CHAPTER

FOUR

LEGAL PRINCIPLES OF
INSURANCE CONTRACT
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 Principles of Indemnity
 Principles of Insurable Interest
 Principles of Subrogation
 Principles of Utmost Good Faith
 Principles of Contribution
 Doctrine of Proximate Cause

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 Principle of Indemnity
 The principle of Indemnity states that the insurer is
liable to pay up to the amount of loss and not more
than the actual amount of the loss, which means the
insured should not profit from a loss.
 If the insured could profit from a loss, then the
insured may intentionally cause the loss to make a
profit, or be complacent in preventing a loss.
 Thus, allowing the insured to collect more than their
losses would create a moral hazard, which would be
against public policy, and would drive up premiums
to unaffordable prices.
This principle has two fundamental purposes.
1. To prevent the insured from profiting from a loss, and
2. To reduce moral hazard.
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Actual Cash Value
 In property insurance, the amount of the
indemnity is typically based on the actual cash
value of the loss at the time of the loss.
 Over the years, the courts have used three
methods of determining actual cash value. These
are:
A. Replacement cost less depreciation,
B. Fair market value, and
c. The broad evidence rule

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 Replacement cost is the current price of a new item
of like kind and quality.
 Depreciation is the decrease in the market value of
an item because of wear and tear, age and economic
obsolescence.
 If a 3-year-old car is totally demolished, the
insurance company is only going to pay what the car
was worth at the time of loss. If it paid the full value
of a new car, this would create a moral hazard by
motivating some drivers to intentionally destroy the
car in an attempt to profit from insurance.
 In many cases, the insurance company will determine the
actual cash value by subtracting depreciation from the
replacement value of the car.
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Depreciation = Replacement Cost x Age of Insured Property
Useful Age of Property

Actual Cash Value = Replacement Cost - Depreciation

Example 1: If a 5-year-old car with a useful life of 20 years
suffers a total loss due to fire and a replacement cost is
$120,000. What would be the indemnification for this loss?
Depreciation = 120,000 x 5
20
 Depreciation = 30,000
 Actual Cash Value = Replacement Cost - Depreciation
 Actual cash value = 120,000 – 30,000= 90,000

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Example 2: If a new car costs $500,000, and the
estimated useful life of the car is 16 years. The
car was accidentally totally demolished at the
end of 4 year. What would be the indemnification for
this loss? And Why?

To pay more would violate the principle of

indemnification.

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 Fair market value is the price that a property
would get in an open market.
3. Broad Evidence Rule
 The broad evidence rule uses all relevant
factors in determining the cash value for the loss,
which can include, appraisals, income generated
by the property, and anything else that could
potentially affect the value of the property.
 The factors used are what an expert would use to
determine the value of a property.

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 Sometimes, the principle of indemnity is not
easily applied or cannot be applied because of
the nature of the insurable interest, because of
state law, or because the insured wants greater
protection than afforded by indemnification.
a. Valued Insurance Policy
 A valued policy pays the face amount of the
policy when a total loss occurs. Valued policies
are used 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 is5/2/2024
first issued.
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 Replacement cost insurance pays for the
replacement value of the loss, without any
deduction for depreciation.
 Replacement cost insurance means there is no
deduction for depreciation in determining the
amount paid for a loss.
c. Life Insurance
 Life insurance is not a contract of indemnity and
it is only a valued policy. In life insurance, the
amount paid when the insured dies is the face
value of the policy.
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 It
states that the insured must be in a position to
lose financially if a loss occurs, or to incur some
other kind of harm if the loss takes place.
Insurable interest means the policy holder must
have a pecuniary or monetary interest in the
property, which he has insured.
 An insurable interest involves a relationship
between the person applying for the insurance
and the subject matter of the insurance.

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 To prevent gambling
 To reduce moral hazard
 To measure the amount of the insured’s loss in
property insurance

 What Constitutes Insurable Interest?

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 All insurance contracts must be supported by an
insurable interest. But, there is a difference between
an insurable interest in property and liability
insurance and life insurance.
I. In Property and Liability Insurance
 A. Ownership of property can support an insurable
interest because he/she loses financially if his/her
property is damaged.
 B. Legal liability will also create an insurable
interest. Bailment commonly creates a legal liability
for the bailee, and, thus, creates an insurable interest
in the property for the bailee.
 For instance, an auto repair shop can have insurance
on the vehicles on its lot for possible damage or theft,
even though the shop does not own them.
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 C. Secured creditors have an insurable interest
in the property used as security for the property.
 D. A contractual right also can support an
insurable interest.
II. In Life Insurance
 There is no question of insurable interest if the life
insurance is purchased on their own life.
Obviously, you have an insurable interest in your
own life, and you can purchase any amount of life
insurance up to the limits imposed by the
insurance company.

