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Chapter 2: legal aspects of insurance and risk management.


Most contracts are agreements between equals where both have an opportunity to say what the contact will and will not cover. Insurance is different. Generally parties are free to bargain at will with no restrictions, even about illegal transactions (although a contract pertaining to an illegal act will be held unenforceable as the court will not involve itself with illegal matters). Except for large commercial insureds, there is very little opportunity to bargain with the insurance company. When an individual or business purchases an insurance policy, the buyer has no say in wording of the contract or any of the conditions. The policy is offered on a take it or leave it basis. This is because the public policy or social aspect of insurance has been held to be so important to the efficient operation of society that certain principles operate in insurance policy interpretation that are not so with other types of contracts.


The insurance contract relies on the principle of indemnity. Its purpose is to indemnify the policyholder in the event of a covered loss. Indemnify means "to make whole" or "to reimburse." Ideally, after a loss an insured should be in the same position he was in prior to the loss.

Example. ABC manufactures widgets in a factory that is ten years old. A tornado takes off the roof. With a 20-year lifespan, the roof has lost one-half of its use. Instead of putting on a ten-year old roof, the insurer will put on a new roof, but reduce its payment by 50%. ABC is indemnified for its loss. The actual cash value of the roof is the cost to replace it minus depreciation.


Paying claims based on a depreciated value--actual cash value or ACV

basis--led to policyholder dissatisfaction. The remedy was Replacement Cost Coverage. Under this program, the policy replaces or repairs the damaged property without depreciation. Old property is replaced with new. Replacement cost coverage will typically restrict an insured to the lesser of (1) the cost to replace the property with equivalent property, (2) the amount actually spent for the replacement property, or (3) the policy liability limit applicable to the property. Other policies may limit an insurer's payout to no more than the actual cash value for the damaged property until the repair or replacement is completed. This provision may also require that the replacement or repair be completed within a certain time frame. A third provision may allow the insured to elect to collect the actual cash value of the damaged or destroyed property, disregarding the replacement cost provisions, without prejudicing the right to later claim additional payment on a replacement cost basis. Usually this type of provision imposes a time limit in which a replacement cost claim can be made.

Example. A homeowner loses his 15-year old roof to a tornado. His insurer doesn't try to find 15-year old shingles to make the repairs. Rather, the insurer pays to put back new shingles and whatever else is needed to "replace" the damaged roof. The difference between "replacement cost" and "actual cash value" is the deduction for depreciation.

While the concept of actual cash value may seem off kilter with the principle of indemnity, it is statistically calculable under the Law of Large Numbers and developed to deal with a number of problems that arise under a purely actual cash value (actual worth) adjustment of a loss.


Another important aspect of the insurance transaction is that a party must have an insurable interest in property in order to enter into an insurance contract or policy regarding that property. Couch on Insurance, 3rd Edition, defines insurable interest as "any lawful and substantial economic interest in the safety or preservation of the subject of the insurance free from loss, destruction, or pecuniary damage." The concept of insurable interest in a property insurance contract is essential because it is the insured's interest in property, and not the property itself, that is protected. If the insured suffers no direct financial loss from the property's destruction, the insurer has the right to question or withhold payment. To allow otherwise would encourage speculation (For instance, buying life insurance coverage on a complete stranger could encourage wrongful acts. Likewise, allowing someone to buy fire insurance coverage on a building where the policy is written for a party with no financial or economic interest in that property might increase the morale risk of arson.)

Without an insurable interest, the insurance policy would become a wager and against public policy. An insured must have a legitimate financial interest in the property to be insured. While the interest does not have to rise to the level of ownership, its loss must cost the insured money. Individuals may insure their leased autos, for example.

