Chapter Five

Analysis of Insurance Contracts

Although insurance contracts are not identical, they contain some common contractual
provisions. Topics discussed in this chapter include: basic parts of an insurance contract,
coinsurance and other insurance provisions.

5.1. Basic Parts of an Insurance Contract

Insurance contracts are complex legal documents. Despite their complexities, insurance contracts
generally can be divided into six parts:

 Declarations
 Definitions
 Insuring agreement
 Exclusions
 Conditions
 Miscellaneous provisions

Although all insurance contracts do not necessarily contain all six parts in the order given,
such a classification provides a simple and convenient framework for analyzing most
insurance contracts.

a) Declarations

The declarations section is the first part of an insurance contract. Declarations are statements that
provide information about the property or activity to be insured. Information contained in the
declarations section is used for identification of the property or activity to be insured. The
declarations in an insurance contract typically constitute the first page or pages of the contract,
often taking the form of a table in which information identifying the insured objects or situations
is filled in.

In property insurance, the declarations page contains information concerning the identification of
the insurer, name of the insured, location of the property, period of protection, amount of
insurance, amount of premium, and any other relevant information. In life insurance, the first
page of the policy usually contains the insured’s name, age, premium amount, issue date, and
policy number.

To avoid later disputes or unexpected denial of claims, an insurance analyst should verify that
the information appearing on the policy declarations is complete and correct and that the desired
coverage is provided.

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 b) Definitions

Insurance contracts typically contain page or section of definitions. Key words or phrases have
quotation marks (“…”) around them or are boldface type. For example the insurance is
frequently referred to as “we, “or “us.” The insured is referred to as “you” and “your.” The
purpose of the various definitions is to define clearly the meaning of key words or phrases so that
coverage under the policy can be determined more easily.

c) Insuring agreement

The insuring agreement is the heart of an insuring contract. The insuring agreement summarizes
the major promises of the insurer. The insuring agreement normally states what the insurer
agrees to do and the major conditions under which it so agrees. The insurer, in other words,
agrees to do certain things, such as paying losses from insured perils, providing certain services
(such as loss-prevention service),or agreeing to defend the insured in a liability lawsuit. The
promises of the insurer and the condition under which losses are to be paid are described in the
insuring agreement.

Named perils versus all-risk agreements: There are two basic forms of an insuring agreement in
property and liability insurance (1) named perils coverage and (2)”all-risk” coverage. Under
named-perils policy, only those perils specifically named in the policy are covered. If the peril
is not named, it is not covered. For example, in the homeowners’ policy, personal property is
covered for fire, lighting, windstorm, and certain other named perils. Only losses caused by these
perils are covered. Flood damage is not covered, since flood is not a listed peril.

Under an “all-risks” policy (also called an open perils policy), all losses are covered except
those losses specifically excluded. “All risks” coverage is generally preferable to a named-perils
contract, since the protection is broader with fewer gaps in coverage. Life insurance is an
example of an “all-risks” policy. Most life insurance contracts cover all causes of death whether
by accident or by disease. The major exclusions are suicide during the first two years of the
contract, certain aviation hazard exclusions, such as military flying, and in some contracts, death
caused by war.

d) Exclusions

Exclusions are used to help define and limit the coverage provided by an insurer. Policies often
have very broad insuring agreements, with the coverage subsequently narrowed by the use of
exclusions. Typically, exclusions are used to restrict coverage of given perils, losses, property,
and locations.

e) Conditions

The conditions section is another important part of an insurance contract. Conditions are
provisions in the policy that qualify or place limitations on the insurer’s promise to perform. In

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effect, the conditions section imposes certain duties on the insured if he or she wishes to collect
for a loss. If the policy conditions are not met, the insurer can refuse to pay the claim. Common
policy conditions include notifying the insurer if a loss occurs, protecting the property after a
loss, filing a proof of a loss with the insurer, and cooperating with insurer in the event of a
liability suit.

Miscellaneous Provisions

Insurance contracts also contain miscellaneous provisions that are common to all insurance
contracts. These provisions deal with the relationship between the insured and insurer, and the
relationship and responsibility of the insurer toward third parties. In property and liability
insurance, some common provisions refer to cancellation, subrogation, and requirements if a loss
occurs, assignment of the policy, and other-insurance provisions. In life and health insurance,
some common provisions refer to the grace period, the reinstatement of a lapsed policy, and the
misstatement of age.

