1. Fundamental Principles in Insurance
Lecture Four：
Fundamental Principles in Insurance

2. Learning objectives
Explain the fundamental legal principles that are reflected in insurance contracts
Explain how the legal concepts of representations, concealment, and warranty support the principle of utmost good faith
Describe the basic requirements for the formation of a valid insurance contract
Access an internet site and obtain consumer information on insurance law

3. Main Contents Principle of Indemnity Principle of Insurable Interest
Principle of Utmost Good Faith
Principle of Proximate Cause
Principle of Subrogation

4. Principle of Indemnity
Definition
The main contents
The exceptions
The principles derived from indemnity

5. Definition of Principle of Indemnity
It is one of the most important legal principles in insurance.
It states that the insurer agrees to pay no more than the actual amount of the loss; namely, the insured should not profit from a loss.
Most property and liability insurance contracts are contract of indemnity.
A contract of indemnity does not mean that all covered losses are always paid in full.

6. Definition of the principle of Indemnity
Why this principle?
Two purposes:
First， prevent the insured from profiting from a loss.
Second, reduce moral hazard.
How to do？
Deductibles
Limits on the amount paid
Other contractual provisions

7. Actual cash value
Actual Cash Value underlies the principle of indemnity.
In property insurance, the basic method for indemnifying the insured is based on the actual cash value.
There are three major methods to determine actual cash value:
Replacement cost less depreciation
Fair market value
Broad evidence rule

8. Actual cash value Replacement cost less depreciation:
Replacement cost is the current cost of restoring the damaged property with new materials of like kind and quality.
The rule is used for property insurance :
Actual cash value=replacement cost –depreciation
It takes into consideration both inflation and depreciation of the property value over time.
(Examples)

9. Actual cash value Fair market value:
It is another method to determine actual cash value of a loss
It is the price a willing buyer would pay a willing seller in a free market.
Maybe lower than its actual cash value (Examples)

10. Actual cash value Broad evidence rule：
It is another method to determine actual cash value of a loss
when determining the actual cash value of property, an expert considers all the relevant factors including as follows:
Replacement cost less depreciation
Fair market value,
Present value of expected income from the property
Comparing the similar property, etc.

11. Exceptions of principle of indemnity
There are several important exceptions to the principle of indemnity including the following:
valued policy
valued policy laws
replacement cost insurance
life insurance

12. Exceptions of principle of indemnity
Valued policy
It is one that pays the face amount of insurance if a total loss occurs.
Valued policy is used to insure antiques, fine arts, rare paintings, and family heirlooms, etc.
Valued policy violates the principle of indemnity (Examples)

13. Exceptions of principle of indemnity
Valued policy laws
It is a law that exists in some states in U.S. 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.

14. Exceptions of principle of indemnity
Replacement cost insurance
It means there is no deduction for depreciation in determining the amount paid for a loss.
the replacement cost insurance is based on the recognition that payment of the actual cash value can still result in a substantial loss to the insured due to depreciation. (examples)
It violates the principle of indemnity

15. Life Insurance：
Life insurance contract is not a contract of indemnity.
It is a valued policy that pays a stated sum to the beneficiary upon the insured’s death.
The actual cash value (replacement cost less depreciation) is meaningless in determining the value of human life. (examples)

16. Principle of Insurable Interest
Definition
The purpose of an insurable interest
Examples of an insurance interest

17. Definition of insurable interest
The principle of insurable interest states that the insured must be in a position to lose financially if a loss occurs, or to incur some other kind of harm if the loss takes place.
(examples)

18. The purpose of an insurable interest
All insurance contracts must be supported by an insurable interest.
The reasons are:
to prevent gambling
to reduce moral hazard
to measure the amount of the insured’s loss in property insurance

19. The important conditions of insurable interest
First, it is a legal interest. All the property from theft, fraud, smuggle has no insurable interest
Second, it is predictable value
Third, it is economic value

20. Examples of an insurance interest
An insurable interest In property and liability insurance
ownership of property: (examples)
potential legal liability (examples)
secured creditors (examples)
employer for employee
contractual right: (examples)

21. Examples of an insurance interest
An insurable interest In life insurance:
No requirement on the insurable interest when a person buy life insurance for himself or herself.
An insurable interest is required if a person wish to buy a life insurance for another person.
e.g. relationship by close family ties, or marriage is insurable ;While remote family relationship is not insurable.
a pecuniary interest is exceptional

22. Examples of an insurance interest
When must an insurable interest exist?
In property insurance, the insurable interest must exist at the time of the loss.
In life insurance, the insurable interest requirement must be met only at the inception of the policy, not at the time of death.