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 However, for anyone to purchase life insurance on
someone else's life, they must have an insurable
interest on that person's life, which is usually
satisfied if they are closely related, and, especially,
if the beneficiary would suffer financial loss from
the insured's death.
 Therefore, close ties of blood or marriage or a
pecuniary interest will satisfy the insurable
interest requirement in life insurance. So, for
instance, spouses can insure each other.
 However, life insurance cannot be purchased on
someone who is more remotely related or
unrelated, unless the beneficiary would suffer a
financial loss from the death.
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Time that an insurable
interest must be exist

When should an insurable

interest exist?
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 In property insurance and Property, the insurable
interest must exist at the time of the loss.
Because property and liability insurance are
contracts of indemnity, which only covers losses,
the insurable interest must exist at the time of the
loss
 In life Insurable interest requirement must be
met only at the inception of the policy and not at
the time of death.
 Because life insurance is a valued policy
insurance that pays a specified sum to the
beneficiary at the time of the insured's death, the
beneficiary does not have to prove a loss to
collect the insurance.
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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.
 Example, in an accident the insured victim gives
legal rights to the insurer to collect damages
from the negligent third party instead of
collecting himself directly from the third party.
Insurer must pay before it claims subrogation.
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 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.

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 Utmost Good Faith mean higher degree of honesty is
imposed on both parties to an insurance contract.
 The practical effect of the principle of utmost good
faith today lies in the requirement that the applicant
for insurance must make full and fair disclosure of the
risk to the agent and the company.
 Any information about the risk that is known to one
party should be known to the other.
 If the insured intentionally fails to inform the insurer of
any facts that would influence the issue of the policy
or the rate at which it would be issued, the insurer
may have grounds for avoiding coverage.

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These are:
 Representations,
 Concealments,
 Warranties, and
 Mistake
A. Representations
 Representations are the statements made by the
insured on the insurance application. Many of
these representations are responses to questions
to determine whether the applicant is insurable
and how much should be charged.

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 For instance, for auto insurance, insurers will ask
how you travel to work, whether you had any
accidents or citations, and so on.
 Here both the parties are under an obligation not
to attempt to deceive or withhold material
information from the other. The insurance contract
is voidable at the insurer's option if the
misrepresentation is:
1. Material,
2. Relied upon by the insurer, and
3. False
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A material representation is one that was relied
upon by the insurer in issuing the policy. If the
truth were known, the insurer either would not
have issued the policy, or would have issued it
with different terms, and probably would have
charged higher premiums.
 Any material misrepresentations after a loss can
also void an insurance contract.
 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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 For example, Kebede may apply for life
insurance and state in the application that he has
not visited a doctor within the last five years.
However, he has undergone surgery for lung
cancer six months earlier.
 In this case, he has made a statement that is both
false and material and the policy is voidable at
the insurer’s option.
 If Kebede dies shortly after the policy is issued,
the company could contest the death claim on
the basis of a material misrepresentation.

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 Avoiding the contract does not follow unless the
misrepresentation is material to the risk.
 If the misrepresentation is inconsequential, its
falsity will not affect the contract.
 Innocent or unintentional misrepresentation.
An insurance company can also void a contract if
there was an innocent misrepresentation of a
material fact.

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B. Concealment
 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
insurer.
 However, before an insurance company can deny
payment for concealment it must prove:
 The insured knew that the fact was important in
regard to the insurance being applied for; &
 There was an intention to defraud the insurer.

