Class 3 Insurance and Risk Management

1
Class 3Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Autumn Quarter 2007

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Mid-term Exam

• Correct Date Wednesday, 10/24/07
• Mid-Term Material Chapters 1-3, 9-12,
• 13 (p. 275-277, 284-289), 14, 16 18

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Agenda

• 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

4
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

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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

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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
  insureds death

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Actual Cash Value

• Underlies the principle of indemnity
• The standard method for indemnifying in a
  property loss
• ACV Replacement cost minus depreciation
• Example of Sarahs couch (p. 176 of text)

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Exceptions to the Principle of Indemnity

• Valued policy
• Antiques
• Fine arts
• Rare paintings
• Family heirlooms

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Exceptions to the Principle of Indemnity

• Valued policy laws
• Original purpose to protect insured from
  over-insurance
• Less important now

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Exceptions to the Principle of Indemnity (cont.)

• Life Insurance
• Not a contract of indemnity
• Valued policy that pays a stated sum at the
  Insureds death

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Exceptions to the Principle of Indemnity (cont.)

• Replacement Cost Insurance
• No deduction taken for depreciation in
  determining the amount paid for a loss
• Recognizes that few people budget for
  depreciation.
• Under ACV, Insured could be required to come up
  with a substantial cash to restore the property
  to its original condition.

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Indemnity versus Valued Contracts

• Indemnity contract - insurer pays based on the
  amount of loss that occurred
• Example auto physical damage
• Valued contract - insurer pays a pre-determined
  amount
• Example life insurance

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Type of contract explained by two factors

• The costs of assessing value
• Moral hazard

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Indemnity versus Valued Contracts?

• When the amount of loss can be assessed at low
  cost following the loss, more likely to have
  indemnity contracts
• When moral hazard is less likely to be a problem,
  fixing the insurance payment before a loss can
  avoid costly haggling following a loss
• (e.g., life insurance, valuable personal articles)

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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

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Importance of Insurable Interest

• To be legally enforceable, all insurance
  contracts must be supported by insurable
  interest.
• A policy can be voided if insurable interest is
  found to be non-existent.

17
Examples of Insurable Interest

• Ownership of property
• Homeowner
• Potential Legal Liability
• Dry Cleaner
• Secured Creditors
• Bank granting a mortgage
• Contractual Right
• Business contracting to purchase goods from abroad

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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

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Principle of Subrogation

• The insurer is entitled only to the amount it has
  paid under the policy
• The insured cannot impair the insurers
  subrogation rights
• Subrogation does not apply to life insurance and
  to most individual health insurance contracts
• The insurer cannot subrogate against its own
  insureds

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Subrogation Example

• Assume a negligent motorist
• Fails to stop at a red light
• Smashes into the Insureds car
• Causing damages to the Insureds car of 5,000.
• Insured has purchased collision insurance for her
  car.
• The Insureds Insurance Company will
• Pay the physical damage loss (less any
  deductible)
• Then attempt to collect from the negligent
  motorist

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Subrogation Example (cont.)

• Alternatively, the Insured could attempt to
  collect directly from the negligent motorist.
• Subrogation does not apply, if a loss payment is
  not made by the Insureds insurance company.
• To the extent that a loss payment is made, the
  Insurer receives the legal right to collect
  damages from the negligent third party.

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Subrogations Effects

• Prevents the Insured from collecting twice for
  the same loss.
• Holds the guilty party responsible
• Holds down insurance rates
• Generally, subrogation recoveries are factored
  into the rate-making process

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Subrogation Caveats

• The Insured cannot do anything after the loss
  that impairs the Insurers subrogation rights.
• Subrogation does not apply to life insurance and
  most health insurance contacts.
• Insurer cannot recover against its own Insureds.

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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
• Insurance contracts are contracts uberrimae
  fidei, or of the utmost good faith.
• Neither party is to take advantage of the others
  lack of information.

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Historical Roots of Utmost Good Faith

• Legal foundation rests on principles established
  long ago for insurance on ocean vessels and
  cargoes
• Marine underwriter had to place great faith in
  the statements made by the applicant for
  insurance
• The cargo may not have been able to be visually
  inspected
• The contract may have been issued in a location
  far removed from the cargo or ship
• Thus, a high degree of honesty was imposed on the
  applicant for insurance

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Principle of Utmost Good Faith

• 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

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Principle of Utmost Good Faith Supporting Legal
Doctrines

• 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
• A statement achieves the status of a warranty if
  it becomes a condition of the insurers promise

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Elements of Misrepresentation

• Material means that
• If the Insurer knew the true facts, the policy
  would not have been issued or would have been
  issued on different terms.
• False means that
• The statement is not true or is misleading.
• Reliance means that
• The Insurer relies on the misrepresentation in
  issuing the policy at a specified premium

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Concealment Legal Significance

• Concealment is the same as non-disclosure.
• The applicant for insurance deliberately
  withholds material information from the insurer
• Legal significance is the same as
  misrepresentation
• The contract is voidable at the Insurers option.

