Insurance: An Overview

Chapter Three & Four

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1. Definitions
It is an economic institution that reduces risk by combining under one
management a group of objects so situated that the aggregate accidental
losses to which the group is subject become predictable within narrow limits.
 It is a device by means of which the risks of two or more persons or firms are
combined through actual or promised contributions to a fund out of which
claimants are paid.
The pooling of fortuitous losses by transfer of such risks to insurers, who
agree to indemnify insureds for such losses, to provide other pecuniary
benefits on their occurrence, or to render services connected with the risk.
A device for transfer of risks of individual entities to an insurer who agrees, for
a consideration, to assume to a specified extent, losses suffered by the insured.
It is a contract under which the insurer for consideration promises to
reimburse the insured or render services in cases of certain described
accidental losses.
It is a co-operative device to spread the loss caused by a particular risk over a
number of persons who are exposed to it and who agree to ensure themselves
against that risk.
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The following basic elements of insurance can be
identified from the ongoing definitions:
It is pooling of losses. Large number of insured persons is
involved.
It involves sharing of risks.
It is a cooperative device.
The value at risk is evaluated before insuring.
Payment is made at contingency.
 The amount of payment depends on the value of loss expected to
occur.
It involves payment of fortuitous losses.
It involves risk transfer.
It involves indemnification.
There are usually two parties to the contract.
 Insurer
 Insured 3
2. Functions of Insurance
Primary Functions
Insurance provides certainty.
Insurance provides protection.
Risk-sharing.
Secondary Functions
Prevention of loss.
It provides capital.
It improves efficiency.
It helps in economic progress.

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3. SOCIAL BENEFITS AND COSTS OF INSURANCE
i. BENEFITS OF INSURANCE:
Encourages investment 
Provide risk minimization and control advice
 Decreasing the chance of loss through loss prevention activities
Financial compensation
Increasing social and business stability
 Stability in employment and
 supply of goods and services

Peace of mind 
Source of income
 mobilize fund from both internal and external source
Reducing uncertainty
 Reducing imperfect knowledge by eliminating uncertainty of financial losses

Reducing worry for individuals and businesses

solve complex social problems
 Helping solve complex social problems such as industrial and automobile accidents
and financial problems of unemployment, old age, disability, death, and medical care
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ii. COSTS OF INSURANCE:
Expenses of insurers
 which increase premiums above the cost of losses

Insurance induced losses (create temptations)

 “Losses that occur solely due to the presence of insurance. Some
insurance induced losses are fraudulent; others are the result of a
lower standard of care for insured property. Examples include:
 Murder for life insurance proceeds

 Arson for profit

 Self caused disabling injuries

 Variety of intentional losses

 Carelessness with the insured property 

Reduced incentive to protect property against loss

 These events raise the cost of insurance to all
consumers.
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4. Requisites of Insurable Risks
Not all risks are commercially insurable.
 Certain requirements usually must be filled before a
pure risk can be insured. Such requirements are
requisites of insurable risk.
The requirements should not be considered as
absolute, iron rules but rather as guides or ideal
standards that are not always completely attained in
practice.
From the viewpoint of the insurer, there are ideally six
requisites of insurable risk.
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Cont’d
1. Large Number of exposure unites
2. Accidental and Unintentional Loss
Ideally, the loss should be fortuitous and outside the insured’s
control.
3. Determinable and measurable
4. No catastrophic Loss
5. Calculable chance of loss
6. Economically Feasible Premiums
Based on these requisites, it can be said that personal risks,
property risks, and liability risks are insurable whereas market
risks, financial risks, production risks, and political risks are
normally uninsurable by insurer.
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 5. Requirements of all legal contracts
A contract of insurance is an agreement whereby one
party called the insurer undertakes in return for an
agreed consideration called the premium, to pay the
other party namely the insured, the sum of money or its
equivalent in kind upon the occurrence of a specified
event resulting in loss to him.
 An insurance policy is based on the law of contracts.
To be legally enforceable, an insurance contract must
meet four basic requirements:
i. Offer and acceptance
ii. Consideration
iii. Capacity
iv. Legal purpose
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i. There must be valid offer and acceptance: The first
requirement of a binding insurance contract is that there
must be an offer and an acceptance of its terms. In most
cases, the applicant for insurance makes this offer, and
the company accepts or rejects the offer. An agent merely
solicits or invites the prospective insured to make an
offer.
A legal offer by an applicant for insurance must be
supported by a tender of the premium and it should
always be prior to commencement of the ‘coverage’. The
agent usually gives the insured a conditional receipt that
provides that acceptance takes place when the
insurability of the applicant has been determined by the
Insurer. In property and liability insurance, the offer and
acceptance can be oral or written.
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ii. Promises must be supported by the exchange
of Consideration: A consideration is the value
given to each contracting party. The insured’s
consideration is made up of the monetary amount
paid in premiums, plus an agreement to abide by
the conditions of the insurance contract. The
insurer’s consideration is its promise to indemnify
upon the occurrence of loss due to certain perils,
to defend the insured in legal actions, or to
perform other activities such as inspection or
collection services, or loss prevention and safety
services or as the contract may specify.

