This post discusses the principles of insurance. In this post, you will understand the meaning of insurance, how insurance work, the differences between commercial and insurance contracts, and the principles of insurance, including utmost good faith, insurable interest, indemnity, subrogation, contribution, and proximate cause.

WHAT IS AN INSURANCE CONTRACT? 

A contract is a legally binding agreement between two or more parties whereby rights are acquired by one or more parties to act or forbearances on the part of the other. Insurance is a contract between two parties, the insured and the insurer, whereby the insurer undertakes to make good a loss of the insured caused by specified perils during the contract period in exchange for a consideration known as the premium. 

Insurance is the pooling of fortuitous losses by transferring such risks to insurers, who agree to indemnify insureds for such losses, provide other pecuniary benefits on their occurrence, or render services connected with the risk. Individuals, households and businesses can purchase insurance policies to manage risk exposures. The insurer assesses all risks proposed to ensure that each insured pays a commensurate premium and that appropriate terms and conditions are included in the policy document. Hence, insurance may be viewed as the custodian or treasurer of the fund.

BENEFITS OF INSURANCE

Benefits of insurance include: 

1) Payment of loss – Provides compensation or indemnity as may be necessary,

2) Reduction of uncertainty by covering possible loss exposures,

3) Ensures compliance with the legal requirement – statutory and contractual requirements,

4) Promotes loss control activity, 

5) Efficient use of insured’s financial resources after premium payment, and 

6) Reduces social burden by indemnifying or compensating the accident victims.

HOW DOES INSURANCE WORK?

Insurance works based on ‘risk pooling’. An insurance company collects premiums from all its insureds to form a pool of funds from which claims of the unfortunate insureds who experienced losses are settled or paid. When a firm buys an insurance policy from the insurance company for a specified period with specific cover, the insured pays a premium to the insurer for the insurance protection.

If the insured event occurs, the insured claims the insurance company will settle the claim from the pool of funds created through the accumulated premiums paid by policyholders. If an insured does not claim during the period, no claim will be settled on the policy. There are several types of products offered by insurance companies today.

DIFFERENCE BETWEEN COMMERCIAL AND INSURANCE CONTRACTS

Both parties to a commercial contract are required to observe good faith by law. Suppose you go to a shop to buy an electrical appliance. You will not just enter, pay, and pick the item but also check two, three or even more pieces. You may even ask the shopkeeper to test the item to ensure it is in good condition and ask several questions to satisfy yourself about what you are buying. If you get home and discover that the thing is not exactly the type you wanted, if you decide to return the item, the shopkeeper might refuse to collect the item on the ground that you examined it before purchasing it. 

This will be justified as he may rely on “Caveat Emptor” (letting the buyer beware), which applies to commercial contracts. Hence, the buyer must satisfy himself that the agreement is good because he has no legal redress later if he has made a bad bargain. The seller cannot misrepresent the item he has sold or deceives the buyer by giving wrong or misleading information. However, he is not obligated to disclose all the information to the buyer, and only selective information in reply to the buyer’s queries must be given. Nevertheless, in insurance contracts, the principle of Utmost Good Faith is observed because simple good faith is not enough.

DIFFERENCES BETWEEN COMMERCIAL AND INSURANCE CONTRACTS

Firstly, in insurance contracts, the seller is the insurer and does not know the property to be insured. The proposer, on the other hand, knows or is supposed to know everything about the property. The condition is the reverse of ordinary commercial contracts, and the seller is entirely dependent upon the buyer to provide the information about the property. Hence, the need for Utmost Good Faith on the part of the proposer. 

Secondly, insurance is an intangible product. It cannot be seen or felt. It is simply a promise on the insurer to make good the loss incurred by the Insured if it occurs. The insurer must also practice Utmost Good Faith in dealings with the Insured. He cannot and should not make false promises during negotiations. He should keep information from the insured, such as the discounts available for good features, e.g., fire extinguishing appliances discount in fire policies or that earthquake risk is not covered under the standard fire policy. However, it can be covered on payment of an additional premium.

PRINCIPLES OF INSURANCE

There are six principles of insurance: 

1. Utmost good faith, 

2. Insurable interest, 

3. Indemnity, 

4. Subrogation, 

5. Contribution, and 

6. Proximate cause.

Now let us briefly discuss the principles of insurance.

UTMOST GOOD FAITH

Utmost Good Faith can be defined as a positive duty to disclose voluntarily, accurately and fully all facts material to the risk proposed whether requested for or not. In Insurance contracts, Utmost Good Faith means that “each party to the proposed contract is legally obliged to disclose all information which can influence the other party’s decision to enter the contract”.

WHAT IS A MATERIAL FACT?

