INDEMNITY

Definition

Indemnity means an exact financial compensation for an insured loss, no more no less.

Implications

Indemnity cannot apply to all types of insurance. Some types of insurance deal with ‘losses’ that cannot be measured precisely in financial terms. Specifically, we refer to Life Insurance and Personal Accident Insurance. Both are dealing with death of or injury to human beings, and there is no way that the loss of a finger, say for instance, can be measured precisely in money terms. Thus, indemnity cannot normally apply to these classes of business. (Note: medical expenses insurance, which is often included in personal accident and travel insurance policies, is indemnity insurance unless otherwise specified in the policies.)

Other insurances are subject to the principle of indemnity.

Note: It is sometimes said that life and personal accident insurances involve benefit policies rather than policies of indemnity. Since indemnity cannot normally apply, the policy can only provide a benefit in the amount specified in the policy for death or for the type of injury concerned.

Link with Insurable Interest

We studied insurable is above. That represents the financial ‘interest’ in the subject matter, which is exactly what should be payable in a total loss situation, if the policyholder is to be completely compensated. However, life and personal accident insurances may generally be regarded as involving an unlimited insurable interest, and therefore indemnity cannot apply to them.

How Indemnity is Provided

It is common for property insurance policies to specify that the insurer may settle a loss by any one of four methods named and described below. However, both marine and non-property policies are silent on this issue so that the insurer is obliged to settle a valid claim by payment of cash.

(a) Cash payment (to the insured): This is the most convenient method, at least to the insurer.

(b) Repair: Payment to a repairer is the norm, for example, with motor partial loss claims.

(c) Replacement: With new items, or articles that suffer little or no depreciation, giving the insured a replacement item may be a very suitable method, especially if the insurer can obtain a discount from a supplier.

(d) Reinstatement: This is a word that has a number of meanings in insurance. As a method of providing an indemnity, it means the restoration of the insured property to the condition it was in immediately before its destruction or damage.

Note: You are absolutely correct if you understand that the term ‘reinstatement’ overlaps in meaning with ‘repair’ and with ‘replacement’.

Salvage

When measuring the exact amount of loss (which indemnity is), it has to be borne in mind with certain property damage that there will sometimes be something left of the damaged subject matter of insurance (fire-damaged stock, the wreck of a vehicle, etc.). These remains are termed ‘salvage’. If the remains have any financial value, this value has to be taken into account when providing an indemnity. For example: (a) The value of the salvage is deducted from the amount otherwise payable to the insured (who then keeps the salvage); or

(b) The insurer pays in full and disposes of the salvage for its own account.

Note: The term ‘salvage’ in maritime law has a very different meaning, where it usually refers to acts or activities undertaken to save a vessel or other maritime property from perils of the sea, pirates or enemies, for which a sum of money called ‘salvage award’ (or just ‘salvage’) is payable by the property owners to the salvor provided that the operation has been successful. The term is sometimes also used to describe property which has been salved.

Abandonment

This is a term mostly found in marine insurance, where it refers to the act of surrendering the subject matter insured to the insurers in return for a total loss payment in certain circumstances. This is quite standard in marine practice, but in other classes of property insurance, policies usually specifically exclude abandonment.

The important thing to be remembered with abandonment is that the subject matter insured (or what is left of it) is completely handed over to the insurer, who may therefore benefit from its residual value. (This will be important with Subrogation).

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Policy Modification of the Principle

It is very common for insurers to adopt policy wording that has the effect of modifying the application of proximate cause rules. Two examples of such practice are given below:

(a) ‘Directly or indirectly’: There are a whole number of ways that an insurer can frame his policy wording for the purposes of specifying what he wants to cover or not to cover. For instance, it may use such wording as ‘loss caused by …’, ‘loss directly caused by …’ and ‘loss proximately caused by …’. Well do they mean different things to you? Will any of them have the effect of modifying the rules of proximate cause? The answer is that they have been held to mean the same thing. That is to say, whether the term ‘directly’ or ‘proximately’ is adopted or left out, the legal rules to be applied are exactly the same and the same scope of cover is given or excluded, as the case may be. But what if the term ‘indirectly’ is used? A policy exclusion that says that loss ‘directly or indirectly’ arising from a particular peril (excepted peril) is excluded has been construed by the courts to mean that a loss will not be recoverable even where the operation of that excepted peril has only been a remotely (as opposed to ‘proximately’) contributory factor. Read the following decided court case for illustrations:

An army officer was insured under a personal accident policy, which excluded claims ‘directly or indirectly caused by war’. During wartime, the insured was on duty supervising the guarding of a railway station. Walking along the track in the darkness, he was struck by a train and killed. It was held that although the war was merely an ‘indirect’ cause of the death, the policy wording meant that the insurer was not liable.

