The Seven Basic Principles of Insurance: A Complete Guide
Insurance is not a mere financial product, but a legally binding contract on the basis of some guiding principles that secure the insured as well as the insurance firm. These are the principles of the functioning of the insurance and provide fairness, transparency, and confidence in the relations.
These principles should be observed in order to influence the validity of the insurance contract in case either party breaches them, and that leads to the denial of claims.
There are seven standard tenets of insurance which are:
I would like to discuss each of the principles.
1. Utmost Good Faith
Meaning:
The insurer and the insured are expected both to tell the truth and provide all facts about the insurance contract.
The insured is required to disclose full and correct information concerning the risk he/she is insuring.
The insurer should be able to articulate the terms, conditions, limits of coverage and exclusions.
Example:
When you seek health insurance you are required to reveal preexisting medical conditions. Otherwise, it can result in the denial of claims in the future.
Why It Matters:
Insurance relies on accurate risk assessment. In case material facts are concealed, the insurer can accept risks that they have not entered into.
Common Violation:
Lying or omission of conditions (e.g. lying regarding smoking behavior in life insurance).
2. Insurable Interest
Meaning:
The policy holder needs to have a legal or financial interest in the insured thing that is, they would lose money should the insured thing happen.
Example:
You may make your own house insurable, not that of your neighbor.
A firm may cover its delivery vehicles since they are destroyed, and this leads to direct financial loss.
Why It Matters:
Removes instances of insurance of things that a person is not interested in and this may be an incentive to commit fraud.
Key Rule:
There has to be insurable interest:
At the time of policy inception for life insurance.
At the time of loss for property insurance.
3. Indemnity
Meaning:
The purpose of insurance is to put you in the same financial standing before the loss took place to make a profit on the loss.
Example:
In case you have an insured car worth 20,000 and this car is involved in an accident, the company will not pay you over and above the value of the car; they will only allow you to repair (or buy a new one).
Why It Matters:
Plugs unfair enrichment - the insured is not supposed to be enriched but to be compensated to actual losses.
Limitations:
Life insurance is an exception - you cannot replace a human life in the monetary sense, and thus the payouts are given according to the amount of money understood by the agreement.
4. Contribution
Meaning:
When a risk is insured by more than one insurance, the insured would not be able to recover the entire amount on that risk one after the other. Instead, insurers share the payout proportionally.
Example:
Assuming you have a house worth 100,000, and your two insurers are Insurer A and Insurer B, and you have 60,000 and 40,000 limits on your coverage, respectively, and you lose 50,000 of the property, the claim will be divided in two:
Insurer A pays: 50,000×60,000100,000=30,00050,000 \times \frac{60,000}{100,000} = 30,000
Insurer B pays: 50,000×40,000100,000=20,00050,000 \times \frac{40,000}{100,000} = 20,000
Why It Matters:
Stops the insured making more than the loss and makes it fair on the part of insurers.
5. Subrogation
Meaning:
Once the insurer has paid the claim, he or she has the legal claim to recover the amount through a third party who causes the loss.
Example:
Your vehicle is wrecked by someone in an accident. Insurance covers you through repairs and you sue the responsible driver (or his insurer) to get back the payout.
Why It Matters:
Eliminates duplication of payment to the insured (one through the insurer and the other through the party at fault).
Helps is a form of insurers who manage the expenses of claims.
6. Proximate Cause
Meaning:
In the unfortunate event of a loss occurring because of more than one cause, the claim can only be paid in cases where the proximate (nearest) cause of the loss is a covered risk.
Example:
When a fire (covered) destroys a warehouse and heavy rain (not covered) thereafter destroys the rest of the goods, the insurer would compensate the loss that was directly caused by fire.
Why It Matters:
Excludes the secondary cause of the loss and makes sure that an insurer only covers insured perils.
Key Rule:
The immediate cause should be one that is directly related to the loss without introduction of some new unrelated events.
7. Loss Minimization
Meaning:
Even after the insured event has taken place, the insured should take reasonable steps in order to reduce the loss or damage.
Example:
When a pipe breaks in your home you need to have the main supply of water in your house off rather than have the water pour in your house as you wait to see the insurer.
Why It Matters:
Insurance is a joint venture in risk management - the insured has a role to play in reducing the damage.
Common Violation:
Failure to be proactive and this may result in fewer claim payments.
How the Principles Work Together
These principles are related:
Utmost Good Faith gives proper risk evaluation.
Insurable Interest is that which guarantees a true stake in the insured.
Indemnity and Contribution prevent overcompensation.
Claim responsibility is explained with the help of Subrogation and Proximate Cause.
Loss Minimization makes the insured also actively engaged in risk management.
In case of violation of any principle, the insurers can get lawful powers to reject claims or cancel policies.
Practical Example: All Principles in Action
Imagine you own a factory:
Good Faith: You inform us that the factory stocked flammable chemicals.
Insurable Interest: You are the owner of the factory, thus you will lose it in case it is damaged.
Indemnity: In case of fire, which costs about $200,000, the insurer will only compensate only the actual loss.
Contribution: In case of two insurers, each one will pay his proportional share.
Subrogation: In case the fire was due to the faulty equipment provided by a supplier, the insurer is able to recoup the costs with the supplier.
Proximate Cause: In the case of the direct cause, meaning the fire, the damage is valid (even in case the subsequent rains exacerbated the damage).
Loss Minimization: You summon the fire department so as to prevent further dispersion.
The significance of These Principles.
To policyholders: Knowing them is the way to select the right coverage and make good claims.
To insurers: They bring about fairness, minimise fraud, and promote trust.
On the financial system: They stabilise and make the insurance market reliable.
In Conclusion
All insurance contracts are bound by the seven fundamental principles of insurance, Utmost Good Faith, Insurable Interest, Indemnity, Contribution, Subrogation and Loss Minimization. They bring transparency, fairness and shared responsibility between the insurer and the insured.
Being aware of such principles can help you to be an effective user of insurance, prevent conflicts, and keep trust in the relationship between insured and insurance companies. These principles will be followed whether you are insuring your life, health, property or business and from policy formulation to settlement of claims.
