Topic 10.

Legal Principles in Insurance Contracts

BUS 200 Introduction to Risk Management and Insurance Jin Park

Overview

Distribution of Insurance Contracts Insurance as contracts

Characteristics of Insurance Contracts Fundamental Principles of Insurance Contracts

legally enforceable agreements

Principle of indemnity Principle of insurable interest Principle of utmost good faith Principle of subrogation

Distribution of Insurance Contracts

Direct Marketing

No outside agent is involved Mail marketing, internet based marketing

represents one insurer

Exclusive Agent

Independent Agent

represents more than one insurer

Distribution of Insurance Contracts

Agent versus Broker Binding Authority by Agent

Property/Liability Insurance

Binder Conditional premium receipt

Life/Health Insurance

Insurance as Contracts

Elements of contract

Agreement

Consideration

Offer and Acceptance Insured premium payment and fulfillment of policy conditions Insurer promise to do certain things as specified in the contract (insurance policy) Parties must have legal capacity to enter into a binding contract Contract must be for a legal purpose Contract may be oral or written Some insurance policy provisions and attachments must be approved by regulator before being marketed

Legally competent parties Legal Purpose Legal Form

Insurance as Contracts
Property - Casualty Offer

Life Offer

Submission of application with a down payment

Acceptance

Binder

Submission of application with a down payment Issuance of a life insurance policy Conditional premium receipt

Acceptance

Note: Giving a quotation to a prospective insured is deemed as mere solicitation or invitation to make an offer.

Characteristics of Insurance Contracts

1. Personal Contracts

Insurance protects insured, not the property or liability subject to loss. Assignment provision
In property insurance, if ownership of a property changes, insurance contracts (policies) cannot be transferred to another party (buyer) without the insurers written consent. In life insurance, the beneficiary or ownership of policy may be freely reassigned.

Characteristics of Insurance Contracts

2. Aleatory Contracts

A contract whose value to either or both of the parties depends on chance or future events, or where the monetary values of the parties' performance are unequal.

The insurer's obligation to pay a loss depends on uncertain events Premium paid by Insured

cf: commutative contract

< Claim paid by Insurer

The values exchanged are theoretically equal.

Characteristics of Insurance Contracts

3. Contracts of adhesion

Insurance contracts are drafted by an insurer and an insured must accept or reject all the terms and conditions. Insured gets the benefit of the doubt.

Contracts may be altered by the addition of riders or endorsements

Courts tend to construe an ambiguous term in an insurance policy in favor of an insured.

cf: Contracts of cohesion

Rider or endorsement a document that amends or changes the original policy. Contracts are drafted by both parties.

Characteristics of Insurance Contracts

4. Conditional contracts

An insurers obligation to pay a claim depends on whether the insured or the beneficiary has complied with all policy conditions. The insurer may not pay a claim if one or more of policy conditions are not complied.

Duties after loss Homeowners (p. 562) Duties after an accident or loss Automobile (p. 585) Duties after in the event of loss or damage CP

Characteristics of Insurance Contracts

5. Unilateral contracts

Only one party makes a legally enforceable promise. Insured are not legally forced to pay premium or renew the policy.

Fundamental Legal Principles of Insurance Contracts

1. Principle of indemnity 2. Principle of insurable interest 3. Principle of utmost good faith 4. Principle of subrogation

Principle of Indemnity

The insurer agrees to pay no more than the actual amount of the loss suffered by the insured. Why?

The purpose of the insurance contract is to restore the insured to the same economic position as before the loss. The insured should not profit from a loss. It reduces the moral hazard by eliminating the profit incentive.

Principle of Indemnity

To support the principal of indemnity an insurance contact uses Actual Cash Value (ACV) method

Replacement cost (RC) less depreciation

Fair market value

RC current cost of restoring the damaged property with new materials of like kind and quality. The price of a wiling buyer would pay a willing seller in a free market.

Broad evidence rule

The determination of ACV should include all relevant factors an expert would use to determine the value of the property.

Principle of Indemnity

To support the principal of indemnity insurance contact includes Other Insurance Provisions.

Escape clause

Primary-Excess

The policy (or insurance) would not apply if the insured was covered by another policy. It (or This insurance) is excess insurance over any other valid and collectible insurance.

