contracts of

indemnity, if the insured has taken out more than one policy on the same subject matter. According
to this principle, the insured can claim the compensation only to the extent of actual loss either
from all insurers or from any one insurer. If one insurer pays full compensation then that insurer
can claim proportionate claim from the other insurers.

For example: - Mr. Biniyam insures his property worth Br. 100,000 with two insurers "Nib
Insurance Company" for Br. 90,000 and "Awash Insurance Company ." for Br. 60,000. Biniyam’s
actual property destroyed is worth Br. 60,000, then Mr. Biniyam can claim the full loss of Br.
60,000 either from Nib Insurance Company or Awash Insurance Company, or he can claim Br.
36,000 (90,000/150,000 X 60,000) from Nib Insurance Company and Br. 24,000 (60,000/150,000
X 60,000) from Awash Insurance Company.

So, if the insured claims full amount of compensation from one insurer then he cannot claim the
same compensation from other insurer and make a profit. Secondly, if one insurance company
pays the full compensation then it can recover the proportionate contribution from the other
insurance company.

4.5.1 Essentials of Contribution

8
Risk Management and Insurance Handout
Contribution only applies when the following conditions are fulfilled.

 There must be two or more polices

 Each must cover the same peril given rise to the same loss
 The subject matter must be the same
 The policy or policies must have been in force at the time of loss
 The insured must be the same person

4.5.2. Base of Contribution

1. Pro-Rata Liability(Contribution According To Sum Assured)
Under this method each insurer’s share of the loss is based on the proportion that its insurance
bears to the total amount of insurance on the property. The basic purpose of pro-rata liability
clause is to preserve the principle of indemnity and prevents profiting from insurance.
Example: Assume that Selamawit purchased three liability policies; the first is with Nib Insurance
Company for Br. 30,000, the second is with Awash Insurance Company for Br. 40,000, and the
third is with Nyala Insurance Company for Br. 10,000. Assume that Selamawit incurs a covered
liability claim of Br. 48,000. How much would each insurer pay under each of the other-insurance
provisions?

According to the pro rata liability,each insurer would pay the proportion of the loss that their
coverage bears to the total coverage in force. The total coverage available in this example is Br.
80,000. Thus, Nib Insurance Company would pay (Br. 30,000/ Br. 80,000) or three-eighths of the
loss. Awash Insurance Company would pay (Br. 40,000/Br. 80,000) or one-half of the loss, and
Nyala Insurance Company would pay one-eighth. The loss payments, respectively, are Br. 18,000,
Br. 24,000 and Br. 6,000.

2. Contribution by equal share

Each insurer shares equally in the loss until the share paid by each insurer equals the lowest
limit of liability under any policy, or until the full amount of the loss is paid.

Assume the preceding example, how much would each insurer pay based on contribution by equal
shares?

Under contribution by equal shares, each insurer contributes equally until the loss is paid or the
policy limit is reached. Thus, each policy would contribute Br. 10,000, the limit of liability under
the Nyala Insurance Company policy. Nib Insurance Company and Awash Insurance Company
9
Risk Management and Insurance Handout
would then contribute equally to pay the remaining Br. 18,000. So Nib Insurance Company and
Awash Insurance Company would each pay Br. 9,000, while Nyala Insurance Company policy
would pay Br. 10,000.

3. Primary and excess insurance

In this case, the primary insurer pays first, and the excess insurer pays only after the policy limits
under the primary are exhausted.
Assume the preceding example, how much would each insurer pay based on primary and excess?
If Nib Insurance Company for Br. 30,000 was primary and Awash Insurance Company was excess,
Nib Insurance Company would pay Br. 30,000 and Awash Insurance Company would pay Br.
18,000. If their roles were reversed, Awash Insurance Company would pay Br. 40,000 and Nib
Insurance Company would pay Br. 8,000. In both instances, Nyala Insurance Company would not
pay anything because the other two insurers would be able to cover the loss. If, on the other
hand, Nyala Insurance Company was the primary insurer, it would pay Br. 10,000; Nib Insurance
Company would pay Br. 30,000 if it was the first excess insurer, and Awash Insurance Company
would pay the remaining Br. 8,000.

