The Principles of Insurance

Tuesday, January 8, 2013

The insurance industry can function to the advantage of both insurers and the insured only if both parties adhere to the basic principles of insurance. If, for example, the insured were to make many false claims for damaged property that is either not damaged or not owned by them, insurance companies would not be able to afford the required payouts and would subsequently have to pass fraudulent claims on to other customers in the form of higher premiums. From the other direction, if insurance companies were to refuse to pay out legitimate claims, the insurance industry would lose so many customers that it would collapse entirely.

Luckily for everyone, there are some principles that keep the insurance industry functioning:

  • The principle of outmost good faith: According to this principle, both the insurer and insured have to enter into the contract in good faith and with honesty.   The insurer should be prepared to shoulder the responsibilities placed on it by the contract, and the insured should be willing to disclose all information relevant to the insured property. Neither side would be able to live up to its side of the contract if the other was dishonest.

  • The indemnity principle: The point of insurance is to compensate the insured person for a loss. It is not to provide her with an extra income. Accordingly, the amount paid out by the insurer should be no more or less than the amount lost by the insured. The insured should be no better or worse off after the payout. This is also why a property owner is not permitted to insure her property with two insurance companies and claim the full amount from both in event of damage. It would represent a profit, not just a compensation for a loss.

  • The principle of insurable interest: The insured person can insure something only if its loss or damage will harm her. She can insure her house, since she will suffer considerable financial loss if it is damaged. But she cannot insure a house that she has sold and to which she is no longer financially tied. That is why we can insure only things that we own, or in which we have a financial interest.

  • The principle of loss minimization: The Insured person should make all possible effort to minimize the damage to her property in event of a disaster. For example, if she notices robbers breaking into her house and steal her possessions, she cannot simply stand by in the hope that the insurance company will replace them with shiny new models. She has a responsibility to call the police.

  • The principle of proximate cause: When claiming for damages, this principle requires that the most immediate cause of the damage is considered when deciding whether to make the payment. In other words, when a house burns down due to the dog knocking over an oil lamp, the fire is the proximate cause of the damage.

  • The insurance industry can function to the advantage of both the insured and insurers only if both parties observe these principles.