Topic 10. Legal Principles in Insurance Contracts BUS 200 Introduction to Risk Management and Insurance Jin Park

Topic 10. Topic 10. Legal Principles in Legal Principles in

Insurance ContractsInsurance ContractsBUS 200 BUS 200

Introduction to Risk Management and InsuranceIntroduction to Risk Management and Insurance

Jin ParkJin Park

OverviewOverview Distribution of Insurance ContractsDistribution of Insurance Contracts Insurance as contracts Insurance as contracts

legally enforceable agreementslegally enforceable agreements Characteristics of Insurance ContractsCharacteristics of Insurance Contracts Fundamental Principles of Insurance Fundamental Principles of Insurance

ContractsContracts Principle of indemnityPrinciple of indemnity Principle of insurable interest Principle of insurable interest Principle of utmost good faithPrinciple of utmost good faith Principle of subrogationPrinciple of subrogation

Distribution of Insurance Distribution of Insurance ContractsContracts

Direct MarketingDirect Marketing No outside agent is involvedNo outside agent is involved Mail marketing, internet based Mail marketing, internet based

marketingmarketing Exclusive AgentExclusive Agent

represents one insurerrepresents one insurer Independent AgentIndependent Agent

represents more than one insurerrepresents more than one insurer

Distribution of Insurance Distribution of Insurance ContractsContracts

Agent versus BrokerAgent versus Broker Binding Authority by AgentBinding Authority by Agent

Property/Liability InsuranceProperty/Liability Insurance BinderBinder

Life/Health InsuranceLife/Health Insurance Conditional premium receiptConditional premium receipt

Insurance as ContractsInsurance as Contracts Elements of contractElements of contract

Agreement Agreement Offer and AcceptanceOffer and Acceptance

ConsiderationConsideration Insured – premium payment and fulfillment of policy Insured – premium payment and fulfillment of policy

conditions conditions Insurer – promise to do certain things as specified in the Insurer – promise to do certain things as specified in the

contract (insurance policy)contract (insurance policy) Legally competent partiesLegally competent parties

Parties must have legal capacity to enter into a binding Parties must have legal capacity to enter into a binding contractcontract

Legal PurposeLegal Purpose Contract must be for a legal purposeContract must be for a legal purpose

Legal FormLegal Form Contract may be oral or writtenContract may be oral or written Some insurance policy provisions and attachments must be Some insurance policy provisions and attachments must be

approved by regulator before being marketedapproved by regulator before being marketed

Insurance as ContractsInsurance as Contracts

Property - CasualtyProperty - Casualty OfferOffer

Submission of Submission of application with a down application with a down paymentpayment

AcceptanceAcceptance BinderBinder

LifeLife OfferOffer

Submission of Submission of application with a down application with a down payment payment

Issuance of a life Issuance of a life insurance policyinsurance policy

AcceptanceAcceptance Conditional premium Conditional premium

receipt receipt

Note: Giving a quotation to a prospective insured is deemed Note: Giving a quotation to a prospective insured is deemed

as mere solicitation or invitation to make an offer.as mere solicitation or invitation to make an offer.

Characteristics of Characteristics of Insurance ContractsInsurance Contracts

1. Personal Contracts1. Personal Contracts Insurance protects insured, not the Insurance protects insured, not the

property or liability subject to loss.property or liability subject to loss. Assignment provisionAssignment provision

In property insurance, if ownership of a In property insurance, if ownership of a property changes, insurance contracts property changes, insurance contracts (policies) (policies) cannot be transferredcannot be transferred to another to another party (buyer) without the insurer’s written party (buyer) without the insurer’s written consent.consent.

In life insurance, the beneficiary or ownership In life insurance, the beneficiary or ownership of policy may be of policy may be freely reassignedfreely reassigned..


2. Aleatory Contracts2. Aleatory Contracts A contract whose value to either or both A contract whose value to either or both

of the parties depends on chance or future of the parties depends on chance or future events, or where the monetary values of events, or where the monetary values of the parties' performance are unequal. the parties' performance are unequal.

The insurer's obligation to pay a loss depends The insurer's obligation to pay a loss depends on uncertain eventson uncertain events

Premium paid by Insured Premium paid by Insured << Claim paid by Claim paid by InsurerInsurer

cf: commutative contract cf: commutative contract The values exchanged are theoretically equal.The values exchanged are theoretically equal.


3. Contracts of adhesion3. Contracts of adhesion Insurance contracts are drafted by an insurer Insurance contracts are drafted by an insurer

and an insured must accept or reject all the and an insured must accept or reject all the terms and conditions.terms and conditions.

Insured gets the benefit of the doubt.Insured gets the benefit of the doubt. Courts tend to construe an ambiguous term in an Courts tend to construe an ambiguous term in an

insurance policy in favor of an insured.insurance policy in favor of an insured. Contracts may be altered by the addition of Contracts may be altered by the addition of

riders or endorsementsriders or endorsements Rider or endorsement – a document that amends or Rider or endorsement – a document that amends or

changes the original policy.changes the original policy. cf: Contracts of cohesion cf: Contracts of cohesion

Contracts are drafted by both parties.Contracts are drafted by both parties.


