Syllabus

Legal Principals of Insurance Contracts

Principal of Indemnity

Principal of Insurable Interest

Principal of Subrogation

Utmost Good faith

Distinguishing legal characteristic of Insurance Contract

Legal Power of Insurance Agents

 Principal of Indemnity

The principle of indemnity is one of the fundamental principles of insurance because it is the
part of an insurance contract that ensures the insured has the right to compensation and sets
limits on how much about compensation.

The principle of indemnity states that an insurance policy shall not provide compensation to
the policyholder that exceeds their economic loss.

“The principle of indemnity states that the insurer agrees to pay no more than the
actual amount of the loss; stated differently, the insured should not profit from a loss .”

The principle of indemnity is a central, regulatory principle in insurance that applies to most
policies, except life insurance, and other similar policies. This exception is because it is
impossible to accurately quantify a human life in monetary terms.
 Contd…..

The principle of indemnity has two fundamental purposes.

The first purpose is to prevent the insured from making profit from loss

For example, if Ram’s home is insured for Rs 200,000, and a partial loss of Rs 50,000 occurs,
the principle of indemnity would be violated if Rs 100,000 were paid to him. In this case, he is
making profit from insurance.

The second purpose is to reduce moral hazard . If dishonest policyholders could profit from a
loss, they might deliberately cause losses with the intention of collecting the insurance.
If the loss payment does not exceed the actual amount of the loss, the temptation to be
dishonest is reduced.
 Contd…..
Actual Cash Value
The concept of actual cash value supports the principle of indemnity. There are three
methods of determining actual value which are as follows.
 Replacement cost less depreciation

 Fair market value

 Broad evidence rule

Replacement Cost Less Depreciation : Under this rule, actual cash value is defined as
replacement cost less depreciation.

Replacement cost – Depreciation = Actual cash value

 Contd…..
Fair market value is the price a willing buyer would pay a willing seller in a free market .

Broad Evidence Rule :It means that the determination of actual cash value should include all
relevant factors an expert would use to determine the value of the property .
Relevant factors include replacement cost less depreciation, fair market value, present value
of expected income from the property, comparison sales of similar property, opinions of
appraisers, and numerous other factors.
 Exception to Principal of Indemnity

There are several important exceptions to the principle of indemnity which are as follows.
 Valued policy

 Valued policy laws

 Replacement cost insurance

 Life insurance
 Contd…..

Valued Policy : It is a policy that pays the face amount of insurance, if a total loss occurs .

Valued policies typically are used to insure antiques, fine arts, rare paintings

Valued Policy Laws : A valued policy law is a law that exists in some states 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 .

For example, a building insured for Rs 200,000 may have an actual cash value of Rs 175,000.
If a total loss from a fire occurs, the face amount of Rs 200,000 would be paid.
 Contd…..

Replacement cost insurance : It means there is no deduction for physical depreciation in

determining the amount paid for a loss.
Assume that roof is 5 year old and estimated life is next 20 years. If a roof is damaged by
earthquake , and current cost current cost of replacement is Rs 10,000.
Under a replacement cost policy, beneficiary would receive the full Rs 10,000.

Life insurance : It is a valued policy that pays a stated amount to the beneficiary upon the
insured’s death.
The indemnity principle is difficult to apply to life insurance because the actual cash value
rule (replacement cost less depreciation) is meaningless in determining the value of a human
life.
That’s why life insurance policy is another exception to the principle of indemnity.
 Principal of Insurable Interest

Insurable interest refers to the interest of a person, financial, or otherwise, in

obtaining insurance for a person or property.
Insurable interest is the basis of all insurance policies linking the insured and owner of the
policy.
Insurable interest can be an object which, if damaged or destroyed, would result in financial
hardship for the policyholder.
To exercise insurable interest, the policyholder would buy insurance on the item or entity in
question.
The policy must not create a moral hazard.

The principle of insurable interest also works along with the indemnification principle, which
requires insurance policies to compensate a policyholder for the losses covered.
 Contd……..

Purposes of an Insurable Interest

To be legally enforceable, all insurance contracts must be supported by an insurable interest.
Insurance contracts must be supported by an insurable interest for the following reasons
 To prevent gambling
 To reduce moral hazard
 To measure the amount of the insured’s loss in property insurance

First, an insurable interest is necessary to prevent gambling .

If an insurable interest were not required, the contract would be a gambling contract and
would be against the public interest.
For example, Somebody could insure the property of another and hope for a loss to occur.
Similarly insure the life of another person and hope for an early death.
These contracts clearly would be gambling contracts and would be against the public
interest.
 Contd……..

