Lecture slide chapter 2 insurance and risk management

Chapter Contents2.1 Nature of Insurance Contract

2.2 Elements of Insurance Contract

2.3 Principles of Insurance2.3.1 Insurable Interest

2.3.2 Utmost Good Faith

2.3.3 Principles of Indemnity

2.3.4 Doctrine of Subrogation

2.3.5 Warranties

2.3.6 Proximate Cause

2.3.7 Assessment or Transfer of Interest

2.3.8 Return of Premium

2.3.9 Contribution

Prepared By:

Md. Moulude Hossain

Faculty Member, Department of Business Administration

Insurance and

Risk Management

Lecture Slides

Insurance

Contract and

Principles

Chapter2

Insurance as Contract

• As we earlier define (contractual definition) insurance as a contract between two parties whereby one party called insurer undertakes, in exchange for a fixed sum called premiums, to pay the other party called insured a fixed amount of money on the happening of a certain event.

• It is good news for me that you are studying Commercial Law in the same semester, so I can hope that you certainly know about the fundamental law of contract.

May I have the Pleasure……….Or I need to have my footstep on the Law of Contract


• According to the Law of Contract

“All agreement are contracts if they are made by free consent of the parties, competent to contract, for a lawful

consideration and with a lawful object and which are hereby declare to be void.”

• Thus for a insurance contract: free consent of the parties – free consent of insurer and the insured

competent to contract – are legally eligible to enter into the contract

for a lawful consideration – the consideration is said to be exchange of risk in exchange of premium

a lawful object – it may be someone’s life or property

declare to be void – both to declare all the material facts with utmost good faith

Distinct Legal Characteristics of

Insurance Contracts

• Aleatory Contract: where the values exchanged may not

be equal but depend on an uncertain event . For e.g..-

?????????? (Commutative Contract?)

• Unilateral Contract: only one party makes a legally

enforceable promise. Only the insurer makes a legally

enforceable promise to pay a claim . After the first

premium is paid, the insured can not be legally forced to

pay the premiums (Bilateral Contract?)

• Personal Contract: the contract is between the insured

and the insurer

Distinct Legal Characteristics of

Insurance Contracts

• Conditional Contract: Insurer’s obligations to pay a claim depends on whether the insured has compiled with all policy conditions

• For e.g. In a homeowner’s policy , the insured must give immediate notice of loss. If the insured delays for an unreasonable period in reporting the loss, the insurer can refuse to pay the claim

• Contract of Adhesion: means the insured must accept the entire contract, with all of its terms and conditions


• The insurance contract involves

A. The elements of General Contract

B. The elements of special contract relating to

insurance

General Parts of Contract

A. General parts of a contract :- The general parts of a insurance contract contain the following parts-

– Offer & acceptance

– Free consent

– Legal consideration (Premium)

– Competency

– Legal object


1. Offer & acceptance

• Generally comes from the insured

• Insurer may also propose to make the contract

• Any act precedes it is an offer or counter-offer

• All that precede the offer or counter-offer is an

invitation to offer

• In insurance, the publication of prospectus, the

canvassing of the agents are invitation to offer


2. Free consent– The consent will be free when it is not

caused by1. Coercion

2. Undue influence

3. Fraud or

4. Misrepresentation

– When there is no free consent except fraud the contract becomes voidable at the option of the party whose consent was so caused

– In case of fraud the contract would be void.


3. Legal consideration – As we know form the law of contract that, “no

consideration no contract.”

– Thus in case insurance there need to be a

consideration for the validity of the contract.

– The promiser (insurer) pay a sum at given

contingency

– It need not to be money only but it must be valuable, it may be sum, rights, interest or benefits


– On the other side (insured), premium is a valuable

consideration for starting an insurance contract.

– The fact is that without payment of premium

(consideration) the insurance contract cannot be start.

