Lecture Four ：

Fundamental Principles in Insurance

Learning objectives

Explain the fundamental legal principles that are reflected in insurance contractsExplain how the legal concepts of representations, concealment, and warranty support the principle of utmost good faithDescribe the basic requirements for the formation of a valid insurance contractAccess an internet site and obtain consumer information on insurance law

Main Contents

Principle of Indemnity

Principle of Insurable Interest

Principle of Utmost Good Faith

Principle of Proximate Cause

Principle of Subrogation

Principle of Indemnity

Definition

The main contents

The exceptions

The principles derived from indemnity

Definition of Principle of Indemnity

It is one of the most important legal principles in insurance.

It states that the insurer agrees to pay no more than the actual amount of the loss; namely, the insured should not profit from a loss.

Most property and liability insurance contracts are contract of indemnity.

A contract of indemnity does not mean that all covered losses are always paid in full.

Definition of the principle of Indemnity

Why this principle? Two purposes:

First ， prevent the insured from profiting from a loss.

Second, reduce moral hazard. How to do ？

DeductiblesLimits on the amount paidOther contractual provisions

Actual cash value

Actual Cash Value underlies the principle of indemnity. In property insurance, the basic method for indemnifying the insured is based on the actual cash value. There are three major methods to determine actual cash value:

Replacement cost less depreciation Fair market value Broad evidence rule

Actual cash value

Replacement cost less depreciation: Replacement cost is the current cost of restoring the damaged property with new materials of like kind and quality.The rule is used for property insurance : Actual cash value=replacement cost –depreciation It takes into consideration both inflation and depreciation of the property value over time. (Examples)

Actual cash value

Fair market value: It is another method to determine actual cash value of a lossIt is the price a willing buyer would pay a willing seller in a free market. Maybe lower than its actual cash value

(Examples)

Actual cash value

Broad evidence rule ：It is another method to determine actual cash value of a loss when determining the actual cash value of property, an expert considers all the relevant factors including as follows:

Replacement cost less depreciation Fair market value,Present value of expected income from the propertyComparing the similar property, etc.

Exceptions of principle of indemnity

There are several important exceptions to the principle of indemnity including the following:

valued policy valued policy laws replacement cost insurance life insurance

Exceptions of principle of indemnity

Valued policy It is one that pays the face amount of insurance if a total loss occurs. Valued policy is used to insure antiques, fine arts, rare paintings, and family heirlooms, etc. Valued policy violates the principle of indemnity (Examples)

Exceptions of principle of indemnity

Valued policy laws It is a law that exists in some states in U.S. 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.

Exceptions of principle of indemnity

Replacement cost insurance It means there is no deduction for depreciation in determining the amount paid for a loss. the replacement cost insurance is based on the recognition that payment of the actual cash value can still result in a substantial loss to the insured due to depreciation. (examples)It violates the principle of indemnity

Life Insurance ：Life insurance contract is not a contract of indemnity. It is a valued policy that pays a stated sum to the beneficiary upon the insured’s death. The actual cash value (replacement cost less depreciation) is meaningless in determining the value of human life. (examples)

Principle of Insurable Interest

Definition

The purpose of an insurable interest

Examples of an insurance interest

Definition of insurable interest

The principle of insurable interest 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.

(examples)

The purpose of an insurable interest

All insurance contracts must be supported by an insurable interest. The reasons are:

to prevent gambling to reduce moral hazard to measure the amount of the insured’s

loss in property insurance

The important conditions of insurable interest

First, it is a legal interest. All the property from theft, fraud, smuggle has no insurable interest

Second, it is predictable value

Third, it is economic value

Examples of an insurance interest

An insurable interest In property and liability insurance ownership of property: (examples) potential legal liability (examples) secured creditors (examples) employer for employee contractual right: (examples)

Examples of an insurance interest

An insurable interest In life insurance: No requirement on the insurable interest when a person

buy life insurance for himself or herself.

An insurable interest is required if a person wish to buy a life insurance for another person. e.g. relationship by close family ties, or

marriage is insurable ;While remote family relationship is not insurable.

a pecuniary interest is exceptional

Examples of an insurance interest

When must an insurable interest exist?

In property insurance, the insurable interest must exist at the time of the loss.

In life insurance, the insurable interest requirement must be met only at the inception of the policy, not at the time of death.

Principle of Utmost Good Faith

Definition

Main contents

The legal effect of breaking the utmost good faith principle

Definition of utmost good faith principle

The principle of utmost good faith means a higher degree of honesty is imposed on both parties to an insurance contract This principle has its historical roots in ocean marine insuranceThe principle imposes a more higher degree of honesty on the applicant for insurance

Main contents of utmost good faith principle

The principle of utmost good faith is supported by three important legal doctrines as follows: RepresentationsConcealment warranty

Main contents of utmost good faith principle

Representations:

The statements made by the applicant for insurance. That’s tell the true facts about the insured and/or the subject matter( 保险标的 ).