5.2. Coinsurance

The term coinsurance has different meanings in various types of insurance. In health insurance,
the coinsurance clause functions much like a straight deductible, expressed as a percentage. Its
purpose in health insurance is to make the insured bear a given portion, say 20 percent, of every
loss because it has been found through experience that without such a control the charges for
doctors and other medical service tend to be greatly enlarged, thus increasing the premium to a
prohibitive level. The insured who must personally bear a substantial share of the loss is less
inclined to be extravagant in this regard.

In property insurance the coinsurance clause is a device to make the insured bear a portion of
every loss only when underinsured. Underinsurance is looked on as undesirable for two reasons.

First insurers are supposed to restore their insured to the positions or situations they had before
the loss. They obviously cannot accomplish this objective unless the insured is willing to protect
the whole value of the property. Second, it costs relatively more to insure the businesses of those
who are underinsured than it does to handle the businesses of those who purchase insurance
equal to the full value of the object.

5.2.1. Operation of the Coinsurance Clause

Coinsurance is a clause that requires the insured to insure to value or share the loss with the
insurance company. The typical coinsurance clause prorates partial losses between the insurer
and the insured in the proportion that the actual insurance carried bears the amount required
under the clause. Usually 80 or 90 percent of the value of the property is the amount required.

Thus, if there is a building with a value of birr 100,000 written with a 90 percent coinsurance
clause, birr 90, 000 of insurance is required. The insured who carries at least this amount collects

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in full for any partial loss. But the insured who carries half of this amount or birr 45,000, collects
only half of any partial loss. The amount collected in any case may be determined by the
following formula:
Amount of insurance carried x Loss= Amount of recovery
Amount of insurance required
Where amount of insurance required= (coinsurance percent) (value of property)

If the loss equals or exceeds the amount required under the clause (if the loss is nearly total),
there is no penalty invoked by the coinsurance clause. Thus, if in the preceding case the loss
were Birr 90,000 at a time when the insured is carrying only Birr 60,000 of insurance,
substitution in the formula yields
Birr 60,000 x Birr 90,000= Birr 60, 000
Birr 90,000
The recovery is Birr 60,000, the amount of insurance carried, and there is no penalty other than
the fact that the insured did not carry sufficient insurance to cover the entire loss. But if the
losses were birr 15, 000, the recovery would be only (Birr 60,000÷ Birr 90,000) x Birr 15,000=
Birr 10,000. Thus, the coinsurance clause places the burden on the insured to keep the amount of
insurance equal to or above the amount required by the clause. Failing this, the insured becomes
a coinsurer and must bear part of any partial loss. Other examples illustrating the operation of the
coinsurance clause are given below:

Illustration of the coinsurance clause

A. Building value = Birr 500,000

Coinsurance requirement=80%
Insurance carried=Birr 300,000
Loss= Birr 100,000
Recovery from insurance =Birr 300,000 x Birr 100,000= Birr 75,000
0.80x Birr 500,000
B. Building value =Birr 700,000

Coinsurance requirement=80%

Insurance carried=Birr 600,000

Loss =Birr 100,000

Insurance required =0.80 x Birr 700,000=Birr 560,000

Because Birr 600,000>Birr 560,000, the coinsurance requirement is met, and these is no
coinsurance penalty in the recovery of the birr 100,000 loss.

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In applying the coinsurance formula two points should be kept in mind. First, the amount paid
can never exceed the amount of the actual loss even though the coinsurance formula produces
such a result. This could happen if the amount of insurance carried is greater than the required
amount of insurance. Second, the maximum amount paid for any loss is limited to the face
amount of insurance.

5.2.2. Coinsurance in Health Insurance

Health insurance contracts frequently contain a coinsurance clause which is technically called a
percentage participation clause. In particular, major medical policies typically have a
coinsurance provision that requires the insured to pay a certain percentage of covered medical
excess of the deductible. A typical plan requires the insured to pay 20 or 25 percent of covered
expenses in the amount of the deductible. For example assume that Tigist has covered medical
expenses in the amount of birr 50,500 and that she has a major medical policy with a birr 500
deductible and an 80-20 coinsurance clause. The insurer pays 80 percent of the bill in excess of
the deductible or birr 40,000 and Tigist pays 20 percent or birr 10,000(plus the deductible).

The purposes of coinsurance in health insurance are (1) to reduce premiums and to prevent over
utilization of policy benefits. Because the insured pays part of the cost, premiums are reduced. In
addition, it is argued that physicians and other health –care providers will be more restrained in
setting their fees if the patient pays part of the cost, and the patient will not demand the most
expensive medical services if he or she pays part of the cost.