For Insured: Payment of first premium plus an

agreement to abide by the conditions specified in

the policy

For insurer: Promise to do certain things as

specified in the contract. For e.g.: paying for a loss

from the insured peril


4. Competency• Every person is competent to contract:

a) Who is of the age of majority according to the law

b) Who is of sound mind and

c) Who is not disqualified from contracting by any law to which he is subject

• Thus the competency to contract implies that,a) A minor is not competent to contract

b) A person of sound mind means, he/she is capable to understand it and forming a rational judgment about it and the effects upon his/her interests.

c) A person of unsound mind occasionally can enter into contract when he/she is in sound mind

d) An alien enemy, undercharged insolvent and criminals cannot enter itno a contract.


5. Legal object

• In order to make a valid contract, the object

of the agreement must be lawful. An object

is lawful if it is-

Not forbidden by law, or

Is not immoral, or

Opposed to public policy, or

Which does not defeat any provision of any law

Principles of Insurance

B. Principles of Insurance/Special parts of the contract :- The special parts of a insurance contract are described as the fundamental principles of Insurance. The principles of insurance are as follows:

1. Insurable Interest

2. Utmost Good Faith

3. Principles of Indemnity

4. Doctrine of Subrogation

5. Warranties

6. Proximate Cause

7. Assignment or transfer of interest

8. Return of Premium


1. Insurable interest:-Insurable interest means pecuniary relationship. There must be a pecuniary or monetary relation between insured and the insured object.

• The principle of insurable interest is a pre-condition for a valid contract of insurance. The person getting an insurance policy must have an insurable interest in the subject matter to be insured.

• The insured must positively stand benefited financially due to existence or continuance of life.

• Ex – An employer has insurable interest in lives of his employees. A banker has an insurable interest in properties mortgaged to it against a loan.

Insured Insured object

Pecuniary relation


• Importance of Insurable Interest

– If the insurer has not insurable interest in property insured, the contract of insurance would amount to a gambling or speculative contract.

– Most clear and common case of existence of insurable interest is ownership of property being insured.

• Essentials of Insurable Interest

Subject matter of insurance must be certain. There must exist some property, rights, interest, like or potentially liability.

The policy holder should monetary relationship with the subject-matter.

The insured must bear a legal relationship to subject matter or he must be owner. He stands to benefit by safety.

The insured must be owner or may posses the legal rights or interest in subject matter to be insured.


2. Utmost good faith :- The concept of utmost good faith

describe that the contract of insurance is a contract of

uberrimae fidei i.e. of absolute good faith where both parties

of the contract must perform the following responsibility,

these are,

a) Material disclose

b) Full & true disclose

c) Duties of both parties

Under the contract of insurance, the insured’s duty is bound

to disclose all material facts relating to the risk to be covered.

Without good faith, it shall be null and void.


– Materiality of Facts

• A material fact is a fact which would influence the mind

of prudent underwriter in deciding whether to accept a

risk for insurance and on what terms. Examples:

– Motor – details of young drivers

– Household – details of commercial use of private dwelling

– Commercials – previous hazards / loss

– Life – details of heart disease

– Ubereimae Fidei

• It means the contracts which require absolute and utmost

good faith on part of all the parties concerned with the

contract.


• Material Information– Material information which enables the insurance company to

decide whether to accept or not to accept any risk

– If accepted, at what rate of premium and on what terms of and conditions.

– The legal binding applies to insured, who is in possession of all material facts relating to subject matter.

• Duty of Disclosure– Duty of disclosure applies to both proposer and insurer.

– Duty of disclosure operates at inception,

– Until the data cover is confirmed by insurers renewal

– Up to the renewal date mid term alternation

– Until the insurer confirm cover in respect of alternation.


• Facts need not be disclosed by the insured

The following facts, however, are not required to be

disclosed by the insured:

• Facts which tend to lessen the risk

• Facts of public knowledge

• Facts which could be inferred from the information

disclosed

• Facts waived by the insurer

• Facts governed by the conditions of the policy


3. Principle of indemnity :-Insurance contract is a

contract of indemnity. Insurer will pay the claim just

as the loss suffered by the insured, not more or less.

