Principles Of Insurance

There are some principles of insurance which are generally accepted throughout the world. And if you are well-conversant with these principles, you will be in better position in negotiating your insurance needs as well

We live in a very risky and uncertain world. This has been reinforced by the recent pandemic of the corona virus, which is still taking life of many globally. There are forces that threaten our financial wellbeing which constantly surround us and are largely outside our direct control. Some people experience the premature death of their near and dear ones and loss and destruction of their property from both manmade and natural disasters. Risk is the possibility of an adverse outcome, an outcome which was not expected to be that bad or adverse. Risk is the part of every human endeavour. From the moment we get up in the morning, drive or take public transportation to get to work, school or college until we get back to sleep, we are exposed to risks of different degrees.

How one can protect oneself against such risks financially? As every adversity comes with financial stress it’s very important to protect yourself financially but the question is how can one do so? The answer lies in purchasing insurance. Insurance is the most common method used for transferring risks. It shifts the risk from an individual to group. It also provides a means for paying for losses occurred due to some mishap or adversity. Insurance provides an important means of preventing risk from interfering with an individual’s achievement of financial objectives. Basically, it is protection from any possible financial loss as against premium paid by you to the insurance company.

Law of ContractInsurance policies are based on the law of contracts but an insurance contract is different from a normal contract. Insurance is the contract of a risk transfer mechanism whereby a company promises to compensate or indemnify another party i.e. the policyholder upon the payment of reasonable premium to the insurance company to cover the subject matter of insurance. There are some principles of insurance which are generally accepted throughout the world. And if you are well-conversant with these principles, you will be in better position in negotiating your insurance needs as well. Let’s look at what the fundamental principles of insurance are in this article.

Fundamental Principles of InsuranceLet us understand the following six fundamental principles of insurance in detail:

1. Utmost Good Faith :
The doctrine of good faith applies to all forms of insurance. Both parties of the insurance contract must be of the same mind at the time of contract. There should not be any fraud, non-disclosure or misrepresentation concerning the material facts. An insurance contract is a contract of absolute good faith whereby both parties of the contract must disclose all the material facts truly and fully as insurance shifts risks from one party to another. This is called as doctrine ‘uberrima fides’ (utmost good faith). For instance, if a person suffers from serious disease but does not disclose the fact while getting his life insured, the insurance company can avoid the contract and can hold back the claim in case it comes to know about the disease which the policyholder had during purchasing insurance.

Breach of duty of utmost good faith happens due to:
•Misrepresentation: It happens when the proposer does not report the facts accurately.
•Non-Disclosure: It happens when the policyholder omits to report material facts. If the policyholder deliberately hides the facts that he knows to be material.

2. Insurable Interest :

Generally, it is believed that if you are willing to pay the premium, almost anything can be insured by anyone. This is not correct. A person has an insurable interest in something when loss or damage to it would cause that person to suffer a financial loss or certain other kinds of losses. For instance, if the house you own is damaged in fire, the value of your house has been reduced, and whether you pay to have the house rebuilt or sell it at reduced value, you have suffered a financial loss resulting from the fire.

Conversely, if your neighbour’s house, which you do not own, is damaged by fire, you may feel sympathy for your neighbour, but you have not suffered a financial loss from fire. You have an insurable interest in your own house, but in this example, you do not have an insurable interest in your neighbour’s house or property. A basic requirement for all types of insurance is that the person who buys a policy must have an insurable interest in the subject of the insurance. You have an insurable interest in any property you own or which is in your possession.

Application of insurable interest:

a) Life Insurance:
• Every person has an unlimited insurable interest in his own life.
• A person also has an automatic insurable interest in the life of his or her spouse.
• A person has an insurable interest in the life of a debtor, but only to the extent of loan outstanding.

b) Property Insurance
• The absolute owner has an insurable interest in the property owned by him or her.
• Any person who has partial or joint interest in some property.
• Mortgagees and mortgagors both have insurable interest.
• Trustees or executors or administrators are legally responsible for the property in their charge.
• A bailee is a person who legally holds the goods of another and also has an insurable interest as he or she is responsible to take reasonable care of the property.
• Spouses have insurable interest in each other’s property.

c) Liability Insurance
• A person has an insurable interest to the extent of any potential liability which may be incurred by way of damages or costs. For instance, a drug manufacturing company may incur a liability due to ill-effects of a new drug. • In liability insurance it is possible to pre-determine the extent of interest because there is no way of knowing how and when one may incur liability and what would be the monetary value of the liability.