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Concealment generally has two elements

• The concealed fact was known by the Insured to be
  material
• The Insured intended to defraud the Insurer

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Harsher standard applies in marine insurance

• An ocean marine insurer is not required to prove
  that the concealment is intentional.
• An ocean marine insurer can successfully deny a
  claim if it can be shown that the concealed fact
  is material

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Two Types of Warranties

• Affirmative warranty states a condition that is
  supposed to exist on the date the statement is
  made
• Example Auto policy applicant states at time
  of application that no auto insurer has cancelled
  coverage in the last three years
• Promissory warranty states a condition that is
  to exist throughout part or all of the policy
  period
• Example Burglary policy applicant warrants
  that burglar alarm system described in the policy
  will be maintained in working order throughout
  the policy period

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Breach of Warranty

• If a statement is construed as a warranty, the
  court may allow the insurer to deny coverage, if
  there has not been literal compliance with the
  statement
• Effect can be very harsh.
• To deny coverage, all the insurer may need to
  show was that the warranty was breached, even if
  the breach were unintentional and not related to
  the loss.

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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

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Requirements of Legal Contract Applied to
Insurance

• Offer and Acceptance
• In Insurance, offer made by the applicant
• Insurer may accept or make counteroffer
• Consideration
• Payment of premium
• Promise to pay premium

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Requirements of Legal Contract Applied to
Insurance (cont.)

• Legal Capacity
• Insane or intoxicated not competent
• Minors may void contract before attaining
  majority (some exceptions)
• Insurer presumed to be competent if meets
  statutory requirements to be licensed

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Requirements of Legal Contract Applied to
Insurance (cont.)

• Purpose Not Contrary to Public Interest
• All Contracts agreement to commit criminal act
  is not a legal contract
• Insurance Must be an Insurable Interest
• Life insurance when the contract is written
• Property insurance at the time of the loss

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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

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Aleatory Contract

• Characterized by two design elements
• Chance element
• Uneven exchange
• Performance of at least one of the parties is
  dependent on chance.
• And, one party promises to do much more than the
  other party.

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Aleatory Contract (cont.)

• Most non-insurance contracts are commutative
  the exchange is of equal values.
• Many people mistakenly employ this concept when
  thinking about insurance.
• An insurance contract will only result in an
  equal exchange by coincidence or over a very long
  period of time.

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Aleatory Contract (cont.)

• The uneven exchange is not a flaw in the
  contract.
• Rather it is a fundamental feature of a contract
  that is both conditional and aleatory.

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Unilateral Contract

• Most contracts are bilateral
• This means the courts may be used to enforce the
  contract
• They can require the performance of either party
• In contrast, most insurance contracts are
  unilateral.

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Unilateral Contract (cont.)

• The courts will enforce the contract against only
  one party the insurer
• Exception If the insureds promise to pay in the
  future induced the insurer to issue coverage, the
  insurer could use the courts to force payment.
• Example of Unilateral Contract Typical Life
  Insurance Policy

44
Conditional Contract

• Insurance contract is an conditional Contract
• Insurer can refuse to perform if insured does not
  satisfy certain conditions in the contract
• Examples of conditions
• If the insured increased the chance of loss in a
  manner prohibited in the contract
• The insured failed to submit a proof of loss as
  required by the contract

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Examples of Conditions (cont.)

• Conditions found in a liability policy
• Failure to provide assistance to insurer in
  investigating circumstances giving rise to the
  claim
• Refusal to testify in court if requested

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Personal Contract

• Insurance contract insures the legal interest of
  a person or entity in the valued object
• If the owner at time insurance contract is issued
  sells the property, the new owner is not insured,
  unless the insurer agrees to an assignment of the
  insureds rights to the new owner

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Contracts of Adhesion

• A contract drafted by one party to which the
  other party must adhere.
• In most insurance transactions, the Insured is
  not allowed to participate in the drafting of the
  contract.
• Since contract is presented as take it or leave
  it the company is held responsible for unclear
  or ambiguous provisions.

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Contracts of Adhesion (cont.)

• This is often referred to as the ambiguity rule
• Ambiguities are interpreted in favor of
  policyholder
• Ambiguity rule applied less often to commercial
  insurance.
• Bargaining over wording results in a manuscript
  policy

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Summary Characteristics of the Insurance
Contract

• 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