Insurance Legal principles chapter four

CHAPTER FOUR
LEGAL PRINCIPLES OF INSURANCE CONTRACTS
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 is one of the most important legal principles in
insurance. The principle of indemnity states that the insurer agrees to
pay no more than the actual amount of the loss; stated differently, the
insured should not profit from a loss. Most property and liability
insurance contracts are contracts of indemnity. If a covered loss occurs, the
insurer should not pay more than the actual amount of the loss. Nevertheless, a
contract of indemnity does not mean that all covered losses are always paid full.
Because of deductibles, birr limits on the amount paid, and other contractual
provisions, the amount paid may be less than the actual loss. Thus, the principle
eliminates the intention of gambling, which incorporates profit motive. The
principle of indemnity has two fundamental purposes.
The first purpose is to prevent the insured from profiting from a loss.
For example, if Kristin’s home is insured for $100,000, and a partial loss of
$20,000 occurs, the principles of indemnity would be violated if $100,000 were
paid to her. She would be profiting from insurance.
The second purpose is to reduce moral hazard. If dishonest insured 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.
Actual Cash Value (Actual Amount of the Loss):
The concept of actual cash value underlies the principles of indemnity. In
property insurance, the basic method of indemnifying the insured is based on the
actual cash value of the damaged property at the time loss. The courts have
used three major methods to determine actual cash value:
 Replacement cost less depreciation

Admas University Page 1

Insurance Legal principles chapter four

 Fair Marker Value

 Broad Evidence Rule
4.2 PRINCIPLE OF INSURABEL INTEREST
The principle, of insurable interest is another important legal principle. The
principle of insurable interest states that the insured must be in a
position to loss financially if a loss occurs. For example, you have an
insurable interest in your car because you may loss financially if the car damage
or stolen. You have an insurable interest in you personal property, such as a
television set or computer, because you may loss financially if the property is
damaged or destroyed.
Insurance contract must be supported by an insurable interest for the following
reasons.
 To prevent gambling
 To reduce moral hazard
 To measure the amount of the insured’s loss in property insurance.
Several situations that satisfy the insurable interest requirement are discussed in
this section. However, it is helpful at this point to distinguish between an
insurable interest in property and liability insurance and in the life insurance.
Property Insurance: Ownership of property can support an insurable
interest because owners of property will loss financially if their property is
damaged or destroyed. E.g. A husband has an insurable interest in his wife’s
property as he is legally entitled to share her enjoyment of it, and a wife similarly
has an insurable interest in her husband’s property as their relationship is
reciprocal.
Liability Insurance: Potential legal liability can also support an insurable
interest. For example, a dry-cleaning firm has an insurable interest in the
property of customers. The firm may be legally liable for damaged to the
customer’s goods caused by the firm negligence.
Life Insurance: An individual has an insurable interest in his own life, and
there is not limit to sum for which a man may insure his own life. In practice, the
sum insured is restricted by the insured’ ability to pay premium.

Admas University Page 2

Insurance Legal principles chapter four

The insurable interest to be valid must be recognized as such under the law and
must satisfy the following conditions:
 There must be some subject matter of insurance such as physical object or
potential liability;
 There must be risk to which the subject matter is exposed
 The insured must have some legally recognized relationship with the
subject matter insured.
 The insured should stand to benefit by the safety of the subject matter and
should incur loss by its destruction or damage; and
 The subject matter should be measurable in terms of money.

4.3 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. The insurer is therefore entitled to
recover from a negligent third party any loss payments made to the insured, for
Example, assume that a negligent motorist fails to stop at a red light and smashes
into X’s car, causing damage in the amount of $5,000. If X has collision
insurance on her car, her company will pay the physical damage loss to the car
and then attempt to collect from the negligent motorist who cause the accident.
Alternatively X could attempt to collect directly from the negligent motorist form
the damage to her car. Subrogation does not apply if a loss payment is not made.
However, to the extent that a loss payment is made, the insured gives to the
insurer legal rights to collect damages from the negligent third party.
Purposes of Subrogation: Subrogation has three basic purposes.
First, Subrogation prevents the insured from collecting twice for the same loss.
Second, Subrogation is used to hold the guilty person responsible for the loss.
Finally, Subrogation helps to hold down insurance rates.

