Academic Purpose

1. LEGAL PRINCIPLES IN
INSURANCE CONTRACTS
Soumendra Roy

2. OVERVIEW
• Distribution of Insurance Contracts
• Insurance as contracts
–legally enforceable agreements
• Characteristics of Insurance Contracts
• Fundamental Principles of Insurance
Contracts
–Principle of indemnity
–Principle of insurable interest
–Principle of utmost good faith
–Principle of subrogation

3. DISTRIBUTION OF INSURANCE
CONTRACTS
• Direct Marketing
–No outside agent is involved
–Mail marketing, internet based marketing
• Exclusive Agent
–represents one insurer
• Independent Agent
–represents more than one insurer

4. DISTRIBUTION OF INSURANCE
CONTRACTS
• Agent versus Broker
• Binding Authority by Agent
–Property/Liability Insurance
• Binder
–Life/Health Insurance
• Conditional premium receipt

5. INSURANCE AS CONTRACTS
• Elements of contract
– Agreement
• Offer and Acceptance
– Consideration
• Insured – premium payment and fulfillment of policy
conditions
• Insurer – promise to do certain things as specified in
the contract (insurance policy)
– Legally competent parties
• Parties must have legal capacity to enter into a binding
contract
– Legal Purpose
• Contract must be for a legal purpose
– Legal Form
• Contract may be oral or written
• Some insurance policy provisions and attachments
must be approved by regulator before being marketed

6. INSURANCE AS CONTRACTS
Property - Casualty
• Offer
– Submission of application
with a down payment
• Acceptance
– Binder
Life
• Offer
– Submission of application
with a down payment
– Issuance of a life
insurance policy
• Acceptance
– Conditional premium
receipt
Note: Giving a quotation to a prospective insured is deemed
as mere solicitation or invitation to make an offer.

7. CHARACTERISTICS OF INSURANCE
CONTRACTS
1. Personal Contracts
– Insurance protects insured, not the property or
liability subject to loss.
– Assignment provision
• In property insurance, if ownership of a
property changes, insurance contracts
(policies) cannot be transferred to another
party (buyer) without the insurer’s written
consent.
• In life insurance, the beneficiary or ownership
of policy may be freely reassigned.

8. CHARACTERISTICS OF INSURANCE
CONTRACTS
2. Aleatory Contracts
– A contract whose value to either or both of the
parties depends on chance or future events, or
where the monetary values of the parties'
performance are unequal.
• The insurer's obligation to pay a loss depends on
uncertain events
• Premium paid by Insured < Claim paid by Insurer
– cf: commutative contract
• The values exchanged are theoretically equal.

9. CHARACTERISTICS OF INSURANCE
CONTRACTS
3. Contracts of adhesion
– Insurance contracts are drafted by an insurer and an
insured must accept or reject all the terms and
conditions.
– Insured gets the benefit of the doubt.
• Courts tend to construe an ambiguous term in an insurance policy
in favor of an insured.
– Contracts may be altered by the addition of riders or
endorsements
• Rider or endorsement – a document that amends or changes the
original policy.
– cf: Contracts of cohesion
• Contracts are drafted by both parties.

10. Characteristics of
Insurance Contracts
4. Conditional contracts
– An insurer’s obligation to pay a claim
depends on whether the insured or the
beneficiary has complied with all policy
conditions.
– The insurer may not pay a claim if one or
more of policy conditions are not complied.
• Duties after loss – Homeowners (p. 562)
• Duties after an accident or loss – Automobile (p.
585)
• Duties after in the event of loss or damage – CP

11. Characteristics of
Insurance Contracts
5. Unilateral contracts
– Only one party makes a legally enforceable
promise.
– Insured are not legally forced to pay
premium or renew the policy.

12. Fundamental Legal Principles of
Insurance Contracts
1. Principle of indemnity
2. Principle of insurable interest
3. Principle of utmost good faith
4. Principle of subrogation

13. Principle of Indemnity
• The insurer agrees to pay no more than
the actual amount of the loss suffered
by the insured.
• Why?
– The purpose of the insurance contract is to
restore the insured to the same economic
position as before the loss.
– The insured should not profit from a loss.
– It reduces the moral hazard by eliminating
the profit incentive.

