Topic 10. Legal Principles in Insurance Contracts

1. Topic 10. Legal Principles in Insurance Contracts BUS 200 Introduction to Risk Management and Insurance Jin Park

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. 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 Insurance as Contracts 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.

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.

19. Principle of Indemnity • Pro-ration by Amounts Otherwise Payable • What if the loss amount is $60,000?

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

21. Principle of Indemnity • Contribution by Equal Shares • What is the loss amount is $400,000?

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. 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