A material fact is every circumstance or information which would influence the judgement of a prudent insurer in assessing the risk. Material facts can also be described as circumstances that influence the insurer to accept or refuse the risk or affect the premium’s fixing, or the contract’s terms and conditions must be disclosed.

FACTS THAT MUST BE DISCLOSED BY THE INSURED TO THE INSURER

The insured must disclose material facts, including:

1. Facts show that risk represents a greater exposure than expected from its nature, e.g., a part of the building is being used to store inflammable materials.

2. External factors that make the risk greater than average, e.g., the building is beside a petrol station or warehouse storing explosive material.

3. Facts that would make the loss more significant than expected, e.g., no segregation of hazardous goods from non-hazardous goods in the storage facility.

4. History of Insurance, including other insurance details and previous losses and claims (if any).

5. Company has earlier declined to insure the property and special conditions imposed by the other insurers (if any).

6. Full facts relating to the description of the subject matter of insurance.

FACTS THAT NEED NOT BE DISCLOSED

1. Facts of Law: Everyone is deemed to know the law. Overloading of goods carrying vehicles is legally banned. The transporter cannot give the excuse that he was not aware of this provision.

2. Facts that lessen the Risk: The existence of an excellent fire-fighting system in the building.

3. Facts of Common Knowledge: The insurer is expected to know the areas of strife and susceptibility to riots and the process followed in a particular trade or Industry.

4. Facts that could be reasonably discovered: e.g., the previous history of claims that the insurer should have in his record.

5. Facts which the insurers representative fails to notice: In burglary and fire insurance it is often the practice of Insurance companies to depute surveyors to inspect the premises, and in case the surveyor fails to notice hazardous features and provides the details are not withheld by the Insured or concealed by him them the Insured cannot be penalised.

6. Facts covered by policy condition: Warranties applied to insurance policies – i.e., there is a warranty that a watchman is deployed during night hours, then this circumstance need not be disclosed.

BREACHES OF UTMOST GOOD FAITH

Breaches of Utmost Good Faith may arise due to (1) misrepresentation and (2) non-disclosure.

1. MISREPRESENTATION

Misrepresentations are false statements of truth. A misrepresentation is a false statement of a material fact made by a party, which affects the other party’s decision in an insurance contract. The contract can be declared void if the misrepresentation is discovered, depending on the situation. The adversely impacted party may seek damages. Misrepresentation is a basis of contract breach but applies only to statements of fact, not opinions or predictions. Misrepresentation in insurance may be either innocent or intentional.

1.1 INNOCENT MISREPRESENTATION

Innocent misrepresentation occurs when a person states a fact with the belief or expectation that it is correct, but it turns out to be wrong. While taking out a Marine Insurance Policy, the owner states that the ship will leave on a specific date, but the ship leaves on a different date.

1.2 INTENTIONAL MISREPRESENTATION

Intentional misrepresentation is a deliberate distortion of the known information by the proposer or insured to defraud the insurer. If the misrepresentation is intentional, it is fraudulent, and the insurer can repudiate liability or refuse to settle a claim. The selfish objective is somehow to enter the contract or reduce the premium, e.g., If an applicant for motor Insurance stated that no one under 18 would drive the vehicle when he is 17, his son goes frequently. Misrepresentation would be material as it would affect the insurer’s decision.

2. NON-DISCLOSURE

Non-disclosure is the failure of the proposer or insured to disclose material information to the insurer. Non-disclosure may be either innocent or fraudulent. If the non-disclosure is fraudulent, then it is called concealment.

2.1 INNOCENT NON-DISCLOSURE

Innocent Non-disclosure arises when a person is not aware of the facts or is aware of the fact but does not appreciate its significance. For example, a proposer at the time of effecting the contract has undetected cancer and does not disclose it, or a proposer suffered from rheumatic fever in his childhood. However, he does not disclose this, knowing that people with this are later susceptible to heart diseases.

2.2 FRAUDULENT NON-DISCLOSURE

Fraudulent non-disclosure is a deliberate intention by a proposer or insured to conceal material information to defraud the insurer. For example, a proposer for fire insurance knowingly hides the fact by not disclosing that he has an outhouse next to his building, which is used as a store for highly inflammable material.

HOW TO DEAL WITH BREACHES OF UTMOST GOOD FAITH

How insurers deal with breaches depends on whether the breaches are (1) innocent, (2) deliberate, (3) material to the risk, and (4) immaterial to the risk.

1. The contract becomes void ab initio or from the very beginning if deliberate misrepresentation or non-disclosure is resorted to misleading the insurer to enter a contract. When a breach of Utmost Good Faith occurs, the aggrieved party has the right to avoid the contract. The contract does not become automatically void, and the aggrieved party must decide on the course to be taken. The options available are on a case-by-case basis, such as: 

2. To consider the contract void, the aggrieved party must notify the offending party that the breach has been noticed. If the breach is discovered at the time of the claim, the insurer will refuse to honour the promise to pay the claim. This again occurs when there has been a deliberate breach.