Second, an insurable interest reduces moral hazard .

If an insurable interest were not required, a dishonest person could purchase property
insurance on someone else’s property and then deliberately cause a loss to receive the
proceeds.
In life insurance, an insurable interest requirement reduces the incentive to murder the
insured for the purpose of collecting the proceeds.

Finally, in property insurance, an insurable interest measures the amount of the insured’s
loss .
Most property insurance contracts are contracts of indemnity, and one measure of recovery
is the insurable interest of the insured. If the loss payment cannot exceed the amount of
one’s insurable interest, the principle of indemnity is supported.
 Contd……..

. Examples of an Insurable Interest

Property and Casualty Insurance Ownership of property can support an insurable interest
because owners of property will lose financially if their property is damaged or destroyed.

Potential legal liability can also support an insurable interest.

For example, a dry-cleaning firm has an insurable interest in the property of the customers.

Secured creditors have an insurable interest as well.

A commercial bank that lends money to buy a house has an insurable interest in the property.

Finally, a contractual right can support an insurable interest.

Thus, a business firm that contracts to purchase goods from abroad on the condition that they
arrive safely in Nepal has an insurable interest in the goods because loss will occur, if the
merchandise does not arrive.
 Practical example of Subrogation

Ram and Shyam were involved in a car accident. As a result, Ram’s car was severely damaged,
and he required Rs 3,000 for the repair of the vehicle.

Luckily, Ram’s car was insured, and he recovered the full cost of the repair (Rs 3,000) through
an insurance claim.
Later, an investigation determined that Shyam was responsible for the accident as he was
drunked while driving.
Ram’s insurance company decides to recover the amount of the claim from Shyam, as he
caused the damages.
In such a case, Ram’s insurance company can use the subrogation doctrine to recover its
losses. The insurer can sue Shyam to recover its losses..
.
 How Does Subrogation Work?
Subrogation in the insurance sector generally involves three parties:
 The Insurer (insurance company),
 Insured party
 The Party responsible for the damages.
The process usually starts when the insurer pays out the losses of the insurance claim filed by
the insured party.
When the Insured Party receives the amount of money for the claim, the insurance company
may start the process of collecting the amount of the claim from the party that caused the
damages.
 Principal of Subrogation

The principle of subrogation strongly supports the principle of indemnity.

Subrogation means substitution of the insurer in place of the insured for the purpose of
claiming indemnity from a third party for a loss covered by insurance.

In simple word, the insurer is entitled to recover from a negligent third party any loss
payments made to the insured.

Essentially, subrogation provides a legal right to a third party to collect damages on behalf of
another party.
Generally, in most subrogation cases, an individual’s insurance company pays its client’s claim
for losses directly, then seeks reimbursement from the other party's insurance company.
Subrogation is most common in an auto insurance policy but also occurs in property/casualty
and healthcare policy claims.
 Purpose of Subrogation

Subrogation has three basic purposes.

First, subrogation prevents the insured from collecting twice for the same loss .
In the absence of subrogation, the insured could collect from his or her insurer and from the
person who caused the loss.
The principle of indemnity would be violated because the insured would be profiting from a
loss.

Second, subrogation is used to hold the negligent person responsible for the loss .
By exercising its subrogation rights, the insurer can collect from the negligent person who
caused the loss.

Finally, subrogation helps to hold down insurance rates .

Subrogation recoveries are reflected in the ratemaking process, which tends to hold rates
below where they would be in the absence of subrogation.
 Importance of Subrogation

The general rule is that by exercising its subrogation rights, the insurer is entitled only to the
amount it has paid under the policy.

After a loss, the insured cannot interfere with the insurer’s subrogation rights

Subrogation does not apply to life insurance contracts

 Principal of Utmost Good Faith

'Utmost good faith' is one of the first principles of an insurance contract. 

The principle of utmost good faith states that the insurer and insured both must be transparent
and disclose all the essential information required before signing up for an insurance policy.

It states that both the parties must disclose all the material facts before subscribing to the
policy.

Violations of the doctrine of good faith in a contract often has legal consequences depending
upon the nature or degree of the violation.

The injured party can take legal actions against the other party that provides inaccurate
information.
 Contd…….

The principle of utmost good faith is supported by three important legal doctrines:

 Representations,
 Concealment,
 Warranty

Representations are statements made by the applicant for insurance .

For example, if you apply for life insurance, you may be asked questions concerning your age,
weight, height, occupation, state of health, family history, and other relevant questions. Your
answers to these questions are called representations.

Concealment :It is intentional failure of the applicant for insurance to reveal a material fact
to the insurer . Concealment is the same thing as nondisclosure.
 Contd…….

