Chapter 9: Fundamental Legal Principals

Legal Principles of Insurance 

• Principle of Indemnity 

• Principle of Insurable Interest 

• Principle of Subrogation  

• Principle of Utmost Good Faith

Principle of Indemnity

• The insurer agrees to pay no more than the actual amount of the loss. 

• Purpose is to prevent the insured from profiting from the loss. 

Replacement Cost vs. Actual Cash Value

• Replacement Cost (RC)

  • The cost to replace property with an item of like kind and quantity (similar workmanship and materials). 

  • Not the same as historical cost! 

• Actual Cash Value (ACV)

  • Replacement Cost less depreciation. 

  • In property insurance, indemnification is usually based on the actual cash value of the property at the time of loss. 

 

What is the Value?

• Roof installed in 2016 for $5000 (historical cost), has a useful life of 20 years. 

• Will cost $6000 to replace based on current costs (replacement cost). 

• After depreciation, the actual cash value is $3600. Depreciation is 40% (8 years old / 20 year useful lifespan).  

$135

Example 1 – What is the ACV? 

Samsung 50" TV 

• Cost $750 when purchased in 2017.

• Useful life is 10 years 

• Current model (like kind/quality) is $450. 

$2250000 

Example 2 – What is the ACV? 

• Warehouse Building 

  • Cost $2500000 when built in 2019. 

  • Useful life of 20 years 

  • Fire completely destroys building in 2024 

  • Current reconstruction cost is $3000000 

Other Types of Indemnity 

• Market Value: Price a buyer would be willing to pay in a free market. 

• Valued Policy: A policy that pays the face amount of insurance if a total loss occurs (life insurance). 

• Valued Policy Law (in some states): Requires payment of the face amount of insurance if a total loss to real property occurs from a peril specified in law. 

Principle of Insurable Interest

• The insured/beneficiary must be in a position to lose financially if a covered loss occurs. 

• Why? 

  • Prevents gambling on losses. 

  • Reduces moral hazard. 

 

Examples of Insurable Interest

• Ownership of property (house, car) 

• Potential legal liability (business owner) 

• Secured creditors (mortgage company, auto lender) 

• Contractual right (goods in transit)  

When Must an Insurable Interest Exist?

• Property Insurance

  • At time of loss. 

  • Can't collect on an insurance policy after you sell your home. 

• Life Insurance

  • At inception of policy 

  • Ex-spouse can still collect on life insurance if listed as policy beneficiary. 

Principle of Subrogation

• Substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third-party loss covered by insurance. 

• Example 

  • Someone else hits your car. 

  • Your insurance company pays you for the damages to your vehicle. 

  • Your insurance company sues the other driver for reimbursement. 

Reasons for Subrogation

• Prevents insured from collecting twice (once from insurer, once from responsible party). 

• Holds the negligent party responsible for the loss. 

• Reduces insurance claims costs (and therefore, rates). 

Principle of Utmost Good Faith

• A higher degree of honesty is imposed on both parties to insurance contracts than is imposed on parties to other contracts. 

• Supported by three legal doctrines: 

  • Representations 

  • Concealment 

  • Warranty 

Representations

• Statements made by the applicant for insurance. 

• What if the statements are false (misrepresentations)? 

• Contract is voidable if the misrepresentation is:

  1. Material,

  2. False, and 

  3. Relied on by the insurer. 

The contract is voidable.

Is the contract voidable?  

A smoker lies on their life insurance application and later dies in an auto accident.

The contract is not voidable.

Is the contract voidable? 

Insured's birthday on an application is listed as August 1 when it's August 11.

Concealment

• Intentional failure of the applicant for insurance to reveal a material fact to the insurer. 

• Contract can be voided if: 

  • Concealed fact was known by the insured to be material. 

  • Insured intended to defraud the insurer. 

Warranty

• A statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all respects. 

• A condition agreed to by an insured in order to receive coverage. 

• Violation of a warranty may result in a claim being denied. 

What is Bad Faith?

• Law that allows lawsuits against insurance companies for: 

  • Improper denial of claims. 

  • Improper delay of claims. 

• Bad faith damages can exceed policy limits and include:  

  • Attorney's fees 

  • Emotional distress 

  • Punitive damages 

Requirements of an Insurance Contract

To be legally enforceable, an insurance contract must meet the following requirements: 

• Offer and Acceptance 

• Exchange of Consideration 

• Competent Parties 

• Legal Purpose 

Offer and Acceptance

• Insured and completes an application (the offer). 

• Insurance companies issues a binder or policy (acceptance). 

• The insurance company can also reject the offer. 

• Conditional Premium Receipt 

  • Receipt given to applicant for life insurance. If policy is approved, coverage becomes effective as of the date of the application. 

Exchange of Consideration

• The value that each party gives one another. 

• Insured pays a premium. 

• The insurer promises to pay future claims covered by the contract (policy). 

Competent Parties

• Parties must have legal capacity to enter into a binding agreement. 

• Insured must: 

  • Be old enough to enter into a contract. 

  • Not intoxicated. 

  • Not insane.

• Insurer must be legally competent and licensed to sell within state.  

Legal Purpose

• Contract that encourages something illegal or immoral is contrary to public interest and cannot be enforced. 

Distinct Legal Characteristics of Insurance Contracts

• Aleatory Contract  

• Unilateral Contract 

• Conditional Contract 

• Personal Contract 

• Contract of Adhesion 

Aleatory Contract

• Values exchanged may not be equal but depend on an uncertain event. 

• Examples: 

  • Mia pays $1000 for homeowners insurance. Her house burns down and the insurance company pays her $200000. 

  • Jules has paid $1000 a year every year for 20 years for homeowners insurance. He's never filed a claim, so his insurer has never paid him any money. 

Unilateral Contract

• Only one party (insurer) makes a legally enforceable promise.  

• Insurer makes legally enforceable promise to pay claims.  

• Insured cannot be legally required to pay premiums. 

Conditional Contract

• The insured must comply with all policy conditions to collect for a covered loss. 

• Conditions – Provisions within the policy that qualify or place limitations on the insurer's promise to perform. 

• Example – Your Duties After Loss 

  • Give immediate notice to us or our agent. 

  • Protect the property from further damage. 

Personal Contract

• Contract is between the insured and insurer. 

• Policy cannot be validly assigned to another party without the insurer's consent. 

Contract of Adhesion

• Insured must accept the entire contract, with all of its terms and conditions. 

• Because this is imbalanced, courts have ruled that any ambiguities or uncertainties in the contract are construed against the insurer. 

• Principle of Reasonable Expectations 

  • An insured is entitled to coverage under a policy that he or she reasonably expects it to provide, regardless of policy provisions. 

Law of Agency

• There is no presumption of an agency relationship. 

• An agent must be authorized to represent the principal. 

• A principal is responsible for the acts of agents acting within the scope of their authority. 

• Limitations can be placed on the powers of agents. 

 

Waiver and Estoppel

• The doctrines of waiver and estoppel may require an insurer to pay a claim that it ordinarily would not have to pay. 

• Waiver: The voluntary relinquishment of a known legal right. 

• Estoppel: The loss of a legal defense because of previous actions that are now inconsistent with that defense.