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 Warranty is promise made by the insured in the
contract.
 A warranty is a promise by the insurance
applicant to do certain things or to satisfy certain
requirements, or, it is a statement of fact that is
attested by the insurance applicant. The warranty
becomes part of the insurance contract.
 • Any breach of warranty, even if immaterial, will
void the contract.
 If the insured breaches the warranty, the insurer
can void the contract and deny payment of a
claim.
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 Warranties may be either express or implied.
Express warranties are those stated in the contract,
while implied warranties are not found in the contract
but are assumed by the parties to the contract.
 Warranties also may be either promissory or
affirmative.
 A promissory warranty is a condition, fact or
circumstance to which the insured agrees to be held
during the life of the contract. for example that an
insured will ensure that all fire extinguishers on
the ship are serviced annually is an example of a
promissory warranty.
 An affirmative warranty is the one that must exist
only at the time the contract is first put into effect.
 For example, if someone sells a car and promises
that it has no problems, that is an affirmative
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 Some losses may be covered by more than 1 insurance
policy. Insurance companies have developed various
solutions to prevent the insured from profiting from multiple
insurance policies.
 These provisions apply when more than one policy covers
the same loss.
 The purpose of these provisions is to prevent profiting from
insurance and to support the principle of indemnity policies.
The conditions to satisfy the requirement of contribution are:
 All the insurance must relate to the same subject matter,
 They should cover the same interest of the same insured,
 They should cover same peril, and
 All of them should be in force at the time of loss.

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 Pro-rata liability clause
 Contribution of equal shares, and
 Primary and excess insurance
1. Pro-rata Liability Clause
If a loss occurs that is covered by more than 1
insurance policy that was purchased by the
insured, then each policy pays a portion of the
loss that is proportional to the amount of that
policy over the total amount of all policies for the
loss―each policy pays its pro rata share.

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 You want to insure a building for $1,000,000, but,
for underwriting reasons, the maximum amount
that you can purchase from 3 insurance
companies is $600,000; $300,000, and $100,000,
so you purchase the 3 policies with the maximum
limits.
 If you suffer a $200,000 loss, then the 1stcompany
will pay 60% of the loss, the 2nd, 30%, and the 3rd,
10%.

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 According to contribution by equal shares, each
company pays an equal amount until the loss is
covered, or the policy limit of any policy is
reached.
 If 1 or more of the policy limits are reached, then
the equal share principle applies to the
remaining insurers.
 As each policy limit is reached, the remaining
insurers make equal payments with the remaining
amount of uncovered loss until the loss is covered
or all policies are maxed out.
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 Consider the same facts as in the 1st example.
 If you have a $150,000 loss, then each company
pays$50,000 for a total of $150,000.
 If your loss was $400,000, then each company
pays $100,000, and the 2 with higher coverage
pay an additional $50,000 for a total of $400,000.
 If your loss was$800,000, then the low-limit
company pays its policy limit of $100,000, the
next company pays its policy limit of $300,000,
and the remaining insurance company pays the
remaining $400,000 to cover the loss.

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 This method of determining insurance payouts is
commonly used where insurance by different
people's policies cover the same loss.
 Sometimes the amount that each company pays is
determined by which insurance company is
considered primary and which is excess.
 The primary insurer pays first, and the excess
insurer pays only after the policy limits under the
primary policy are exhausted.
 Many liability insurance policies are set upon an
excess basis.

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 For example, suppose that Kombolcha Textile
Factory has Birr 500, 000 in liability insurance from
X, with a Birr 1 million excess liability policy from
insurer Y. If Kombolcha Textile Factory incurs a
Birr 750, 000 liability risk, insurer X will pay up to
its limit of Birr 500,000.
 Then the excess insurance provided by insurer Y
becomes payable,
In this case, insurer Y will pay Birr Birr 250,000.

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 The term proximate cause refers to the nearest
cause leading to the loss. It is the direct cause of
a loss event. The principle of proximate cause is
the cause that is primary to the occurred
event.
 The legal doctrine of proximate cause is based
on the principle of cause and effect.
 And it does not concern itself with the cause of
causes. The law provides the rule "cause
proximate non remote spectator" which means to
be proximate; a cause must be immediate cause,
which is effectual in producing that result but not
the remote or distant one.
 And this cause has to be selected by applying
common sense standards i.e.,5/2/2024
the standards of a36
 An insurance policy is designed to provide
compensation only for insured perils i.e., Named
in the policy as insured ex. Fire, theft etc. but not
for uninsured (not mentioned in the policy).
 And the liability of the insurer arises only if the
loss is caused by an insured.
 The selection of proximate cause is not an easy
and simple task because loss may be caused by
several events acting simultaneously or one after
the other.
 It is necessary to differentiate between the
insured peril, the excepted peril and the
uninsured peril.
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 Ato Abebe insured his car worth of Br. 500,000 in
two insurance companies: Ethiopian insurance
and Awash insurance company for birr 300,000
and Br. 200,000 respectively. While the policy is in
force the car was damaged due to collusion done
intentionally by kebede. The loss is estimated to
be birr 200,000
 Required
A. How much each insurance is going to pay to ato
Abebe? Why?

