Introduction
Insurance developed several hundreds of years ago in response to a
basic human need, to avoid hardship and suffering. Since that time it
has grown into a major worldwide industry and as it has developed, so
have a number of principles that govern its workings.
In this module, we study the insurance principles. This is an important
module because the principles are the foundations for the business of
insurance as it is practised. A proper understanding of these principles
will enable you to understand why many insurance practices are done in
the manner they are done.
Utmost good faith is a legal principle governing the formation of the
contract and we take another closer look at insurable interest. Indemnity
and its supporting principles, subrogation and contribution control how
much the insured can receive as compensation and finally proximate
cause is used to assist in determining the cause of loss.
The principles relate to all classes of insurance, (Marine, Life and
General) although there are variations in the way they are applied to
each.
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2.1 - Utmost good faith
When buying a product, a car, TV etc, the buyer can examine the goods
and the seller does not have to say anything although any question from
the buyer must be truthfully answered. The legal principle governing
such contracts is caveat emptor - let the buyer beware - it is up to the
two parties (but mainly the buyer) to ensure that they are satisfied with
the terms. Neither party is under any obligation to volunteer any facts
or information to the other. This is not the case with insurance.
In insurance, the insurer must rely on the truthfulness and integrity of
the proposer. In return, the insured must rely on the insurer’s promise
to pay future claims. Further only one party (the proposer) knows all the
facts about himself and the ‘thing’ to be insured. Insurance is therefore
subject to a much stricter duty than let the buyer beware it is the duty
of Utmost Good Faith.
Utmost Good Faith is a duty of disclosure because each party must
voluntarily disclose all information; they cannot remain silent. Utmost
Good Faith applies to both insurer and insured although it is a more
onerous duty on the proposer.
An insurance company is aware that the insured is entitled to a discount
on his premium, as he has made no claims for the previous year. The
insured does not ask for his discount and the insurance company
remains silent. Is this a breach of the duty of utmost good faith?
Utmost Good Faith is a duty of disclosure and all parties to the contract
are obliged to disclose all material facts.
A material fact is defined as a fact that would influence the judgement
of a prudent insurer in deciding whether to accept a risk for insurance
and if so the terms and conditions that should apply, e.g. premium,
conditions, deductibles etc.
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The duty of disclosure begins at the
start of negotiations and continues
until the contract is in force. After
that, both parties are subject to the
terms and conditions of the contract.
However, even if there were changes
after inception, the insured should
disclose them. Most policies contain
a condition that the insured must disclose any alteration that increases
the possibility of loss. Even without this condition, the insured should
disclose any such alteration because the essential terms of contract
have altered.
Insurance contracts are issued for a period of time, 12 months being
the most common. At expiry insurers usually offer to renew the policy.
The terms and conditions may change but even if renewal is on existing
terms, the renewal is a new contract. The duty of utmost good faith,
therefore, revives at renewal and both parties must voluntarily disclose
any changes.
A landlord takes out a fire policy on his building. Two months after the
contract the tenant who used the building as a warehouse for storing
groceries moves out and a new tenant, who is using the building as a
garage and motor repair shop moves in. Do you think the landlord
should notify his insurers of the change in risk? Give reasons for your
answer.
A material fact is one that influences the decision of the insurer to
accept or decline risks or continue with an existing risk. Determining
exactly what a material fact is can be difficult especially for proposers
who are new to insurance. A proposal form normally asks for those facts
generally considered material by insurers. However, if there are other
facts not covered by the proposal then the proposer should voluntarily
disclose them; staying silent is not an option. Many insurance companies
remind the proposer to disclose any other information that may be
relevant to the insurance. The general rule is, if in doubt regarding the
relevance, disclose the information.
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Some of the information disclosed will relate to the subject matter of the
insurance and these are primarily physical hazards. Others relate to the
person taking out the insurance and are primarily be moral hazards.
Facts that require disclosure include:
• A full description of the subject matter of the insurance. The car,
property, liability etc.
• Any other policies covering the same risk
• Previous insurances. Especially relevant if an insurance company has
declined insurance or imposed special or restrictive terms.
