Representations

When people are negotiating with insurers for coverage, they make statements concerning their exposures, and these statements are called representationsStatements concerning an insured’s exposures.. They are made for the purpose of inducing insurers to enter into contracts; that is, provide insurance. If people misrepresent material factsInformation that influences a party’s decision to accept a contract.—information that influences a party’s decision to accept the contract—insurers can void their contracts and they will have no coverage, even though they do have insurance policies. In essence, the contracts never existed.

Note that “material” has been specified. If an insurer wants to void a contract it has issued to a person in reliance upon the information she provided, it must prove that what she misrepresented was material. That is, the insurer must prove that the information was so important that if the truth had been known, the underwriter would not have made the contract or would have done so only on different terms.

If, for example, you stated in an application for life insurance that you were born on March 2 when in fact you were born on March 12, such a misrepresentation would not be material. A correct statement would not alter the underwriter’s decision made on the incorrect information. The policy is not voidable under these circumstances. On the other hand, suppose you apply for life insurance and state that you are in good health, even though you’ve just been diagnosed with a severe heart ailment. This fact likely would cause the insurer to charge a higher premium or not to sell the coverage at all. The significance of this fact is that the insurer may contend that the policy never existed (it was void), so loss by any cause (whether related to the misrepresentation or not) is not covered. Several exceptions to this rule apply, as presented in chapters discussing specific policies. In the case of life insurance, the insurer can void the policy on grounds of material misrepresentation only for two years, as was discussed in Chapter 1 "The Nature of Risk: Losses and Opportunities".

It is not uncommon for students to misrepresent to their auto insurers where their cars are garaged, particularly if premium rates at home are lower than they are where students attend college. Because location is a factor in determining premium rates, where a car is garaged is a material fact. Students who misrepresent this or other material facts take the chance of having no coverage at the time of a loss. The insurer may elect to void the contract.

Concealment

Telling the truth in response to explicit application questions may seem to be enough, but it is not. One must also reveal those material facts about the exposure that only he or she knows and that he or she should realize are relevant. Suppose, for example, that you have no insurance on your home because you “don’t believe in insurance.” Upon your arrival home one afternoon, you discover that the neighbor’s house—only thirty feet from yours—is on fire. You promptly telephone the agency where you buy your auto insurance and apply for a homeowner’s policy, asking that it be put into effect immediately. You answer all the questions the agent asks but fail to mention the fire next door. You have intentionally concealed a material fact you obviously realize is relevant. You are guilty of concealmentIntentionally withholding a material fact. (intentionally withholding a material fact), and the insurer has the right to void the contract.

If the insurance company requires the completion of a long, detailed application, an insured who fails to provide information the insurer neglected to ask about cannot be proven guilty of concealment unless it is obvious that certain information should have been volunteered. Clearly, no insurance agent is going to ask you when you apply for insurance if the neighbor’s house is on fire. The fact that the agent does not ask does not relieve you of the responsibility.

In both life and health insurance, most state insurance laws limit the period (usually one or two years) during which the insurer may void coverage for a concealment or misrepresentation. Other types of insurance contracts do not involve such time limits.

Insurable Interest

If a fire or auto collision causes loss to a person or firm, that person or firm has an insurable interest. A person not subject to loss does not have an insurable interest. Stated another way, insurable interestFinancial interest in life or property that is subject to loss. is financial interest in life or property that is subject to loss. The law concerning insurable interest is important to the buyer of insurance because it determines whether the benefits from an insurance policy will be collectible. Thus, all insureds should be familiar with what constitutes an insurable interest, when it must exist, and the extent to which it may limit payment under an insurance policy.

Basis for Insurable Interest

Many situations constitute an insurable interest. The most common is ownership of property. An owner of a building will suffer financial loss if it is damaged or destroyed by fire or other peril. Thus, the owner has an insurable interest in the building.

A mortgage lender on a building has an insurable interest in the building. For the lender, loss to the security, such as the building being damaged or destroyed by fire, may reduce the value of the loan. On the other hand, an unsecured creditor generally does not have an insurable interest in the general assets of the debtor because loss to such assets does not directly affect the value of the creditor’s claim against the debtor.