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iii. Parties must have legal capacity to contract: This
requirement of a valid insurance contract is that each
party to a contract must be legally competent. This
means the parties must have legal capacity to enter
into binding contract. Parties who have no legal
capacity to contract include:
• insane persons who cannot understand the nature
(obligations and liabilities) of the agreement
• Intoxicated persons
• Corporations acting outside the scope of their
charters, bylaws, or articles of incorporation, or
authority
• Minors

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 iv. Agreement must be for legal purpose: For
insurance policies, this requirement means that the
contract must neither violate the requirements of
insurable interest nor protect or encourage illegal
ventures. In other words, an insurance policy that
encourages or promotes something illegal and
immoral is contrary to public interest and cannot
be enforced.
 

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6. Insurance Classifications
The most common four basic types of insurances (property, liability,
life and health) are generally divided into two broad categories:
1. Property/Liability insurance
2. Life/Health insurance
Property insurance provides coverage for property and net income
loss exposures. It protects an insured’s assets by paying to repair, or
replace property that is damaged, lost, or destroyed or by replacing
the net income lost and extra expenses incurred as a result of
property loss.
Liability insurance covers the liability loss exposures. It provides for
payments on behalf of the insured for injury to others or damage to
others’ property for which the insured is legally liable.

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Cont’d
Life and health insurance covers the financial
consequence of human (personal) loss exposures. Life
insurance replaces the income-earning potential lost
through death and also helps to pay expenses related
to insured’s death. Health insurance provides
additional income security by paying for medical
expenses. Disability income as popular in most of the
Western countries, replaces as insured’s income if the
insured is unable to work because of injury or illness.

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7. Fundamental Principles of Insurance Contracts
The business of insurance aims to protect the economic value
of assets or life of a person. Through a contract of insurance
the insurer agrees to make good any loss on the insured
property or loss of life (as the case may be) that may occur in
course of time in consideration for a small premium to be
paid by the insured.
Apart from the above essentials of a valid contract, insurance
contracts are subject to additional principles. These are:
 Principle of Insurable interest
 Principle of Utmost good faith
 Principle of Indemnity
 Principle of Subrogation
 Principle of Contribution
 Principle of Proximate cause
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 Principle of Insurable interest
This principle requires that an insured must
demonstrate financial loss if a loss occurs, or must incur
other kind of harm if the loss takes place.
The purpose of this principle is three fold:
(1) to prevent gambling – an individual may insure the
property or the life of another individual on which he or
she may not have insurable interest and hope for loss of
the property or life insured;
(2) to reduce moral hazard – an individual may buy an
insurance policy on the property or life on which he/she
may not have an insurable interest and may deliberately
cause a loss to receive the proceeds of the policy; and
(3) to measure loss.
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Essentials of Valid Insurable interest
There must be a subject matter to be insured.
 any property of intrinsic value eg house, life
 an event happening of which causes a loss to third party

The policyholder should have monetary relationship

with the subject matter.
The relationship between the subject matter and the
policyholder must be recognized by law.
the policyholder is economically benefited by the
survival of the subject matter and/or suffer a loss at the
death or existence of subject matter.

What shall constitute an insurable interest?

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 When must an insurable interest exist?
 For Property and liability insurance, insurable interest
must exist at the time of loss. It may not have to exist at the
time of the inception of the policy because:
 Most property and liability insurances are contracts of
indemnity; and
 You may not have an insurable interest in property and liability
when the contract is first written, but may expect to have an
insurable interest in the future, at the time of possible loss.

 For life insurance, insurable interest must exist at the

inception of the policy. It may not have to be there at the
time of the occurrence of the death of the insured life. This
is because life insurance is not a contract of indemnity.

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Principle of Utmost good faith
It is a positive duty to voluntarily disclose ,
accurately and fully, all facts material to the risk
being proposed, whether asked for them or not.
As the underwriter knows nothing and the man who
comes to him to ask him to insure knows everything,
it is the duty of the insured …to make a full
disclosure to the underwriter without being asked of
all the material circumstances. This is expressed by
saying it is a contract of the utmost good faith.