(b) ‘Loss proximately caused by delay, even though the delay be caused by a risk insured against’ (an exclusion wording quoted from a marine cargo insurance clause most commonly used): Suppose an insured shipment of calendar for the year 2011, expected to arrive on 1 December 2010, does not arrive until 15 February 2011 because of a collision (insured peril) involving the carrying vessel during the insured voyage. By relying on the exclusion, the insurer can deny a ‘loss of market’ claim from the insured even though the loss is due to an insured peril.

Note: Remember that the principle of proximate cause is sometimes very complicated. There have been many interesting, sometimes surprising court cases which have decided its application. In particular, not too rarely are inconsistent or opposing judicial decisions seen in factually similar cases which are made on the basis of the same rule(s) of proximate cause, perhaps because the judgments of the judges vary from one case to another on how the facts of a case relate to one another. Therefore, please do not assume that knowledge of the above brief notes will make you an expert in this area.

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Types of Breach of Utmost Good Faith

A breach of utmost good faith can be in the form of either a misrepresentation (i.e. the giving of false information) or a non-disclosure (i.e. failure to give material information). Alternatively, it can be classified into a fraudulent breach and a non-fraudulent breach (i.e. a breach committed either innocently or negligently, rather than fraudulently). Both classifications combined produce a four-fold categorisation as follows:

(a) Fraudulent Misrepresentation: an act of fraudulently giving false material facts to the other party;

(b) Non-fraudulent Misrepresentation: an act of giving false material facts to the other party done either innocently or negligently;

(c) Fraudulent Non-disclosure: a fraudulent omission to give material facts to the other party; or

(d) Non-fraudulent Non-disclosure: an omission to give material facts to the other party done either innocently or negligently.

Remedies for Breach of Utmost Good Faith

If the duty of utmost good faith is breached (any one of the four types mentioned above), the aggrieved party (normally the insurer) may have available certain remedies against the guilty party:

(a) To avoid within a reasonable time the whole contract as from policy inception, with the effect that premiums (and claims) previously paid without knowledge of the breach are generally returnable, unless it was a fraudulent breach on the part of the insured or his agent;

(b) In addition to (a) above, it is in principle possible to sue in tort (see Glossary) for damages in the case of fraudulent or negligent misrepresentation;

(c) To waive the breach, alternatively, in which case the contract becomes valid retrospectively.

Note: An insurer aggrieved by a breach of utmost good faith has not the option to refuse payment of a particular claim, to treat the policy as valid for the remainder of the insurance period, and to retain part of or the whole of the premium paid. This is because rescinding only part of a contract is not an available remedy.

PROXIMATE CAUSE

Meaning and Importance of the Principle

The proximate cause of a loss is its effective or dominant cause. Why is it important to find out which of the causes involved in an accident is the proximate cause? A loss might be the combined effect of a number of causes. For the purposes of insurance claim, one dominant cause must be singled out in each case, because not every cause of loss will be covered.

Types of Peril

In search of the proximate cause of a loss, we often have to analyse how the causes involved have interacted with one another throughout the whole process leading to the loss. The conclusion of such an analysis depends very much on the identification of the perils (i.e. the causes of the loss) and of their nature. All perils are classified into the following three kinds for the purposes of such an analysis:

(a) Insured peril: It is not common that a policy will cover all possible perils. Those which are covered are known as the ‘insured perils’ of that policy, e.g. ‘fire’ under a fire policy, and ‘stranding’ under a marine policy.

(b) Excepted (or excluded) peril: This is a peril that would be covered but for its removal from cover by exclusion, e.g. fire damage caused by war is irrecoverable under a fire policy because war is an excepted peril of the policy.

(c) Uninsured peril: This is a peril that is neither insured nor excluded. A loss caused by an uninsured peril is irrecoverable unless it is an insured peril that has led to the happening of the uninsured peril. For example, raining and theft are among the uninsured perils of the standard fire policy.

Application of the Principle

The principle of proximate cause applies to all classes of insurance. Its practical applications may be very complex and sometimes controversial. For our purposes, we should note the following somewhat simplified rules:

(a) There must always be an insured peril involved; otherwise the loss is definitely irrecoverable.

(b) If a single cause is present, the rules are straightforward: if the cause is an insured peril, the loss is covered; if it is an uninsured or excepted peril, it is not.

(c) With more than one peril involved, the position is complex, and different rules of proximate cause are applicable, depending on whether the perils have happened as a chain of events or concurrently, and on some other considerations. Specific cases should perhaps be a matter of consultation with the insurer and/or lawyers, but the general rules are:

(i) uninsured perils arising directly from insured perils: the loss is covered, e.g. water damage (uninsured peril) proximately caused by an accidental fire (insured peril) in the case of a fire policy;

(ii) insured perils arising directly from uninsured perils: the loss from the insured peril is covered, e.g. fire (insured peril) damage proximately caused by a careless act of the insured himself or of a third party (uninsured peril) in the case of a fire policy.