If part or all of a building is leased to a tenant who makes improvements in the leased space, such improvements become the property of the building owner on termination of the lease. Nevertheless, the tenant has an insurable interest in the improvements because he or she will suffer a loss if they are damaged or destroyed during the term of the lease. This commonly occurs when building space is rented on a “bare walls” basis. To make such space usable, the tenant must make improvements.

If a tenant has a long-term lease with terms more favorable than would be available in the current market but that may be canceled in the event that the building is damaged, the tenant has an insurable interest in the lease. A bailee—someone who is responsible for the safekeeping of property belonging to others and who must return it in good condition or pay for it—has an insurable interest. When you take your clothes to the local dry-cleaning establishment, for example, it acts as a bailee, responsible for returning your clothes in good condition.

A person has an insurable interest in his or her own life and may have such an interest in the life of another.Although a person who dies suffers a loss, he or she cannot be indemnified. Because the purpose of the principle of insurable interest is to implement the doctrine of indemnity, it has no application in the case of a person insuring his or her own life. Such a contract cannot be one of indemnity. An insurable interest in the life of another person may be based on a close relationship by blood or marriage, such as a wife’s insurable interest in her husband. It may also be based on love and affection, such as that of a parent for a child, or on financial considerations. A creditor, for example, may have an insurable interest in the life of a debtor, and an employer may have an insurable interest in the life of a key employee.

When Insurable Interest Must Exist

The time at which insurable interest must exist depends on the type of insurance. In property insurance, the interest must exist at the time of the loss. As the owner of a house, one has an insurable interest in it. If the owner insures himself against loss to the house caused by fire or other peril, that person can collect on such insurance only if he still has an insurable interest in the house at the time the damage occurs. Thus, if one transfers unencumbered title to the house to another person before the house is damaged, he cannot collect from the insurer, even though the policy may still be in force. He no longer has an insurable interest. On the other hand, if the owner has a mortgage on the house that was sold, he will continue to have an insurable interest in the amount of the outstanding mortgage until the loan is paid.

As a result of the historical development of insurance practices, life insurance requires an insurable interest only at the inception of the contract. When the question of insurable interest in life insurance was being adjudicated in England, such policies provided no cash surrender values; the insurer made payment only if the person who was the subjectThe person whose death requires the insurer to pay the proceeds of a life insurance policy is usually listed in the policy as the insured. He or she is also known as the cestuique vie or the subject. The beneficiary is the person (or other entity) entitled to the proceeds of the policy upon the death of the subject. The owner of the policy is the person (or other entity) who has the authority to exercise all the prematurity rights of the policy, such as designating the beneficiary, taking a policy loan, and so on. Often, the insured is also the owner. of insurance died while the policy was in force. An insured who was also the policyowner and unable to continue making premium payments simply sacrificed all interest in the policy.

This led to the practice of some policyowners/insureds selling their policies to speculators who, as the new owners, named themselves the beneficiaries and continued premium payments until the death of the insured. This practice is not new but appears to have grown, as reported in the Wall Street Journal.Lynn Asinof, “Is Selling Your Life Insurance Good Policy in the Long-Term?” Wall Street Journal, May 15, 2002. Life-settlement companies emerged recently for seniors. Life-settlement companiesFirms that buy life insurance policies from senior citizens for a percent of the value of the death benefits. buy life insurance policies from senior citizens for a percentage of the value of the death benefits. These companies pay the premiums and become the beneficiary when the insured passes away. This is similar to viatical-settlement companiesFirms that buy life insurance policies from persons with short life expectancies., which buy life insurance policies from persons with short life expectancies, such as AIDS patients in the 1990s. An example of a life-settlement company is Stone Street Financial, Inc., in Bethesda, Maryland, which bought the value of $500,000 of life insurance for $75,775 from an older person. The person felt he was making money on the deal because the policy surrender value was only $5,000. Viatical settlement companies ran into trouble after new drug regimens extended the lives of AIDS patients, and investors found themselves waiting years or decades, instead of weeks or months, for a return on their investments. In contrast, life-settlement companies contend that, because there is no cure for old age, investors cannot lose in buying the policies from people over sixty-five years old with terminal illnesses such as cancer, amyotrophic lateral sclerosis (Lou Gehrig’s disease), and liver disease.Ron Panko, “Is There Still Room for Viaticals?” Best’s Review, April 2002. These companies don’t sell to individual investors, but rather package the policies they buy into portfolios for institutional investors. According to Scope Advisory GmbH (Berlin), which rates life-settlement companies, “Institutional investments helped increase the face value of life insurance policies traded through the life settlement market to about $10 billion in 2004, from $3 billion in 2003.”“Life Settlement Group Sets Premium Finance Guidelines,” National Underwriter Online News Service, April 5, 2005; “Firm to Offer Regular Life Settlement Rating Reports,” National Underwriter Online News Service, April 21, 2005; and Jim Connolly, “Institutions Reshape Life Settlement Market,” National Underwriter, Life/Health Edition, September 16, 2004. There is a regulatory maze regarding these arrangements.Allison Bell, “Life Settlement Firms Face Jumbled Regulatory Picture,” National Underwriter, Life/Health Edition, September 16, 2004.