3. If the breach is innocent but is material to the fact, the insurer may impose a penalty in an additional premium.

4. If the breach is innocent and immaterial, the insurer can choose to ignore the breach or refuse to settle under the policy.

INSURABLE INTEREST

One of the essential ingredients of an insurance contract is that the insured must have an insurable interest in the subject matter of the contract. Without an insurable interest on the part of the insured, insurance would be a mere wager and legally unenforceable. The subject matter of an insurance contract may be a property, an event that may create liability, potential liability which is insured, or the pecuniary interest of the insured in a property. The term ‘subject matter of the contract’ means the pecuniary or financial interest (i.e., the insurable interest) a person has in the subject matter of insurance.

SUBJECT MATTER OF INSURANCE AND SUBJECT MATTER OF THE CONTRACT

The subject matter of insurance is a term used in describing the thing (e.g., car, building, ship, aircraft etc.), events and liabilities insured. The insured’s financial interest (insurable interest) in the subject matter of insurance gives him the right to purchase the insurance. 

The subject matter of the contract is the legal right to insure an item or an event. It is the policyholder’s interest or financial involvement in the subject matter of Insurance (e.g., Insured building). This is what the insurance contract is guaranteed, i.e., the insured financial involvement is protected by his insurer.

HOW INSURABLE INTEREST ARISES

Insurable interest may be acquired in four significant ways: 

1. Through ownership

2. Under Common Law

3. Through Contract

4. By Statute

Here are some practical ways a person could acquire insurable interest:

1. Mortgagees and Mortgagers

2. Bailee

3. Trustees

4. Ownership – Wholly or partly

5. Agents

6. Husband and Wife

7. Creditor

8. Liability – Subject to the extent of potential liability

WHEN SHOULD INSURABLE INTEREST EXIST?

1. In Life Insurance: Insurable interest must exist at the beginning or inception of an insurance contract but is not required at the time of claim.

2. In Marine Insurance: Insurable interest must exist at the time of loss or claim, but insurable insurance need not exist at the contract’s inception.

3. In all insurance contracts other than life and marine insurance: Insurable interest must exist at the inception and time of loss.

OTHER SALIENT FEATURES OF INSURABLE INTEREST

Other valuable features of insurable interest include: 

1. Insurable Interest of Insurers under primary insurance contracts

2. Legally Enforceable

3. Possession

4. Criminal Acts

5. Financial Value

6. Employers have an insurable interest in their employees’ lives during their employment.

7. Assignment of policies is possible but usually only with the permission of the insurer because it can mean a change in the underwriting consideration as the new policyholder may have a different insurable interest.

PRINCIPLE OF INDEMNITY

Indemnity is a mechanism insurers engage in placing the insured in the position he was in before the loss. The sole purpose of insurance is the provision of indemnity. The insurance contract is an agreement between the insured and the insurer whereby the insurer agrees to indemnify the insured subject to the terms of the agreement in consideration of a premium.

Indemnity is a system through which an insurer puts the insured in the same financial position he was immediately before the loss. For instance, if the insured insures his house against fire and fire eventually destroys it, the insurer will provide indemnity by paying the insured the cost of rebuilding the house or rebuilding the house themselves. It is important to note that the insurer provides indemnity, subject to the insured’s interest (sum insured).

HOW INDEMNITY IS PROVIDED

In insurance, there are four methods of indemnification: 

1. Cash, 

2. Repair, 

3. Replacement, and 

4. Reinstatement.

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FACTORS THAT LIMIT INDEMNITY

In as much as the insurer is bound to provide full indemnity in case of any loss, six factors prevent the insured from obtaining full indemnity: 

1. Sum insured, 

2. Franchise, 

3. Excess, 

4. Average, 

5. Limit, and 

6. Deductible.

COROLLARIES OF INDEMNITY

There are two corollaries of indemnity: 

1. Subrogation and 

2. Contribution.

SUBROGATION

Subrogation is the right of an insurer, after indemnifying the insured, to stand in the place of the insured against the negligent third party to avail himself of all his rights and remedies, whether already enforced on not. Simply put, when an insurance company pays you the amount you claimed when a negligent third party was responsible for the damage in question, you subrogate your rights to the insurance company. 

This means you give the insurance company the legal right to hold the person who caused the accident responsible for recovering the money paid to you for the damages. If the insured, after receiving indemnity, also recovers losses from another, then he shall be in a position of gain which is not correct, and this amount recovered from another shall be held in trust for the insurer who has already given indemnity.

HOW DOES SUBROGATION WORK IN INSURANCE?