(iii) the occurrence of an excluded peril is generally fatal to an insurance claim, subject to complicated exceptions.

(d) Other Features of the Principle (i) Neither the first nor the last cause necessarily constitutes the proximate cause. (ii) More than one proximate cause may exist. For example, the dishonesty of an employee and the neglect on the part of his supervisor of a key to a company safe may both constitute proximate causes of a theft loss from the safe. (iii) The proximate cause need not happen on the insured premises. Suppose a flat insured under a household policy is damaged by water as a result of a fire happening upstairs. The damage is recoverable under the policy, although the insured flat has never been on fire. (iv) Where the proximate cause of a loss is found not to be an insured peril, it does not necessarily mean that the loss is irrecoverable under the policy.

[Illustration: There are four containers of cargo being carried on board a vessel and insured respectively under four marine cargo policies. The first policy solely covers the peril of collision, the second fire only, the third explosion only, and the fourth entry of water only. During the insured voyage, because of the master’s negligence, this vessel collides with another. The collision causes a fire, which then triggers an explosion. As a result, the vessel springs several leaks and all the cargo is damaged by seawater entering through the leaks. These facts show that the cargo damage was proximately caused by negligence. Bearing in mind that negligence is merely an uninsured rather than insured peril of each of the four cargo policies, an immediate, important question that has to be grappled with is: ‘Is the cargo damage irrecoverable under those policies?’ In search of an answer to this question, we must look at the links between the individual events of the incident. Negligence, the identified proximate cause, naturally causes a collision, which then naturally causes a fire. The fire naturally leads to an explosion, which then naturally causes an entry of water. At last, the water damages the cargo. Before us is a chain of events, happening one after another without being interrupted by other events. With respect to each policy, the water damage is regarded as a result of its sole insured peril, notwithstanding that this peril can be traced backward to an uninsured peril. Therefore, the only conclusion that we can reach is that each of the policies is liable for the water damage to the cargo it has insured. (Of course, if the proximate cause is found to be an excepted peril, the opposite conclusion will have to be made.)]

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UTMOST GOOD FAITH

Ordinary Good Faith

At common law, most types of contracts are subject to the principle of good faith, meaning that the parties have to behave with honesty and such information as they supply must be substantially true. However, it is not their responsibility to ensure that the other party obtains all vital information which may affect his decision to enter into the contract, or may affect the terms on which he would enter into the contract. For example, if only after you have boarded a double-decker and paid the fare do you find that no seats on it are vacant, you will have no grounds for complaint. In technical terms, you are not entitled, in such circumstances, to avoid your contract with the bus company for its failure to voluntarily disclose to you the fact that all the seats have been taken on the bus.

Utmost Good Faith

Insurance is subject to a more stringent common law principle of good faith, often called the principle of utmost good faith. It means that each party is under a duty to reveal all vital information (called material facts) to the other party, whether or not that other party asks for it. For example, a proposer of fire insurance is obliged to reveal the relevant loss record to the insurer, even where here is not a question on this on the application form.

Note: 1 Insurers sometimes extend the common law duty of utmost good faith by requiring the proposer to declare (or warrant) that all information supplied, whether relating to ‘material’ matters or not, is totally (not simply substantially) true. For example, where a proposer for medical insurance enters ‘30’ as his current age on the proposal form when he is aged 31, this is a technical breach of the above kind of warranty, if any, although this inaccuracy is unlikely to be material in the eyes of the common law principle of utmost good faith as applied to medical insurance. 2 On the other hand, a policy provision may state that an innocent or negligent (as opposed to ‘fraudulent’) breach of the duty will be waived (excused).

Material Fact

(a) Statutory Definition: ‘Every circumstance which would influence the judgment of a prudent insurer in fixing the premium, or determining whether he will accept the risk’. From this definition, it can be seen that there are three categories of material facts, by reference to the kinds of decisions likely to be affected by their disclosure. The first one only concerns the decision to accept or to reject a proposed risk (e.g. the fact that a proposed life insured has an inoperable malignant brain tumour.) The second only concerns the setting of premium (e.g. the fact that the insured person of a proposed personal accident insurance is a salesperson). And the third concerns both (e.g. where a proposed life insured is a diabetic). You should also note that the law looks at an alleged ‘material fact’ in the eyes of a prudent insurer - not a particular insurer, a particular insured or a reasonable insured.

(b) Facts that need not be disclosed: In the absence of enquiry, certain facts need not be disclosed; they include: (i) matters of common knowledge (e.g. the explosive character of hydrogen); (ii) facts already known, or deemed to be known, to the insurer (e.g. the problem of piracy in Somalia); (iii) facts which diminish the risk.