5.3. Other Insurance Provisions

Other insurance provisions typically are present in property and liability insurance and health
insurance contracts. These provisions apply when more than one contract covers the same loss.
The purpose of these provisions is to prevent profiting from insurance and violation of the
principle of indemnity. If the insured could collect the full amount of the loss from each insurer,
there would be profiting from insurance and a substantial increase in moral hazard. Some
dishonest insured would deliberately cause a loss in order to collect multiple benefits.

Some important other insurance provisions in property and liability insurance include (1) the pro
rata liability clause,(2)contribution by equal shares, and (3) primary and excess insurance.

5.3.1. Pro Rata Liability Clause

The pro rata liability clause is a generic term for a provision that applies when two or more
policies of the same type cover the same insurable interest in the property. Each insurer’s share
of the loss is based on the proportion that its insurance bears to the total amount of insurance on
the property. The pro rata clause typically states that if more than one policy is in force on a
given price of property, each policy will pay in the ratio of the face value of each policy divided
by the total amount of insurance in force on the property. For example, assume that Aster owns a

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building and wishes to insure it for birr 200,000. For underwriting reasons, insurers may limit the
amount of insurance they will write on a given property. Assume that an agent places Birr
100,000 of insurance with company A, Birr 50,000 with company B, and Birr 50,000 with
company C, for a total of birr 200,000. If a Birr 10,000 loss occurs, each company will pay only
its pro rata share of the loss as shown below. Thus, Aster would collect Birr 10,000 for the loss
and not Birr 30,000.

Pro rata liability clause

Company A Birr 100,000 x Birr 10,000=Birr 5,000
Birr 200,000
Company B Birr 50,000 x Birr 10,000= Birr 2,500
Birr 200,000
Company C Birr 50,000 x Birr 10,000 =Birr 2,500
Birr 200,000
Total paid = Birr 10,000

The basic purpose of the pro rata liability clause is to preserve the principle of indemnity and to
prevent profiting from insurance. In the preceding example, if the pro rata liability clause were
not prevented the insured would collect Birr 10,000 from each insurer, or a total of birr
30,000`for Birr 10,000 loss.

5.3.2. Contribution by Equal Shares

An alternative to the pro rata approach to apportionment is the equal shares method that is
frequently found in liability insurance contracts. With this method, each insurer shares equally in
the loss until the share paid by each insurer equals the lowest limit of liability under any policy
or until the full amount of the loss is paid. For example, assume that the amount of insurance
provided by companies A, B, and C is Birr 100,000,Birr 200,000,and Birr 300,000 respectively.
If the loss is Birr 150,000 each insurer pays an equal share, or Birr 50,000 as seen below:

Contribution by equal shares

Amount of loss =Birr 150,000

Amount of Insurance Contribution by Equal Shares Total Paid

Company A Birr 100,000 Birr 50,000 Birr 50,000

Company B 200,000 50,000 50,000

Company C 300,000 50,000 50,000

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However if the loss were Birr 500,000, how much would each insurer pay? In this case, each
insurer would pay equal amounts until its policy limits are exhausted. The remaining insurers
then continue to share equally in the remaining amount of the loss until each insurer has paid its
policy limits in full, or until the full amount of the loss is paid. Thus, company A would pay Birr
100, 000, company B would pay Birr 200, 000, and company C would pay birr 200,000 as you
can observe below. If the loss were birr 600, 000, company C would pay the remaining Birr
100,000.

Amount of loss =Birr 500,000

Amount of Insurance Contribution by Equal Shares Total Paid

Company A birr 100,000 birr 100,000 Birr 100,000

Company B 200,000 100,000+100,000 200,000

Company C 300,000 100,000+100,000 200,000

5.3.4. Primary and Excess Insurance

The final approach to stating other insurance clauses is to specify that a particular policy is to
always pay either first or last. The primary insurer pays first, and the excess insurer pays only
after the policy limits under the primary policy are exhausted. Clearly, all else the same, the
premium for primary coverage will exceed that for excess protection.

Many liability insurance policies are set upon an excess basis. For example, suppose Adama
Food Co. has birr 500,000 in liability insurance from insurer X, with a Birr 1million excess
liability policy from insurer Y. If Adama Co. incurs a Birr 750,000 adverse liability judgment,
insurer X will pay up to its limit of birr 500,[Link] the excess insurance provided by insurer Y
becomes payable, up to either its limit or the amount necessary to cover the remaining loss. In
this case, insurer Y will pay Birr 750,000- Birr 500,000,or Birr 250,000.