Admas University Page 3

Insurance Legal principles chapter four

Importance of Subrogation:
1. The general rule is that 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 insurer’s subrogation rights.
3. The insurer can waive its subrogation rights in the contract.
4. Subrogation does not apply to life insurance and to most individual health
insurance contracts.
5. The insurer cannot subrogate against its own insured.
4.4 PRINCIPEL OF UTMOT GOOD FAITH
An insurance contract is based on the principle of utmost good faith –
that is, a higher degree of honest is imposed on both parties to an
insurance contract than is imposed on parties to other contracts. The
principle has its historical roots in ocean marine insurance.
The principle of utmost good faith is supported by three important legal
doctrines:
 Representations
 Concealments
 Warranty
Representations:Representations are statements made by the applicant for
insurance. For example if you apply life insurance you may be asked questions
concerning you age, weight, height, occupation, state of health, family history,
and other relevant questions. Your answers to these questions are called
representations. The legal significance of a representation is that the insurance
contract is violable at the insurer’s option if the representation is (1) material, (2)
false, and (3) relied on by the insurer.
Material- means that if the insurer knew the true facts, the policy would not have
been issued, or it 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.

Admas University Page 4

Insurance Legal principles chapter four

Concealment: The doctrine of concealment also supports the principle of

utmost good faith. Concealment is intentional failure of the applicant for
insurance to reveal a material fact to the insurer. Concealments the same thing
as nondisclosure; that is, the applicant for insurance deliberately withholds
material information from the insurer. The legal effect of a material concealment
is the same as a misrepresentation the contract is voidable at the insurer’s option.
Warranty: The doctrine of warranty also reflects the principle of utmost goof
faith. A warranty is a statement of fact or a promise made by the insured, which
is part of the insurance contract and must be true if the insurer is to be liable
under the contract. For example, in exchange for a reduce premium the owner of
a liquor store many warrant that an approved burglary and robbery alarm system
twill be operations at all times. The clause describing the warranty becomes part
of the contract.
4.5 PRINCIPLE OF CONTRIBUTION
Contribution is the right of an insurer who has paid under a policy, to
call upon other insurers equally or otherwise liable for the same loss
to contribute to the payment. Where there is over insurance because a loss is
covered by policies affected with two or more insurers, the principle of indemnity
still applies when this happen; insurance becomes a profit making mechanism.
In these circumstances, the insured will only be entitled to recover the full
amount of his loss and if one insurer has paid out in full, he will be entitled to
nothing more. So, the insured is paid only to the extent of the loss he has
suffered. , 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.
Like subrogation, contribution supports to principle so indemnity and applies
only to contracts of indemnity. There is, therefore, no contribution in personal
accident and life policies under which insurers contract to pay specific sums on
the happening of certain events. Such policies are not contracts of indemnity,
except to the extent that they may important e a benefit by way of indemnity,

Admas University Page 5

Insurance Legal principles chapter four

example, payment of medial expenses incurred, in which respect contribution

would apply.
It is important to understand the different between contribution and
subrogation. Subrogation is concerned with rights of recovery against third
parties or elsewhere in respect of payment of an indemnity, and need not
involved any other insurance, although it frequently does. In Contribution more
than one insurers involved and each covering the interest of the same insured.
The principle of contribution is enforceable only under the following conditions:
 The policies must cover the same period
 The policies must have been inforce at the time of loss
 They must protect the same peril
 The subject matter of insurance must be the same, and
 The insured must be the same person.
4.6. PRINCIPLE OF PROXIMATE CAUSE
Proximate cause literally means the ‘nearest cause’ or ‘direct cause’. This
principle is applicable when the loss is the result of two or more causes. The
principle 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. This
principle is applicable when there are series of causes of damage or loss.
However, in case of life insurance, the principle of Cause Proximate 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.
 ESSENTIAL REQUIREMNTS OF AN INSURANCE CONTRACT
A contact is an agreement embodying a set of promises that are enforceable at
law, or for breach of which the law provides a remedy. These promises must have
been made under certain conditions before they can be enforced by law. In
general, there are four such conditions, or requirements, that maybe stated as
follows:
1. The agreement must be for a legal purpose; it must be not against
public policy or be otherwise illegal. For example, a contract of insurance

