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.

Admas University Page 1

Insurance Legal principles chapter four

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
 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

Admas University Page 2

Insurance Legal principles chapter four

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.
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
Admas University Page 3
Insurance Legal principles chapter four

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.

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

Admas University Page 4

Insurance Legal principles chapter four

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.
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.

Admas University Page 5

Insurance Legal principles chapter four

Warranty: The doctrine of warranty also reflects the principle of

utmost good 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,
example, payment of medial expenses incurred, in which respect
contribution would apply.

Admas University Page 6

Insurance Legal principles chapter four

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:

Admas University Page 7

Insurance Legal principles chapter four

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 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.

Admas University Page 8

Insurance Legal principles chapter four

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 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.

Admas University Page 9

Insurance Legal principles chapter four

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).

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

Admas University Page 10

Insurance Legal principles chapter four

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 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 11