（ 1 ） In life insurance, the applicant should be asked questions concerning the insured’s age, height, occupation, state of health, family history, and other relevant questions.

（ 2 ） In property insurance, such information as quality, quantity, location, value, so on should be stated.

（ 3) Increase in hazard

Main contents of utmost good faith principle

Representations:

An Insurance contract is voidable at the insurer’s option if the presentation is ：

(1) Material (the true facts not fitting for the required conditions by the insurer. )

(2) False (not true facts, or misleading)

(3) Relied on by the insurer (at specified /adjusted premium)

(4) Innocent misrepresentation （ unintentional ）

Main contents of utmost good faith principle

Concealment: It is intentional failure for the applicant to reveal a material fact to the insurer. That is the applicant deliberately withholds material information from the insurer. The legal affect of a material concealment is:The contract is voidable at the insurer’s option (examples)

Main contents of utmost good faith principle

warranty: It is 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. Examples:

Not drunk drivingLocking the doorFire extinguisherAny breach of the warranty allows the

insurer to deny payment of a claim.

The legal effect of breaking the utmost good faith principle

Against the responsibilities of Representation:

the insurer may not take the responsibility due to such reasons as: negligence, mis-represent the facts, or conceal the facts deliberately .

The legal effect of breaking the utmost good faith principle is that the insurer will deny the loss claim.

Principle of Proximate Cause

Definition of the principle of proximate causeIn many cases, a loss is caused by several reasons, not a single one. Thus, the principle of proximate cause is used in the insurance contract. It means among several causes, the insurer tries to examine whether the most effective and decisive cause is under the coverage of the insurance contract. If yes, the insurer pay the sum of insurance amount; otherwise, will not pay.

Principle of Proximate Cause

Application of the principle of proximate cause

in the case of a single cause: (examples)

in the case of multi causes (examples)

in the case of multi and continuous causes (examples)

principle of subrogation

The principle of subrogation strongly support the principle of indemnity. ((TEXT P 34-35)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. (examples)The insurer is entitled to recover from a negligent third party any loss payments made to the insured.

principle of subrogation

Subrogation does not apply if a loss payment is not made.

However, if a loss payment is made by the insurer, the insured gives to the insurer legal rights to collect damages from the negligent third party.

principle of subrogation

Purpose of subrogation:

subrogation has three basic purposes:

first, prevent the insured from collecting twice for the same loss.

second, hold the guilty person responsible for the loss.

third, help to hold down insurance rates.

principle of subrogation

Importance of subrogation: (TEXT P35) There are five importance of the principle of subrogation as follows:

By exercising subrogation rights, the insurer is entitled only to the amount It has paid under the policy.

The insured cannot impair the insurer’s subrogation rights.

The insurer can waive its subrogation rights in the contract.

Subrogation does not apply to life insurance The insurer cannot subrogate against its own insured.

principle of pro rata liability

Pro Rata Liability is a generic term for a provision that applies when two or more policy 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 propose of Pro Rata Liability clause is to preserve the principle of indemnity and to prevent profiting from insurance. （ examples)

the principle of contribution by equal shares

Contribution by Equal Share( 等额分摊 ) is another type of provision used in liability insurance contracts.

It means 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.

(to be explained in detail in chapter 5 ）

Summary

Insurance has four fundamental legal principles:the principle of indemnity states that the insurer should not pay more than the actual amount of loss. In other words, the insured should not profit from a covered loss.there are several exception to the principle of indemnity.

The principle of insurable interest means that the insured must stand to lose financially if a loss occurs, or must incur some other kind of harm if the loss takes place.

Summary

The principle of utmost good faith means that a higher degree of honesty is imposed on both parties to an insurance contract.

The legal doctrine of representations, concealment and warranty support the principle of utmost good faith .

There are several derived principles from the principle of indemnity .

Review questions

1. Explain the principle of indemnity. How does the concept of actual cash value support the principle of indemnity?

2. What is an insurable interest? Why is an insurable interest required in every insurance contract?

3. Explain the principle of utmost good faith. How do the legal doctrines of representations, concealment, and warranty support the principle of utmost good faith?

Review questions

4. Explain the principle of subrogation? Why subrogation used?

5.What is the Principle of Proximate Cause? Use examples to explain how it works in different situations?

6. Explain what is the principle of pro rata liability ?

Case Application