Risk CH 4

CHAPTER 4: LEGAL PRINCIPLES OF INSURANCE CONTRACTS
1. Principle of Indemnity:
 The principle of indemnity states that the insured should not profit from a
covered loss but should be restored to approximately the same financial
position that existed prior to the loss.
 The principle of indemnity has two fundamental purposes:

1. The first purpose is to prevent the insured from profiting from insurance.
The insured should not profit if a loss occurs, but should be restored to
approximately the same financial position that existed before the loss. For
example, if Mr.X has insured his house for 100,000 birr and a loss amounted to
10,000 birr occurs, the principle of indemnity would be violated if 100,000
birr were paid to him; because he would be profiting out of insurance.
2. The second purpose is to reduce moral hazard. If dishonest insured can
profit from a loss, they may deliberately cause a loss with the intention of
collecting the insurance. Thus, if the loss payment does not exceed the actual
amount of the loss, the attraction to be dishonest is reduced.
2. Principle of Insurable Interest:
 The principle of insurable interest states that the

insured must lose financially if a loss occurs, or must
incur some other kind of harm if the loss takes place.
 For example, a person has an insurable interest in his

automobile, television or other property have been
damaged or stolen.
Purposes of principle Insurable Interest

 to prevent gambling
 to reduces moral hazard
 to measures the amount of the insured’s loss
When must an insurable interest exist?
 In property & liability insurance, the principle insurable interest
must exist at the time of loss.
 But In life insurance contracts, the insurable interest requirement

must be met only at the inception of the policy, not at the time of
death.
3. Principle of Subrogation:
 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. This means that the insurer is
entitled to recover from a negligent third party, any loss payments
made to the insured.
 For example, assume that a negligent motorist smashes into Mr.X’s

car, causing damages of 5,000 Birr. If Mr.X has the collision
insurance on his car, his insurance company will pay 5,000 Birr and
then attempt to collect from the negligent motorist who caused the
accident.
Cont…
Purposes of Subrogation
 Subrogation prevents the insured from collecting twice for the
same loss
 Subrogation is used to hold the guilty person responsible for the
loss
 Subrogation tends to hold down insurance rates
Importance of Subrogation:
 The insurer is entitled only to the amount it has paid under the
policy
 The insured cannot impair(prevent) the insurer’s subrogation rights
 Subrogation does not apply to life insurance and to most individual

health insurance contracts
 The insurer cannot subrogate against its own insured

4. Principle of Utmost Good faith
 Utmost good faith means that a higher degree of honesty is

imposed on both parties to an insurance contract.
 The principle of utmost good faith is supported by three important

legal principles;
(i) Representations
(ii) Concealment, and
(iii) Warranty
(i) Representations:
 Representations are statements made by the applicant for insurance.

 For example, if a person wants to apply for life insurance, he may be
asked questions concerning his age, weight, height, occupation,
state of health and other relevant questions. The answers given by
that person are called representations.
 The legal importance of a representation is that the insurance
contract is voidable at the insurer’s option if the representation is (a)
material, (b) false, and (c) relied on by the insurer.
 Material means that if the insurer knew the true facts, the policy
would not have been issued, or would have been issued on different
terms.
 False means that the statement given by the insured is not true or it
is misleading.
 Reliance means that the insurer relies on the misrepresentation in
issuing the policy at the specified premium.
(ii) Concealment
 Concealment is intentional failure of the applicant for insurance to

reveal a material fact to the insurer.
 The legal effect of a material concealment is also voidable at the
insurer’s option
(iii) Warranty
 A warranty is 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 under the contract.
5. Principle of Contribution
 Contribution is the right of the insurer who has paid under a

policy, to call upon other or otherwise liable for the same loss to
contribute to the payment.
 Contribution supports the principle of indemnity and applies

only to contracts of indemnity.
 Therefore, there is no contribution in personal accident and life

policies.
Basis of Contribution
(i) Contribution according to Independent Liability

(ii) Contribution according to the Sums Insured
I. Contribution according to Independent Liability
 This means that the amount payable by each insurer is assessed as

if the other insurances do not exist. If the aggregate of the amounts
so calculated exceeds the loss, each insurer’s contribution is scaled
down proportionately, so that an indemnity is provided.
II. Contribution according to the Sums Insured

 This is the normal method of contribution. Insurers will pay
proportionately to the coverage they have provided, in accordance
with the following formula;
Sum insured with the particular insurer X Loss = Contribution

Total sums insured with all insurers
Cont…
E.g. Assume that Mr.X has insured his house, which is worth 80,000 Birr against fire with three
insurers namely A, B & C for 60,000 Birr, 40,000 Birr, and 20,000 Birr respectively. Mr.X’s house
was completely destroyed by a fire caused by Mr.Y’s negligence. The amount of indemnity that
Mr.X will be entitled to receive would be 80,000 Birr. Requirement: how each insurers share the
amount of loss occurred?
Solution:
The amount that each insurer is entitled to contribute would be as follows;
Br.60, 000
A’s share of loss = ---------------- X Br.80, 000 = Br.40, 000
Br.120, 000
Br.40, 000
B’s share of loss = --------------- X Br.80, 000 = Br.26, 667
Br.120, 000

Br.20, 000
C’s share of loss = ---------------- X Br.80, 000 = Br.13, 333
Br.120, 000 ----------------
Total Indemnity = Br.80, 000
6. Principle of Proximate Cause:
 The rule is that immediate and not the remote cause is to be
regarded.
 See the proximate cause and not the distant cause. The real cause
must be seen while payment of the loss.
 If the real cause of loss is insured, the insurer is liable to
compensate the loss; otherwise the insurer may not be responsible
for loss.
 The efficient cause of a loss is called the proximate cause of the
loss.
 For the policy to cover, the loss must have an insured peril as the
proximate cause of the loss.
 The proximate cause is not necessarily the cause that was nearest
to the damage, but is rather the cause that was actually responsible
for loss; e.g. in marine insurance, sea water.
Determination of proximate cause:
(i) If there is a single cause of the loss, the cause will be the
proximate cause and further if the peril was insured, the
insurer will have to indemnify the loss.
(ii) If there are concurrent causes, the insured perils and

excepted perils have to be segregated.
(iii) If the causes occurred in the form of chain, they have to be

observed seriously.
The end

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CHAPTER 4: LEGAL PRINCIPLES OF INSURANCE CONTRACTS

 The principle of indemnity has two fundamental purposes:

 The principle of insurable interest states that the

 For example, a person has an insurable interest in his

Purposes of principle Insurable Interest

 But In life insurance contracts, the insurable interest requirement

 Subrogation means substitution of the insurer in place of the

 For example, assume that a negligent motorist smashes into Mr.X’s

 Subrogation does not apply to life insurance and to most individual

 The insurer cannot subrogate against its own insured

 Utmost good faith means that a higher degree of honesty is

 The principle of utmost good faith is supported by three important

 Representations are statements made by the applicant for insurance.

 Concealment is intentional failure of the applicant for insurance to

 Contribution is the right of the insurer who has paid under a

 Contribution supports the principle of indemnity and applies

 Therefore, there is no contribution in personal accident and life

(i) Contribution according to Independent Liability

 This means that the amount payable by each insurer is assessed as

II. Contribution according to the Sums Insured

Sum insured with the particular insurer X Loss = Contribution

(ii) If there are concurrent causes, the insured perils and

(iii) If the causes occurred in the form of chain, they have to be

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