Principle of Indemnity

Now that you have been introduced to risk, risk management, and insurance, it's time to analyze the fundamental legal principles surrounding insurance contracts. Insurance contracts are technical in nature and have many provisions that you will learn 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 called the 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 asset was later destroyed by an insured peril. The asset was 40 percent depreciated at the time of the loss. However, the cost to replace the asset had increased to $700 when the loss occurred. Using the 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 replacement values 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 an incentive to try to profit by causing the loss. This problem is one form of moral hazard discussed in the previous lesson. There are several exceptions to the principle of indemnity: 1. Valued policies 2. Valued policy laws 3. Replacement cost insurance 4. Life insurance Under a valued policy, you collect the face value of the policy if a total loss occurs, regardless of the 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 the face 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 allowance for depreciation. This type of coverage is more expensive than actual cash value coverage. A fourth exception is life insurance. How can the "replacement cost" of a life or the extent to which

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

Principle of Insurable Interest

The principle of insurable interest states that the insured must stand to lose financially or in some other way if a loss occurs in order to recover from an insurer. This "standing to lose" is called insurable interest. You have an insurable interest in your car in that you are financially harmed if the car is damaged or stolen. A husband or wife has an insurable interest in their spouse based on ties of love and affection as well as financial support. A complete stranger, however, does not have an insurable interest in your property or your life as the stranger does not stand to lose should 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 devious person could, for example, purchase fire insurance on every home in a 12-square block area, hire an arsonist to set fire to the homes, and collect a fortune based on the losses sustained by strangers. The requirements concerning insurable interest are different for life insurance and property insurance. 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 and name himself the beneficiary. Even if there is an acrimonious divorce later, he would still be able to collect the proceeds when his ex-wife died, provided the policy was kept in force. In property insurance, however, the insurable interest requirement must be met at the time of a loss to collect from an insurer. If, for example, you sell a house and it is later damaged by an insured peril, you cannot collect for the loss as you no longer own the home. You can purchase property insurance based upon an expectation of insurable interest, but in order to collect, you must have an insurable interest when the loss occurs.

Subrogation

The principle of subrogation supports the principle of indemnity. Subrogation means substituting the insurer in place of the insured in order to collect from a third party for a loss covered by insurance. The insurer (e.g., Fireman's Fund, or Nationwide) pays the insured (their policyowner) for a loss, and the insured gives up their right of action against the negligent third party. An example will help to clarify this principle. Assume that a driver ran a red light and damaged Susan's car. Further assume that Susan had collision coverage under her auto insurance policy. Susan could collect from the other driver (or the driver's insurer) or from her own insurer. If her insurer paid for Susan's loss, the insurer will then try to collect from the negligent driver for the loss paid to Susan. Subrogation accomplishes three things. First, it prevents the insured from collecting twice (once from their own insurer and once from the negligent third-party) for the same loss. It also makes the 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 recover money paid to their own insureds. Subrogation recoveries help to hold down insurance premiums. Insureds should be careful not to impair the right of their insurer to proceed against third parties. Interference with the insurer's right to collect from the third party may jeopardize recovery from their own insurer.

Utmost Good Faith

Insurance contracts are contracts based on the principle of utmost good faith. This tenet means that a high degree of honesty is expected from each party to the contract. When an insurance contract 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 the decision to write the policy. Statements made by the applicant in the course of applying for insurance are called representations. If an applicant makes a material, false representation that is relied upon by the insurer, the contract becomes voidable at the insurer's option. The test of materiality usually involves whether the representation would have had an impact upon the decision of the insurer to write the coverage and the terms under which the coverage would be written. Innocent misrepresentations of material facts, if relied upon by the insurer, also make the contract voidable. A recent court case involved material misrepresentation. An applicant for life insurance was asked 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 determined that the insured was a smoker. When the insurer denied payment of the face value, the beneficiary filed suit. The case was decided in favor of the insurer. The applicant's statement that he did not smoke was false, material (the insurer had separate rates for smokers and nonsmokers), and relied upon by the insurer. Therefore the insurer was permitted to deny the claim on the grounds of material misrepresentation.

Whereas misrepresentation is the act of lying about a material fact, concealment means deliberately withholding material information from the insurer. For example, if you are applying for a health insurance policy and you have been having sharp abdominal pain for the past two weeks and you do not volunteer this information, you have concealed a material fact. Just because 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 the insurer. Warranty refers to a statement of fact or promise made by the insured, which is part of the insurance contract and which must be true if the insurer is to be liable. If the warranted conditions are not in effect at the time of a loss, the insurer may not be liable. For instance, a company may insure your business only if you promise, or warrant, that you will have a security alarm system operational during nonbusiness hours. If you are the victim of a theft after closing and the security alarm system is not operating when the thieves strike, the insurer may not be liable for the loss. Proceed t