• Details of previous losses and insurance claims.
• Any fact that increases the risk from normal. For example, a car
engine modified to make it go faster.
There are some facts that do not need disclosing. These include:
• Facts of law. The assumption is that everyone knows the law and
ignorance is not a defence.
• Facts of public or common knowledge. This could include well-
known flood or crime areas, earthquake zones, war areas, trade and
industrial processes.
• Facts that lessen the risk. Additional fire or security precautions for
example.
• When further information has been waived. If there is a blank or
inadequate answer on a proposal that insurers do not follow up the
assumption is they have accepted the position and cannot later rely
on facts they do not like.
A question on the proposal form asks: ‘Have you ever suffered any
previous losses?’ The proposer answers with a dash ( -). Later, when
investigating a claim, insurers discover that the proposer had a history
of losses. Do you think they could refuse to pay the claim? Give reasons
for your answer.
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A breach of utmost good faith is typically either non-disclosure i.e.
failing to disclose a material fact or misrepresentation i.e. incorrect or
inadequate disclosure. A breach that is a deliberate misrepresentation of
the facts may be fraudulent and referred to as concealment.
The breach leaves the injured party, typically the insurance company
with the option to:
• Cancel the contract from the beginning – almost as if it never existed.
• Insurers usually discover breaches at the time of a claim and refusing
to pay the claim is an option.
• Insurers may choose to charge additional premium or impose
additional terms on the policy.
• They may choose to ignore the breach and just continue with the
insurance.
Although unlikely, in the event that the insured suffers a breach, he will
be able to recover any damages that he has suffered.
Khalid bought an old building to store his stock. The previous owner
told him that the building suffers from flood damage from a nearby
river because every time it rained the river flooded. He does not tell
insurers. Later the river floods, stock damaged and a claim submitted.
Could insurers refuse to pay the claim? Give reasons for your answer.
Insurable Interest means that the person receiving the benefit of the
insurance policy must have suffered a financial loss when the insured
item suffers loss or damage.
To emphasise the importance of insurable
interest, in a fire policy, it is not the building
that is insured but the insured’s interest in
that building. This is insurable interest and
is the legal right to insure. Without insurable
2.2 - Insurable Interest
interest, an insurance policy becomes invalid as it ceases to be an
insurance contract but almost a gambling contract.
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Note that the owner of the property also has insurable interest and it is
possible for both parties to insure these items.
It follows that a legal relationship, between the person affecting the
insurance and the ‘thing’ being insured, must exist. The most common
of these is ownership. Clearly if a piece of property, car, house, camera,
watch, gold pen or whatever is damaged the owner will suffer financially.
Consequently, the owner has insurable interest in his property.
It is also possible to have an insurable interest in property that is
not owned but is in another person’s possession. Although with that
possession should be responsibility for the property. Garages, laundries,
hotels, airlines, repair shops and warehouses are just a few examples of
people who are in possession of property not belonging to them but
because they are responsible for its safety they have insurable interest.
You are leaving for a month’s holiday touring Europe. You borrow
a camera from your friend. Do you have insurable interest in the
camera?
We have referred to the ‘thing’ being insured and given property as an
example but the ‘thing’ can be an individual’s life or limb. We all have an
insurable interest in our own life to an unlimited extent but we can also
have insurable interest in the life of others.
Being a relative does not necessarily create insurable interest, as there
must be a financial loss on the death of the life insured. There might
be emotional loss on the death of a relative or close friend but not
necessarily a financial loss.
Families do however have insurable interest in the life of the
‘breadwinner’; business partners may have interest in each other’s lives;
a bank has insurable interest to the extent of the amount of any loan
they make.
Insurable interest varies slightly depending on the branch of insurance
- Marine, Life or General.
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Legal Principles of Motor Insurance in Saudi Arabia
Marine
In marine insurance, there must be
insurable interest at the time a loss occurs
and not necessarily at policy inception.
The nature of marine business is such
that goods can be in transit for several
months and its ownership could change
during the journey. Therefore, the person who may have taken out the
insurance may not be the person who suffers the loss.