Property insurance contracts need not contain a description of the insurable interest. The interest may change while the policy is in force without any change needed in the way the insurance is written, unless a variation in the amount of insurance or a change in the additional insured or loss payee is necessary. And although a party who is not named as an insured, additional interest, or loss payee typically cannot recover under a policy, no matter what the interest might be, there may be exceptions. For example, a person can insure a lease interest or property in his care for which he is legally liable. Therefore, renters, leaseholders, and bailees have an insurable interest in nonowned property in their possession or care, and may therefore insure that property. The burden of proving that an insurable interest exists at the time one claims coverage under the policy.


An insurance contract is a personal contract between the insurer and the insured. While all contracts require "good faith" dealings between the parties, insurance requires more. It requires "utmost good faith." The dictionary tells us good faith is an abstract and comprehensive term that encompasses a sincere belief or motive without any malice or the desire to defraud others. It derives from the translation of the Latin term bona fide, and courts use the two terms interchangeably.

Because of the importance of insurance to the financial security of people, and of society itself, insurance contracts have a public interest component that other types of private contracts do not. It is of interest to the general public good to hold insurers to higher standards of good faith and fair dealing than in other types of private contracts.

Insurance contracts differ from other types of private contracts between people or businesses because of this public interest. Insurance contracts are aleatory and are contracts of adhesion.

There is disparate bargaining power between the parties--on the one hand, a large and legally sophisticated insurance company, on the other, a small and legally unsophisticated consumer. Because of these things, courts have allowed extra-contractual damages for the breach of an insurance contract by an insurer--including punitive damages. This is something not available in the general contract law area.

As mentioned above, insurance contracts are aleatory. This is because the dollar amount to be exchanged is unequal.

Black's Law Dictionary says that an aleatory contract is one "in which promise by one party is conditioned on a fortuitous [unexpected or accidental] event." In other words, before an insurance contract performs, a fortuitous event must happen to the insured.

As an example, a policy covering a $200,000 home may cost $700 per year. But, if that home burns to the ground, the insurer will pay $200,000 for the home. It will also pay for any lost personal property and for the homeowner to live elsewhere while a new home is being built.

On the one hand, a party to the contract (the insured) may get nothing for his $700 but peace of mind. On the other hand, her $700 might buy $200,000 or more of worth, in the event of catastrophic damage to the home. Insurance is not a quid-pro-quo, dollar-for-dollar contract.

Most contracts are bargained--both parties have input as to the final contents. An insurance contract, however, is different. It is written and drawn by the insurer and offered to the customer on a "take it or leave it" basis. This is what is meant by a contract of adhesion.

Since insurance contracts are written this way, courts interpret any ambiguity in the language strictly against the insurer. The insured gets the benefit of any unclearness of the phrasing. If the insurer wanted a specific meaning of a contract provision, it had the opportunity to write it that way. Where the policy does not clearly say what the insurer wants, the benefit of the doubt goes to the insured.


Early in the 20th century, there were court and legislative attempts to bring insurance (as interstate commerce) under the purview of the federal government. This resulted in the 1945 McCarran-Ferguson Act, which allowed the individual states to regulate insurance and insurance companies within their borders. Although there have been movements to federalize insurance regulation, to date, McCarran-Ferguson still holds.

Up until 1887, no standard fire (or property) policy existed. In that year, the New York legislature drafted a form for use in that state. It was quickly adopted by insurers in New York and by other states. This was the beginning of insurance policy regulation, wherein the states set various statutory requirements to which all property policies written within the state must adhere.

The New York policy was updated in 1918 and again in 1943. It is that version, "The 1943 New York Standard Fire Policy" that was adopted by nearly all the states, with only minor variations. It was more flexible than its predecessors, as it allowed for the addition of endorsements to modify the coverage.

The "1943 Policy" was the basis for all property insurance until the 1976 "simplified language" homeowners policy and the simplified commercial policies of the 1980s.

Even though the "1943 Policy" has been replaced by modular policies, many of its basic provisions may still be found in the policies in use today. In fact, some states still use the 1943 New York policy as the base requirement for property policies. Until recently, some states even required it to be attached to a simplified language homeowners policy.