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B. How much Ato Abebe is going to claim? Why?
c. Ato Abebe has an intention to claim compensation from
the two insurance companies and kebede at the same
time. Advice him. What he/she does?

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A. The insured has the right to claim compensation from
the insurer as far as the policy is in force an equal
amount to the loss or face value of the policy.
(indemnity principle).
Due to contribution principle, Abebe can claim the
amount of loss br 200,000 from the two companies.
They contribute to the loss based on the proportion
insured.
The proportion is calculated as
For EIC = 300,000/500,000 = 0.6 or 60%
For AwIC = 200,000/500,000 = 0.4 or 40%

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B. Ato Abebe can collect a total of Birr. 200,000 an
amount of the loss and 120,000 br. (0.6*200,000) from
EIC and 80,000 br. (0.4*200,000) from AIC
C. Ato Abebe cannot collect from the insurance companies
and the wrong doer Ato Kebede because of the principle
of indemnity and subrogation.

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 Understanding of the legal interpretation of
insurance contracts can be important to a risk
manager, for several reasons.
 One reason in fundamental in deciding whether
to use insurance or some other risk management
tools, the insured or the risk manager should
know what the insurer promises to do under the
contract.
 The risk manager also should understand the
rights and responsibilities of the insurer and the
insured under the contract.

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 Insurance contracts are agreements between the
insurance companies and the insured for the
purpose of transferring from the insured to the
insurer part of risk or loss arising out of
contingent events. The contract serves the
following functions:
 Define the risk to be transferred
 State the condition under which the contract
parties should know such as premium and
performance of certain acts.
 Explain the procedure for selling loss claims.

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A. 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.
 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 an
assignment of the insured’s (Mr. Y) rights to the
new owner (Mr. X)

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 Insurance contracts are commonly unilateral
contract.
 After the insured has paid the premium and the
contracts 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” mean; in this case the
insurer. A typical contract other than insurance is
bilateral.

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 Insurance contract are conditional contract.
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 conditions 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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 Insurance contracts 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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 Insurance contract is usually contract of adhesion.
 The insured seldom participate 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
provision in the favor of the insured and interpreted
for the benefit of the insured.

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F. Contracts of uberrimae Fidei
 The literal meaning of “uberrimae Fidei” is
utmost good faith that can be restated as the
highest standards of honesty.
 Insurance contract are contracts of utmost good
faith.
 Both parties to the contract are bound to disclose
all the fact relevant to the transaction.
 Neither party is advantage of the others lack of
information.

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 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 insured do not allow insured’s to make
profit from happening of a particular risk, life and
frequently health insurance contracts of
indemnity.

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 According to the law of contracts, a contract must satisfy
some conditions before it is legally enforceable some of
these are:
 The contract must serve a legal purpose
 One party must make a definite offer and a second party
must accept the offer.
 Each party to the contract must be required to make
some consideration on behalf of the other party.
 The contract is not enforceable unless one part gives up a
right power , or privilege that he/she already has in
exchange for an equivalent renouncement by the other.
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 The parties to the contract must be legally
competent . insane, minors or intoxicated
persons are not considered competent .
 The purpose of the contract should not be
contrary to public interest.
 Valid elements common to insurance
contracts
 A valid insurance contract includes the following
documents and conditions. They are:
 application
 binders
 policy forms
 endorsement

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 Application: is an offer to enter into a contract.
The prospective insured sets forth the facts and
figures required by the insurance company.
Application may take oral or written form.
 Binders: are temporary documents, which remain
in force for few days for not more than 10 days.
 Policy forms: policy form is a formal written
contract of insurance. the common provisions
included in this document are:

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 Declarations: This identifies the insured, describes the
property, activity or life being insured, states the types of
coverage purchased, terms of coverage, and indicates the
premium paid.
The purpose of declaration is to give sufficient information
needed for the insured.
 Insuring agreement: this part states what the insurer
promise to do.
 Exclusions: the contract may exclude certain perils,
property sources of liability, persons, losses, location or
time periods.
 Conditions: this prescribes certain conditions that should
be meeting by the insured.
 Endorsement: is a form that is used to modify the policy
contract.
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