Admas University Page 6

Insurance Legal principles chapter four

that covers a risk promoting a business or venture prohibited by a law is

void. Similarly a gambling contract will not be enforced by law.
2. The parties must have legal capacity to contract. This requirement
excludes persons who have been deemed incapable of contracting, such as
those who have been judicially declarledinsane; and persons who are
legally incompetent such as infants, drunken persons ect.
3. There must be evidence of agreement of the parties to the promises (offer
and acceptance).In general this is shown by an offer by one party and
acceptance of that offer by the other.
4. The promises must be supported by some consideration, which may
take the form of money or by some action by the parties that would not
have been required had it not been for agreement.
 EVENTS COVERD UNDER INSURANCE CONTRACTS
Most insurance contracts contain certain exclusions, such as for loss due to war,
loss to property of an extremely fragile character, and loss due to the deliberate
action of the named insured. Mot property insurance contracts require the
insured to notify the insurer of loss as soon as practicable, and usually require
that the insured prove the loss.
Named Peril Versus All Risk: The name peril agreement, as the name
suggests, lists the peril that are proposed to be covered. Perils, not named are, of
course, not covered. The other type, all risk, states that it is the insurer’s
intention to cover all risk of accidental loss to be described property except those
perils specifically excluded.
Excluded Losses: Most insurance contracts contain provisions excluding
certain types of losses even though the policy may cover the period that causes
these losses. For example, the fire policy covers direct loss by fire, but excludes
indirect loss by fire. Thus, the policy will not cover loss of fixed charges or a
profit resulting from the fact the fire has caused an interruption in business.
Separate insurance is necessary for this protection.
Excluded Property: A contract of insurance may be written to cover certain
perils and losses resulting from that period but it will be limited to certain types

Admas University Page 7

Insurance Legal principles chapter four

of property. For example the fire policy excludes fir losses to money, deeds bills,
bullion, and manuscripts. Unless it is written to cover the contents, the fire
policy on building includes only integral parts of the building and excludes all
contents.
Defining the Insured: All policies of insurance name at least one person who
is to receive the benefit of the coverage provided. The person is referred to as the
named insured. In life insurance he is often called the policyholder.
Third party Coverage: Many insurance contracts may provide coverage on
individuals who are not direct parties to the contract. Such persons are known as
third parties.
In life insurance the beneficiary is a third party and has right to received the
death proceeds of the policy. The beneficiary can be changed at anytime by the
insured, unless this right has been formally given up i.e., the insured has named
the beneficiary irrevocably. The beneficiary’s rights are thus contingent upon the
death of the insured.
Excluded Location: The policy may restrict its coverage to certain geographical
locations. Relatively few property insurance contracts give complete worldwide
protection. For example automobile insurance may be limited to cover the auto
while it is in Ethiopia. If the car is, say in Kenya coverage is suspended.
Insurance contracts may be discharged by the lapse of time, failure to pay
premiums, failure to renew the contract or cancellation of the contract.
 DISTINGUSING FEATURES OF INSURANCE CONTRACTS
Features discussed below tend to distinguish insurance from other contracts.
1. 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 assignment of the insured’s (Mr. Y’s) rights to the new owner
(Mr. X).

Admas University Page 8

Insurance Legal principles chapter four

2. Unilateral Contract
Insurance contracts are commonly unilateral contracts. After the insured has
paid the premium and the contract 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" means that courts will enforce the contract in
one direction only: against one of the parties: in this case, the insurer. A typical
contract other than insurance is bilateral. However, in some cases the insured
may promise to pay premium during the contract period. In this situation, the
contract becomes bilateral.
3. Conditional Contract
Insurance contracts are conditional contracts. 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 certain conditions contained 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.
4. Aleatory Contract
Insurance contract 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.
5. Contract of Adhesion
Insurance contract is usually contracts of adhesion. The insured seldom
participates in the drafting of the contract. Usually the insurer offers the Insured
a printed document on a take-it or- leave -it -basis.
-basis. Courts frequently refer
to this characteristic of insurance contracts when they interpret ambiguous
provisions in favor of the insured. And interpreted for the benefit of the insured.
6. Contracts of Uberrimae Fidei
The literal meaning of "Uberrimae Fidei" is utmost good faith that can be restated
as the highest standard honesty. Insurance contracts are contracts of the utmost
good faith. Both parties to the contract are bound to disclose all the facts relevant

Admas University Page 9

Insurance Legal principles chapter four

to the transaction. Neither party is to take advantage of the other's lack of

information.
7. Contract 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 insurance do not allow insured's to make profit from happening
of a particular risk. Life and frequently health insurance contracts are not
contracts of indemnity.

Admas University Page 10