Chapter-Four Legal Principles of Insurance Contract

Chapter-Four Legal Principles of Insurance Contract 4.1.1. 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. •If a covered loss occurs, the insurer should not pay more than the actual amount of the loss. Fundamental Purpose of principle of indemnity •The first purpose is to prevent the insured from profiting from a loss. For example, if Kristin's home is insured for $100,000, and a partial loss of $20,000 occurs, the principle of indemnity would be violated if $100,000 were paid to her. She would be profiting from insurance. •The second purpose is to reduce moral hazard. If dishonest insured's 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 •In property insurance, the basic method for 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:  Replacement cost less depreciation  Fair market value  Broad evidence rule Replacement Cost Less Depreciation •Under this rule, actual cash value is defined as replacement cost less depreciation. It takes into consideration of depreciation of property values over time. Replacement cost is the current cost of restoring the damaged property with new materials of like kind and quality. Depreciation is a deduction for physical wear and tear, age, and economic obsolescence. Replacement Cost Less Depreciation •Hana equipment that burns in a fire. Assume she bought the equipment five years ago, the couch is 50 percent depreciated, and a similar couch today would cost $1000. Under the actual cash value rule, hana will collect based on replacement cost less depreciation method? Fair Market Value •Fair market value is the price a willing buyer would pay a willing seller in a free market. •In one case, a building valued at $170,000 based on the actual cash value rule had a market value of only $65,000 when a loss occurred. The court ruled that the actual cash value of the property should be based on the fair market value of $65,000 rather than on $170,000. Broad Evidence Rule • Many states now use the broad evidence rule to determine the actual cash value of a loss. The broad evidence rule means that 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 replacement cost less depreciation, fair market value, present value of expected income from the property, comparison sales of similar property, opinions of appraisers, and numerous other factors. 2. PRINCIPLE OF INSURABLE 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 lose financially if a loss occurs. For example, Abebe has an insurable interest in his car because he may lose financially if the car is damaged or stolen. He has an insurable interest in his personal property, such as a television set or computer, because you may lose financially if the property is damaged or destroyed. Purposes of an insurable interest •To be legally enforceable, all insurance contracts must be supported by an insurable interest. Insurance contracts 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 Purposes of an insurable interest •Firs, an insurable interest is necessary to prevent gambling. If an insurable interest were not required, the contract would be a gambling contract and would be against the public interest. For example, one could insure the property of another and hope for a loss to occur. One person could similarly insure the life of another person and hope for an early death. These contracts clearly would be gambling contracts and would be against the public interest. Purposes of an insurable interest •Second, an insurable interest reduces moral hazard. If an insurable interest were not required, a dishonest person could purchase a property insurance contract on someone else's property and then deliberately cause a loss to receive the proceeds. But if the insured stands to lose financially, nothing is gained by causing the loss. Thus, moral hazard is reduced. •Finally, in property insurance, an insurable interest measures the amount of the insured's loss. Most property contracts are contracts of indemnity, and one measure of recovery is the insurable interest of the insured. If the loss payment cannot exceed the amount of one's insurable interest, the principle of indemnity is supported. The essentials of insurable interest are as follows: 1. Presence of subject matter to be insured. 2. Existence of monetary relationship between the subject matter and they would be policyholder. 3. The relationship existing between the policyholder and the subject matter need to be legal. 4. The policyholder must be economically benefited by the survival or suffer an economic-loss from the damage of destruction of the subject matter. 5. An insurable interest may be applied on life, property, or potential liability. Life 1. Self Insurance: An individual has an insurable interest in his own life, and there is no limit to the sum for which a man may insure his own life. 2. Husband and Wife: A wife may insure the life of her husband because his continued existence is valuable to her and she would suffer a financial loss upon his death and vice versa. 3. Creditors and Debtors: A creditor stands to lose if his debtor dies without paying the debt. Thus, he has the right to insure the debtor up to the amount of the loan. 4. Partners: The death of a partner could well cause financial loss to the survivor(s), who therefore, have a right to insure him. 5. Minor-child: A father may insure the life of a minor-child, but a brother may not ordinarily insurance the life of his sister. Property 1. Ownership:  There may be full ownership, part or joint ownership gives the right to insure.  With part ownership, the insurable interest is strictly limited to the financial involvement, but  A part owner may insure the property for the full value, if he act as an agent for others  Any amount he receives from the insurance, over and above his own interest, is to be held in trust for the co-owners. 2. Husband and wife: A husband has an insurable interest in his wife’s property as he is legally entitled to share her enjoyment of it, and vice versa Property 3. Administrators, Executors and Trustees: These are all persons entrusted with the estate and affairs of others. They have a right to insure the property for which they are responsible. 4. Bailess: These are persons or entities legally in possession of goods belonging to others, for example, laundries, 5. Agents: Provided the principal possesses an insurable interest, an agent may effect an insurance on his behalf. The insurance must be authorized or ratified by the principal. 6. Mortgagees and Mortgagors: The interest of the mortgagee is limited to the sum of money that he has advanced. Liability •A person clearly has an interest in the sums he may be called upon to pay to third parties as a result of accident. Principle of Subrogation •Subrogation is a corollary of the principle of indemnity and the right of subrogation, therefore, applies only to policies which are contracts of indemnity. Under the principle of subrogation one who has indemnified another’s loss is entitled to recovery from any liable third parties who are responsible. Thus, subrogation is the transfer by an insured to an insurer of any right to proceed against a third party who has negligently caused the occurrence of an insured loss.  