4. Conditional contracts4. Conditional contracts An insurer’s obligation to pay a claim An insurer’s obligation to pay a claim

depends on whether the insured or the depends on whether the insured or the beneficiary has complied with all policy beneficiary has complied with all policy conditions.conditions.

The insurer may not pay a claim if one or The insurer may not pay a claim if one or more of policy conditions are not more of policy conditions are not complied.complied.

Duties after loss – Homeowners (p. 562)Duties after loss – Homeowners (p. 562) Duties after an accident or loss – Automobile Duties after an accident or loss – Automobile

(p. 585)(p. 585) Duties after in the event of loss or damage – Duties after in the event of loss or damage –

CPCP


5. Unilateral contracts5. Unilateral contracts Only one party makes a legally Only one party makes a legally

enforceable promise.enforceable promise. Insured are not legally forced to pay Insured are not legally forced to pay

premium or renew the policy.premium or renew the policy.

Fundamental Legal Principles Fundamental Legal Principles of Insurance Contractsof Insurance Contracts

1. Principle of indemnity1. Principle of indemnity

2. Principle of insurable interest 2. Principle of insurable interest

3. Principle of utmost good faith3. Principle of utmost good faith

4. Principle of subrogation4. Principle of subrogation

Principle of IndemnityPrinciple of Indemnity

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

Why?Why? The purpose of the insurance contract is The purpose of the insurance contract is

to restore the insured to the same to restore the insured to the same economic position as before the loss.economic position as before the loss.

The insured should not profit from a loss.The insured should not profit from a loss. It reduces the moral hazard by It reduces the moral hazard by

eliminating the profit incentive.eliminating the profit incentive.


To support the principal of indemnity an To support the principal of indemnity an insurance contact uses insurance contact uses Actual Cash Value Actual Cash Value (ACV)(ACV) method method Replacement cost (RC) less depreciationReplacement cost (RC) less depreciation

RC – current cost of restoring the damaged property RC – current cost of restoring the damaged property with new materials of like kind and quality.with new materials of like kind and quality.

Fair market valueFair market value The price of a wiling buyer would pay a willing seller The price of a wiling buyer would pay a willing seller

in a free market.in a free market. Broad evidence ruleBroad evidence rule

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


To support the principal of indemnity To support the principal of indemnity insurance contact includes “insurance contact includes “Other Other Insurance ProvisionsInsurance Provisions”.”. Escape clauseEscape clause

The policy (or insurance) would not apply if the The policy (or insurance) would not apply if the insured was covered by another policy.insured was covered by another policy.

Primary-ExcessPrimary-Excess It (or This insurance) is excess insurance over any It (or This insurance) is excess insurance over any

other valid and collectible insurance. other valid and collectible insurance. Pro-rata provisionPro-rata provision

Proration by face amountsProration by face amounts Proration by amounts otherwise payableProration by amounts otherwise payable

Contribution by equal sharesContribution by equal shares


Primary-ExcessPrimary-Excess Accident while test driving a dealer’s Accident while test driving a dealer’s

car.car. Health insurance between a couple Health insurance between a couple

working for different employers.working for different employers. Own insurance – primaryOwn insurance – primary Spouse insurance – excessSpouse insurance – excess Birthday rule for dependents’ coverageBirthday rule for dependents’ coverage


Pro-ration by Face AmountsPro-ration by Face Amounts It limits an insurer’s maximum obligation to the It limits an insurer’s maximum obligation to the

proportion of the loss that the insurer’s policy proportion of the loss that the insurer’s policy limit bears to the sum of all applicable policy limit bears to the sum of all applicable policy limits.limits.

Assume that there are three polices covering the Assume that there are three polices covering the same loss and the loss amount is $150,000.same loss and the loss amount is $150,000.

Insurer AInsurer A Insurer BInsurer B Insurer CInsurer C

Policy LimitPolicy Limit $100,000$100,000 $200,000$200,000 $300,000$300,000

ShareShare 1/61/6 2/62/6 3/63/6

PaymentPayment $25,000$25,000 $50,000$50,000 $75,000$75,000


Pro-ration by Amounts Otherwise PayablePro-ration by Amounts Otherwise Payable The amount what would be payable under The amount what would be payable under

each policy in the absence of other insurance each policy in the absence of other insurance Assume that there are three polices covering Assume that there are three polices covering

the same loss and the loss amount is the same loss and the loss amount is $150,000.$150,000.



PayablePayable $100,000$100,000 $150,000$150,000 $150,000$150,000

ShareShare 1/41/4 1.5/41.5/4 1.5/41.5/4

PaymentPayment $37,500$37,500 $56,250$56,250 $56,250$56,250


Pro-ration by Amounts Otherwise PayablePro-ration by Amounts Otherwise Payable What if the loss amount is $60,000?What if the loss amount is $60,000?



PayablePayable $60,000$60,000 $60,000$60,000 $60,000$60,000

ShareShare 1/31/3 1/31/3 1/31/3

PaymentPayment $20,000$20,000 $20,000$20,000 $20,000$20,000


Contribution by Equal SharesContribution by Equal Shares Each insurer contributes equal amount until it Each insurer contributes equal amount until it

has paid its applicable limit of insurance or none has paid its applicable limit of insurance or none of the loss remains, whichever comes first.of the loss remains, whichever comes first.