• Indemnity means that the insured person is placed

financially in the same position as he was before the loss.

The principles of indemnity also applies to all contracts of

insurance except life insurance where

– Loss suffered by insured can be measured in monetary terms

• The measure of indemnity is decided at the time of

entering into contract itself in events of insured:

– Prove that he has sustained a monetary loss

– Prove the extent and value of his loss


** Use of indemnity Principles:- Claim not more than the actual loss

To avoid the anti-social act

To minimize the premium

** Conditions of indemnity Principles :-

1. How to suffer loss

2. Claim not more than the actual loss

3. If claim>loss, residual to insurer

4. Third party compensation

5. Principle of indemnity does not apply to personal

insurance


• Features

– All contracts of insurance, except life insurance and personal

accident insurance are contracts of indemnity.

– There exists indirect relationship between principle of

indemnity and principle of insurable interest, because insured

has to prove amount of actual loss.

– The amount of compensation shall never exceed the amount

of actual loss or value of policy.

– Valued policies are not covered under scope of principle of

indemnity.


Methods of Indemnity

A. Cash payment:– It’s the claim of insurance in easiest and common method. After receiving the claim

form, make analysis of the surveyor’s report, and evaluate the amount of actual loss to be compensated.

B. Repairs:– The subject matter may be partially damaged or not fully destroyed in such case, the

insurer instead of cash payment prefers to settle claim of damage to get repair.

– Ex – motor vehicle insurance, machine and building insurance

C. Replacement: – In case of fully destroyed or loss, there is no chance of repair, the insurer many

arrange replacement.

– Ex – Theft or burglary insurance.

D. Reinvestment:– It is a rarely used method, where subject is destroyed is placed in its former position

or condition as it existed just before loss.

– Ex – Destroyed by fire


4. Doctrine of subrogation :- It means the

substitution at a certain occurrence , of the

insured by the insurer for the scrape value.

Subrogation is, “Transfer of rights and remedies of

insured to the insurer who has indemnified the insured in

respect of loss.”

Ex – Insurer of an importer of electrical goods receives a

claim in respect of a faulty toaster. The insurer pays the

claim but takes over insured’s right to claim back against

manufacturer.

Subrogation rights only apply where there is a “legal

liability”


** Essentials of doctrine of subrogation :-

1. Corollary to the principal of indemnity

2. Subrogation is the substitution

3. Subrogation only up to the amount of loss

4. Subrogation may be applied before payment

5. Not applied in personal insurance


5. Warranties :- It is a commitment to do

, or not to do something , by the insured

to the insurer. It may be any of the

following figure.

Warranties

Express Implied

Affirmative

Promissory


• Expressed Warranties

– Warranties which are mentioned in the policy

• Implied Warranties

– Warranties which are not mentioned in the policy

• Affirmative Warranties

– Warranties which are answer to the questions

• Promissory Warranties

– Warranties fulfilling certain conditions or promise


6. Proximate cause :- The proximate cause

describe the rule that immediate and not the

remote cause is to be regarded i.e. see the

proximate cause not the distant cause.

• The real cause must be seen while payment the

loss.

• It must be clearly mentioned in the contract only

in what case payment will be made, otherwise the

insurer will not responsible for a certain loss.


• Determination of Proximate Cause

– If there is a single cause of the loss, the cause will be the

proximate cause and further if the peril was insured insurer will

have to indemnify the loss

– If there are concurrent causes, the insured perils and expected

perils have to be segregated. The concurrent cause may be first,

separable and second, inseparable.

– If the causes occurred in from of chain, they have to be

observed seriously

• If there is unbroken chain the expected and insured perils have to be

separated

• If there is a broken chain of events with no expected perils involved, it is

possible to separate the loss.