14. Principle of Indemnity
• To support the principal of indemnity an insurance
contact uses Actual Cash Value (ACV) method
– Replacement cost (RC) less depreciation
• RC – current cost of restoring the damaged property with new
materials of like kind and quality.
– Fair market value
• The price of a wiling buyer would pay a willing seller in a free
market.
– Broad evidence rule
• The determination of ACV should include all relevant factors an
expert would use to determine the value of the property.

15. Principle of Indemnity
• To support the principal of indemnity insurance
contact includes “Other Insurance Provisions”.
– Escape clause
• The policy (or insurance) would not apply if the insured was
covered by another policy.
– Primary-Excess
• It (or This insurance) is excess insurance over any other valid
and collectible insurance.
– Pro-rata provision
• Proration by face amounts
• Proration by amounts otherwise payable
– Contribution by equal shares

16. Principle of Indemnity
• Primary-Excess
– Accident while test driving a dealer’s car.
– Health insurance between a couple working
for different employers.
• Own insurance – primary
• Spouse insurance – excess
• Birthday rule for dependents’ coverage

17. Principle of Indemnity
• Pro-ration by Face Amounts
– It limits an insurer’s maximum obligation to the
proportion of the loss that the insurer’s policy
limit bears to the sum of all applicable policy
limits.
– Assume that there are three polices covering the
same loss and the loss amount is $150,000.
Insurer A Insurer B Insurer C
Policy Limit $100,000 $200,000 $300,000
Share 1/6 2/6 3/6
Payment $25,000 $50,000 $75,000

18. Principle of Indemnity
• Pro-ration by Amounts Otherwise Payable
– The amount what would be payable under each
policy in the absence of other insurance
– Assume that there are three polices covering the
same loss and the loss amount is $150,000.
Insurer A Insurer B Insurer C
Policy Limit $100,000 $200,000 $300,000
Payable $100,000 $150,000 $150,000
Share 1/4 1.5/4 1.5/4
Payment $37,500 $56,250 $56,250

19. Principle of Indemnity
• Pro-ration by Amounts Otherwise Payable
– What if the loss amount is $60,000?
Insurer A Insurer B Insurer C
Policy Limit $100,000 $200,000 $300,000
Payable $60,000 $60,000 $60,000
Share 1/3 1/3 1/3
Payment $20,000 $20,000 $20,000

20. Principle of Indemnity
• Contribution by Equal Shares
– Each insurer contributes equal amount until it has
paid its applicable limit of insurance or none of
the loss remains, whichever comes first.
– Assume that there are three polices covering the
same loss and the loss amount is $150,000
Insurer A Insurer B Insurer C
Policy Limit $100,000 $200,000 $300,000
Equal Share $50,000 $50,000 $50,000
Payment $50,000 $50,000 $50,000

21. Principle of Indemnity
• Contribution by Equal Shares
– What is the loss amount is $400,000?
Insurer A Insurer B Insurer C
Policy Limit $100,000 $200,000 $300,000
Equal Share 1 $100,000 $100,000 $100,000
Equal Share 2 N/A $50,000 $50,000
Payment $100,000 $150,000 $150,000

22. Principle of Indemnity
• Exceptions to the Principle of Indemnity
– Valued policy (or agreed value)
• Pays face value of insurance if a total loss occurs
• Life insurance, disability insurance, fine arts, antiques
– Ex.) Value of a fine art is agreed at $250,000.
– Valued policy law
• A law that requires payment of the face amount of
insurance to the insured if a total loss to real property
occurs from a covered peril, regardless of the property’s
ACV.
– Replacement cost
• No deduction for depreciation in determining the amount
paid for a loss.

23. Principle of Insurable Interest
• The insured must be in a position to
financially suffer if a loss occurs.
• Why?
– To prevent gambling
• Insurance on a property and wait for a loss occur.
– To reduce moral hazard
• Life insurance on a person and pray for his/her death for
insurance proceeds.
– In order not to indemnify more than an insured’s
financial interest
• It supports the principle of indemnity.