Policyholders, when acquainted with the term ‘Subrogation’, will instantly think that this is one term and is beneficial only for insurance companies, but it is surprisingly and indirectly beneficial to the insured. It is an act of pursuing the third party on behalf of the policyholder after paying the claim amount. The insured gets his payment on time in case of a claim, and the insurance company reimburses the same amount from the third party who may have caused the impairment. 

So, in such a situation where the third party does the damage, you get your claim amount plus the deductible once the third party pays the compensation to the insurance company. Some insurance companies add the deductible amount, too, in the case of a subrogation. Subrogation does not apply to life, sickness, and personal accident insurance because these contracts are benefit contracts, not contracts of indemnity.

HOW SUBROGATION ARISES

Subrogation can arise in four ways: 

1. Tort, 

2. Contract, 

3. Statute, and 

4. Subject matter of insurance.

CONTRIBUTION

Contribution is the second corollary of indemnity. Contribution is the right of an Insurer to call on other insurers who are liable, but not equally liable, to share the cost of an indemnity payment after the settlement of a claim. The common law allows the insured to recover his total loss within the sum insured by insurers. Conversely, the contribution principle ensures that Insurers or Insurers who have paid a loss recover a proportionate amount (known as rate-able proportion) from other Insurers who are also liable for the same loss. It means that each insurer will pay only its share. If the Insured wants full indemnity, he should appropriately lodge proportionate claims with the other Insurers.

CONDITIONS FOR APPLICATION OF CONTRIBUTION PRINCIPLE

The following conditions must be fulfilled before the application of the contribution principle:

1. There must be two or more policies of indemnity.

2. The policies must cover common interest.

3. The policies must cover common subject matter.

4. The policies must cover common peril that causes the loss.

5. The policies must be in operation at the time of loss.

The policies don’t need to be identical. What is essential is that there should be an overlap between the policies, i.e., the subject matter should be common, and the peril that causes loss must be the same.

RATEABLE PROPORTION

The accepted way to interpret the term ‘Rate-able Proportion’ can be illustrated because Insurers should pay in proportion to the sum insured. For example, if a building is insured by three insurers (Companies A, B, and C) in the following ratio:

Sum insured of Company A = $10,000, which is 1/6 of the sum insured

Sum insured of Company B = $20,000, which is 2/6 of the sum insured

Sum insured of Company C = $30,000, which is 3/6 of the sum insured

The total sum insured           = $60,000

If there is a loss and a claim of $6,000 is reported. The loss will be settled by the 3 insurers based on their rateable proportion as follows:

Company A bears 1/6 of the loss, which is $1,000.

Company B bears 2/6 of the loss, which is $2,000.

Company C bears 3/6 of the loss, which is $3,000.

 The total loss settled = $6,000.

However, the drawback of this simple method is that the policies’ terms and conditions may differ, and it would not be prudent to ignore these terms and conditions. For example, the average condition may apply to one or more policies, or there may be an excess clause in one policy that may affect their share of contribution to the loss. It is correct to assess the loss per the individual policy’s terms and conditions and pay the claims accordingly. Suppose by following this method, the total sum of the Insurers’ liability is more than the claim amount. In that case, the Insurers should pay in proportion to each liability amount.

PROXIMATE CAUSE

Proximate cause was defined in the case of Pawsey v Scottish Union & National Insurance Company (1908) as: “the active efficient cause that sets in motion a train of events which brings about a result, without the intervention of any force started and working actively from a new and independent source.” The immediate cause and not the remote one should be taken into consideration.

Hence, the proximate cause should be the immediate cause. Immediately does not mean the nearest to the loss in point of time but the one most effective or efficient. If there are several causes and the proximate cause should be determined, the proximate cause should be the most predominant and efficient cause – i.e., the cause that effectively caused the result.

WHAT IS A PERIL?

A peril is a loss-causing event, e.g., fire, theft, flood, and tempest. Three types of perils may cause losses in insurance contracts: insured, excepted and uninsured perils.

 Insured Perils: are perils stated explicitly in a policy as being insured by the policy, e.g., fire, lightning, storm etc., in the case of a fire policy.

 Excepted Perils: are perils stated explicitly in a policy as being excepted or excluded by the policy, e.g., riot, strike and flood, which may have been excluded and discount in premium availed.

Uninsured Perils: are not stated in the policy either as the insured or excepted perils, e.g., snow, smoke, or water damage. In practice, insurers will pay for losses caused by uninsured perils provided they are actions aimed at reducing the extent of the damage. On the other hand, insurers will not pay for losses caused by uninsured perils if they are actions that increase the extent of the damage.

Insurers are liable to pay claims arising out of losses caused by Insured Perils, not those caused by excepted or Uninsured perils. 

See my video on Credit Risk and Credit Risk Management: https://youtu.be/-vpGpV7jhFc