3. Indemnity

Indemnity is an undertaking given to compensate for (or to provide protection against) injury, loss, incurred penalties, or from a contingent liability. Indemnity is a generalised promise of protection against a specific type of event by way of making the injured party whole again. An insurance contract is a contract of indemnity. It means the insurance company will indemnify the insured to the extent he suffered the financial loss. Insurance contracts promise to make good the loss or damage. However, payments for loss or damage are limited to the actual amount of the loss or damage subject to the sum you have insured.

The principle of indemnity arises under common law which requires that an insurance contract should be a contract of indemnity only and nothing more. This means that the loss or damage must be made good in such a manner that financially the policyholder should neither be better off nor worse off as the result of the loss. Indemnity is closely related with insurable interest. As per the concept of insurable interest, the amount of loss that a person suffers due to any event is limited to the insurable interest that he has in asset or property.

Hence, in the event of claim, the amount of indemnity cannot exceed the insurable interest that the insured has in the subject matter. There are various methods of providing indemnity. The right to choose the method of providing indemnity is vested with the insurer. Accordingly, the method chosen is the one which is convenient in the circumstance, always keeping cost in mind. Indemnity can be in cash, or by repairing, or by reinstating, or by replacing and is chosen by the insurance company in order to avoid moral and morale hazards.

4. Contribution

In some cases, more than one policy may be in force on the same subject matter at the time of loss. In this circumstance, each insurer or insurance companies would need to bear a proportion of loss. This is referred to as contribution. Contribution is the right of the insurance company to call upon others similarly (but not necessarily equally) liable to the same policyholder to share the cost of an indemnity payment. If an insurer (insurance company) has paid the indemnity in full, he can recover an equitable proportion of the risk from other insurers.

The following features are to be met before the condition of contribution arises:
• Two or more policies of indemnity must exist.
• The policies must cover same interest.
• The policies must cover common peril which gives rise to the loss.
•The policies must cover a common subject matter.
• Each policy must be liable for loss.

For instance, let us assume that a business has insured its warehouse against the peril of fire with three different insurers (insurance companies) for Company A (Rs2 lakhs), Company B (Rs4 lakhs) and Company C (Rs3 lakhs). Suppose the warehouse is partly destroyed due to fire and the amount of loss is assessed at Rs1 lakh.

Then the amounts payable by each insurer will be:

5. Subrogation

Subrogation is corollary to the principle of indemnity, in the sense that it prevents the policyholder to be benefited by loss after receiving the loss from the insurance company as well as a responsible third party. The policyholder may recover the loss from another source after receiving the claim from the insurance company, but that additional money must be given to the insurance company. Subrogation arises when there is a  contract of indemnity. Subrogation is the right of one person (insurance company) having indemnified another (policyholder) under a legal obligation to do so, to stand in the place of that other (policyholder) and avail himself (insurance company) of all the rights and remedies in case the policyholder is indemnified by a third person. This principle does not only apply to the policyholder but also to the insurance company, as an insurance company is entitled to recover what it has paid as claim. Just like a policyholder, the insurance company must also not make any profit out of the insurance claim.

6. Proximate Clause

The principle of proximate cause means when a loss is caused by more than one causes, the proximate or the nearest or the closest cause should be taken into consideration to decide the liability of the insurer. This principle is found very useful when loss has occurred due to a series of events. The principle states that to find out whether the insurer is liable for the loss or not, the proximate (closest) and not the remote (farthest) must be looked into. However, in case of life insurance, the principle of proximate cause does not apply. Whatever be the reason of death, the insurance company is liable to pay the amount of insurance claim to the policyholder.

Therefore, to determine if loss is payable, the following questions need to be answered:
• What is the root cause of the loss?
• Is the peril, identified above, specifically covered under the insurance policy?
• What is the root cause of loss?

Sometimes the root cause of the loss may be straightforward. For example, two cars may have an accident on the road. But, at other times it may not be so simple. For instance, suppose a fire breaks out in a building containing a library but is swiftly brought under control by the firemen. However, the water used by the firemen to control the fire damages the books. In this case, what would be cause of damage – fire or water? In such cases, it becomes necessary to identify the root cause, which is also called proximate cause. Here in this example, we see that the immediate cause of damage was water and the root cause of damage was fire due to which water was sprayed. Water would have been not sprayed if the fire had not broken out in the building.

Conclusion

So, to conclude, an individual should be aware of these fundamental principles of insurance which can help him better understand the terms and conditions of an insurance policy while purchasing it. An individual will be well aware of how or what he can claim and what he cannot. It will help you understand that the insurance company is also bound to its policyholder and has to comply with the same. As such, a policyholder can be more educated about the principles of insurance which will help him understand in case of loss how he can get indemnified or while purchasing insurance what can be insured, etc.