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Cont’d
The doctrine of the utmost good faith requires
each party to tell the truth, the whole truth and
nothing but the truth.
What are the facts that must be disclosed?
The duty is reciprocal which means it will
also rest with the underwriter.
The insurer must not withhold information
from the proposer so as to lead him to a less
favorable contract.

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 Representations &warranties
 Representation is a written or oral statement made during
the negotiation for a contract. Representations:
 Need only be substantially correct
 Allow repudiation if a breach is material
 Do not normally appear on the policy
 Warranty is an undertaking by the insured that something
shall or shall not be done or that certain state of fact does
or does not exist. Warranties:
 Must be strictly and literally be comply with
 Give the right to repudiate on any breach
 Are written into the policy

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Breach of the doctrine of utmost good faith
Breach of the utmost good faith arises from:
 Misrepresentation: innocent or fraudulent. Innocent
misrepresentation occurs when incorrect information is
given unintentionally. But fraudulent misrepresentation
represents the deliberate supply of false or misleading
information.
 Non-disclosure: Is failure to disclose a fact that is material
by accident because the fact was not considered to be
important.
 Concealment: Is the omission to disclose a fact
intentionally. Fraudulent non disclosure is called
concealment.

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The breach of utmost good faith gives the
aggrieved party the right to:
(a) Avoid the contract
 repudiating the contract "ab initio", or
 avoiding liability for an individual claim.

(b) To sue for damages in addition to (a) if

concealment or fraudulent
misrepresentation is involved.
(c) To waive his rights to (a) and/or (b)
and allow the contract to carry on
unhindered.

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 Principle of Indemnity
The word ‘indemnify’ means, literally, to save from loss or
harm and , accordingly indemnity means the protection or
security against damage or loss.
For the purpose of insurance, indemnity can be defined “ ...as
exact financial compensation sufficient to place the insured in
the same financial position after a loss as he enjoyed
immediately before it occurred.“
Indemnity insurance are those where the insurer agrees to pay
only when the insured suffers a loss and only for the amount of
the loss. All property, pecuniary, and liability insurances are
virtually indemnity insurances.
Non- indemnity/contingency insurances are policies in which
insurers agree to pay a specified sum when a particular defined
event occurs.
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Life insurances are not indemnity
insurances because first it is
impossible to place a value on human
life and, second, because life policies
are not to cover financial loss, in many
cases the object is to provide a means
of saving for the future.

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 Measure of indemnity
A claim under a policy of indemnity has
been described as a claim for unqualified
damage. This means that the exact amount
of compensation is not known in advance
but is to be fixed afterwards on the basis of
the loss actually suffered.

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Property Insurance. The general rule is that the measure
of indemnity for the loss of property is determined not
by its cost, but by its value at the date and place of loss.
If the value has increased, the insured is therefore
entitled to an indemnity on the basis of the increased
vale subject, of course, to the adequacy of the sum
insured.
 If the value has decreased during the policy period, the
insured will recover only the reduced value at the time of
the loss, not the original value. They cannot claim for loss of
prospective profit or other
 Liability insurance. Indemnity is the amount of court
award or negotiated out court settlement plus costs and
expenses arising in connection with the claim.
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 Methods of providing indemnity
The terms of the policy normally give the
insurer the right to choose which method
to adopt.
The methods of providing indemnity are
usually set out in the operative clause.
There are four methods of providing
indemnity.

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Payment of money. Money payment is the
widely used mode of indemnity. There is no legal
obligation on the part of the insured to spend the
insurance money on restoring the property
damaged under the contract.
Reinstatement. In this case, reinstate means
actual rebuilding of the property that has been
damaged instead of paying money to the insured.
Insurers rarely exercise this option. If they chose
to rebuild they become responsible for any
problem in the reconstruction of the building.

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Repair . Insurers make quite extensive use of
repair as a method of providing indemnity. Motor
insurance is perhaps the best known example,
where motor repairs are commonly authorized by
insurers to carryout repair work on damaged
vehicles.
Replacement. This method is used where
insurers arranged for the replacement of broken
glass of their policyholders. Its also used for other
household goods.
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Principle of Subrogation
The principles of subrogation and contribution
are described as corollaries of the principle of
indemnity.
They automatically apply to insurances which
are contracts of indemnity and apply only to
indemnity contracts.
The principle of indemnity prevents
policyholders from receiving more than their loss.
Definition of subrogation- The right of one person, having
indemnified another under a legal obligation to do so, to
stand in the place of that other and avail himself of all rights
and remedies of that other, whether already enforced or not.
An insurer having indemnified a person, was entitled to
receive back from the insured anything the latter might 32
Subrogation allows the insurers to recoup
any profit the insured might make from an
insured event. It also allows them to pursue,
always in the name of the insured any rights
or remedies which the insured may possess
which may reduce the loss.
The insured is not prevented from recovering
from other sources in addition to his insurers,
but the money he succeeded to recover
belongs to the insurer who have already
provided indemnity.
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Principle of Contribution
Contribution is also a corollary of the principle
of indemnity which effectively prevents the
insured from making profit from his loss.
The possibility of profit in fact arises from
double insurance.
Contribution Defined as “ the right of an insurer
to call upon others similarly, but not necessarily
equally liable to the same insured, to share the
cost of an indemnity payment.”