23. Principle of Utmost Good Faith
Definition
Main contents
The legal effect of breaking the utmost good faith principle

24. Definition of utmost good faith principle
The principle of utmost good faith means a higher degree of honesty is imposed on both parties to an insurance contract
This principle has its historical roots in ocean marine insurance
The principle imposes a more higher degree of honesty on the applicant for insurance

25. Main contents of utmost good faith principle
The principle of utmost good faith is supported by three important legal doctrines as follows:
Representations
Concealment
warranty

26. Main contents of utmost good faith principle
Representations:
The statements made by the applicant for insurance. That’s tell the true facts about the insured and/or the subject matter(保险标的).
（1）In life insurance, the applicant should be asked questions concerning the insured’s age, height, occupation, state of health, family history, and other relevant questions.
（2）In property insurance, such information as quality, quantity, location, value, so on should be stated.
（3) Increase in hazard

27. Main contents of utmost good faith principle
Representations:
An Insurance contract is voidable at the insurer’s option if the presentation is：
Material (the true facts not fitting for the required conditions by the insurer. )
False (not true facts, or misleading)
Relied on by the insurer (at specified /adjusted premium)
Innocent misrepresentation（unintentional）

28. Main contents of utmost good faith principle
Concealment:
It is intentional failure for the applicant to reveal a material fact to the insurer. That is the applicant deliberately withholds material information from the insurer.
The legal affect of a material concealment is:
The contract is voidable at the insurer’s option (examples)

29. Main contents of utmost good faith principle
warranty:
It is a statement of fact or a promise made by the insured, which is part of the insurance contract and must be true if the insurer is to be liable under the contract. Examples:
Not drunk driving
Locking the door
Fire extinguisher
Any breach of the warranty allows the insurer to deny payment of a claim.

30. The legal effect of breaking the utmost good faith principle
Against the responsibilities of Representation:
the insurer may not take the responsibility due to such reasons as: negligence, mis-represent the facts, or conceal the facts deliberately .
The legal effect of breaking the utmost good faith principle is that the insurer will deny the loss claim.

31. Principle of Proximate Cause
Definition of the principle of proximate cause
In many cases, a loss is caused by several reasons, not a single one. Thus, the principle of proximate cause is used in the insurance contract.
It means among several causes, the insurer tries to examine whether the most effective and decisive cause is under the coverage of the insurance contract. If yes, the insurer pay the sum of insurance amount; otherwise, will not pay.

32. Principle of Proximate Cause
Application of the principle of proximate cause
in the case of a single cause: (examples)
in the case of multi causes (examples)
in the case of multi and continuous causes (examples)

33. principle of subrogation
The principle of subrogation strongly support the principle of indemnity. ((TEXT P 34-35)
Subrogation means 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. (examples)
The insurer is entitled to recover from a negligent third party any loss payments made to the insured.

34. principle of subrogation
Subrogation does not apply if a loss payment is not made.
However, if a loss payment is made by the insurer, the insured gives to the insurer legal rights to collect damages from the negligent third party.

35. principle of subrogation
Purpose of subrogation:
subrogation has three basic purposes:
first, prevent the insured from collecting twice for the same loss.
second, hold the guilty person responsible for the loss.
third, help to hold down insurance rates.

36. principle of subrogation
Importance of subrogation: (TEXT P35)
There are five importance of the principle of subrogation as follows:
By exercising subrogation rights, the insurer is entitled only to the amount It has paid under the policy.
The insured cannot impair the insurer’s subrogation rights.
The insurer can waive its subrogation rights in the contract.
Subrogation does not apply to life insurance
The insurer cannot subrogate against its own insured.

37. principle of pro rata liability
Pro Rata Liability is a generic term for a provision that applies when two or more policy of the same type cover the same insurable interest in the property.
Each insurer’s share of the loss is based on the proportion that its insurance bears to the total amount of insurance on the property.
The propose of Pro Rata Liability clause is to preserve the principle of indemnity and to prevent profiting from insurance. （examples)

38. the principle of contribution by equal shares
Contribution by Equal Share(等额分摊) is another type of provision used in liability insurance contracts.
It means each insurer shares equally in the loss until the share paid by each insurer equals the lowest limit of liability under any policy, or until the full amount of the loss is paid.
(to be explained in detail in chapter 5）

39. Summary Insurance has four fundamental legal principles:
the principle of indemnity states that the insurer should not pay more than the actual amount of loss. In other words, the insured should not profit from a covered loss.
there are several exception to the principle of indemnity.
The principle of insurable interest means that the insured must stand to lose financially if a loss occurs, or must incur some other kind of harm if the loss takes place.

40. Summary
The principle of utmost good faith means that a higher degree of honesty is imposed on both parties to an insurance contract.
The legal doctrine of representations, concealment and warranty support the principle of utmost good faith .
There are several derived principles from the principle of indemnity .

41. Review questions
1. Explain the principle of indemnity. How does the concept of actual cash value support the principle of indemnity?
2. What is an insurable interest? Why is an insurable interest required in every insurance contract?
3. Explain the principle of utmost good faith. How do the legal doctrines of representations, concealment, and warranty support the principle of utmost good faith?

42. Review questions
4. Explain the principle of subrogation? Why subrogation used?
5.What is the Principle of Proximate Cause? Use examples to explain how it works in different situations?
6. Explain what is the principle of pro rata liability ?

43. Case Application