Legal Principles & Contracts in Insurance

RMI 3500 Intro. to Risk Management & Insurance Robert Klein

Revised: 12/27/09

Topic Objectives
Outline basic legal principles underlying insurance contracts. Explain their purpose and how they work.

Why do we care? Legal provisions enforce economic principles. They also determine our rights in contracts.

Important Legal Principles

Indemnity Actual Cash Value Insurable Interest Subrogation Utmost Good Faith Company/Agent Relationship

Principle of Indemnity
Insured should be restored to approximate financial position prior to loss, not better. Purposes
prevent insured from profiting from insurance reduce moral hazard

Actual Cash Value

Basis of loss settlement that supports principle of indemnity ACV = replacement cost depreciation

ACV Example
Couch cost $800 when new. 5 years later, couch is destroyed by fire from cigarette. Couch is estimated to be 60% depreciated. Cost of replacing couch is $1,000. ACV = $1,000 - .6 x $1,000 = $400

Variations of ACV
Fair Market Value
price that would be paid in free mkt. FMV may be less than ACV market value policies common in home insurance

Broad Evidence Rule

ACV determination includes all relevant factors considered by expert

Exceptions to Indemnity Principle

Valued Policy
policy with specific face amount

Valued Policy Laws Scheduled Items in HO Insurance Replacement Cost

used when moral hazard chance low

Life Insurance
policy pays face amount amount of loss difficult to determine

Why would insurers offer replacement cost coverage?

May be viewed as accommodation to insureds that they value. In certain circumstances, insurers may believe that risk of moral hazard is low. Insured may be required to actually replace property damaged or destroyed to receive replacement cost payment.

Insurance to Value
Insurers have encouraged homeowners to choose adequate policy limits; why? If insured has inadequate coverage, they could suffer uninsured losses in event of total loss. This problem has arisen in the aftermath of California wildfires. Property owners may fail to raise policy limits when the value of their homes increases.

Insurable Interest
Any contingency that will cause loss or harm to person or firm. Purposes
prevent gambling reduce moral hazard measure loss

Basis for Insurable Interest

Property-Liability Contracts
ownership of property potential legal liability secured creditors contractual rights

Life Insurance Contracts

family pecuniary interest

When does insurable interest exist?

Would insurer sell me a life insurance policy taken out on my wife? Would insurer sell me a life insurance policy I took out on a student? Would insurer sell me a home insurance policy I took out on a neighbors home?

Subrogation
Allows insurer to collect loss payments to insured from 3rd party. Purposes
prevent dual payments discourage negligence

Conditions
insured must be fully indemnified only used for property-liability ins.

How might subrogation be used in insurance claims stemming from Firestone tire problems?

Utmost Good Faith

Higher degree of honesty imposed on parties to insurance contracts. Representations: statements by insurance applicant Insurance contracts voidable if representation is:
material false relied upon by insurer

Company-Agent Relationship
Participants
principal - insurance company agent - acts on behalf of company

Agent has authority to bind company under certain conditions. Principal is responsible for acts of agents. Potential conflicts?