[Example: A proposer for commercial fire insurance did not mention the fact that his premises were protected by an automatic sprinkler system, which fact, if disclosed, would have influenced the determination of the premium. This omission does not breach utmost good faith, as the fact (although very relevant) actually indicates a lower risk.]

When to Disclose Material Facts

It may be said that utmost good faith involves a duty of disclosure by the proposer/insured. Technically, the insurer is under the same duty, but here we will concentrate on the proposer's duty. This duty has some features that we should note:

(a) Duration (at common law): Those material facts which do not come to the proposer’s (or his agent’s) knowledge until the insurance contract has been concluded do not have to be disclosed. Suppose a proposal for a one-year medical insurance commencing on 15 January 2011 was accepted on 2 January, and the insured had a routine medical examination on 10 January, which revealed to him on 16 January the contraction of malaria. An important question to ask is: ‘Is the insured legally obliged to disclose such finding to his insurer?’ Applying the legal rule just said, the insured is not obliged to do so, assuming that the terms of insurance are silent on this point. Of course, the policy will normally contain an exclusion for preexisting diseases, in which case the insurer may rely on this exclusion rather than a breach of utmost good faith in trying to deny a claim in respect of malaria.

(b) Duration (under policy terms): Some non-life policies require the disclosure of material changes in risk happening during the currency of the contract, such as a change in occupation in the case of a personal accident insurance. At common law, such a change, which could at most represent an increase in risk, need not be notified until renewal.

(c) Renewal: when the policy is being renewed, the duty of utmost good faith revives. (Note: the duty of utmost good faith does not revive when a life policy is approaching its anniversary date.)

(d) Contract alterations: If these are requested during the currency of the policy, the duty of utmost good faith applies in respect of these changes. Where, for example, the insured of a fire policy is requesting an extension to cover theft, he is immediately obliged to disclose all material facts relating to the theft risk, e.g. the physical protections of the insured premises and his record of theft losses, if any.

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PRINCIPLES OF INSURANCE

INSURABLE INTEREST

The word ‘interest’ can have a number of meanings. In the present context, it means a financial relationship to something or someone. There are a number of features to be considered with ‘insurable interest’, as below.

Definition

Insurable interest is a person’s legally recognised relationship to the subject matter of insurance that gives them the right to effect insurance on it. Since the relationship must be a legal one, a thief in possession of stolen goods does not have the right to insure them.

Importance of Insurable Interest

An insurance agreement is void without insurable interest. The rules relating to return of premiums under such an agreement vary as between the different classes of insurance. These rules are the general rules on illegality of contract and the relevant provisions of the Insurance Companies Ordinance (‘ICO’) and of the Marine Insurance Ordinance.

Its Essential Criteria

For insurable interest to exist, the following criteria must be satisfied:

(a) there must be some person (i.e. life, limbs, etc.), property, liability or legal right (e.g. the right to repayment by a debtor) capable of being insured;

(b) that person, etc. must be the subject matter of the insurance (that is to say, claim payment is made contingent on a mishap to such person, etc.);

(c) the proposer must have the legally recognised relationship to the subject matter of insurance, mentioned in 3.1.1 above, so that financial loss may result to him if the insured event happens. (However, insurable interest is sometimes legally presumed without the need to show financial relationship. For example, any person is regarded as having an insurable interest in the life of their spouse.)

Note: A financial relationship alone is not sufficient to give rise to insurable interest. For instance, a creditor is legally recognised to have insurable interest in the life of his debtor, but is not allowed to insure the debtor’s property despite his financial relationship to it, unless the property has been mortgaged to him.

How It Arises

Insurable interest arises in a variety of circumstances, which may be considered under the following headings:

(a) Insurance of the Person: everyone has an insurable interest in his own life, limbs, etc. One also has an insurable interest in the life of one's spouse. Further, one may insure the life of one's child or ward (in guardianship) who is under 18 years of age, and a policy so effected will not become invalid upon the life insured turning 18.

(b) Insurance of Property (physical things): the most obvious example arises in absolute ownership. Executors, administrators, trustees and mortgagees, who have less than absolute ownership, may respectively insure the estate, the trust property and the mortgaged property. Bailees (i.e. persons taking possession of goods with the consent of the owners or their agents, but without their intention to transfer ownership) may insure the goods bailed.

(c) Insurance of Liability: everyone facing potential legal liability for their own acts or omissions may effect insurance to cover this risk (sometimes insurance is compulsory), such liability being termed ‘direct liability’ or ‘primary liability’. Insurance against vicarious liability (see 2.2(c) above) is also possible, where, for example, employers insure against their liability to members of the public arising from negligence, etc. of their employees.

(d) Insurance of Legal Rights: anyone legally in a position of potential loss due to infringement of rights or loss of future income has the right to insure against such a risk. Examples include landlords insuring against loss of rent following a fire.