24. Principle of Insurable Interest
• Property-Casualty insurance
– At the time of a loss, an insured must have
insurable interest.
– No insurable interest no financial loss
no indemnity support Prin. of
indemnity
• Life Insurance
– Insurable interest must exist at the time
of a policy inception, but not at the time of
a loss (death)

25. Principle of Utmost Good Faith
• A higher degree of honesty is imposed
on an insurance contract than is imposed
on other contracts
– Honesty is mainly imposed on the insurance
applicants.
– It is supported by three legal doctrines
• Representation
• Concealment
• Warranty

26. Principle of Utmost Good Faith
• Representation
– Statements made by an applicant
– Insurance is voidable at the insurer’s option.
• Material
• False
• Reliance
– cf: Innocent misrepresentation
• Concealment
– Intentional failure to disclose a material fact
• Warranty
– 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.
• In exchange for a reduced premium, a store owner warrants
that a burglar alarm will be always on.

27. Principle of Subrogation
• Substitution of the insurer in place of
the insured for the purpose of claiming
indemnity from a third party wrongdoer
for a loss paid by the insurer.
– Why?
• To prevent collecting twice
• To hold the negligent party responsible
• To hold down insurance rates

28. Principle of Subrogation
• The insurer is entitled only to the amount it
has paid under the policy.
– What if the insurer collects more, from the
negligent party, than the amount the insurer paid
to its insured?
– The insured cannot impair the insurer’s
subrogation rights.
• Subrogation does not apply to life insurance
and to individual health insurance contracts.
• The insurer cannot subrogate against its own
insured.

29. 29
Life Insurance Products
• Pure Term
• Pure Endowment
Term Plans
Endowment
Whole Life
Money back

30. 30
Pure Term
Year 1 2 3 4 5 6 7 8 9 10
Policy issued for 10 years
death
Payout
to family
Insured person survives till end of policy term =No payout
This is a plan to cover the risk of Early Death

31. 31
Pure Endowment
Year 1 2 3 4 5 6 7 8 9 10
death
No Payout
to family
Pay out only if Insured person survives till end of policy term
This is a plan to cover the risk of Living too Long

32. 32
Traditional Products
Term Plan
Year 1 2 3 4 5 6 7 8
Policy issued for 10 years
death
Year 1 2 3 4 5 6 7 8 9 10
Payout
to family
Insured person survives till end of policy term NO PAYOUT

33. 33
Endowment is a combination of pure term and
pure endowment for the entire policy duration
Year 1 2 3 4 5 6 7 8
Policy issued for 10 years death
Year 1 2 3 4 5 6 7 8 9 10
Payout
To
family
Insured person survives till end of policy term =Payout to policy holder
Endowment would cover the risk of Early Death also the risk of Living too Long

34. 34
Money Back is combination of pure term for the policy
duration and pure endowment for short periods within the
policy term
Yr 0 2 4 6 8 12 14 16 18 20
Policy issued for 20 years with money
back at 5th, 10th, 15th & 20th yr.
death
Payout to family in case of death and
also Payout at regular intervals in case
insured survives
payout
payout
payout
payout
Pure Term Plan from year 1 to year 20
Pure Endowment Plan from
year 1 to year 5
Pure Endowment
Plan from year
6 to year 10
Pure Endowment Plan
from year
11 to year 15
Pure Endowment
Plan from year
16 to year 20
PLUS
Yr 0 5 10 15 20

35. 35
Unit Linked Insurance Plan
ULIP is life insurance solution that provides the
benefits of protection and flexibility in
investment.
The investment is denoted as units and is
represented by the value that it has attained
called as Net Asset Value (NAV).

36. 36
ULIP- A transparent product
In ULIP the premium components are clearly
expressed under following categories
Expenses- The administration and management
charges deducted from the premium
Investment- The amount available to invest in a
fund of client’s choice
Mortality- The mortality charges deducted from
the premium

37. 37
Working of a ULIP Plan
1st year Premium
Deduct
Mortality Charge Admin Charge
Premium Related Charge
With balance amount
Units are purchased
As NAV moves up so as does the Fund Value
2nd year Premium
Mortality Charge Admin Charge
Premium Related Charge
Less
More units are purchased
With balance amount

38. Additional Reading Assignments
• Two insurers seek to void Enron
policies
• Coming Clean on Insurance Applications
• Rescission of Life Insurance Policy
Upheld on Finding of Intent to Deceive
in Application