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 Purposes of Subrogation •Subrogation has three basic purposes. 1. Prevents collecting twice for the same loss.-Maintain principle of indemnity 2. Used to hold the negligent person responsible for the loss. 3. Insurer can collect from the negligent person who caused the loss. •Importance of Subrogation 1. The insurer is entitled only to the amount it has paid under the policy.  Some insured may not be fully indemnified because of:  Insufficient insurance,  Satisfaction of deductible or  Legal expenses in trying to recover from a negligent third party. Principle of Subrogation •Example •Ato Dula insures his house for Br 1 million. The house is totally destroyed by the negligence of his neighbor Ato.Tola. The insurance company shall settle the claim of Ato Dula for Br 1 million. At the same time, it can file a law suit against Ato.Tola for Br 1.2 million, the market value of the house. If insurance company wins the case and collects Br 1.2 million from Ato.Tola, then the insurance company will retain Br 1 million (which it has already paid to Ato Dula) plus other expenses such as court fees. The balance amount, if any will be given to Ato Dula, the insured Purposes of Subrogation 2. The insured can not impair the insurer’s subrogation rights.  The insured cannot do anything For example,  If the insured waives the right to sue the negligent party, the right to collect from the insurer is also waived. (If insured admits fault, or settle a loss without the insurer’s consent 3. Subrogation does not apply to life insurance and to most individual health insurance contracts.  Life insurance is not a contract of indemnity, and subrogation has relevance only for contracts of indemnity.  Individual health insurance contracts usually do not contain subrogation clauses. 4. The insurer cannot subrogate against its own insured.  If so, the basic purpose of purchasing the insurance would be defeated 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 entitled to recover from a negligent third party and loss payments made to the insured. •For example, a negligent motorist fails to stop at a red light and smashes into Ato Tereie's car, causing damage in the amount of 5000 Br. If he has collision insurance on his car, his company will pay the physical damage loss to the car and then attempt to collect from the negligent motorist who caused the accident, the insured gives to the insurer legal rights to collect damages from the negligent third party. 4 PRINCIPLE OF UTMOST 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. •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, and warranty. Representations •Representations are statements made by the applicant for insurance. For example, if you apply for life insurance, you may be asked questions concerning you age, weight, height, occupation, state of health, family history, and other relevant questions. Your answers to these questions are called representations. Representations •The legal significance of a representation is that the insurance contract is avoidable at the insurer's option if the representation is (1) material, (2) false, and (3) relied on by the insurer. •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. Representations Example •Jamana applies for life insurance and states in the application that he has not visited a doctor within the last five years. However, six months earlier, he had surgery for lung cancer. In this case, he has made a statement that is false, material, and relied on by the insurer. therefore, the policy is voidable at the insurer's option. If Jamana dies shortly after the policy is issued, say three months, the company could contest the death claim on the basis of a material misrepresentation. Concealment •The doctrine of concealment also supports the principle of utmost good faith. A concealment is intentional failure of the applicant for insurance to reveal a material fact to the insurer. Concealment is 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. •For example, Joseph DeBellis applied for a life insurance policy on his life. Five months after the policy was issued, he was murdered. The death certificate named the deceased as Joseph DeLuca, his true name. The insurer denied payment on the grounds that Joseph had concealed a material fact by not revealing his true identity and that he had an extensive criminal record. Warranty •The doctrine of warranty also reflects the principle of utmost good faith. 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 reduced premium, the owner of a liquor store may warrant that an approved burglary and robbery alarm system will be operational at all time. The clause describing the warranty becomes part of the contract. PRINCIPLE OF CONTRIBUTION •Contribution is the right of the 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 overinsurance because a loss is covered by policies effected 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. CONTRIBUTION Vs. SUBROGATION •It is important to understand the difference between contribution and subrogation. Subrogation is concerned with the rights of recovery against third parties or elsewhere in respect of payment of indemnity, and need not involve any other insurance, although it frequently does. Contribution necessarily involves two or more insurance each covering the interest of the same insured. PRINCIPLE OF CONTRIBUTION  Contribution According to Independent Liability: This means that the mount 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. This method is usually found where for some reason one or more of the policies will not cover the loss in full. This happens particularly in many fire policy contributions.  Contribution According to the sums Insured: This is the normal method of contribution. Insurers will pay proportionately to the cover they have provided, in accordance with the following formula: PRINCIPLE OF CONTRIBUTION PRINCIPLE OF CONTRIBUTION •Example: Assume that Ato Beka has inured his house, which is worth Birr 80,000 against fire insurances X, Y, and Z for Birr 60,000, Birr 40,000, and Birr 20,000 respectively Ato Beka’s house was completely destroyed by a fire caused by Ato Tigabu’s negligence. The amount of indemnity that Ato Beka will be entitled to receive would be Birr 80,000, the value of the actual loss or the amount of insurance carried. •The amount that each insurer is entitled to contribute would be as follows: PRINCIPLE OF CONTRIBUTION Total indemnity =Br.80,000 PRINCIPLE OF PROXIMATE CAUSE •The rule is that immediate and not the remote cause is to be regarded. The maxim is “proximate non-remote spectatuture”, i.e., 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. Example, In marine insurance, sea water. Principle of Proximate Cause:  When loss is caused by more than one causes, the proximate or the nearest or the closest cause should be taken into consideration to decide the liability of the insurer. If the proximate cause is insured, the insurance company pays the compensation and vice versa.  Determination of proximate cause a.If there is a single cause of the loss b.If there are concurrent causes