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How contribution may arise
Two or more policies of indemnity exist
Each insures common subject matter
Each insures the peril which brings about the loss
Each insures the same interest in the subject matter
Each policy is liable for the loss

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Basis of contribution
Ratable proportion clause. This clause states that the
insurers will be liable for ratable proportion only of
any loss that is also insured by another policy.
Policy A: sum insured Birr 100,000.00
Policy B: sum insured Birr 200,000.00
Policy C: sum insured Birr 300,000.00
Loss : Birr 50,000.00

Rateable proportion =
Sum insured by a particular insured x loss
Total sum insured by all insurers

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A pays = 100,000 X 50,000
100,000+200,000+300,000
=8,333.33
B pays = 200,000 x50, 000
100,000+200,000+300,000
= 16,666.66
C pays = 300,000 x 50,000
100,000+200,000+300,000 =25,000
TOTAL= 50,000.00

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Principle of Proximate cause/causation
Careful drafting of insurance policies is believed to
minimize dispute about the meaning of words used in
an insurance contract. However , dispute may still
arise on the true cause of a loss.
The issue of determining how close the relationship
between an insured peril and a loss should be
addressed by putting rules.
The issue of the relationship between a cause and peril
is governed by the doctrine of proximate cause.
Proximate cause is simply the main cause of a loss
or the cause that is the most powerful in its effect.
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Proximate cause is the active, efficient cause
that sets in motion a train of events which
brings about a result, without the intervention
of any force started and working actively from
a new and independent source.
The proximate cause is not necessarily the first, nor the
last cause, it is the dominant cause.

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8. Distinct Legal Characteristics of Insurance Contracts
Insurance contracts have distinct legal characteris­tics
that make them different from other legal contracts.
 Aleatory Contract
 Unilateral Contract
 Conditional Contract
 Personal Contract
 Contract of Adhesion

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Aleatory Contract

 An insurance contract is aleatory rather than

commutative in that the values exchanged may no be
equal but depend on an uncertain event. Depending
on chance one party may receive a value out of
proportion to the value that is given.e.g Premium of
Birr 600 for sum inured of 200,000.But if no loss the
insurer will profit Birr 600.In case of Commercial
contracts theoretically there is equal exchange.

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Unilateral Contract

 An insurance contract is a unilateral contract in that

one party makes a legally enforceable promise. In this
case only an insurer makes a legally enforceable
promise to pay claims or other services to the inured
and so it drafts an insurance contract.
 In fact premiums are expected to be paid so as to be
compensated at the time of loss. Other Commercial
contracts are bilateral.

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 Conditional Contract

 An insurance contract is a conditional contract in that

the insurer's obligation to pay claims depends on
whether the insured or the beneficiary has complied
with all policy conditions. Conditions are provisions
that qualify or place limitations on the insurer’s
promise to perform.
 The condition section imposes certain duties on the
insured if he or she wishes to collect for a loss.
Although the insured is not compelled to abide by the
policy conditions, he or she must do so to collect for an
insured loss; Otherwise, the insurer is not obliged to
pay a claim if policy conditions are not met.
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 Personal Contract
 Personal contracts means in a sense in property insurance
it is not actually the property which is insured but it is the
owner who is insured;
 The contract is b/n the insurer and the insured;
 It is said to be personal because certain underwriting
standards like moral values or credit should be fulfilled.
 If property is sold to another person the new owner may
not be acceptable to the insurer.
 In practice, new property owners get their own insurance
in consistent with their risk.

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 Contract of Adhesion
 Contracts of adhesion means the insured must accept the
entire contract with all its terms and conditions.
 However, it is possible that an insurance contract can be
altered by the addition of endorsements,
riders(provisions)or other forms. The insurer drafts the
whole contract and if there are any ambiguities they are
construed against the insurer.
 There is reasonable expectation from part of the insured
to be entitled to the coverage under the policy so that
exclusions, qualifications and conditions have to be plain
conspicuous and clear.
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