Fundamental Legal Principles

Lecture No. 17

Objectives

• Principle of Indemnity• Principle of Insurable Interest• Principle of Subrogation• Principle of Utmost Good Faith• Requirements of an Insurance Contract• Distinct Legal Characteristics of Insurance

Contracts• Law and the Insurance Agent

Principle of Indemnity

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

• Purpose:– To prevent the insured from profiting from a

loss– To reduce moral hazard

Principle of Indemnity

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

• There are three main methods to determine actual cash value:– Replacement cost less depreciation– Fair market value is the price a willing buyer would pay a

willing seller in a free market– Broad evidence rule means that the determination of ACV

should include all relevant factors an expert would use to determine the value of the property

Principle of Indemnity

• There are some exceptions to the principle of indemnity:– A valued policy pays the face amount of insurance if a total loss

occurs– Some states have a valued policy law 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

– Replacement cost insurance means there is no deduction for depreciation in determining the amount paid for a loss

– A life insurance contract is a valued policy that pays a stated sum to the beneficiary upon the insured’s death

Principle of Insurable Interest

The insured must stand to lose financially if a loss occurs

• Purpose:– To prevent gambling– To reduce moral hazard– To measure the amount of loss

• When must insurable interest exist?– Property insurance: at the time of the loss– Life insurance: only at inception of the policy

Principle of Subrogation

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.

• Purpose:– To prevent the insured from collecting twice for the same

loss– To hold the negligent person responsible for the loss– To hold down insurance rates

Principle of Subrogation

• The insurer is entitled only to the amount it has paid under the policy

• The insured cannot impair the insurer’s subrogation rights

• Subrogation does not apply to life insurance and to most individual health insurance contracts

• The insurer cannot subrogate against its own insureds

Principle of Utmost Good Faith

A higher degree of honesty is imposed on both parties to an insurance contract than is imposed on parties to other contracts

• Supported by three legal doctrines:– Representations are statements made by the

applicant for insurance• A contract is voidable if the representation is material,

false, and relied on by the insurer• An innocent misrepresentation of a material fact, if

relied on by the insurer, makes the contract voidable

Principle of Utmost Good Faith

– A concealment is intentional failure of the applicant for insurance to reveal a material fact to the insurer

– A warranty is a statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all respects• Statements made by applicants are considered

representations, not warranties

Requirements of an Insurance Contract

• To be legally enforceable, an insurance contract must meet four requirements:– Offer and acceptance of the terms of the

contract– Consideration – the values that each party

exchange– Legally competent parties, with legal capacity

to enter into a binding contract– The contract must exist for a legal purpose

Distinct Legal Characteristics of Insurance Contracts

• Aleatory: values exchanged are not equal• Unilateral: only the insurer makes a legally enforceable promise• Conditional: policyowner must comply with all policy provisions

to collect for a covered loss• Personal: property insurance policy cannot be validly assigned

to another party without the insurer's consent• Contract of adhesion: since the insured must accept the entire

contract as it is written, any ambiguities are construed against the insurer

Law and the Insurance Agent

• An agent is someone who has the authority to act on behalf of a principal (the insurer)

• Several laws govern the actions of agents and their relationship to insureds– There is no presumption of an agency relationship– An agent must be authorized to represent the principal

• Authority is either express, implied, or apparent– Knowledge of the agent is presumed to be knowledge of

the principal with respect to matters within the scope of the agency relationship

– Insurers can place limitations on the power of agents by adding a nonwaiver clause to the application or policy

Law and the Insurance Agent

• Waiver is defined as the voluntary relinquishment of a known legal right

• Estoppel occurs when a representation of fact made by one person to another person is reasonably relied on by that person to such an extent that it would be inequitable to allow the first person to deny the truth of the representation

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The Commercial Package Policy (CPP)

• In January 1986, a new, simplified approach to commercial insurance coverage was introduced by the insurance industry

• Under the Commercial Package Policy (CPP) – The insured can obtain almost all types of

insurance coverage • Broader contract provisions are included in

the CPP • The CPP has seven separate sets of

coverage – Commercial property, liability, crime, boiler and

machinery, commercial auto, inland marine, and farm

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The Commercial Package Policy (CPP)

• An insured can pick and choose coverages in the CPP

• The CPP allows many insureds to use one policy to meet most of their insurance needs – Workers’ compensation and ocean marine

insurance must be purchased separately • The CPP has many options available

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Building and Personal Property Coverage Form • Basic protection for buildings and personal

property in the CPP • Property coverage is divided into three major

categories – Buildings

• Includes the buildings described on the declarations page • Any additions, extensions, fixtures, machinery and

equipment constituting a permanent part of the described buildings

• Service equipment – Your business personal property

• Includes business personal property owned by the insured and usual to the occupancy of the insured