All property and casualty insurance policies contain the following: the declarations page, the insuring agreement, exclusions, conditions, and endorsements, if any.

The first page of an insurance policy is the declarations or the "dec page." It contains basic information about the policy, such as name of the insurer and agent, name and address of the insured, policy period, limits of liability, forms applicable, and premium. This is who is being insured, for how long, and at what price.

The insuring agreement is the heart of the policy. This is the coverage pledge. It states what the insurer will do--indemnify the insured for covered losses--in exchange for the insured's payment of the premium.

The insuring agreement from a typical Homeowners policy reads, "We will provide the insurance described in this policy in return for the premium and compliance with all applicable provisions of this policy."

It is important to know and understand what an insurance policy covers. It is equally important to know what the policy does not cover. The Exclusions section states what losses are not covered by a particular policy.

There are several reasons for insurance policy exclusions:

* The loss is not commercially insurable--such as war.

* The exposure is more appropriately covered in another type of policy--such as automobile, aircraft, workers compensation, or flood.

* The loss is wholly or partially in the control of the insured--such as the exclusion of marring and scratching damage to certain types of personal property. The policy also will not cover damage intentionally caused by the insured.

* The loss is more appropriately covered by an endorsement to the basic policy--such as a jewelry floater endorsed to a homeowners policy. When floaters are added, coverage typically attaches with first dollar coverage when the items are listed or scheduled in advance. Appraisals of the scheduled items are usually required so that the values insured are agreed upon in advance.

* Small, predictable losses that are relatively expensive for the insurer to process--such as damage to a home or its contents done by a pet. This is wear and tear, the normal deterioration process that occurs as any item is used.

The Conditions section lays out the rules and procedures that must be followed by both the insurer and the insured:

* How to file a claim.

* How to make changes in the policy and what kinds of changes the insurer will allow the policyholder to make without having to rewrite the policy. Usually, the company will insist on a new policy if the named insured changes.

* How and when each party may cancel the contract. Few states require the insured to provide advance notification to the insurer for cancellation, so typically the insured will simply stop paying the premium and replace the coverage. The company spells out the specific conditions, including those required by state law, under which it can cancel or nonrenew coverage. This will include the specific reasons that may be used for a cancellation and the length of time required for the company to notify the insured.

* What each party must do after a loss.

* How disagreements between the parties are handled. Arbitration may be required. Arbitration ordinarily is a proceeding voluntarily undertaken by parties who want a dispute resolved on the merits of the case by an impartial decision maker. Both parties agree to accept the decision as final and binding. Arbitration usually implies a procedure that is speedy, economical, and bears equally on insured and insurer. When Arbitration fails, the Legal Action Against the Company section explains what is involved in filing a suit against the insurer.

* Sometimes there is more than one policy providing coverage. In such cases, the Two or More Policies section describes how coverage is to be apportioned to each insurer.

Bankruptcy of the Company describes what will happen if the insurer goes bankrupt. While most insurance policies are rather generic in nature, a generic policy may not meet the needs of all insureds. Endorsements provide a way to tailor a basic policy to better meet the needs of a particular insured. Coverages can be added or deleted.

Example. One way a standard policy can be customized is by adding endorsements. One homeowner may have a valuable stamp collection; another may need liability coverage for a boat; a third needs liability coverage for a summer home on the beach. Each of these special situations can be handled on a homeowners policy with the use of special endorsements.

These coverages may be added to a homeowners policy, or they may be insured separately. When written on a separate policy, it is called an inland marine policy. Inland marine policies became known as floaters since the property insured is easily moved or "floating." The coverage provided is on an "all risk" basis, subject to exclusions such as war, governmental actions, a nuclear hazard, and intentional actions. Inland marine insurance is an outgrowth of ocean marine insurance.