Because the legal concept of requiring an insurable interest only at the inception of the life insurance contract has continued, it is possible to collect on a policy in which such interest has ceased. For example, if the life of a key person in a firm is insured, and the firm has an insurable interest in that key person’s life because his or her death would cause a loss to the firm, the policy may be continued in force by the firm even after the person leaves the firm. The proceeds may be collected when he or she dies. This point was brought to light with the publication of the Wall Street Journal story “Big Banks Quietly Pile Up ‘Janitors’ Insurance.”Theo Francis and Ellen E. Schultz, “Big Banks Quietly Pile Up ‘Janitors’ Insurance,’” Wall Street Journal, May 2, 2002. The article reports that banks and other large employers bought inexpensive life coverage—or janitor’s insuranceInexpensive life insurance coverage.—on the lives of their employees. This practice did not require informing the employees or their families. Coverage was continued even after the employees left the company. Upon the death of the employees, the employer collected the proceeds and padded their bottom-line profits with tax-free death benefits. Many newspapers reported the story as a breach of ethical behavior. The Charlotte Observer (North Carolina) reported that employers were not required to notify workers of corporate-owned life insurance (COLI)Policies in which employers own life insurance policies on employees. policies in which employers own life insurance policies on employees. However, the newspaper continued, “some of the Charlotte area’s biggest companies said they have notified all employees covered by the policies, but declined to say how they informed the workers. Use of COLI policies has raised outcries from human rights activists and prompted federal legislation calling for disclosure.”Sarah Lunday, “Business Giants Could Profit from Life Insurance on Workers,” The Charlotte (North Carolina) Observer, May 12, 2002: “Some of Charlotte’s biggest companies—Bank of America Corp., Wachovia Corp. and Duke Energy Corp. included—stand to reap profits from life insurance policies purchased on current and former workers. In some cases, the policies may have been purchased without the workers or their families ever knowing.” The National Association of Insurance Commissioners (NAIC) formed a special working group to study these issues. Dissatisfaction with the janitor insurance scandal led the state of Washington to instate a law requiring employers to obtain written permission from an employee before buying life insurance on the employee’s life. Key employees can still be exempt from the law. In 2005, members of the U.S. House of Representative also proposed legislation to limit such practices.Arthur D. Postal, “House Revives COLI Bill,” National Underwriter Online News Service, May 12, 2005.

Extent to which Insurable Interest Limits Payment

In the case of property insurance, not only must an insurable interest exist at the time of the loss, but the amount the insured is able to collect is limited by the extent of such interest. For example, if you have a one-half interest in a building that is worth $1,000,000 at the time it is destroyed by fire, you cannot collect more than $500,000 from the insurance company, no matter how much insurance you purchased. If you could collect more than the amount of your insurable interest, you would make a profit on the fire. This would violate the principle of indemnity. An exception exists in some states where valued policy laws are in effect. These laws require insurers to pay the full amount of insurance sold if property is totally destroyed. The intent of the law is to discourage insurers from selling too much coverage.

