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

Overview Distribution of Insurance Contracts Distribution of Insurance Contracts Insurance as contracts Insurance as contracts legally enforceable agreements legally enforceable agreements Characteristics of Insurance Contracts Characteristics of Insurance Contracts Fundamental Principles of Insurance Contracts Fundamental Principles of Insurance Contracts Principle of indemnity Principle of indemnity Principle of insurable interest Principle of insurable interest Principle of utmost good faith Principle of utmost good faith Principle of subrogation Principle of subrogation

Distribution of Insurance Contracts Direct Marketing Direct Marketing No outside agent is involved No outside agent is involved Mail marketing, internet based marketing Mail marketing, internet based marketing Exclusive Agent Exclusive Agent represents one insurer represents one insurer Independent Agent Independent Agent represents more than one insurer represents more than one insurer

Distribution of Insurance Contracts Agent versus Broker Agent versus Broker Binding Authority by Agent Binding Authority by Agent Property/Liability Insurance Property/Liability Insurance Binder Binder Life/Health Insurance Life/Health Insurance Conditional premium receipt Conditional premium receipt

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

Insurance as Contracts Property - Casualty Offer Offer Submission of application with a down payment Submission of application with a down payment Acceptance Acceptance Binder 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.

Characteristics of Insurance Contracts 1. Personal Contracts Insurance protects insured, not the property or liability subject to loss. Insurance protects insured, not the property or liability subject to loss. Assignment provision 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 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. In life insurance, the beneficiary or ownership of policy may be freely reassigned.

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. 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 The insurer's obligation to pay a loss depends on uncertain events Premium paid by Insured < Claim paid by Insurer Premium paid by Insured < Claim paid by Insurer cf: commutative contract cf: commutative contract The values exchanged are theoretically equal. The values exchanged are theoretically equal.

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. 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. Insured gets the benefit of the doubt. Courts tend to construe an ambiguous term in an insurance policy in favor of an insured. 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 Contracts may be altered by the addition of riders or endorsements Rider or endorsement – a document that amends or changes the original policy. Rider or endorsement – a document that amends or changes the original policy. cf: Contracts of cohesion cf: Contracts of cohesion Contracts are drafted by both parties. Contracts are drafted by both parties.

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. 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. 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 loss – Homeowners (p. 562) Duties after an accident or loss – Automobile (p. 585) Duties after an accident or loss – Automobile (p. 585) Duties after in the event of loss or damage – CP Duties after in the event of loss or damage – CP

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

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

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

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

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

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

Principle of Indemnity Pro-ration by Face Amounts 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. 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. 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 Share1/62/63/6 Payment$25,000$50,000$75,000

Principle of Indemnity Pro-ration by Amounts Otherwise Payable Pro-ration by Amounts Otherwise Payable The amount what would be payable under each policy in the absence of other insurance 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. 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 Share1/41.5/41.5/4 Payment$37,500$56,250$56,250

Principle of Indemnity Pro-ration by Amounts Otherwise Payable Pro-ration by Amounts Otherwise Payable What if the loss amount is $60,000? 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 Share1/31/31/3 Payment$20,000$20,000$20,000

Principle of Indemnity Contribution by Equal Shares 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. 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 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

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

Principle of Indemnity Exceptions to the Principle of Indemnity Exceptions to the Principle of Indemnity Valued policy (or agreed value) Valued policy (or agreed value) Pays face value of insurance if a total loss occurs Pays face value of insurance if a total loss occurs Life insurance, disability insurance, fine arts, antiques Life insurance, disability insurance, fine arts, antiques Ex.) Value of a fine art is agreed at $250,000. Ex.) Value of a fine art is agreed at $250,000. Valued policy law 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. 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 Replacement cost No deduction for depreciation in determining the amount paid for a loss. No deduction for depreciation in determining the amount paid for a loss.

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

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

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

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

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. 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? Why? To prevent collecting twice To prevent collecting twice To hold the negligent party responsible To hold the negligent party responsible To hold down insurance rates To hold down insurance rates

Principle of Subrogation The insurer is entitled only to the amount it has paid under the policy. 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? 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. The insured cannot impair the insurer’s subrogation rights. Subrogation does not apply to life insurance and to individual health insurance contracts. Subrogation does not apply to life insurance and to individual health insurance contracts. The insurer cannot subrogate against its own insured. The insurer cannot subrogate against its own insured.

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