8/3/2019 Principle of Indemnity

1/4

Principle of Indemnity

Now that you have been introduced to risk, risk management,and insurance, it's time to analyze the fundamental legalprinciples surrounding insurance contracts. Insurance contracts

are technical in nature and have many provisions that you willlearn about in this lesson.

The first topic we will look at is the principle of indemnity.Under this principle, you should collect the amount of your loss;no more, no less. In insurance terminology, that value is calledthe actual cash value (ACV) of the loss. ACV is computed using the following equation:

ACV = Replacement Cost - Applicable Depreciation

Calculation of the actual cash value can be illustrated with an example. Assume an insured

purchased an asset that cost $600 and insured the asset on an actual cash value basis. The assetwas later destroyed by an insured peril. The asset was 40 percent depreciated at the time of theloss. However, the cost to replace the asset had increased to $700 when the loss occurred. Usingthe above equation, the insurer would be liable for:

Actual Cash Value = $700 - (40%) x ($700)

Actual Cash Value = $420

Actual cash value settlements preserve equity by taking into consideration that replacementvalues change over time and that the original asset may have decreased in value since the time it

was purchased. If you were paid more than the actual cash value of your loss, you might have anincentive to try to profit by causing the loss. This problem is one form of moral hazard discussedin the previous lesson.

There are several exceptions to the principle of indemnity:

1. Valued policies2. Valued policy laws3. Replacement cost insurance4. Life insurance

Under a valued policy, you collect the face value of the policy if a total loss occurs, regardless ofthe actual cash value at the time of loss. Such policies are commonly used to insure artwork,antiques and family keepsakes. Some states have enacted valued policy laws under which theface value of the policy must be paid if a total loss is caused by a specified peril such as wind,fire, or lightning. Replacement cost insurance is another exception to the principle of indemnity.Under replacement cost coverage, the replacement cost of the asset is paid without an allowancefor depreciation. This type of coverage is more expensive than actual cash value coverage. Afourth exception is life insurance. How can the "replacement cost" of a life or the extent to which

8/3/2019 Principle of Indemnity

2/4

a life is "depreciated" be measured? Life insurance policies are commonly purchased to provideincome replacement should a breadwinner die. The principle of indemnity does not apply to lifeinsurance contracts.

Principle of Insurable Interest

The principle of insurable interest states that the insured must stand to lose financially or in someother way if a loss occurs in order to recover from an insurer. This "standing to lose" is calledinsurable interest. You have an insurable interest in your car in that you are financially harmed ifthe car is damaged or stolen. A husband or wife has an insurable interest in their spouse based onties of love and affection as well as financial support. A complete stranger, however, does nothave an insurable interest in your property or your life as the stranger does not stand to loseshould a loss occur.

Insurable interest is necessary to:

(a) prevent gambling,(b) reduce moral hazard, and(c) measure the loss.

Moral hazard would be a serious problem if insurable interest was not required. A deviousperson could, for example, purchase fire insurance on every home in a 12-square block area, hirean arsonist to set fire to the homes, and collect a fortune based on the losses sustained bystrangers.

The requirements concerning insurable interest are different for life insurance and propertyinsurance. In life insurance, it is only necessary to demonstrate insurable interest at the start

(inception) of the contract. A husband could purchase a life insurance policy on his wife andname himself the beneficiary. Even if there is an acrimonious divorce later, he would still be ableto collect the proceeds when his ex-wife died, provided the policy was kept in force. In propertyinsurance, however, the insurable interest requirement must be met at the time of a loss to collectfrom an insurer. If, for example, you sell a house and it is later damaged by an insured peril, youcannot collect for the loss as you no longer own the home. You can purchase property insurancebased upon an expectation of insurable interest, but in order to collect, you must have aninsurable interest when the loss occurs.

Subrogation

8/3/2019 Principle of Indemnity

3/4

The principle of subrogation supports the principle of indemnity.Subrogation means substituting the insurer in place of the insured inorder to collect from a third party for a loss covered by insurance. Theinsurer (e.g., Fireman's Fund, or Nationwide) pays the insured (theirpolicyowner) for a loss, and the insured gives up their right of action

against the negligent third party. An example will help to clarify thisprinciple. Assume that a driver ran a red light and damaged Susan's car.Further assume that Susan had collision coverage under her autoinsurance policy. Susan could collect from the other driver (or thedriver's insurer) or from her own insurer. If her insurer paid for Susan'sloss, the insurer will then try to collect from the negligent driver for theloss paid to Susan.

Subrogation accomplishes three things. First, it prevents the insured from collecting twice (oncefrom their own insurer and once from the negligent third-party) for the same loss. It also makesthe negligent third party, the person responsible for the loss, bear the burden of the loss. Finally,

subrogation leads to lower insurance rates. Through subrogation recoveries, insurers can recovermoney paid to their own insureds. Subrogation recoveries help to hold down insurancepremiums. Insureds should be careful not to impair the right of their insurer to proceed againstthird parties. Interference with the insurer's right to collect from the third party may jeopardizerecovery from their own insurer.

Utmost Good Faith

Insurance contracts are contracts based on the principle of utmost good faith. This tenet meansthat a high degree of honesty is expected from each party to the contract. When an insurancecontract is formed, the applicant has an information advantagethere are some facts that only the

applicant knows. The insurer must rely on information the applicant provides when making thedecision to write the policy. Statements made by the applicant in the course of applying forinsurance are called representations. If an applicant makes a material, false representation that isrelied upon by the insurer, the contract becomes voidable at the insurer's option. The test ofmateriality usually involves whether the representation would have had an impact upon thedecision of the insurer to write the coverage and the terms under which the coverage would bewritten. Innocent misrepresentations of material facts, if relied upon by the insurer, also make thecontract voidable.

A recent court case involved material misrepresentation. An applicant for life insurance wasasked if he smoked cigarettes. He answered "no." The policy was issued, and the insured died

shortly thereafter in an auto accident. When the insurer investigated the claim, it was determinedthat the insured was a smoker. When the insurer denied payment of the face value, thebeneficiary filed suit. The case was decided in favor of the insurer. The applicant's statement thathe did not smoke was false, material (the insurer had separate rates for smokers andnonsmokers), and relied upon by the insurer. Therefore the insurer was permitted to deny theclaim on the grounds of material misrepresentation.

8/3/2019 Principle of Indemnity

4/4

Whereas misrepresentation is the act of lying about a material fact, concealment meansdeliberately withholding material information from the insurer. For example, if you are applyingfor a health insurance policy and you have been having sharp abdominal pain for the past twoweeks and you do not volunteer this information, you have concealed a material fact. Justbecause the representative of the insurance company did not ask you about the pain does not

excuse you from disclosure. Your material concealment makes the contract voidable by theinsurer.

Warranty refers to a statement of fact or promise made by the insured, which is part of theinsurance contract and which must be true if the insurer is to be liable. If the warrantedconditions are not in effect at the time of a loss, the insurer may not be liable. For instance, acompany may insure your business only if you promise, or warrant, that you will have a securityalarm system operational during nonbusiness hours. If you are the victim of a theft after closingand the security alarm system is not operating when the thieves strike, the insurer may not beliable for the loss.

Proceed t

http://www-student.unl.edu/cis/fina307w04/online_course/unit1/lsn02-tp02.htmlhttp://www-student.unl.edu/cis/fina307w04/online_course/unit1/lsn02-tp02.htmlhttp://www-student.unl.edu/cis/fina307w04/online_course/unit1/lsn02-tp02.html