Note: Anyone (agent) who has authority from another (principal) to effect insurance on the principal’s behalf will have the same insurable interest to the same extent as the principal. For instance, a property management company may have obtained authority from the individual owners of a building under its management to purchase fire insurance on the building. There is no question of a fire insurance effected under such authority being void for lack of insurable interest, even if it is the property management company (rather than the property owners) which is designated in the policy as the insured.

When Is It Needed?

(a) With life insurance, insurable interest is only needed at policy inception. Suppose a woman had effected a whole life policy on the life of her husband, who died some years later. When the woman presented a claim to the insurer, the latter discovered that at the time of the man’s death, they were no longer in the relationship of husband and wife. That means the woman had no insurable interest in the life of the deceased at the time of the death. Nevertheless, this lack of insurable interest will not disqualify her for the death benefit.

(b) However, with marine insurance, insurable interest is only needed at the time of loss.

(c) The above marine insurance rule is probably applicable to other types of indemnity contracts as well.

Assignment

‘Assignment’ is a legal term that generally means a transfer of property. In insurance, there are broadly two types of assignment: assignment of the insurance contract (or insurance policy) and assignment of the right to insurance money (or insurance proceeds). They are different from each other in the following manner:

(a) Effect of an assignment of the insurance contract: With an effective assignment of a policy (or contract) from the assignor (original policyholder) to the assignee (new policyholder), the interest of the assignor in the contract passes wholly to the assignee to the effect that when an insured event occurs afterwards, the insurer is obliged to pay the assignee for his loss, not that suffered by the assignor, if any. In the case of life insurance, assignment will never substitute a new life insured.

(b) Effect of an assignment of the right to insurance money (sometimes simply referred to as an assignment of policy proceeds): Assignment of policy proceeds will have an effect on both losses that have arisen and those that may arise. An assigned policy remains to cover losses suffered by the assignor, not those by the assignee, although it is now the assignee (instead of the assignor) who has the right to sue the insurer to recover under the policy.

(c) Necessity for insurable interest: With assignment of the insurance contract, both the assignor and the assignee need to have insurable interest in the subject matter of insurance at the time of assignment; otherwise the purported assignment will not be valid. (Taking assignment of motor policy as an illustration, the requirement of insurable interest will be satisfied by having the motor policy assigned to the purchaser contemporaneously with the transfer of property in the insured car.) However, with assignment of the right to insurance money, no insurable interest is needed on the part of the assignee, so that it may actually take effect as a gift to the assignee.

(d) Necessity for insurer’s consent: An assignment of the right to insurance money requires no consent from the insurer, irrespective of the nature of the insurance contract concerned. But the position is not that simple with assignment of the insurance contract. Different types of insurance are subject to different legal rules as to whether a purported assignment of the insurance contract will have to be agreed to, by the insurer. The matter is further complicated by the fact that very often non-marine policies include rovisions that override these legal rules. Fortunately, it is sufficient for you simply to know that, in practice, unlike all other types of policies, life policies and marine cargo policies are assignable without the insurers’ consent.

(e) Assignment of benefits as opposed to obligations: Assignment does not have the effect of transferring the assignor’s obligations under the insurance contract to the assignee. Such a transfer requires the insurer’s consent.

Note: 1. It is sometimes misunderstood that any policy provision that claim payments have to be made to a designated person other than the insured is an assignment of the right to insurance money. In fact, the courts may construe such a provision as a mere instruction to pay, which will at most give the designated payee an expectation to be paid, rather than the right to sue the insurer, which right remains in the hands of the insured. 2 Statutory assignment, the best known form of assignment, is subject to the requirements of Section 9 of the Law Amendment and Reform (Consolidation) Ordinance.

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Duties Owed by Agent to Principal

These may be summarised as follows:

(a) Obedience: The agent has to follow all lawful instructions of his principal, strictly or as best as is reasonably possible.

(b) Personal performance: The agent is not allowed to delegate his authority and responsibilities to others (subagents) unless he has authority to do so.

(c) Due care and skill: The law does not demand perfection, and an agent is normally only required to display all reasonably expected skills and diligence in performing his duties. Whilst his principal may be bound by his lack of care, the principal may in turn reclaim from the agent in respect of a loss caused by the lack of care.

(d) Loyalty and good faith: The agent’s obligations of loyalty and good faith are governed by several strict rules of law, the no conflict rule being one of them.

(e) Accountability: The agent has to account for all moneys or other things he receives on behalf of his principal. He also has to keep adequate records relating to the agency activities.

Duties Owed by Principal to Agent

These may be summarised as follows:

(a) Remuneration: The agent is entitled to receive commission or other remuneration (such as bonus) as agreed. This the principal has to pay within a reasonable time or any specified time limit, as the case may be.

(b) Expenses, etc.: The principal, subject to any express terms in the agency agreement, has to reimburse the agent for costs and expenses properly and reasonably incurred by the agent on behalf of the principal; e.g. legal defence expenses paid by a claims settling agent.