– Personal property of others • Improvements and betterments

– Alterations made to a leased building by the insured that the insured cannot legally remove when the lease is terminated

• Personal property of others in the insureds control – Develops in situations where the insured repairs the property of

others

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Extensions of Coverage

• BPP has extensions of coverage that expand protection to other categories of property – Newly acquired or constructed property – Your business personal property at newly acquired

premises – Personal effects and property of others – Valuable papers and records–cost of research – Property off-premises – Outdoor property

• All of these extensions are an additional amount of insurance – Apply only if the policy has an 80 percent or higher

coinsurance clause

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Specific versus Blanket Coverage

• Under specific coverage, property at one or more locations is listed and specifically insured

• Under blanket coverage, property at several locations may be insured under a single item

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Common Clauses in the BPP

• Common clauses include – Coinsurance– Subrogation– Electrical apparatus

• No loss to electrical items will be covered if caused by artificially generated electrical currents

– Unless fire ensues, and then loss is covered only for the fire damage

– Power failure• Spoilage due to power failure from an insured peril is not

covered unless the loss of power is from an on-premises insured peril

– Operation of building laws• No loss will be paid that results from the operation of

building codes – Alterations and repairs

• Allows the insured to make this type of modification without its being considered an increase in hazard

– Which would cause the coverage to be suspended

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Common Clauses in the BPP

• Two important exclusions were added to property clauses in 2002 – Mold claims

• Have skyrocketed in a few states in the early 2000s• Prior to 2002, mold was listed in the so-called “wear

and tear” exclusion – After the terrorist attacks of September 11,

insurers begin excluding terrorism from their policies • The Terrorism Risk Insurance Act (TRIA) was enacted in

November 2002– By the federal government to provide a backup for

insurers that could not get reinsurance coverage for terrorism

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Insured Perils

• The basic form of the BPP covers – Fire, lightning, explosions, windstorm and hail, smoke, riot

or civil commotion, vandalism, sprinkler linkage, sinkhole collapse, and volcanic action

• The broad form includes the basic perils plus – Falling objects, the weight of ice, sleet, and snow; and

accidental discharge of water or steam from a system or appliance containing steam or water other than an automatic sprinkler system

• The special cause of loss form covers all direct physical losses except those that are excluded – Examples of excluded perils

• Earth movement, flood, war, enforcement of building ordinance, smog, insect damage, and wear and tear

– The old name for this type of coverage was “all risk” • The new name is “open perils”

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Debris Removal

• The BPP form includes coverage for debris removal – However if the loss is > or equal to the policy

• There is additional debris coverage up to $10,000

• BPP provides coverage for costs of pollution cleanup and removal from land or water at the described premises

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Subrogation • Practically all contracts of property

insurance are subject to the right of subrogation – By the insurer against any liable third party

• It may turn out, for example, that while the insured’s property insurance provides coverage for loss – Someone else has agreed to assume this

liability by contract or is held liable because of its negligence in causing the damages • If the insurer pays the claim, it has a right to any such

claims that the insured may have had against others • Such recoveries assign responsibility to the party that

is responsible for the damages – Holding that party accountable for its actions

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Endorsements used with the BPP

• An insured can add earthquake and radioactive contamination to the list of insured perils

• The limits of recovery on such property as outdoor signs, trees, shrubs, plants, and radio and television antennas may be increased

• Special market value endorsements are available for distilled spirits and wines

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Endorsements used with the BPP

• Two endorsements that modify the BPP include – Replacement cost

• Like that found in the homeowner’s policy and changes the basis of recovery from actual cash value to replacement cost

– Ordinance and law endorsement • Used when older buildings must be repaired according

to a more stringent building code

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Boiler and Machinery Insurance (Equipment Breakdown Coverage)• Explosions caused by steam boilers, compressors,

engines, electrical equipment, flywheels, air tanks, and furnaces constitute a serious source of loss that the layperson often does not recognize

• Has developed along somewhat different lines from the usual insurance contract – Recognizing that prevention of losses is even more

important than indemnification of loss• Insurers have taken on the service of inspection and

servicing of boiler operations and technical machinery – Failure of the vessel to pass an inspection may mean imminent

danger to continued operations – The insurer reserves the right to suspend coverage immediately

if recommended repairs or replacements are not made

End of Lecture 17