Chapter 9

1. Chapter 9 Fundamental Legal Principles

2. Fundamental Legal Principles • Principle of Indemnity • Principle of Insurable Interest • Principle of Subrogation • Principle of Utmost Good Faith

3. PRINCIPLES OF INDEMNITY The principles 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.

4. PRINCIPLES OF INDEMNITY…. The principles of indemnity has two fundamental purposes. • The first purpose is to prevent from profiting from a loss. E.g., if Kristin’s home is insured for $200,000, and a partial loss of $50,000 occurs, the principle of indemnity would be violated if $200,000 were paid to her. She would be profiting from insurance.

5. PRINCIPLES OF INDEMNITY…. • The second purpose is to reduce moral hazard. If dishonest insureds could profit from a loss, they might deliberately cause losses with the of collecting the insurance. • If the loss payment does not exceed the actual amount of the loss, the temptation to be dishonest is reduced.

6. Actual Cash Value • The concepts of actual cash value supports the principle of indemnity. • In property insurance, the basic method for indemnifying the insured is based on the actual cash value of the damage property at the time of loss.

7. Determinants of Actual Cash Value • Replacement cost less depreciation • Fair market value • Broad evidence rule

8. Replacement cost less depreciation • Under this rule, actual cash value is defined as replacement cost less depreciation. • 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.

9.  Example 

10. Fair Market Value • Fair market value is the price a willing buyer would pay a willing seller in a free market. • The fair market value of a building may be below its actual cash value based on replacement cost less depreciation. • The difference due to several factors; • Poor location • Deteriorating neighborhood • Economic obsolescence of the building.

11.  Example 

12. Broad Evidence Rule • 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 • Etc.

13. Exception to the Principle of Indemnity • Valued Policy • Valued Policy Laws • Replacement Cost Insurance • Life Insurance

14. Valued 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; • Antiques, • Fine arts, • Rare paintings, • Family heirlooms etc.

15. Valued Policy Laws • A valued policy law is a law that exists in some states that requires 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.  Example 

16. Replacement Cost Insurance • Replacement cost insurance means there is no deduction for physical depreciation in determining the amount paid for a loss.  Example 

17. Life Insurance • A life insurance contract is not a contract of indemnity but is a valued policy that pays a stated sum 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 cost less depreciation) is meaningless in determining the value of a human life.

18. PRINCIPLE OF INSURABLE INTERST • The principle of insurable interest states that the insured must be in a position to lose financially if a covered loss occurs. • E.g., you have an insurable interest in your car because you may lose financially if the car is damaged or stolen. • Same as for personal property such as; • Television • computer

19. Purposes of Insurable Interest • To be legally enforceable, all insurance contract must be supported by an insurable interest. • And for the following reasons; • To prevent gambling • To reduce morale hazard • To measure the amount of the insured’s loss in property insurance

20. Property and Casualty Insurance • In property and casualty insurance, the ownership of property, potential legal liability, secured creditors, and contractual rights can support the insurable interest requirement.

21. Life Insurance • In life insurance, the question of an insurable interest does not arise when a person purchase life insurance on his or her own life. • If life insurance is purchased on the life of another person, there must be an insurable interest in that person’s life. • E.g., a husband can purchase a life insurance policy on his wife or vice versa.

22. When Must an Insurable interest Exist? • In property insurance, the insurable interest requirement must be met at the time of loss. • In life insurance, the insurable interest requirement must be met only at the inception of the policy.

23. 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. • The insurer is entitled to recover from a negligent third party any loss payments made to the insured.  Example 

24. Purposes of Subrogation • The purposes of subrogation are to; • Prevent the insured from collecting twice for the same loss. • To hold the negligent person responsible for the loss and • To hold down insurance rates.

25. 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 do anything that might impair the insurer’s subrogation rights. • The insurer cannot subrogate against its own insureds. • Finally subrogation does not apply to life insurance and to most individual health insurance.

26. PRINCIPLE OF UTMOST GOOD FAITH • The principle of utmost good faith means that a higher degree of honesty is imposed on both parties to an insurance contract than is imposed on parties on other contracts.

27. Representation, Concealment, Warranty • Representations are statements made by the applicants for insurance. • The insurer can deny payment for a claim if the representation is material and false, and is relied on by the insurer in issuing the policy at a specified premium. • In the case of statement of belief or opinion, the misrepresentation must also be fraudulent before the insurer can deny a claim.

28. Concealment • 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.

29. Warranty • A warranty is a statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all respects. • E.g., a bank may warrant that a guard will be on the premises 24 hours a day. • Any breach of the warranty, even if slight, allows the insurer to deny payment of a claim.

30. REQUIREMENTS OF AN INSURANCE CONTRACT • To have a valid insurance contract, four requirements must be met; • There must be an offer and acceptance. • Consideration must be exchanged. • The parties to the contract must be legally competent. • The contract must be for a legal purpose.