Life
It has been established that in life
insurance insurable interest has only to be
present when the policy is taken out and
not necessarily when the loss occurs - the
opposite of Marine Insurance. This may
seem a strange position but is not really
a problem. If for example a bank requires a life policy as a condition
for a substantial loan, the debtor takes out the insurance on his life and
names the bank as the beneficiary for the proceeds. If the loan is paid,
the insured can simply change the beneficiary, or cancel the insurance.
General Insurance
For all other policies, insurable interest
must exist at policy inception, during the
currency of the policy and when the loss
occurs. If there is an absence of insurable
interest when the insurance starts then
the contract may be considered invalid
and if there is no insurable interest at the time of the loss then there
will be no loss to the insured.
2.3 - Indemnity
Indemnity in many ways is linked to Insurable Interest. Insurance
contracts to be valid must have Insurable Interest i.e. the insured must
suffer financially from the loss or damage to the ‘thing’ insured but that
Insurable Interest is limited to the financial interest.
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Legal Principles of Motor Insurance in Saudi Arabia
An owner has Insurable Interest in his own property but only to the
extent of the value of that property. Recover more and he would be
financially better off after a loss than before a loss. This would breach the
principle of indemnity and render insurance a gambling proposition..
The Principle of Indemnity is to put the insured in the same financial
position after a loss as he was in immediately before the loss. In theory,
he should be neither better off nor worse off but the same. In practice,
this is very difficult to achieve but it does not detract from the basic
principle, which many consider the foundation of insurance.
Indemnity is therefore the maximum financial interest that the insured
has in the insured item. However, it is not possible to place a monetary
value on a human life and we all have an unlimited interest in our own
life and limbs.
Therefore, life insurance and personal accident policies (excluding
medical expenses) are not policies of indemnity and the principle of
indemnity does not apply to them.
If the insured is to be in the same financial position after a loss as he
was before the loss, it is necessary to establish the value of any items
lost or destroyed at the time of loss.
Example:
Ali has a car model 2008 insured with a comprehensive insurance policy.
He had a car accident that damaged the head lights and the radiator
If Ali is given the new replacement price he would be able to purchase
new items whereas before the loss he had old items, so he would be
better off. To arrive at indemnity it is necessary to make a deduction
from the new price to make allowances for the age and previous use of
these items, known as wear and tear and depreciation.
Indemnity should not include any element of profit. Therefore, a
shopkeeper who has his stock damaged should be indemnified with the
cost price to replace that stock – it is not the selling price, which would
include his profit.
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In liability insurance the amount of indemnity would be limited to the
damages suffered by the third party with his costs.
Having established Indemnity, the insurance contract states that the
method of providing the Indemnity is at the option of insurers. The
typical policy lays down four options and insurers will normally elect
the option that is most convenient and least costly to them.
Monetary payment
In the majority of cases, this is the
most convenient method and insurers
reimburse the insured by cheque.
Repair
Insurers may arrange for a damaged
item to be repaired at their expense.
Collision damage to motor vehicles
is a common example where insurers
arrange repairs. In some cases,
insurance companies own or have a
financial interest in repair shops, which
help them to control costs. Alternatively, they may receive discounts
from repairers due to the volume of business.
Replacement
Insurers may choose to replace an item that has either been lost or
damaged beyond repair. Glass insurance, jewellery, house contents are
examples of replacement, again the insurance company usually gets the
benefit of discounts for the volume of business they supply.
Reinstatement
Reinstatement tends to refer to buildings or
machinery and is similar to repair. Insurers
may choose to undertake to rebuild the
damaged building themselves. An option
rarely exercised because of the problems it
can cause insurers. They would normally
expect the insured to arrange the work and
limit their role to verifying that the work is in order and within the
policy terms. They then reimburse their insured.
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Legal Principles of Motor Insurance in Saudi Arabia
A vehicle is damaged in an accident. The insured takes it to a garage who
estimates the cost of repairs as SR1,000. He submits a claim to his insurers
but due to their bulk purchasing power insurers can have the vehicle
repaired for SR 850. The insured states that he does not want to have the
vehicle repaired. He requests a cash settlement of SR1,000. Does he have
the right to this? Who chooses the type of compensation?