Like all living things, insurance policies have changed and evolved over the years. This process will continue as needs are uncovered. Many years ago, the auto policy provided liability coverage only. If the owner wanted to protect himself against damages to his own car it was necessary to purchase a separate policy. Today a single policy can provide both liability and physical damage coverages. Most states require insurers to offer Uninsured Motorists Coverage to protect against injuries caused by drivers who are not insured. One of the newest coverages available for auto owners is GAP insurance. This coverage came about because the value of a leased vehicle is not always equal to the outstanding loan amount at the time of a total loss. With GAP coverage, the company will pay for the difference in value if the vehicle becomes a total loss and the actual cash value is less than the amount needed to pay off a lease or loan.

Homeowner polices started out covering only fire and vandalism for the building itself. This more limited coverage is called Dwelling Fire insurance and now is used to insure rental property. That type of policy still exists. However when contents coverage became available to provide coverage for the insured's clothing, furniture, and other possessions, the new policy became known as Homeowners insurance. Loss of use coverage came still later. This coverage will pay for the homeowner to live elsewhere while the home is being repaired after damage due to covered perils.

As with policies of personal insurance, commercial policies are now frequently combined and packaged. Many individual policies have been redefined as "coverage parts" to facilitate the combination into packages such as the Businessowners Policy, which may include coverage for vehicles used in the business, products liability, coverage for the business premises, and much, much more.


When analyzing any property and casualty insurance policy, a review of the declarations page will tell you the following:

1. Who is insured? Who has something to lose?

2. What property or activity is insured? What type of policy is this: Auto, Homeowner, Dwelling, Businessowners, Commercial Property, etc.? Are vehicles being insured, or is a residence being insured?

3. What locations are insured?

4. What is the time period of the coverage? This is the policy period.

5. What are the coverage limits? The limits of liability represent the most the company will pay for loss under the policy.

After the Declarations page, you get to the policy itself. The policy will tell you the following:

1. What are the perils insured against? Many personal lines policies are fairly similar. Commercial lines policies are not quite so generic. In any case the only way to determine the perils being covered and the miscellaneous coverages being offered is to read the actual insurance contract.

2. What is not covered under the policy? These are the exclusions.

3. Are direct losses, indirect losses, or both types insured? A direct loss results from a covered peril such as fire. Damage caused by the fire is a direct loss. An indirect loss also results from damage caused by a covered peril, such as fire or windstorm. However, it follows as a consequence of the direct damage. For example, a windstorm is a covered peril that may directly damage a home. However, if a tree is blown down it also may cut off the electricity used to power a freezer, and the food in the freezer will spoil. If the policy extends coverage for consequential loss or damage, then the food spoilage would be covered as an indirect loss.

4. Has the company added endorsements to modify the policy? Coverage endorsements can add or restrict coverage. If a special coverage is needed beyond the standard policy, this is where it would be found.

Each of these items are matched against the particular provisions and phrasing of the insurance policy to determine coverage.


1. An insurance policy is "aleatory" in nature, meaning that the parties had disparate bargaining power in its formation.



2. Parties to insurance contracts are free to bargain for the conditions and provisions in the policy in an unrestricted fashion.



3. In order to enter into a contract of insurance for a piece of real property, the insurable interest requires an ownership interest by the insured in that property.



4. The insurance industry is regulated on a state-by-state basis.



5. A homeowners insurance policy is a contract of adhesion, meaning that it is offered by an insurer to a consumer on a "take it or leave it basis."



6. Provisions in a contract of adhesion are construed against the contract's drafter.



7. The indemnity principle states that an insured must be returned to a position of betterment in the event of a covered loss.



8. The declaration page of the insurance policy is where the insurer declares what perils are excluded under the contract.


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Publication:Tools & Techniques of Risk Management for Financial Planners, 2nd ed.
Date:Jan 1, 2007
Previous Article:Chapter 1: general principles of risk and insurance.
Next Article:Chapter 3: insurance policy selection.

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