Risk Chap 4 P.P

CHAPTER FOUR
LEGAL PRINCIPLES OF INSURANCE CONTRACTS
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.
• The principle of indemnity has two fundamental
purposes.
A, The first purpose is to prevent the insured
from profiting from a loss. For example, if
Kibru 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.
B, 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
• Fair Marker Value
• Broad Evidence Rule
Exceptions to the Principle of Indemnity:
• There are several important exceptions to the
principle of indemnity. They include the
following;
• Value Policy
• Valued Policy Laws
• Replacement Cost Insurance
• Life Insurance
Value Policy:
• A valued Policy is a policy that pays the face
amount of insurance if a total loss occurs.
• Valued policies typically are used to insure
aged, fine arts, rare paintings, and family
heirlooms.
• Because of the difficulty of determining the
actual value 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.
Valued Policy Laws:
Valued policy laws are another exception to
principle of indemnity.
A valued policy law is a law that exists in
some states that required payment of the
face amount of insurance to the insured if a
total loss to real property occurs from a
peril specified in the law.
The specified perils to which a valued policy
law applies vary amount the states.
Replacement Cost Insurance:
• Replacement cost insurance is the
third exception to the principle of
indemnity.
• Replacement cost insurance means
there is not deduction for
depreciation in determining the
amount paid for a loss.
• For example, assume that the roof on your home
is 5 years old and has a useful life of 20 years.
• The roof is damaged by a tornado, and the current
cost of replacement is $10,000.
• Under the actual cash value rule, you would
received only $7,500 ($10,000-$2,500 = $7,500).
• Under a replacement cost policy, you would
receive the full $10,000.
• Because you receive the value of a brand new
rood instead of one that is 5 years old the
principle of indemnity is technically violated.
• Insurance:
• Life insurance is another exception to the
principle of indemnity.
• A life insurance contract is not a contract of
indemnity but is a valued policy that pays a
stated some to the beneficiary upon the
insured’s death.
• The indemnity principle is difficult to apply to
life insurance for the obvious reason that the
actual cash value rule (replacement less
depreciation) is meaningless in determining
the value of human life.
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.
• 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.
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.
• 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:
• The general rule is that by exercising its
subrogation rights, the insurer is entitled only to the
amount it has paid under the policy.
• The insured cannot impair the insurer’s subrogation
rights.
• The insurer can waive its subrogation rights in the
contract.
• Subrogation does not apply to life insurance and to
most individual health insurance contracts.
• The insurer cannot subrogate against its own
insured's.
4. PRINCIPEL OF ATMOST GOOD FAITH
• An insurance contract is based on the principle
of atmost 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. An ocean marine
underwriter had to place great faith in
statements made by the applicant for insurance
concerning the cargo to be shipped.
• Thus, the principle of utmost good faith
imposed a high degree of honesty on the
applicant for insurance.
• The principle of utmost good faith is
supported by three important legal doctrines:
• Representations
• Concealment
• Warranty
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.
• 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.
• 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.
• Contribution necessarily involves more than
one insurance, each covering the interest of the
same insured.
ESSENTIAL REQUIREMENTS 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 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 declarled insane; 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.
• 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.
End of chapter

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CHAPTER FOUR

LEGAL PRINCIPLES OF INSURANCE CONTRACTS

• The principle, of insurable interest is another

• Second, Subrogation is used to hold the guilty

• Finally, Subrogation helps to hold down

• Contribution is the right of an insurer who has

• A contact is an agreement embodying a set of

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