Indemnity is a principle underpinning insurance but in order to satisfy the
needs of policyholders it must be flexible. Insurers have policies that alter
slightly the strict principle of indemnity but achieve the overall objective of
attempting to put the insured in the same financial position after the loss as
he was immediately before the loss.
Agreed Value
In some cases it may be difficult to
assess the value of an item on the day
of loss, especially if that item is rare e.g.
an antique work, a master’s painting. In
these circumstances, insurers offer an
agreed value policy. In these contracts,
the value to be paid in the event of a
total loss is agreed at inception of the
policy. Note only the total loss value is
agreed, any partial loss would be handled
in the usual manner e.g. cost of repairs.
It does mean however that if the value
changes between inception and loss date
(which could be up to a year later) the
agreed value that is paid may differ from the indemnity value on the day
of the loss.
Agreed value policies are rarely used in non-marine insurance but are
very common in marine insurance where the value of cargo can fluctuate
during a long voyage and replacing the goods may be difficult in view of
the time and distances involved.
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Legal Principles of Motor Insurance in Saudi Arabia
A painting insured for SR100,000 on an agreed value policy is destroyed
in a fire. Its value on the day of the loss was SR75,000. How much will
the insured receive?
Give reasons for your answer.
First Loss
A situation may arise when the insured feels the probability of a total
loss is so remote that full insurance is not necessary. For example, in a
large warehouse containing heavy goods it is unlikely that thieves could
remove all the contents in a single loss. In these circumstances a first
loss policy, which permits less than full value insurance, is appropriate.
The insured selects the amount they feel is the
maximum they could suffer from any one loss
and this becomes the first loss sum insured and
is the maximum payable in respect of any one
claim. The full value of the property is noted
but only for information and to aid in premium
calculation. It does mean that if the insured has
made a mistake and does suffer a loss in excess
of the first loss sum insured he would not be
able to receive a full indemnity.
AlMuttahida have a first loss policy for SR500,000 although they have
property valued at SR2M in their warehouse. While closed during
a holiday period thieves break in and remove property valued at
SR600,000. What is the maximum the insurer can pay?
Give reasons for your answer.
In addition to these two types of policy, many other policies contain
conditions that can affect the amount the insured can receive as
indemnity.
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Average
It was stated earlier in the course that insurance is based upon the
common pool and that all contributors must contribute to the pool
according to the degree and size of the risk being introduced.
In the event that somebody undervalues his property, he will not be
making a fair and equitable contribution, as he will be paying less
premium than his risk demands. Insurers, therefore, penalise the insured
for any underinsurance by reducing his claim at the same proportion
that the sum insured is to the full value.
Unless there is a claim the underinsurance may not be discovered and it
will be too late to recover unpaid premiums possibly going back several
years.
Example
If a shopkeeper insures his stock for SR 50,000 but at the time of the
loss, the full value of his stock was SR100,000 then the claim will be
reduced by the same proportion – 50%. If the claim was SR15,000 he
will receive SR 7,500. It can be expressed as follows:
Replacing these with figures above:
If average applies then the insured will not receive a full indemnity.
Al Ikhlas Foods has a fire policy insuring their factory for SR1M. There is
a fire and the cost of repairs is agreed at SR 240,000. The loss adjuster notes
that the actual value of the factory at the time of the loss was SR1.5M.
How much can Al Ikhlas receive under the terms of the policy?
Show your calculation.
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For example, house insurance may have a limit any one item or a limit
in respect of valuables.
Sums Insured
The sum insured is insurer’s maximum indemnity and they cannot pay
more than this amount. In the event the insured suffers a total loss
of a property that is underinsured he will not receive a full indemnity.
However, some policies have sub limits or inner limits.
Deductibles
Also known as ‘excess’
These are the first amounts payable by the insured and are deducted
from any claim payment. Some deductibles are voluntary, which means
that the insured has elected to have the deductible usually in return
for a reduced premium. Others are compulsory because insurers have
imposed them, usually to encourage the insured to be careful.
