CHAPTER FOUR

LEGAL PRINCIPLES OF INSURANCE

CONTRACTS

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•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:
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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.

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Cont’d

• Most property and liability insurance contracts

are contracts of indemnity. Life and most health
insurance policies are not contracts of indemnity.
No money payment can indemnify for loss of life
or for bodily injury to the insured and that is why
life insurance is an exceptional. If a covered loss
occurs, the insurer should not pay more than the
actual amount of the loss.

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Cont’d

• 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.

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Cont’d

•The first purpose is to prevent the

insured from profiting from a loss. For
example, if someone'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. That person
would be profiting from insurance.

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Cont’d

•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.

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Cont’d

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 of loss. The courts have
used three major methods to determine
actual cash value:

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Cont’d

 Replacement cost less depreciation - the cost to repair or

replace the damaged property minus depreciation (the

decrease in the value of property over a period of time as a

result of age wear or tear from use or economic obsolesce)

 Fair Market Value – the fair market value of the property

 Broad Evidence Rule – this rule provides the examination of

every standard of value having a bearing on the property

under consideration such as the age of the property the profit

likely to accrue on the property and the property's tax value

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4.2 PRINCIPLE OF INSURABEL INTEREST

•It 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 damaged or stolen.

You have an insurable interest in your personal

property, such as a television set or computer,

because you may loss financially if the property is

damaged or destroyed.

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Cont’d

•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.

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Cont’d

•Property Insurance: Ownership of property can

support an insurable interest because owners of property

will lose financially if 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.

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Cont’d

• 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

damage to the customer’s goods caused by

the firm negligence.

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Cont’d

•Life Insurance: An individual has an insurable interest in his own life, and there

is no limit to sum for which a man may insure his own life. In practice, the sum

insured is restricted by the insured’s 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.

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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,

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Cont’d

•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 birr. 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 from 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.

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Cont’d

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.

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Cont’d

•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.

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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 honesty

is imposed on both parties to an insurance contract

than is imposed on parties to other contracts.

• The principle of utmost good faith is supported by three

important legal doctrines:

 Representations

 Concealments

 Warranty

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4.4 PRINCIPEL OF UTMOT GOOD FAITH

•Representations:are statements made by the applicant for

insurance. For example if you apply life insurance you may be

asked questions concerning your 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.

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Cont’d

•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.

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Cont’d

•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.

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Cont’d

•Warranty: 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 may warrant that an approved burglary and

robbery alarm system will be operations at all times. The

clause describing the warranty becomes part of the contract.

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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.

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Cont’d

•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.

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Cont’d

•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

medical expenses incurred, in which respect contribution would apply.

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Cont’d

•It is important to understand the difference 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.

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Cont’d

•The principle of contribution is enforceable only under the following

conditions:
 The policies must cover the same period

 The policies must have been enforce 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.

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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 (far) must be looked into.

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Cont’d

•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.

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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:

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.

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Cont’d

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 declared insane; and persons who are legally
incompetent such as infants, drunken persons etc..
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.

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Cont’d

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.

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 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 (breakable) character, and

loss due to the deliberate action of the named insured. Most 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.

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Cont’d

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.

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Cont’d

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.

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Cont’d

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 fire losses to money, deeds (performance) bills,

bullion (precious materials, and manuscripts (documents). Unless it is written to cover

the contents, the fire policy on building includes only integral parts of the building and

excludes all contents.

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Cont’d

•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 (forever). The beneficiary’s rights are thus contingent upon the death of the insured.

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Cont’d

•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.

• Insurance contracts may be discharged by the lapse (delay) of time, failure to pay premiums,

failure to renew the contract or cancellation of the contract.

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 DISTINGUSING FEATURES OF INSURANCE CONTRACTS

Features 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. For instance, 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).

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Cont’d

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.

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Cont’d

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 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.

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Cont’d

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.

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Cont’d

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. 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.

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Cont’d

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.

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Cont’d

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.

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