Warranty :A warranty is a statement that becomes part of the insurance contract and is
guaranteed by the maker to be true in all respects.

For example, a business firm may warrant that an automatic sprinkler system will be in
working order throughout the term of the policy.
 Requirement of Insurance Contract

To be legally enforceable, an insurance contract must meet four basic requirements which
are as follows.

 Offer and Acceptance

 Consideration

 Competent Parties

 Legal Purpose
 Contd……

Offer and Acceptance :The first requirement of a binding insurance contract is that there
must be an offer and acceptance of its terms.

After filling in the requested details, application is sent to the company . This is our offer. 
If the insurance company agrees to insure us, this is called acceptance.
In some cases, insurer may agree to accept our offer after making some changes to our
proposed terms.
The requirement of offer and acceptance can be examined in greater detail by making a
careful distinction between property and casualty insurance, and life insurance
 Contd……

Consideration : The second requirement of a valid insurance contract is consideration —the

value that each party gives to the other.

The insured’s consideration is payment of the premium (or a promise to pay the premium) plus
an agreement to abide by the conditions specified in the policy.

The insurer’s consideration is the promise to do certain things as specified in the contract.

This is the premium or the future premiums that we have to pay to your insurance company.

For insurers, consideration also refers to the money paid to them means client can file an
insurance claim whenever needed.

This means that each party to the contract must provide some value to the relationship.
 Contd………

Competent Parties :The third requirement of a valid insurance contract is that each party
must be legally competent .
This means the parties must have legal capacity to enter into a binding contract.

For e,g Minors , Insane person cannot be a part of contract.

Again, The insurer must also be legally competent.

Insurers generally must be licensed to sell insurance , and the insurance sold must be within
the scope of its charter or certificate of incorporation.
 Contd………

legal purpose . An insurance contract that encourages or promotes something illegal or

immoral is contrary to the public interest and cannot be enforced.

For example, a drug dealer who sells drugs and other illegal drugs cannot purchase a
property insurance policy that would cover seizure of the drugs by the police.
 Legal Characteristic of Insurance Contract

Insurance contracts have distinct legal characteristics that make them different from other
legal contracts.
Other distinct legal characteristics are as follows:
 Aleatory contract

 Unilateral contract

 Conditional contract

 Personal contract

 Contract of adhesion
 Contd………

Aleatory Contract :
An aleatory contract is a contract where the values exchanged may not be equal but depend
on an uncertain event . Or

An aleatory contract is a contract where performance of the promise is dependent on the occurrence of a
unexpected event. Or

Aleatory contracts are agreements where a party doesn't have to perform contractual obligations unless a
specified event happens.
Aleatory contracts are legally binding agreements These contracts are also characterized by an unequal
consideration or exchange of value between the parties.

This means there is an element of chance And potential for unequal exchange of value or consideration for
both parties

Aleatory contracts, (also known as aleatory Insurance, )turn out to be helpful because they support the
insured person to deal with the financial risk, when something bad happens.
 Contd………

For example, Lets say Ram pays a premium of Rs 600 for a Rs 200,000 homeowners policy. If the home
were totally destroyed by fire shortly thereafter, he would collect an amount that greatly exceeds the
premium paid.

On the other hand, a homeowner may faithfully pay premiums for many years and never have a loss.

In contrast, other commercial contracts are commutative.

A commutative contract is one in which the values exchanged by both parties are theoretically equal .

For example, the purchaser of real estate normally pays a price that is viewed to be equal to the value
of the property.
Now we can say, although both gambling and insurance are aleatory in nature, an insurance contract is
not a gambling contract because no new risk is created.
 Contd………

Unilateral Contract :
A unilateral contract means that only one party makes a legally enforceable promise .

In this case, only the insurer makes a legally enforceable promise to pay a claim or provide other
services to the insured.

After the first premium is paid, and the insurance is in force, the insured cannot be legally forced to pay
the premiums .

However, if the premiums are paid, the insurer must accept them and must continue to provide the
protection promised under the contract.

In contrast, most commercial contracts are bilateral in nature.

If one party fails to perform, the other party can insist on performance or can sue for damages because
of the breach of contract.
 Contd………

Lets say someone posts a reward for their lost mobile in social media and announced award
of Rs 5,000 if somebody handover his/her lost mobile.

By offering the reward, the offeror sets up a unilateral contract that stipulates that the
reward will be issued once the lost pet or item is found.

Considering above example, we can say Insurance contracts are another example of
unilateral contracts.
In an insurance contract, the insurance firm promises to indemnify or pay the insured
individual a specific amount of money if a certain event happens.