(c) Breach of duty: The agent may take action against the principal for the latter’s breach of obligations to him.

Termination of Agency

There are a number of ways in which an agency agreement can be brought to an end. These include:

(a) Mutual Agreement: Generally speaking, all agreements may be terminated by mutual agreement, on terms agreed between the parties.

(b) Revocation: Subject to any contract terms as to notice and/or compensation, either the principal or the agent may revoke (i.e. cancel) the agreement during its currency.

(c) Breach: If either the principal or the agent commits a fundamental breach of contract, the other party may treat the contract as ended (with a possible right of compensation). For example, an exclusive agent, upon discovering that the principal, in breach of a contract condition, has appointed a second agent before the expiry of the agency agreement, may terminate performance immediately and sue the principal for any loss of the profit expected from performing the agreement during the remainder period.

(d) Death: Because an agency relationship is a personal one, the death of either the principal or the agent will end the agreement. Should either party be a corporate body (company), its liquidation will have the same effect.

(e) Insanity: If either the principal or the agent becomes insane so that he no longer can perform the agreement, the agreement will automatically come to an end.

(f) Illegality: If it happens that the agency relationship or the performance of the agreement is no longer permitted by law, this will automatically end the agreement. Suppose a British company (buying agent) has a contract with a company (principal) incorporated and domiciled in another country whereby the buying agent will purchase in the United Kingdom stuffs like wheat, steel, sulphur and other chemicals on behalf of the principal. On the outbreak of a war between the two countries, this agreement will, in the English law, automatically end for illegality.

(g) Time: If the agreement is for a determined period, it will terminate at the end of such period.

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Legal PRINCIPLES

This and the next Chapter will concern principles of law, but the Notes will not provide a comprehensive survey of some very complex issues. The purpose of the Notes, as with the overall study, is to give an insight into the important aspects of an insurance intermediary's professional activities.

THE LAW OF CONTRACT

This is an area of law which affects every one of us, whether in our personal or business lives. As we shall see, contract is an essential element in civilised societies, therefore it is important to have some appreciation of this important subject.

Definition

The simplest definition for ‘contract’ is probably: a legally enforceable agreement. There are a large variety of agreements, but not all are intended to have legal consequences. A social arrangement between two persons, such as a lunch appointment for example, is an agreement, but where either of them unilaterally cancels the appointment, there is no suggestion that the disappointed party should be able to take legal action against the other party, because the agreement is not legally recognised as valid.

Contracts comprise promises or undertakings, usually given in exchange for a promise or undertaking from the other side. In legal terminology, contracts are something intangible. Therefore, an insurance policy in itself is not a contract; instead it is the most commonly used evidence of an insurance contract. An insured who has been affected by a fire will not expect the insurer to deny his insurance claim on the grounds that the insurance contract no longer exists after the insurance policy has been destroyed in the fire. Contracts may concern relatively trivial (such as buying a newspaper or taking a tram ride) or very important matters (such as a major building project or employment). In any event, the contracting parties expect promises to be honoured, and can demand compensation or enforced performance if they are not honoured.

Types of Contracts

For our purposes, we may consider that there are two major types of contract, as follows:

(a) Simple contracts: Although these are described as ‘simple’, this does not mean that they only deal with uncomplicated matters and are easy to understand. Rather, it means that they are simple or easy to form. A simple contract is one created verbally, or by writing not under seal. It can also be inferred from conduct. In short, the validity of simple contracts does not depend on special formalities.

[An example of a contract inferred from conduct is where someone picks up a newspaper from a street vendor and where their body language clearly indicates a purchase. Technically, a contract is formed between the seller and buyer, with the acts of handing over and accepting the money for the newspaper: no words or writing are needed.]

In fact, the great majority of insurance contracts are ‘simple’ contracts. Technically, insurance contracts, to be valid, do not have to be evidenced in writing; but in practice, they almost always are. Nevertheless, as we shall see later, insurance contracts of a certain type are legally required to be evidenced by insurance policies.

(b) Contracts by deeds: A deed is a written instrument signed, sealed and delivered. (Delivery is no longer required to be physical delivery; an intention to be unconditionally bound by the deed suffices.) It must be used with certain transactions such as a transfer of land. Besides, suretyship is always issued in the form of a deed; otherwise, when a claim arises, the obligee may possibly face a defence put up by the surety that he has not the right to sue because he has provided no consideration (see 2.1.3 (c) below for the doctrine of consideration).

Elements or Essentials of a Contract

For the purposes of this section, we shall be talking only of simple contracts (see 2.1.2(a) above), since these constitute the great majority of contracts that are met in insurance transactions. To be a valid contract, an agreement must meet certain criteria called ‘elements of contract’ in the course of its formation. Should any of these elements be absent, the proposed contract either does not exist or is defective in another sense. There are three types of defective contracts, as follows:

1 Void (or invalid) contracts: This means that the proposed contract does not exist in law; it is entirely without legal effect. In the context of insurance, the implication is that generally all premiums which have already been paid under a void contract (or invalid agreement) are returnable; so are claims paid.