Reinstatement
This condition simply states that indemnity will be the full cost of
replacement without any deductions for wear and tear i.e. he will receive
the value of new goods.
The condition is quite common in policies covering commercial
buildings and machinery where deductions in any event may be quite
small but where huge funds are needed to continue the business.
The reinstatement condition is available in house insurance policies and
referred to as ‘new for old’. The reason is to avoid hardship when if the
homeowner loses a substantial part of his home indemnity only cover
may not provide enough to refurnish the home. Although not common
in KSA, in other parts of the world, notably the UK almost every home
policy is on this basis.
Why do you think an insurance company will give a discount from the
premium if the insured voluntarily agrees to pay the first SR 2,500 of any
claim instead of 1500 SAR?
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2.4 - Subrogation
Subrogation supports the Principle of Indemnity and does not apply to
insurance policies that are not contracts of Indemnity.
Identify two policies that are not contracts of indemnity. Explain why
they are not contracts of indemnity.
The principle of indemnity is to place the insured in the same financial
position after a loss as he was in at the time of the loss. There are
circumstances, however, when an insured has the possibility to claim
from more than one party. If he did so successfully, he would receive two
payments and make a profit from his loss. This breaches the principle
of indemnity.
Example: “A” is waiting in his
car at a red traffic light. “B” is
approaching the red light but failed
to apply break in time and crashes
into the rear of A’s car causing
serious damage. Fortunately, “A”
has an insurance policy that will pay
for the repairs to his car. However,
he also has the option to make a claim against “B”. What he cannot do
is make two claims, one against his own insurance company and the
other against B’s.
In this example, if A chooses to ask his insurance company to pay his
claim (which is the sensible option as “B” may not be willing to pay
him) then the insurance company can act in Ahmed’s name and try to
recover from “B” (or his insurers).
This is the principle of subrogation, and means that an insured cannot
recover his loss a second time from another party if his insurer has
settled his claim. Those rights of recovery pass to the insurer.
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Subrogation exists as a right but only after the Insurers have settled the
claim. Many claims can however take several months if not years to settle,
very serious fire claims for example or major bodily injury. Insurers would
not want to wait before attempting a recovery neither would they want
their insured to start actions that could spoil their chances of success.
Insurance policies, therefore, have a policy condition that states insurers
may pursue a claim against another party in the insured’s name before
payment. Effectively insurers can start recovery actions immediately
after they are aware of the loss.
In addition to legal rights against a negligent party, Subrogation rights
can also happen under a contract e.g. tenancy or warehouse agreements.
A breach of a contract term may entitle one party to compensation. If
appropriate, these rights could pass to insurers.
Following a theft from Ahmed’s shop, his insurers pay him SR 5,000
in full indemnity. The thief following his arrest repays to Ahmed the
SR 5, 000 he has stolen. What should Ahmed do with the SR 5, 000?
In the same example above, the insurers pay Ahmed only SR 3,000
whereas the sum insured under the policy is SR 5,000 as Ahmed is unable
to substantiate his claim for full amount. The Police, however, recovers
full amount from the thief and passes on the same to the insurers as they
hold the subrogation rights.
What should insurer do with the SR 5, 000?
When insurers agree to pay a total loss
claim, e.g. when a car is so badly damaged
that repairs are impossible, there may
be some salvage value in the damaged
property. As the insured has received a
full indemnity, if he kept the salvage he
would be in an improved position.
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Legal Principles of Motor Insurance in Saudi Arabia
Therefore, the rights in the salvage pass to insurers as part of their
subrogation rights.
Adel’s car is irreparable following an accident. Its value is SR100, 000
and he receives this from his insurers. A dealer says he can break up the
old car for spare parts and offers Adel SR10, 000 for the wreck, which
Adel accepts. Should Adel keep the money?
Insurers have subrogation rights only in respect of losses for which
they have provided an indemnity. If there are uninsured losses such as
loss of wages, car hire then the insured can still attempt to claim these
from the third party.
