Insurance is a cornerstone of risk management, providing financial protection against unforeseen events.
The industry operates on a set of foundational principles that ensure fairness, reliability, and trust between insurers and policyholders.
Understanding these principles is crucial for anyone involved in or considering insurance.
In this blog post, we’ll delve into the seven key principles of insurance, explaining their importance and how they work to protect both parties involved.
1. Principle of Utmost Good Faith (Uberrima Fides)
Explanation
The principle of utmost good faith requires both the insurer and the insured to act honestly and disclose all relevant information truthfully. This principle ensures transparency and trust in the insurance contract.
Importance
- Trust Building: It fosters trust between the insurer and the insured, as both parties are expected to be completely honest.
- Accurate Risk Assessment: Insurers rely on accurate information to assess risks correctly and set appropriate premiums.
- Fair Claims Settlement: Helps in fair settlement of claims as all material facts are disclosed at the inception of the policy.
Example
When applying for health insurance, the applicant must disclose all known medical conditions. Failure to do so can lead to the policy being voided or claims being denied.
2. Principle of Insurable Interest & Principles of Insurance
Explanation
Insurable interest means that the policyholder must have a financial interest in the subject matter of the insurance.
Essentially, the policyholder must stand to suffer a financial loss if the insured event occurs.
Importance
- Preventing Gambling: It ensures that insurance is not used as a form of gambling.
- Legal Requirement: It’s a legal requirement to validate the insurance contract.
- Financial Protection: It ensures that only those who stand to suffer a loss can claim insurance benefits.
Example
A homeowner has an insurable interest in their house, as they would incur a financial loss if it were damaged or destroyed.
Conversely, insuring a stranger’s house without any ownership interest is not permissible.
3. Principle of Indemnity
Explanation
The principle of indemnity ensures that the insured is compensated for the loss incurred, but not allowed to profit from it.
The compensation should be sufficient to restore the insured to their financial position before the loss.
Importance
- Prevents Over-Insurance: Discourages the purchase of excessive coverage that exceeds the value of the insured asset.
- Fair Compensation: Ensures the insured is fairly compensated without making a profit.
- Encourages Accurate Valuation: Promotes accurate valuation of the insured property or interest.
Example
If a car insured for $10,000 is damaged and repair costs $5,000, the insurer will pay $5,000, not more than the actual loss.
4. Principle of Subrogation
Explanation
Subrogation allows the insurer to take legal action against a third party responsible for a loss, after compensating the insured.
This principle ensures that the loss is ultimately borne by the party at fault.
Importance
- Prevents Double Compensation: Ensures the insured does not receive compensation from both the insurer and the responsible third party.
- Recovers Costs: Allows insurers to recover the costs of claims paid out.
- Promotes Accountability: Holds the responsible third party accountable for their actions.
Example
If your insured car is damaged due to another driver’s negligence, your insurer may pay for the repairs and then pursue the negligent driver for reimbursement.
Recommended Reading
- Finance & Insurance HUB
- What are the 7 Types of General Insurance?
- Understanding the Basics of the Stock Market: A Comprehensive Guide
5. Principle of Contribution
Explanation
The principle of contribution applies when an insured has multiple policies covering the same risk. It ensures that the claim is shared proportionately among all insurers.
Importance
- Prevents Over-Compensation: Ensures the insured does not receive more than the total loss.
- Equitable Distribution: Distributes the liability fairly among multiple insurers.
- Encourages Cooperation: Promotes cooperation among insurers to handle claims.
Example
If a property worth $100,000 is insured for the same amount with two insurers, each insurer will pay half of any loss, ensuring that the total payout does not exceed the loss.
6. Principle of Loss Minimization
Explanation
The principle of loss minimization obligates the insured to take reasonable steps to minimize the loss or damage to the insured property.
The insured must act as if they were uninsured to prevent or reduce the loss.
Importance
- Prevents Moral Hazard: Discourages careless behaviour that could lead to increased losses.
- Reduces Claims: Helps in reducing the size and frequency of claims.
- Shared Responsibility: Emphasizes the insured’s role in safeguarding the insured property.
Example
If a fire breaks out in an insured building, the owner should take reasonable steps to extinguish it or call the fire department promptly, rather than letting it burn to increase the insurance claim.
7. Principle of Proximate Cause
Explanation
Proximate cause refers to the primary cause of the loss.
It is the cause that sets off a chain of events leading to the loss.
Insurers will investigate the proximate cause to determine if it is covered under the policy.
Importance
- Clarifies Coverage: Helps determine if the loss is covered based on the primary cause.
- Ensures Fair Claims Handling: Ensures claims are paid only when the covered peril is the main cause of loss.
- Reduces Disputes: Minimizes disputes between insurers and policyholders by clearly defining the cause of loss.
Example
If a policy covers damage caused by fire but excludes flood damage, and a flood leads to a short circuit that starts a fire, the proximate cause (flood) would determine that the claim is not covered.
Conclusion
Understanding these seven principles of insurance is essential for both policyholders and insurers.
They form the bedrock of fair and effective insurance practices, ensuring that risks are managed appropriately, claims are handled justly, and both parties are protected. By adhering to these principles, the insurance industry maintains trust, transparency,
and efficiency, ultimately serving the best interests of all stakeholders involved.
Whether you are purchasing insurance or working within the industry, a solid grasp of these principles will help you navigate the complexities of insurance with confidence and clarity.