31. Offer and Acceptance • The applicant for insurance makes the offer, and the company accepts or rejects the offer. • An agent solicits or invites the prospective insured to make an offer. • The requirement of offer and acceptance can be examined in greater detail by making a careful distinction between property and casualty insurance, and life insurance.

32. Offer and Acceptance …. • Most property and casualty insurance contracts are written form. • The applicant for insurance fills out the application and pays the first premium (or promises to pay the first premium). • In property and casualty insurance, agents typically have the power to bind their companies through use of a binder.

33. Offer and Acceptance …. • A binder is a temporary contract for insurance and can be either written or oral. • The binder obligates the company immediately prior to receipt of the application and issuance of the policy. • Thus, the insurance contract can be effective immediately, because the agent accepts the offer on behalf of the company.

34. Offer and Acceptance …. • In life insurance, the procedures followed are different. • A life insurance agent does not have the power to bind the insurer. • Therefore, the application for life insurance is always in writing, and the applicant must be approved by the insurer before the life insurance is in force.

35. Offer and Acceptance …. • A conditional premium receipt is then given to the applicant. • The most common conditional receipt is the “insurable premium receipt” • If the applicant is found insurable according to the insurer’s normal underwriting standards, the life insurance becomes effective as of the date of the application.

36. Offer and Acceptance …. • Some insurability receipts make the life insurance effective on the date of the application or the date of the medical exam, whichever is later. • Example  • Before the life insurance is in force, the policy must be issued and delivered to the applicant, the first premium must be paid, and the applicant must be in good health when the policy is delivered.

37. Consideration • The second requirement of a valid insurance contract is consideration – the value that each party gives to other. • The insured’s consideration is payment of the premium ( or a promise to pay the premium) plus and agreementto abide by the conditions specified in the policy.

38. Consideration…. • The insurer’s consideration is the promise to do certain things as specified in the contract. • This promise can include paying for a loss from an insured peril, providing certain services, such as loss prevention and safety services, or defending the insured in a liability lawsuit.

39. Competent Parties • Each party must be legally competent. • This means the parties must have legal capacity to enter into a binding contract. • Most adults are legally competent to enter into insurance contracts, but there are some exceptions. • Insane person, • Intoxicated person, and • Corporation that act outside the scope of their authority cannot enter into enforceable insurance contract.

40. Competent Parties • Age restriction for minors under 18. • The insurer must also be legally competent. • Insurers generally must be licensed to sell insurance in the state, and the insurance sold must be within the scope of its charter or certificate of incorporation.

41. Legal Purpose • The contract must be for a legal purpose. • An insurance contract that encourages or promotes something illegal or immoral is contrary to the public interest and cannot be enforced.

42. Legal Purpose…. • E.g., a street pusher of heroin and other illegal drugs cannot purchase a property insurance policy that would cover seizure of the drugs by the police. • This type of contract obviously is not enforceable because it would promote illegal activities that are contrary to the public interest.

43. DISTINCT LEGAL CHARACTERISTICS OF INSURANCE CONTRACTS • Aleatory contract. • Unilateral contract • Conditional contract • Personal contract • Contract of adhesion

44. Aleatory (dependent on chance) Contract • An aleatory contract is a contract where the values exchanged may not be equal but depend on an uncertain event. • Depending on the chance, one party may receive a value out of proportion to the value that is given.

45. Aleatory (dependent on chance) Contract…. Example • Assume that Jessica pays a premium of $600 for $200,000 of homeowners insurance. • If the home were totally destroyed by fire shortly thereafter, she would collect an amount that greatly exceeds the premium paid. • On the other hand, a homeowner may faithfully pay premiums for many years and never have a loss.  remember… pooling of fortuitous losses!!

46. A commutative contract is one in which the values exchanged by both parties are theoretically equal. • E.g., the purchase of real estate normally pays a price that is viewed to be equal to the value of the property.

47. Unilateral Contract • A unilateral contract means that only one party makes a legally enforceable promise. • In this case, only the insurer makes a legally enforceable promise to pay a claim or provide other services to the insured. • After the first premium is paid, and the insurance is in force, the insured cannot be legally forced to pay the premiums or to comply with the policy provisions.

48. Unilateral Contract…. • Although the insured must continue to pay the premiums to receive payment for a loss, he or she cannot be legally forced to do so. • However, if the premiums are paid, the insurer must accept them and must continue to provide the protection promised under the contract.

49. Conditional Contract • An insurer contract is a conditional contract. That is, the insurer’s obligation to pay a claim depends on whether the insured or the beneficiary has complied with all policy conditions. • Conditions are provisions inserted in the policy that qualify or place limitations on the insurer’s promise to perform.

50. Conditional Contract…. • For example, under a homeowners policy, the insured must give immediate notice of a loss. • If the insured delays for an unreasonable period in reporting the loss, the insurer can refuse to pay the claim on the grounds that a policy condition has been violated.