Pro-rata provision

Contribution by equal shares

Proration by face amounts Proration by amounts otherwise payable

Principle of Indemnity

Primary-Excess

Accident while test driving a dealers car. Health insurance between a couple working for different employers.
Own insurance primary Spouse insurance excess Birthday rule for dependents coverage

Principle of Indemnity

Pro-ration by Face Amounts

It limits an insurers maximum obligation to the proportion of the loss that the insurers policy limit bears to the sum of all applicable policy limits. Assume that there are three polices covering the same loss and the loss amount is $150,000.
Insurer A Insurer B
$200,000 2/6 $50,000

Insurer C
$300,000 3/6 $75,000

Policy Limit Share Payment

$100,000 1/6 $25,000

Principle of Indemnity

Pro-ration by Amounts Otherwise Payable

The amount what would be payable under each policy in the absence of other insurance Assume that there are three polices covering the same loss and the loss amount is $150,000.
Insurer A Insurer B $200,000 $150,000 1.5/4 $56,250 Insurer C $300,000 $150,000 1.5/4 $56,250

Policy Limit Payable Share Payment

$100,000 $100,000 1/4 $37,500

Principle of Indemnity

Pro-ration by Amounts Otherwise Payable

What if the loss amount is $60,000?

Insurer A Insurer B $200,000 $60,000 Insurer C $300,000 $60,000

Policy Limit Payable

$100,000 $60,000

Share
Payment

1/3
$20,000

1/3
$20,000

1/3
$20,000

Principle of Indemnity

Contribution by Equal Shares

Each insurer contributes equal amount until it has paid its applicable limit of insurance or none of the loss remains, whichever comes first. Assume that there are three polices covering the same loss and the loss amount is $150,000
Insurer A Insurer B $200,000 $50,000 $50,000 Insurer C $300,000 $50,000 $50,000 $100,000 $50,000 $50,000

Policy Limit Equal Share Payment

Principle of Indemnity

Contribution by Equal Shares

What is the loss amount is $400,000?

Insurer A Policy Limit $100,000

Insurer B $200,000

Insurer C $300,000

Equal Share 1
Equal Share 2 Payment

$100,000
N/A $100,000

$100,000
$50,000 $150,000

$100,000
$50,000 $150,000

Principle of Indemnity

Exceptions to the Principle of Indemnity

Valued policy (or agreed value)

Pays face value of insurance if a total loss occurs Life insurance, disability insurance, fine arts, antiques

Valued policy law

Ex.) Value of a fine art is agreed at $250,000.

Replacement cost

A law that requires payment of the face amount of insurance to the insured if a total loss to real property occurs from a covered peril, regardless of the propertys ACV. No deduction for depreciation in determining the amount paid for a loss.

Principle of Insurable Interest

The insured must be in a position to financially suffer if a loss occurs. Why?

To prevent gambling

To reduce moral hazard

Insurance on a property and wait for a loss occur. Life insurance on a person and pray for his/her death for insurance proceeds.

In order not to indemnify more than an insureds financial interest

It supports the principle of indemnity.

Principle of Insurable Interest

Property-Casualty insurance

Life Insurance

At the time of a loss, an insured must have insurable interest. No insurable interest no financial loss no indemnity support Prin. of indemnity Insurable interest must exist at the time of a policy inception, but not at the time of a loss (death)

Principle of Utmost Good Faith

A higher degree of honesty is imposed on an insurance contract than is imposed on other contracts

Honesty is mainly imposed on the insurance applicants. It is supported by three legal doctrines
Representation Concealment Warranty

Principle of Utmost Good Faith

Representation

Statements made by an applicant Insurance is voidable at the insurers option.

Concealment

cf: Innocent misrepresentation

Intentional failure to disclose a material fact

Material False Reliance

Warranty

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.

In exchange for a reduced premium, a store owner warrants that a burglar alarm will be always on.

Principle of Subrogation

Substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third party wrongdoer for a loss paid by the insurer.

Why?

To prevent collecting twice To hold the negligent party responsible To hold down insurance rates

Principle of Subrogation

The insurer is entitled only to the amount it has paid under the policy.

What if the insurer collects more, from the negligent party, than the amount the insurer paid to its insured? The insured cannot impair the insurers subrogation rights.

Subrogation does not apply to life insurance and to individual health insurance contracts. The insurer cannot subrogate against its own insured.

Additional Reading Assignments

Two insurers seek to void Enron policies Coming Clean on Insurance Applications Rescission of Life Insurance Policy Upheld on Finding of Intent to Deceive in Application