In many of the larger insurance markets insurers enter into agreements
not to recover from each other. The reasoning is the principle of
‘swings and roundabouts’ (what we gain on the swings we lose on
the roundabouts and the result is stalemate). This is due to the large
number of claims and consequently the large number of times insurers
are trying to recover from each other. It becomes more cost effective
not to recover.
In some countries, in Motor insurance, the insurers have an agreement
called «knock for knock» under which each insurer pays the claim for the
motor vehicle under their policies and refrain from proceeding against
the insurer of the opposite vehicle.
2.5 - Contribution
If an insured takes out two insurance
policies covering the same risk, he
would have dual or double insurance.
To allow recovery from both insurance
companies would breach the principle
of indemnity. Contribution is similar
to subrogation; it exists to support the
Principle of Indemnity and like Subrogation, applies only to contracts
of indemnity.
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Dual insurance is not usually intentional but may happen through a
misunderstanding. Examples include:
• The company secretary and financial manager both believing it is
their responsibility to deal with the company’s insurance.
• The owner of goods and the owner of the warehouse both insure
goods stored in the warehouse.
• Cover under two policies overlap e.g. holiday insurance and a house policy.
Insurers allow for dual insurance by a contribution condition in their
policies, which states that in the event of more than one policy they will only
pay their share. This is the contribution or other insurance condition.
The share that each insurer agrees to pay is their rateable proportion
of any loss. There are two methods of calculating an insurers’ rateable
proportion, based on either sums insured or independent liability.
Sums Insured Method
In this method, the contribution to be paid by each insurer is calculated
by apportioning it according to the sums insured under each policy.
Each insurer pays according to the formula
Example
Policy “A” has a sum insured of SR 100,000.
Policy “B” has a sum insured of SR 400,000
The loss is SR10,000
Therefore: Policy “A” pays
Policy “B” pays
Insured Receives SR 10,000
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The method is adequate for property insurance when the policies in
contribution are identical in the cover they provide.
Independent Liability Method
The alternative method is suitable for policies that are not identical;
they may include deductibles, loss limits or when average applies. They
are also suitable for non-property policies e.g. liability insurances.
The independent liability is arrived at by calculating how much each
policy would have paid had it been the only policy issued. Each policy
is calculated and then the claim is apportioned according to the total of
independent liabilities.
The formula is:
Example
Policy “A” has a sum insured of SR 100,000 and a deductible of SR 500.
Policy “B” has a sum insured of SR 400,000 and a deductible of SR 1000
The loss is SR 10,000.
Independent Liability of Policy “A” is SR 9,500 (10,000-500)
Independent Liability of Policy “B” is SR 9,000 (10,000-1000)
Policy “A” pays
Policy “B” pays:
Insured receives SR 10,000
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The correct method is the one that is most appropriate for the
circumstances.
Similar to subrogation, larger insurance markets have agreements on
contribution. The method to use, when contribution is not appropriate
(if less than a certain amount only one insurer will pay), which policy
should take preference. A policy that is more specific would pay first. For
example, if one policy covers jewellery and another a diamond ring. If
the policies are in contribution then diamond ring is more specific than
jewellery. The diamond ring policy will pay and not seek contribution.
2.6 - Proximate Cause
When a loss occurs before making
a decision concerning settlement, it
is necessary to determine the cause
of the loss. In the majority of cases,
there is one cause of loss but there
are occasions when there is more than
one event. In these circumstances,
the rules of proximate cause assist in determining the cause of loss.
After establishing the cause, it is necessary to interpret the policy wording
to see if the loss is insured or not. The cause will fall under one of the
following three headings:
An Insured Peril
This is a peril specifically mentioned in the policy as covered by the policy. A
fire policy will specifically mention that losses caused by fire are insured.
An Excluded Peril
This is a peril specifically mentioned in the policy as not covered. A
fire policy specifically mentions a fire caused by an earthquake is not
covered.
Other Unnamed Perils
These are perils not mentioned in the policy. If the cause of loss is an
unnamed peril, it is not covered. The fire policy does not mention the
peril of theft. It is therefore neither an insured nor an excluded peril but
simply an unnamed peril.
