CHAPTER THREE

INSURANCE

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 Chapter 4

LEGAL PRINCIPLES OF
INSURANCE

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 THE PRINCIPLE OF INDEMNITY
 Indemnity: restoring the insured to the same
(approximately the same) economic position as
before the loss.
 Supported by the principles of insurable

interest and subrogation and not applicable

for life insurance.
• Thus, insurance is only for giving protection
against losses and not for making profit.
Purposes of Principle of Indemnity
 To prevent the insured from profiting from
insurance:
 To maintain premium at lower level
 To reduce moral hazard- temptation of
dishonesty
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 Methods of indemnity
• There are three methods of indemnity.
These are;
• Cash Payment – This is the most
popular method of setting claims, the
payment in cash.
• Replacement - 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.
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 Methods of Determining Actual Cash
Value
1. Replacement cost less
depreciation method
•ACV= RC – Depreciation
It takes in to consideration both
inflation and depreciation.
E.g. A roof is damaged by an
insured peril, after depreciated
20%. If the replacement cost of
the damaged portion is Br.
2,000 at the time of a loss,
actual value = 2000 –
20%(2000) = 1600
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 2. Fair Market Value
• It is a price willing buyer would pay a
willing seller in a free market.
• 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.
 The FMV is less than the ACV due to

poor location, deteriorating

neighborhood, obsolescence.

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 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
RC less depreciation, FMV,
PV of expected income
from the property,
comparison sales of
several property, opinions
of appraisers and
numerous other factors.
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 Exceptions to the Principles 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
ACV 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.
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 Replacement Cost Insurance
• No deduction is taken for depreciation
in determining the amount paid for
loss. Property insurance is often written
on a replacement cost basis.
• With such coverage, the insurer would
pay Br. 2,000 for the roof loss
mentioned above and you would not
pay anything
Life Insurance

• Is an exception to the principle of indemnity.

Eg. RC - depn is meaningless to determine value of human
life.
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 THE PRINCIPLE OF INSURABLE
INTEREST
• 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.
• The insured person must suffer
some financial loss by the
 An insured must demonstrate the existence of
damage of the insured object.
financial relationship to the subject matter
insured; otherwise the insured will be unable
to collect amounts due when the insured peril
occurs.
It applies to both life and non-life insurance.32
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 Conditions for fulfillment of insurable
interest
1. In the case of a property,
• Legal title/ownership/ to a property
• Existence of potential liability. eg. Garage,
loundry…
• Secured creditors. eg. Legal creditor.
2. In the case of life insurance
• When purchasing life insurance in the name
of others (blood r/s, marriage, pecuniary r/s,
etc), insurable interest is required.
3. In the business environment
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A creditor has a financial interest in the life33 of
 Purposes of insurable interest
• To prevent gambling. eg.
Purchasing of insurance on
someone’s house and hoping for
damage.
• To reduce moral hazard: eg. a
dishonest person could purchase a
life insurance contract on someone
else’s life and then killed him/her to
receive the proceeds.
• To measure the loss: supports the
principle of indemnity

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 When Insurable Interest Must Exist?
• In property and liability insurances, the
interest must exist at the time of the loss.
• The insured must have a legal title or at the
time of buying, he shall have a legal title.
• 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 Life insurance, an insurable interest must
be presented only at the inception of the
contract.
• Such policies provide no cash surrender values.
Eg. If husband buys insurance in his wife name
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and then divorced, he can claim payment.
 THE PRINCIPLE 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.
• The insurer is entitled to recover from a
negligent third party any loss payments made
 to
Forthe [Link] your house is
example,
damaged because a neighbor
burned leaves and negligently
permitted the fire to get out of
control, Your insurance
company will pay for the
damage and is then
subrogated (that is, given)
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 THE PRINCIPLE OF SUBROGATION(cont..)

• The insurer can benefit out of subrogation

rights only to the extent of the amount it
has paid to the insured as compensation.
 Mr. Samuel insures his house for Br. 1
million. His house destroyed by 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, then the insurance company
will retain Br. 1 million plus other
expenses such as court fees. The
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 Purposes of subrogation
• Subrogation prevents
the insured from
collecting twice for
the same loss.
• Subrogation is used to
hold the guilty person
responsible for loss.
• Subrogation tends to
hold down insurance
rates.
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 Importance of subrogation