In contrast to property insurance, life insurance payments are usually not limited by insurable interest. Most life insurance contracts are considered to be valued policiesContracts to pay a stated sum upon the occurrence of the event insured against, rather than to indemnify for loss sustained.,Some property insurance policies are written on a valued basis, but precautions are taken to ensure that values agreed upon are realistic, thus adhering to the principle of indemnity. or contracts that agree to pay a stated sum upon the occurrence of the event insured against, rather than to indemnify for loss sustained. For example, a life insurance contract provides that the insurer will pay a specified sum to the beneficiary upon receipt of proof of death of the person whose life is the subject of the insurance. The beneficiary does not have to prove that any loss has been suffered because he or she is not required to have an insurable interest.

Some health insurance policies provide that the insurance company will pay a specified number of dollars per day while the insured is hospitalized. Such policies are not contracts of indemnity; they simply promise to make cash payments under specified circumstances. This makes such a contract “incomplete,” as discussed in the introduction to this chapter. This also leads to more litigation because there are no explicit payout amounts written into the contract while improvements in medical technology change the possible treatments daily.

Although an insurable interest must exist at the inception of a life insurance contract to make it enforceable, the amount of payment is usually not limited by the extent of such insurable interest. The amount of life insurance collectible at the death of an insured is limited only by the amount insurers are willing to issue and by the insured’s premium-paying ability.Life and health insurance companies have learned, however, that overinsurance may lead to poor underwriting experience. Because the loss caused by death or illness cannot be measured precisely, defining overinsurance is difficult. It may be said to exist when the amount of insurance is clearly in excess of the economic loss that may be suffered. Extreme cases, such as the individual whose earned income is $300 per week but who may receive $500 per week in disability insurance benefits from an insurance company while he or she is ill, are easy to identify. Life and health insurers engage in financial underwriting to detect overinsurance. The requested amount of insurance is related to the proposed insured’s (beneficiary’s) financial need for insurance and premium-paying ability. The life insurance payout amount is expressed explicitly in the contract. Thus, in most cases, it is not subject to litigation and arguments over the coverage. The amount of the proceeds of a life insurance policy that may be collected by a creditor-beneficiary, however, is generally limited to the amount of the debt and the premiums paid by the creditor, plus interest.This is an area in which it is difficult to generalize; the statement made in the text is approximately correct. The point is that the creditor-debtor relationship is an exception to the statement that an insurable interest need not exist at the time of the death of the insured and that the amount of payment is not limited to the insurable interest that existed at the inception of the contract. For further discussion, see Kenneth Black, Jr., and Harold Skipper, Jr., Life Insurance, 12th ed. (Englewood Cliffs, NJ: Prentice-Hall, 1994), 187–88.

Subrogation

The principle of indemnity is also supported by the right of subrogation. SubrogationSituation that gives the insurer whatever claim against third parties the insured may have as a result of the loss for which the insurer paid. gives the insurer whatever claim against third parties the insured may have as a result of the loss for which the insurer paid. For example, if your house is damaged because a neighbor burned leaves and negligently permitted the fire to get out of control, you have a right to collect damages from the neighbor because a negligent wrongdoer is responsible to others for the damage or injury he or she causes. (Negligence liability will be discussed in later chapters.) If your house is insured against loss by fire, however, you cannot collect from both the insurance company and the negligent party who caused the damage. Your insurance company will pay for the damage and is then subrogated (that is, given) your right to collect damages. The insurer may then sue the negligent party and collect from him or her. This prevents you from making a profit by collecting twice for the same loss.

The right of subrogation is a common law right the insurer has without a contractual agreement. It is specifically stated in the policy, however, so that the insured will be aware of it and refrain from releasing the party responsible for the loss. The standard personal auto policy, for example, provides that

Actual Cash Value

This clause is included in many property insurance policies. An insured generally does not receive an amount greater than the actual loss suffered because the policy limits payment to actual cash value. A typical property insurance policy says, for example, that the company insures “to the extent of actual cash value…but not exceeding the amount which it would cost to repair or replace…and not in any event for more than the interest of the insured.”

Actual cash valueThe replacement cost at the time of the loss, less physical depreciation including obsolescence. is not defined in the policy, but a generally accepted notion of it is the replacement cost at the time of the loss, less physical depreciation, including obsolescence. For example, if the roof on your house has an expected life of twenty years, roughly half its value is gone at the end of ten years. If it is damaged by an insured peril at that time, the insurer will pay the cost of replacing the damaged portion, less depreciation. You must bear the burden of the balance. If the replacement cost of the damaged portion is $2,000 at the time of a loss, but the depreciation is $800, the insurer will pay $1,200 and you will bear an $800 expense.