Voidable contracts: A voidable contract is one that is apparently of legal effect and that remains to be legally effective unless and until an aggrieved party to the contract treats it as void as from contract conclusion within a reasonable time after acquiring knowledge of the availability of such a right of election. In insurance, it could arise, for instance, with a breach of some types of policy provision, or the discovery that important information was omitted or wrongly given at the proposal stage (see 3.2 below);

3 Unenforceable contracts: This means what it says, an unenforceable contract cannot be enforced (or sued on) in a court of law. However, this is not because it is void, but because some required action has not been taken (e.g. stamp duty not paid on a lease of land, marine insurance policy not issued, etc.). This defect can be remedied by carrying out the required action, so that the contract becomes enforceable (e.g. by issuing a marine policy even after a loss has realised).

Turning to the elements of contract themselves, legal textbooks are not always agreed just exactly how many elements should be found with any one valid contract, but we shall consider six criteria here, as follows (remembering that we eed not go into great detail):

(a) Offer: if no offer is made, obviously there can be no agreement between the two or more parties. In insurance, the offeror may be the intending insured (perhaps by completing and submitting to the insurer a proposal form (or application form)), or the insurer (perhaps as a counter-offer or in connection with a policy renewal); all depends on intention as evidenced by facts. Therefore, although it is widely accepted that an act of completing an insurance proposal form is normally an act of offer, it is technically incorrect to say that it is a settled law that completing an insurance proposal form is an act of offer to the insurer.

(b) Acceptance: the proposed contract cannot come into being unless the offer is accepted by the other party (the offeree). All terms of the offer must be accepted before a contract is concluded. If that other party intends to vary the terms of the proposed contract (requiring increased premium or policy restrictions, for example), this, upon its communication, constitutes a counter-offer, which will have the effect of nullifying the original offer. A counter-offer is subject to acceptance by the original offeror (who becomes the offeree with the counter offer).

(c) Consideration: this is the price (monetary or otherwise) a contracting party pays for the promise the other party (‘promisor’) makes to him. In the case of a simple contract, consideration must be given by both parties; otherwise it is void. On the other hand, a promise contained in a deed, even if it has been given not for consideration, is enforceable at common law by the promisee. In other words, a unilateral promise not made by a deed is invalid. In insurance, the consideration is: the promise by the insured to pay premium; and (ii) the promise by the insurer to pay or compensate as per policy terms.

Note: 1 Where an insured event occurs before the premium promised is paid, the insured will still be entitled to insurance payment in accordance with the terms of the contract and the insurer will have a separate claim against him for the unpaid premium. However, some policies require actual payment of premium as consideration, which requirement will have the effect of overriding the said legal rule.

2 The insurer's consideration is the promise to pay, etc., rather than the actual payment. In many cases, no claim arises under the policy, but when the insured period ends the insurer is treated as having provided consideration, and therefore there will not be a question of the contract being void for lack of consideration leading to an entitlement to return premiums.

(d) Capacity to contract: it means the legal ability to enter into a contract. With individuals, if they are mentally disordered, or are minors, the contracts they make are generally voidable at their option. With companies, they must not act in a way that exceeds their legal powers.

(e) Legality: the subject of the agreement must be legal. A contract to kill or to commit any other crimes, for example, is not valid. Likewise, insurance on smuggled goods would also not be legally recognised. However, exceptions do exist. For instance, the courts may enforce an insurance claim in favour of an insured under an insurance contract that is illegal because the insurer was not authorised to transact the kind of insurance business in question.

(f) Intention to create legal relation: to make a valid contract, each party to it must clearly have the intention that it is to have legal consequences. This seldom gives rise to any problem with insurance contracts because, unlike social or domestic agreements, commercial agreements are presumed to have been made with an intention to create legal relation.

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Functions and benefits of INSURANCE

Insurance has many functions and benefits, some of which we may describe as primary and others as ancillary or secondary, as follows:

(a) Primary functions/benefits: Insurance is essentially a risk transfer mechanism, removing, for a premium, the potential financial loss from the individual and placing it upon the insurer.

The primary benefit is seen in the financial compensation made available to insured victims of the various insured events. On the commercial side, this enables businesses to survive major fires, liabilities, etc. From a personal point of view, the money is of great help in times of tragedy (life insurance) or other times of need.

