April 13, 2016

Principles of Insurance

It is importance that you know the underlying principles of insurance to understand how insurance works and how it benefits the society.

Insurance can be define simplify that a pool of money are contributed by a participating group of people whom will be compensated from this pool of money in an event a participating member encountered a misfortune and suffered loss.

There are 7 principles of Insurance, just like there are 4 Ps to marketing.  The 7 principles of insurance are:

  1. Principle of Uberrimae fidei (Utmost Good Faith)
  2. Principle of Insurable Interest,
  3. Principle of Indemnity,
  4. Principle of Contribution,
  5. Principle of Subrogation,
  6. Principle of Loss Minimization, and
  7. Principle of Causa Proxima (Nearest Cause)

Principle of Uberrimae fidei (Utmost Good Faith)

Insurance by in the form of a contract.  What is payable, in what circumstances, in what amount, etc.  It is a contact between 2 parties; the insured and the insurer.  The most important principle of Insurance is Utmost Good Faith, when entering into a contract.  The person getting insured must willingly disclose and surrender to the insurer his complete true information regarding the subject matter of insurance. The insurer’s liability gets void (i.e legally revoked or cancelled) if any facts, about the subject matter of insurance are either omitted, hidden, falsified or presented in a wrong manner by the insured.  This apply to all types of insurance.

Example: If you are insuring your commercial property by taking up a property damaged policy (Fire Insurance in general) and half way through the coverage period, you change your business nature from a tuition centre to a restaurant.  In an event of a fire and subsequently your property was destroyed. The insurance company will not compensate you as you fail to disclose to the insurer about your change of business.

Principle of Insurable Interest

The principle of insurable interest states that the person getting insured must have insurable interest in the object of insurance. A person has an insurable interest when the physical existence of the insured object gives him some gain but its non-existence will give him a loss. In simple words, the insured person must suffer some financial loss by the damage of the insured object.

Example: You cannot purchase a plate glass insurance for a property you are renting, as the property does not belong to you.  You are deem to have no insurable interest in the property, unless, you are required to do so as stipulated in a tenancy agreement between you and the landlord, thus created you to have an insurable interest.

Principle of Indemnity

According to the principle of indemnity, an insurance contract is signed only for getting protection against unpredicted financial losses arising due to future uncertainties. Insurance contract is not made for making profit else its sole purpose is to give compensation in case of any damage or loss.

In an insurance contract, the amount of compensations paid is in proportion to the incurred losses. The amount of compensations is limited to the amount assured or the actual losses, whichever is less. The compensation must not be less or more than the actual damage. Compensation is not paid if the specified loss does not happen due to a particular reason during a specific time period. Thus, insurance is only for giving protection against losses and not for making profit.

However, in case of life insurance, the principle of indemnity does not apply because the value of human life cannot be measured in terms of money.

Example: You insured your car for RM100,000 based on market value and few months after, your car was stolen and at the time of loss, your car’s market value then is only RM70,000.  You will be compensated RM70,000 as you can then get a similar vehicle at RM70,000.

Principle of Contribution

Principle of Contribution is a corollary of the principle of indemnity. It applies to all contracts of indemnity, if the insured has taken out more than one policy on the same subject matter. According to this principle, the insured can claim the compensation only to the extent of actual loss either from all insurers or from any one insurer. If one insurer pays full compensation then that insurer can claim proportionate claim from the other insurers.

For example :- Mr. Tan insures his property worth RM600,000 with two insurers “Insurer A.” for $ 400,000 and “Insurer B.” for RM200,000. His property was then destroyed and the damage is worth RM90,000, then Mr. Tan can claim the full loss of RM90,000 either from Insurer A or Insurer B, or he can claim RM60,000 from Insurer A and RM30,000 from Insurer B.

So, if the insured claims full amount of compensation from one insurer then he cannot claim the same compensation from other insurer and make a profit. Secondly, if one insurance company pays the full compensation then it can recover the proportionate contribution from the other insurance company.

Principle of Subrogation

According to the principle of subrogation, when the insured is compensated for the losses due to damage to his insured property, then the ownership right of such property shifts to the insurer.

This principle is applicable only when the damaged property has any value after the event causing the damage. The insurer can benefit out of subrogation rights only to the extent of the amount he has paid to the insured as compensation.

For example: A car rammed into your property and you claim compensation from your insurer.  Under the principle of Subrogation, the insurer now have legal right to sue the third party to recover the loss.  That prevents you collecting twice for the same damage and gives the insurer a way to recoup its losses.

Principle of Loss Minimization

According to the Principle of Loss Minimization, insured must always try his level best to minimize the loss of his insured property, in case of uncertain events like a fire. The insured must take all possible measures and necessary steps to control and reduce the losses in such a scenario. The insured must not neglect and behave irresponsibly during such events just because the property is insured. Hence it is a responsibility of the insured to protect his insured property and avoid further losses.

Principle of Causa Proxima (Nearest Cause)

Principle of Causa Proxima (a Latin phrase), or in simple english words, the Principle of Proximate (i.e Nearest) 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.

The principle states that to find out whether the insurer is liable for the loss or not, the proximate (closest) and not the remote (farest) must be looked into.

For example :- A cargo ship’s base was punctured due to rats and so sea water entered and cargo was damaged. Here there are two causes for the damage of the cargo ship – (i) The cargo ship getting punctured beacuse of rats, and (ii) The sea water entering ship through puncture. The risk of sea water is insured but the first cause is not. The nearest cause of damage is sea water which is insured and therefore the insurer must pay the compensation.

However, in case of life insurance, the principle of Causa Proxima does not apply. Whatever may be the reason of death (whether a natural death or an unnatural death) the insurer is liable to pay the amount of insurance.