Another definition of actual cash value is fair market valueThe amount a willing buyer would pay a willing seller., which is the amount a willing buyer would pay a willing seller. For auto insurance, where thousands of units of nearly identical property exist, fair market value may be readily available. Retail value, as listed in the National Automobile Dealers Association (NADA) guide or the Kelley Blue Book, may be used. For other types of property, however, the definition may be deceptively simple. How do you determine what a willing buyer would be willing to pay a willing seller? The usual approach is to compare sales prices of similar property and adjust for differences. For example, if three houses similar to yours in your neighborhood have recently sold for $190,000, then that is probably the fair market value of your home. You may, of course, believe your house is worth far more because you think it has been better maintained than the other houses. Such a process for determining fair market value may be time-consuming and unsatisfactory, so it is seldom used for determining actual cash value. However, it may be used when obsolescence or neighborhood deterioration causes fair market value to be much less than replacement cost minus depreciation.

Property insurance is often written on a replacement costIndemnification for a property loss with no deduction for depreciation. basis, which means that there is no deduction for depreciation of the property. With such coverage, the insurer would pay $2,000 for the roof loss mentioned above and you would not pay anything. This coverage may or may not conflict with the principle of indemnity, depending on whether you are better off after payment than you were before the loss. If $2,000 provided your house with an entirely new roof, you have gained. You now have a roof that will last twenty years, rather than ten years. On the other hand, if the damaged portion that was repaired accounted for only 10 percent of the roof area, having it repaired would not increase the expected life of the entire roof. You are not really any better off after the loss and its repair than you were before the loss.

When an insured may gain, as in the case of having a loss paid for on a replacement cost basis, there is a potential moral hazard. The insured may be motivated to be either dishonest or careless. For example, if your kitchen has not been redecorated for a very long time and looks shabby, you may not worry about leaving a kettle of grease unattended on the stove. The resulting grease fire will require extensive redecoration as well as cleaning of furniture and, perhaps, replacement of some clothing (assuming that the fire is extinguished before it gets entirely out of control). Or you may simply let your old house burn down. Insurers try to cope with these problems by providing in the policy that, when the cost to repair or replace damage to a building is more than some specified amount, the insurer will pay not more than the actual cash value of the damage until actual repair or replacement is completed. In this way, the insurer discourages you from destroying the house in order to receive a monetary reward. Arson generally occurs with the intent of financial gain. Some insurers will insure personal property only on an actual cash value basis because the opportunity to replace old with new may be too tempting to some insureds. Fraudulent claims on loss to personal property are easier to make than are fraudulent claims on loss to buildings. Even so, insurers find most insureds to be honest, thus permitting the availability of replacement cost coverage on most forms of property.

Other Insurance Provisions

The purpose of other insurance provisionsClauses in in insurance contracts is to prevent insureds from making a profit by collecting from more than one insurance policy for the same loss. in insurance contracts is to prevent insureds from making a profit by collecting from more than one insurance policy for the same loss. For example, if you have more than one policy protecting you against a particular loss, there is a possibility that by collecting on all policies, you may profit from the loss. This would, of course, violate the principle of indemnity.

Most policies (other than life insurance) have some provision to prevent insureds from making a profit from a loss through ownership of more than one policy. The homeowner’s policy, for example, provides a clause about other insurance, or pro rata liability, that reads as follows:

Suppose you have a $150,000 homeowners policy with Company A, with $75,000 personal property coverage on your home in Montana, and a $100,000 homeowners policy with Company B, with $50,000 personal property coverage on your home in Arizona. Both policies provide coverage of personal property anywhere in the world. If $5,000 worth of your personal property is stolen while you are traveling in Europe, because of the “other insurance” clause, you cannot collect $5,000 from each insurer. Instead, each company will pay its pro rata share of the loss. Company A will pay its portion of the obligation ($75,000/$125,000 = 3/5) and Company B will pay its portion ($50,000/$125,000 = 2/5). Company A will pay $3,000 and Company B will pay $2,000. You will not make a profit on this deal, but you will be indemnified for the loss you suffered. The proportions are determined as follows: