Simple Financial Positions: Insurance

Introduction:

This note will discuss the meaning and elements of insurance, its various types, and the credit risks associated with insurance.

Meaning of Insurance:

This is a common type of simple financial position. Insurance is a contract in which one person, known as the insurer, agrees to compensate another person, known as the insured or policyholder, for a specific loss if a particular event, known as an insured event, occurs.

The insurer's obligation to compensate is in exchange for the payment of a premium to the insurer by the insured or policyholder.

A definition of insurance was provided by Channell J. in the case of Prudential Insurance Co. v IRC [1904] 2 KB 658, 664, where he said:

A contract of insurance, then, must be a contract for the payment of a sum of money, or for some corresponding benefit such as the rebuilding of a house or the repairing of a ship, to become due on the happening of an event, which event must have some amount of uncertainty about it, and must be ofa character more or less adverse to the interest of the person effecting the insurance.

Elements of Insurance:

In Medical Defence Union Ltd. v Department of Trade [1979] 2 All ER 421, Megarry VC, relying on the definition of insurance set out above, highlighted the following three elements of an insurance contract:

1. First, the contract provides that the assured (insured) will become entitled to something on the occurrence of some event.
2. Second, the event must involve some element of uncertainty.
3. Third, the assured must have an insurable interest in the subject matter of the contract.

These are briefly discussed.

Element One: The Contract Provides that the Assured becomes Entitled to Something on the Occurrence of Some Event:

There are two sub-elements under this element:

1. The contract makes the assured (insured) entitled to receive the benefit. In this sub-element, the focus is on entitlement to receive a benefit. It follows that a contract that gives the insurer discretion to provide something to the insured upon the occurrence of an event, or does not enable the insured to claim the benefit as of right, cannot be said to be an insurance contract. In Medical Defence Union Ltd. v Department of Trade (supra), Medical Defence Union Ltd. was a company limited by guarantee, with members comprising doctors and dentists. Among its objects were the ability to conduct legal proceedings on behalf of its members, to indemnify members against claims for damages and costs, and to give advice on various problems, including employment, defamation, and professional and technical matters. However, it retained discretion to decide whether to conduct or defend any legal proceedings concerning a member, or to indemnify a member for a claim. In light of this discretion, it was held that the arrangement between the union and its members was not in the nature of insurance.
2. The benefit to which the assured (insured) is entitled to receive must be money, money’s worth, or other corresponding benefit. While cash is often paid to the assured, it is essential to note that the benefit to which the assured is entitled may be something other than money. For instance, in the case of Department of Trade and Industry v. St Christopher Motorists Association Ltd. [1974] 1 All ER 395, an insurance contract provided that members of a motorists’ association would receive chauffeur services if they became incapable of driving. It was held to be a valid insurance contract.

Element Two: The Event Must Involve Some Element of Uncertainty:

Insurance contracts are described as aleatory because the insurer's obligation to compensate the insured depends on the occurrence of an uncertain event. An aleatory contract is one in which the rights and obligations of the parties depend on the occurrence of an event that is uncertain as to:

1. Whether it will occur,
2. When it will occur, or
3. The extent of the loss it may cause.

For example, if Legum Ltd. insures its factory against fire, it is uncertain whether the factory will ever catch fire during the insurance period. This uncertainty gives the contract its aleatory character. However, if the factory had already been destroyed by fire before the insurance contract was concluded, the event would no longer be uncertain, and there would be no valid insurance cover for that loss.

Similarly, in life insurance, while it is certain that the person will die, the timing of that death is uncertain.

Element Three: The Assured Must have an Insurable Interest in the Subject Matter of the Contract:

Under this element, the insured or policyholder must have an interest in the subject matter of the insurance contract. For instance, a vehicle owner has an interest in the vehicle and can therefore insure it. However, his friend, who has no interest in the vehicle, cannot insure it.

This element was in issue in the Ghanaian case of Royal Exchange Assurance v. Tailor [1973] 1 GLR 226. In that case, the plaintiffs insured the defendant's vehicle. Subsequently, the defendant sold the vehicle to one Kwasi Twum under a hire purchase agreement. The plaintiffs brought the present action seeking a declaration that the insurance policy became void after the sale, because the defendant no longer had an insurable interest in the vehicle. The issue was “whether the defendant, after selling the vehicle, still had an insurable interest in the vehicle.” Counsel for the plaintiffs argued that, having disposed of the vehicle, the defendant had no further interest in it, because once the vehicle was sold, the defendant’s rights as owner automatically ceased and the policy lapsed. On the other hand, the defendant argued that he still had an insurable interest until the full payment of the purchase price, and that Kwasi Twum had only acquired a right to possession of the vehicle.