4.6. THE PRINCIPLE OF PROXIMATE CAUSE

Proximate cause is the primary cause of an injury. It is not necessarily the closest cause in time or
space or the first event that sets in motion a sequence of events leading to an injury. Proximate
cause produces particular, foreseeable consequences without the intervention of any independent or
unforeseeable cause. It is also known as legal cause. Proximate cause is the efficient cause which
brings about a loss with no other intervening cause which breaks the chain of events.

In case of life insurance, the principle of proximate causedoes 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.

4.6.1. Determination of proximate cause

 If there is a single cause of the loss, the cause will be a proximate cause and further if the
peril was insured, the insurer will have to indemnify the loss.
 If there are concurrent causes, the insured peril and the expected peril should be segregated.
The concurrent cause may be separable and inseparable.
 In separable cause if any cause is expected peril, the insurer will have to pay up to the
extent of loss which occurred due to insured peril.
10
Risk Management and Insurance Handout
 When the perils are inseparable, the insurers are not liable at all.
 If the cause occurred in the form of chain, they have to be observed seriously.
I. If there is unbroken chain the expected and insured perils have to be separated.
 If the expected peril precedes the insured peril, there is no liability
 If the insured peril precedes the expected peril, there is valid liability.
II. If there is broken chain of events with no expected peril involved, it is possible to
separate the losses. The insurer is only liable only for that loss which caused by the
insured peril.

4.7. THE FUNCTIONS OF INSURANCE

The Function of Insurance

 Rate making(insurance pricing)

 Underwriting(selection of risk)
 Production function(selling of insurance policy)
 Claim settlement/loss settlement/managing claims
 Investment

1. Rate making
The process of predicting future losses and expenses and allocating these costs among various
classes of insured is called rate making. Like any other price it depends on the cost of production.
One basic difference between insurance pricing and pricing function in other industries is that the
price of insurance must be based on prediction.

Objective of rate making

i. Regulatory objectives
a. Adequate rate; this means rate charged by the insurers should be high enough to pay all
losses and expenses.
b. Not excessive; rate should not be so high that the policy owners are paying more than the
actual value of their protection.
c. Not unfairly discriminatory; exposure that is similar with respect to losses and expenses
should not be charged substantially different rates.

ii. Business objectives

The rating system should meet the following objectives:
11
Risk Management and Insurance Handout
 Simplicity: the rating system should be easy to understand.
 Stability: rates should be relatively stable over time so that the public is not
subjected to wide variations in cost from year.
 Responsiveness: the rate should be responsive to changing loss exposures and
changing economic conditions.
 Encouragement of loss control: the rating system should also encourage loss
control activities that reduce both frequency and severity.

2. Underwriting
Underwriting is a process of selecting and classifying applicants for insurance. The primary
objective of underwriting is to guard against adverse selection. The underwriting process starts with
a clear statement of underwriting policy that is consistent with company objectives. The policy
specifies the lines of insurance that will be written as well as prohibited exposures, the amount of
coverage to be permitted on various types of exposures, the areas of the country in which each line
will be written, and similar restriction.

There are four sources from which the underwriter obtains information regarding the hazards
inherent in an exposure.
 Application
 Agent’s or brokers report
 Investigations
 Physical examination or inspections

3. Production
One of the vital needs of insurance firm is securing a sufficient number of applicants for insurance
to enable the company to operate. This function is often called production in the context of the
insurance industry; it corresponds to the sales or marketing function in an industrial firm.

4. Claim settlement
Is a process of providing the indemnification of those members of the group who suffer losses. The
nature of the difficulties frequently encountered in the property and liability field is evidenced by
the fact that employees of the claim department in this field are called “adjusters”.
Types of claim adjusters

12
Risk Management and Insurance Handout
 Agent: often has an authority to settle small first- party claims up to some maximum limit.
The insured submits the claim directly to the agent, who has authority to pay up to some
specified amount. It has three advantages; it is speedy, it reduces adjustment expenses, and
it preserves the policy owner’s goodwill.
 Company adjusters: a salaried employee who represents only one company
 Independent adjuster: is a person who offers services to insurance companies and
compensated by a fee.
 Public adjuster: represents the insured rather than the insurance company and is paid a fee
based on the amount of the claim settlement.
Steps in claim settlement
 Notice of loss
 Investigation proof of loss
 Payment or denial of the claim

5. Investment
The advance payment of premiums gives rise to funds that must be invested in some manner. Every
insurance company has such funds, as well as funds representing paid in capital, accumulated
surplus, and various types of loss reserves.

13