Since it is a unilateral contract, the insurer is not obligated to make a payment to the insured
if the event does not occur.
 Contd………

Conditional Contract :
An insurance contract is a conditional contract because the insurer’s obligation to pay a claim depends on
whether the insured has complied with all agreed terms and conditions or not as per previous agreement.

Conditions are provisions inserted in the policy that qualify limitations on the insurer’s promise to perform.

An insurance policy is a conditional contract because whether the insurer pays a claim depends on whether
a covered loss has happened or not.

This means that the insurer’s promise to pay benefits depends on the occurrence of an event covered by
the contract. If the event does not materialize, no benefits are paid.

 Again, timely payment of premiums is a condition for keeping the contract in force. If premiums are not
paid, the company is relieved of its obligation to pay a death benefit.

The insurer is not obligated to pay a claim if the policy conditions are not met.
 Contd………

Personal Contract :
In property insurance, insurance is a personal contract , which means the contract is between the insured and the insurer.
Life insurance is a personal contract or personal agreement between the insurer and the insured.

People who buy life insurance policies are called policy owners rather than policyholders also.

Policy owners actually own their policies and can give them away if they wish.
This transfer of ownership is known as assignment.

To assign a policy, a policy owner simply notifies the insurer in writing.

The company will then accept the validity of the transfer without question. The new owner is granted all of the rights of
policy ownership.

However, A property insurance contract normally cannot be assigned to another party without the insurer’s consent.

If property is sold to another person, the new owner may not be acceptable to the insurer.
Thus, the insurer’s consent is required before a property insurance policy can be validly assigned to another party .
 Contd………

Contract of Adhesion :
An adhesion contract is an agreement where one party has substantially more power than the other
in setting the terms of the contract.

This is a contract that is generally drafted by one party who has greater bargaining power and signed
by another party who has lesser bargaining power.

Terms and conditions of contract are non-negotiable, which means existing clauses cannot be
added, removed, or changed. 

Adhesion contracts are "take it or leave it" agreements where you must accept the contract as a
whole or walk away.

Most of the contracts that consumers sign are adhesion contracts.

While this type of contract would seem unfair or even unenforceable, there is nothing wrong with
entering into such an agreement.
 Contd………

Disadvantages of adhesion contracts

Unequal power terms :

If necessary, The contract will be subject to significant scrutiny by any court if a business wants to
enforce it.
Risk for customers :
Due to the “take it or leave it” nature of a contract of adhesion, the customer carries the risk of
agreeing to the terms of the agreement.

Adhesion contracts are enforceable—when they are done correctly. Due to the unequal
bargaining power associated with a form contract, the agreement must meet certain criteria to
remain enforceable.
Courts will scrutinize adhesion contracts closely to determine if they are unconscionable or unfair.
To do this, many courts use a “Reasonable Expectations” test to determine whether the
agreement is enforceable.
 Legal Power of Insurance Agent

 There is no presumption of an agency relationship.

 An agent must have authority to represent the Principal. ( Insurance Company )

 A principal is responsible for the acts of agents acting within the scope of their authority.

 Limitations can be placed on the powers of agents.

 Contd…

There is no presumption of an agency relationship.: There is no automatic presumption that

one person legally can act as an agent for another. Some visible evidence of an agency
relationship must exist has a business card, rate data, application etc supplied by the insurer.

Authority to represent the Principal : An agent must be authorized to represent the principal.
An agent’s authority comes from three sources:
 Express authority,
 Implied authority
 Apparent authority.

Express authority : It refers to powers specificallydiscussed on the agent before. These powers
are normally stated in the agency agreement between the agent and the principal.
For e.g right to extend the time for payment of premiums , slight modification in contract as
per demand of customer etc etc
 Contd…

Implied authority : Implied authority refers to the authority of the agent to perform all
related acts necessary to fulfill the purposes of the agency agreement.
For example, to collect the first premium from agent himself and later deposit to Company’s
account.

Apparent authority : It is the appearance of power on behalf of the insurer through the
actions or use of identifying materials by the agent.

Principal is responsible for the acts of agents :

Another rule of agency law is that the principal is responsible for all acts of agents when they
are acting within the scope of their authority. This includes fraudulent acts, omissions, and
misrepresentations.
 Contd…

Limitations can be placed on the powers of agents :

In some cases, it states that only certain representatives of the company, such as executive
officers, can extend the time to pay premiums or to change the terms of the policy.

Waiver : the act of intentionally relinquishing or abandoning a known right, claim, or

privilege. For e.g Citizenship is needed to buy insurance policy, however it is issued on the
basis of driving license by taking waiver from top management.