• The insurer is entitled only to the

amount it has paid under the policy.
• The insured cannot impair the insurer’s
subrogation right.
• The insurer can waive its subrogation
right.
• The insurer cannot subrogate against
its own insured.
• Subrogation is supplementary
(corollary)to principle of indemnity.
• Subrogation does not apply to life and
health insurance.
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THE PRINCIPLE OF UTMOST GOOD FAITH

• The insurance contract must

be signed by both parties 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 penalty for departing
from utmost good faith was
having no coverage when a
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loss occurred
 THE PRINCIPLE OF UTMOST GOOD FAITH(cont…)

• The insurer's liability gets void/legally

revoked if any facts, about the subject matter
of insurance are either omitted, hidden,
falsified or presented in a wrong manner by
the insured.
• It applies to all types of insurance contracts.
• The concept of utmost good faith is
implemented (supported) by the doctrines of
Representations
concealment and
warranty.
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 Representations
• Make statements concerning their
exposures.
• 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.
• 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 s/he misrepresented was
material.
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 Representations(cont…)
• 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.
• For auto insurance, insurers will ask how far
you travel to work, whether you had any
accidents or citations, and so on.
• An insurance contract is voidable by the
insurer if any representation is material, was
relied upon by the insurer, and was known to
be false by the insurance applicant.
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 Concealment
• Intentional failure of
applicant to reveal a
material fact to the insurer.
• Telling the truth in response
to explicit application
questions may not be
enough.
• 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.
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 Concealment(cont…)
• 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.
• Before an insurance company can deny
payment for concealment it must prove:
The insured knew that the fact was important
in regard to the insurance being applied for;
and
There was an intention to defraud the insurer.
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 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.
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 THE PRINCIPLE OF CONTRIBUTION
• The insured can claim the
compensation only to the
extent of actual loss either
from all insurers or from any
one insurer.
• It applies to all contracts of
indemnity, if the insured has
taken out more than one policy
on the same subject matter.
• If the insured claims full
compensation from one insurer
then he cannot claim
compensation from other
insurer.
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 THE PRINCIPLE OF CONTRIBUTION(cont…)

• If one insurance company pays the full

compensation then it can recover the
proportionate contribution from the other
insurance company.
• Example: - Mr. Biniyam insures his property worth
Br. 100,000 with two insurers NIB for Br. 90,000
and AIC 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.
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 Essentials of Contribution
• 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

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 Base of Contribution
1. Pro-Rata Liability
•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 for Br. 30,000, the
second is with AIC for Br. 40,000, and the third is with
NIC 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?
Solution:
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 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?
• So NIB and AIC would each pay
Br. 19,000, while NIC policy
would pay Br. 10,000.
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 3. Primary and excess insurance
• 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 for Br. 30,000 was primary and AIC was excess,
NIB would pay Br. 30,000 and AIC would pay Br.
18,000. If their roles were reversed, AIC pay Br.
40,000 and NIB would pay Br. 8,000. In both
instances, NIC would not pay anything because the
other two insurers would be able to cover the loss.
 If, NIC was the primary insurer, it would pay Br.

10,000; NIB would pay Br. 30,000 if it was the first

excess insurer, and AIC would pay the remaining Br.
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 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 is the efficient cause
which brings about a loss with no other
intervening cause which breaks the chain
of events. It is also known as legal cause.
• In case of life insurance, the principle of
proximate cause does not apply. Whatever
may be the reason of death the insurer is
liable to pay the amount of insurance.
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 Determination of proximate cause
• For 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 In separable cause
concurrent causeif may
any cause
be is expected peril,
the insurer
separable andwill have to pay up to the extent of
inseparable.
loss which occurred due to insured peril.
•When the perils are inseparable, the insurers are
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 Determination of proximate cause(cont…)
• If the cause occurred in the form of chain,
they have to be observed seriously.
 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.
 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.
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 THE FUNCTIONS OF INSURANCE

A) Rate making(insurance pricing)

B) Underwriting(selection of risk)
C) Production function(selling of
insurance policy)
D) Claim settlement/loss
settlement/managing claims
E) Investment

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 A) 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.
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 Objective of rate making
• Regulatory objectives
Adequate rate
Not excessive
Not unfairly
discriminatory
• Business objectives
Simplicity
Stability
Responsiveness
Encouragement of loss
control
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 B) 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.
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 Underwriting(cont…)
• 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
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 C) 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.

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 D) 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
– Agent
– Company adjusters
– Independent adjuster
– Public adjuster
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 Steps in claim settlement

• Notice of loss
• Investigation:
proof of loss
• Payment or
denial of the
claim
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 E) 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.
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 The
End!
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