7. Return of premium :- Ordinarily the

premium once paid cannot be refund. How

ever , the following cases the refund is

allowed. These are

1.By agreement in the policy

2.For reasons of Equity

3.Over insurance by double insurance


** For reasons of Equity has the

following points:-

• Non-attachment of ris

• Undeclared balance of an open account

• Payment of premium is apportionable

• Assured has no insurable interest

• Assured has over-insured under an unvalued

policy


8. Assignment or transfer of interest :- It is necessary to distinguish between the assignment of

a) The subject matter of insurance

b)The policy

c) The policy money when payable

• The marine and life insurance can be freely assigned but assignment under fire and accident policies are not valid without the prior consent of the insurer- except change interest by will or operation of law. Moreover, assignment under fire and accident policies must be maid before the insured parts with his interest. Once he has loss the interest, the policy is void and cannot be assigned.

Difference Between-

Insurance and Wager

Insurance Wager

1.Contract of insurance(

except life, accident and

sickness insurances) is a

contract of indemnity.

1.In case of wagering

agreement, however, there is

no question of indemnify as

the parties do not intend to

cover any risk.

2. A contract of insurance

is a contract requiring

utmost good faith by the

parties of the contract.

2. In the wagering

agreement good faith need

not be observed.

Difference Between-

Insurance and Wager

Insurance Wager

3. A contract of insurance is

legally enforceable and is

encouraged as it benefits

the community as a whole.

3. A wagering agreement is

void, because it is against

the public policy.

4.The object of contract of

insurance is to protect the

assured against the losses on

the happening of some

uncertain events.

4.Where as, the object of

wagering agreement is to

earn speculative gains.

Difference Between-

Insurance and Gambling

• To most people, Insurance is Gambling. Some

even see Insurance as legalized form of fraud. The

question is: Is Insurance Not the same as

Gambling?

– Gamblers are risk-seekers whilst insurance policy holders are risk-

averse. Whereas Gamblers seek risk in attempt to get more

money, insurance policy holders buy insurance to reduce risk

– Risk in gambling is Speculative but insurance is Pure risk.

Gambling involves a risk situation of Gain or Loss whilst

Insurance deals with Pure risk i.e. there is the possibility that the

event (e.g injury to person) will occur.

Difference Between-

Insurance and Gambling– Gambling is entertainment; insurance is business. People

engage in gambling mostly for excitement and enjoyment.

– In Gambling, the parties are only interested in the money earned or lost (stakes) and not the occurrence of the event whereas in insurance, parties are interested in the occurrence of the event since this is the main focus of attention.

– The insurable interest is in the event in Gambling; in insurance, the insurable interest is in the non-occurrence of the event. The parties in a Gambling contract choose an arbitrary event on the occurrence of which one party wins whilst the other loses.

– Gambling is unenforceable in court whereas Insurance is a valid contract.

Difference Between-

Insurance and Gambling• An insured must have an insurable interest in the subject matter of

a contract of insurance, which is not required in the case of a wager, where the interest is only restricted to the stake won or lost.

• An insurance contract is guided by the principle of utmost good faith, which is not required in the case of a wager.

• The insured event may or may not take place in the case of insurance (except life insurance). But in case of a wagering agreement the event takes place at a fixed future date.

• Insurance is based on mathematical predictions but gambling is highly speculative in nature.

• Insurance is enforceable by law whereas in gambling none of the parties has any legal remedy.

Insurance and hedging

• Hedging is a process where risk is transferred to a speculator through ways like purchasing a futures contract. Though insurance is not hedging, one similarity that can be drawn between the two is that an insurance contract is used to transfer the risk, without creating any new risks.

• Some distinctions that can be drawn between the two are:

– the risk that can be transferred in insurance is an insurable risk; in the case of hedging, the risks are uninsurable.

– by application of the law of large numbers, the insurer can reduce the risk, whereas in hedging risk can only be transferred and not reduced.

Lecture slide chapter 2 insurance and risk management

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