(b) Ancillary functions/benefits: Insurance contributes to society directly or indirectly in many different ways. These will include:

(i) employment: the insurance industry is a significant factor in the local workforce;

(ii) financial services: since the relative decline in manufacturing in Hong Kong, financial services have assumed a much greater role in the local economy, insurance being a major element in the financial services sector;

(iii) loss prevention and loss reduction (collectively referred to as ‘loss control’): the practice of insurance includes various surveys and inspections related to risk management (see 1.1.3(b) above). These are followed by requirements (conditions for acceptance of risk) and/or recommendations to improve the ‘risk’. As a consequence, we may say that there are fewer fires, accidents and other unwanted happenings;

(iv) savings/investments: life insurance, particularly, offers a convenient and effective way of providing for the future. With the introduction of the Mandatory Provident Fund Schemes in 2000, the value of insurance products in providing for the welfare of people in old age or family tragedy is very evident;

(v) economic growth/development: it will be obvious that few people would venture their capital on costly projects without the protection of insurance (in most cases, bank financing will just not be available without insurance cover). Thus, developments of every kind, from erection of bridges to building construction and a host of other projects, are encouraged and made possible partly because insurance is available.

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Concep of RISK

Meaning of Risk

There have been many attempts to define ‘risk’. Probably, to most of us, ‘risk’ contains a suggestion of loss or danger. We may therefore define it as ‘uncertainty concerning a potential loss’, a situation in which we are not sure whether there will be loss of a certain kind, or how much will be lost. It is this uncertainty and the undesirable element found with risk that underlie the wish and need for insurance.

The potential loss that risk presents may be:

(a) financial: i.e. measurable in monetary terms (e.g. loss of a camera by theft);

(b) physical: death or personal injury (often having financial consequences for the individual or his family); or

(c) emotional: feelings of grief and sorrow.

Only the first two types of risks are likely to be (commercially) insurable risks. Also, from a wider perspective, not every risk will be seen in the negative form we have just outlined.

Note: Without trying to complicate matters, we should also be aware that insurance practitioners may use the word ‘risk’ with other meanings, including:

1. the property or person at risk that they are insuring or considering insuring; and

2. the peril (i.e. cause of loss) insured (so, some policies may insure on an ‘all-risks’ basis, meaning that any loss due to any cause is covered, except where the cause is excluded from cover).

Classification of Risk

To simplify a complex subject, we may classify risk under two broad headings (each having two categories) according to:

(a) its potential financial results; and

(b) its cause and effect.

Financial Results

Risks may be considered as being either Pure or Speculative:

(i) Pure Risks offer the potential of loss only (no gain), or, at best, no change. Such risks include fire, accident and other undesirable happenings.

(ii) Speculative Risks offer the potential of gain or loss. Such risks include gambling, business ventures and entrepreneurial activities. The majority of the risks which are insured by commercial insurers are pure risks, and speculative risks are not normally insurable. The reason for this is that speculative risks are engaged in voluntarily for gain, and, if they were insured, the insured would have little incentive to strive to achieve that gain.

Cause and Effect

Risks may also be considered as being either Particular or Fundamental:

(i) Particular Risks: They have relatively limited consequences, and affect an individual or a fairly small number of people. The consequences may be serious, even fatal, for those involved, but are comparatively localised. Such risks include motor accidents, personal injuries and the like.

(ii) Fundamental Risks: Their causes are outside the control of any one individual or even a group of individual, and their outcome affects large numbers of people. Such risks include famine, war, terrorist attack, widespread flood and other disasters which are problems for society or mankind rather than just the ‘particular’ individuals involved.

The majority of the risks which are insured by commercial insurers are particular risks. Fundamental risks are not normally insurable because it is considered financially infeasible for insurers to handle them commercially.

Risk Management

‘Risk management’ is a term which is used with different meanings:

(a) in the world of banking and other financial services outside insurance, it is probably used with reference to investment and other speculative risks.

(b) insurance companies will probably use the term only in relation to pure risks, but they may well restrict it even further to insured risks only. Thus, when insurers talk about ‘risk management’, they could well be referring to ways and means of reducing or improving the insured loss potential of the ‘risks’ they are insuring, or being invited to insure;

(c) as a separate field of knowledge and research, risk management may be said to be that branch of management which seeks to:

(i) identify;

(ii) quantify; and

(iii) deal with risks (whether pure or speculative) that threaten an organisation. Tools or measures of risk handling include:

- risk avoidance: elimination of the chance of loss of a certain kind by not exposing oneself to the peril (e.g. abandoning a nuclear power project so as to eliminate the risk of nuclear

accidents);

- loss prevention: the lowering of the frequency of identified possible losses (e.g. activities promoting industrial safety);

- loss reduction: the lowering of the severity of identified possible losses (e.g. automatic sprinkler system);

- risk transfer : making another party bear the consequences of one’s exposure to loss (e.g. purchase of insurance and contractual terms shifting responsibility for possible losses);

- risk financing: no matter how effective the loss control measures an organisation takes, there will remain some risk of the organisation being adversely affected by future loss occurrences.

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