Assume that there are three polices covering Assume that there are three polices covering the same loss and the loss amount is $150,000the same loss and the loss amount is $150,000



Equal ShareEqual Share $50,000$50,000 $50,000$50,000 $50,000$50,000

PaymentPayment $50,000$50,000 $50,000$50,000 $50,000$50,000


Contribution by Equal SharesContribution by Equal Shares What is the loss amount is $400,000?What is the loss amount is $400,000?



Equal Share 1Equal Share 1 $100,000$100,000 $100,000$100,000 $100,000$100,000

Equal Share 2Equal Share 2 N/AN/A $50,000$50,000 $50,000$50,000

PaymentPayment $100,000$100,000 $150,000$150,000 $150,000$150,000


Exceptions to the Principle of IndemnityExceptions to the Principle of Indemnity Valued policy (or agreed value)Valued policy (or agreed value)

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

Ex.) Value of a fine art is agreed at $250,000.Ex.) Value of a fine art is agreed at $250,000. Valued policy lawValued policy law

A law that requires payment of the face amount of A law that requires payment of the face amount of insurance to the insured if a total loss to real property insurance to the insured if a total loss to real property occurs from a covered peril, regardless of the occurs from a covered peril, regardless of the property’s ACV.property’s ACV.

Replacement costReplacement cost No deduction for depreciation in determining the No deduction for depreciation in determining the

amount paid for a loss.amount paid for a loss.

Principle of Insurable InterestPrinciple of Insurable Interest

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

Why?Why? To prevent gamblingTo prevent gambling

Insurance on a property and wait for a loss occur.Insurance on a property and wait for a loss occur. To reduce moral hazardTo reduce moral hazard

Life insurance on a person and pray for his/her death Life insurance on a person and pray for his/her death for insurance proceeds.for insurance proceeds.

In order not to indemnify more than an In order not to indemnify more than an insured’s financial interestinsured’s financial interest

It supports the principle of indemnity.It supports the principle of indemnity.

Principle of Insurable InterestPrinciple of Insurable Interest

Property-Casualty insuranceProperty-Casualty insurance At the time of a lossAt the time of a loss, an insured must , an insured must

have insurable interest.have insurable interest. No insurable interest no financial loss No insurable interest no financial loss

no indemnityno indemnity support Prin. of support Prin. of indemnityindemnity

Life InsuranceLife Insurance Insurable interest must exist Insurable interest must exist at the time at the time

of a policy inceptionof a policy inception, but not at the time , but not at the time of a loss (death)of a loss (death)

Principle of Utmost Good FaithPrinciple of Utmost Good Faith

A higher degree of honesty is A higher degree of honesty is imposed on an insurance contract imposed on an insurance contract than is imposed on other contractsthan is imposed on other contracts Honesty is mainly imposed on the Honesty is mainly imposed on the

insurance applicants.insurance applicants. It is supported by three legal doctrinesIt is supported by three legal doctrines

RepresentationRepresentation ConcealmentConcealment WarrantyWarranty

Principle of Utmost Good FaithPrinciple of Utmost Good Faith

RepresentationRepresentation Statements made by an applicantStatements made by an applicant Insurance is voidable at the insurer’s option.Insurance is voidable at the insurer’s option.

MaterialMaterial FalseFalse RelianceReliance

cf: Innocent misrepresentationcf: Innocent misrepresentation ConcealmentConcealment

Intentional failure to disclose a material factIntentional failure to disclose a material fact WarrantyWarranty

A statement of fact or a promise made by the insured, A statement of fact or a promise made by the insured, which is part of the insurance contract and must be true which is part of the insurance contract and must be true if the insurer is to be liable under the contract. if the insurer is to be liable under the contract.

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

Principle of SubrogationPrinciple of Subrogation

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

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

Principle of SubrogationPrinciple of Subrogation

The insurer is entitled only to the amount it The insurer is entitled only to the amount it has paid under the policy.has paid under the policy. What if the insurer collects more, from the What if the insurer collects more, from the

negligent party, than the amount the insurer negligent party, than the amount the insurer paid to its insured? paid to its insured?

The insured cannot impair the insurer’s The insured cannot impair the insurer’s subrogation rights.subrogation rights.

Subrogation does not apply to life insurance Subrogation does not apply to life insurance and to individual health insurance and to individual health insurance contracts.contracts.

The insurer cannot subrogate against its The insurer cannot subrogate against its own insured.own insured.

Additional Reading Additional Reading AssignmentsAssignments

Two insurers seek to void Enron Two insurers seek to void Enron policiespolicies

Coming Clean on Insurance Coming Clean on Insurance ApplicationsApplications

Rescission of Life Insurance Policy Rescission of Life Insurance Policy Upheld on Finding of Intent to Upheld on Finding of Intent to Deceive in ApplicationDeceive in Application

Documents

Topic 10. Legal Principles in Insurance Contracts BUS 200 Introduction to Risk Management and Insurance Jin Park