In the judgment of the court,

It is obvious that if the defendant could not be said to have an insurable interest in the said vehicle, then of course, the said policy would have to be declared void and of no effect, so far as that particular vehicle is concerned.

The court attempted to conceptualise an insurable interest. In its view, where the owner of a property has disposed of his ownership in the property, he no longer has an insurable interest in the said property (because he is no longer the owner). It added that

It is therefore certain that if the sale of the vehicle by the policy-holder is an outright one, then the policy-holder cannot have any “insurable interest” in the vehicle after the said sale, and the policy covering the vehicle will be at an end. The policy will be held to have lapsed even if the policy-holder has transferred or assigned it to the purchaser.

In the present case, however, the defendant's sale was not an outright sale. It was simply a hire-purchase agreement under which the defendant parted with only possession, not ownership, of the vehicle. At the time of the action, the defendant still owned the vehicle and therefore had an insurable interest.

The above decision was appealed to the Court of Appeal, and the appeal was dismissed. The Court of Appeal cited with approval the following definition of insurable interest in  Insurance Law (5th ed.), Vol. 1:

Insurable interest in property is not confined to the absolute legal ownership. Generally, any person who is so situated that he will suffer loss as the proximate result of damage to or destruction of the property has an insurable interest in it. But there must be some direct relationship to the property itself, for otherwise the interest is too remote and therefore not insurable. The Lucena v. Craufurd Lord Eldon said, ‘I am unable to point out what is an interest unless it be a right in the property or a right derivable out of some contract about the property,’ and if we add to this, ‘or some legal liability to make good the loss,’ we get a substantially accurate definition of insurable interest in property.

Their lordships added that where the insured is the owner of the property, it is beyond doubt that he has an insurable interest in it. Their lordships, however, admitted that an insurable interest is not confined to the interest arising from ownership alone, and “every kind of interest that may subsist in or be dependent upon the subject-matter that is insured.” Further, their lordships of the Court of Appeal acknowledged that “It is a fundamental principle of insurance law that an insured person cannot recover under an indemnity policy, unless he has an insurable interest in the subject-matter in respect of which the claim is made, and if the insured car is sold, the insurance policy comes at an end” They concluded that in the present case, the mere transfer of the possession of the vehicle to Kwasi Twum was not sufficient to destroy the respondent’s insurable interest.

Types of Insurance:

There can be various types of insurance depending on the grounds of classification. Insurance can be classified according to:

1. Subject matter of the insurance contract: Here, we have the general categories of life or long-term insurance versus non-life or general insurance.
2. Extent of the benefit to be provided by the insurer: Here, we have indemnity insurance and contingency insurance:
1. Indemnity insurance: The insurer provides indemnity for the loss incurred, up to the extent of the loss. For instance, if an indemnity insurance policy is taken to protect a factory from loss by fire, and only 30% of the factory is destroyed by fire, the insurer provides indemnity only for that 30% loss, not the full value of the factory or a fixed sum. Here, the extent of the loss determines the extent of the benefit provided by the insurer. The benefit cannot exceed or be less than the extent of the loss.
2. Contingency insurance: The insurer makes a payment on the occurrence of a contingent event. The sum to be paid is not measured by the loss, and is simply a sum stated in the insurance policy. For instance, if it is life insurance, the insurer pays a pre-agreed sum to the beneficiaries if the life ends, irrespective of the value of the life. Here, the extent of the loss does not determine the benefit provided by the insurer. The loss only triggers the insurer's obligation to pay a pre-agreed amount.
3. Insurance versus Reinsurance: Reinsurance is insurance taken out by the insurers to lay off the risks arising under their contracts of primary insurance (per Joanna Benjamin). The following are forms of reinsurance:
1. Treaty reinsurance: Here, all or a large part of the insurer’s risks are reinsured.
2. Facultative reinsurance: Here, only a specified risk or risks are reinsured.
3. Excess of loss reinsurance: Here, the insurer retains risks up to a specified sum, and reinsures losses in excess of the specified sum.
4. Quota reinsurance: Here, the insurer takes a specified portion of all losses.
5. Retrocession: This is the reinsurance of a reinsurance.

 Credit Risks Associated with Insurance:

While the insured transfers his risk to the insurance company, there is a new credit risk that the insurance company will not pay compensation to the insured when the insured event occurs. The insurance contract does not provide for what happens in such situations.

For this reason, insurance is often regulated by statute.