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Key Concepts in Insurance

No one can deny the possibility of material assets getting damaged, destroyed, or becoming non-operational due to unforeseen events. Similarly, human life is also exposed to casualties like death, accident, illness, etc.

Key Concepts in Insurance
Key Concepts in Insurance

All assets have an economic value attached to them including humans. No one can deny the possibility of material assets getting damaged, destroyed, or becoming non-operational due to unforeseen events like fire, breakdown, flood, earthquake, etc. Similarly, human life is also exposed to casualties like death, accident, illness, etc.

The basic concept underlying insurance is that a group of people, exposed to similar risk, come together and make a contribution towards the formation of a pool of funds. In case a person or an asset actually suffers a loss on account of some unforeseen risk, he or she is compensated from the same pool of funds. Insurance companies collect premiums from a group of people sharing common risks as their respective contributions to the pool.

Insurance thus works on the basic principle of risk-sharing. A basic advantage underlying insurance is that it spreads the risk of few people over a large group of people exposed to the risk of a similar type.

Though insurance is classified into different types such as life, marine, fire, etc. there are certain general principles that apply to all forms of insurance. These serve as the guide to a sound interpretation of the purpose of insurance contracts in their diversified forms.

In this article, we look at these foundational principles underlying any insurance contract.

Existence of risk. Risk is generally defined as the chance of loss. It can either be due to uncertainty about the outcome of some event or loss as a result of at least one possible outcome. In any case, the promise of the insurer (insurance company) is to save the assured against any such uncertain circumstances. It is indispensable to every contract of insurance that the subject matter should be exposed to the contingency of loss or risk.

Indemnity. Insurance is essentially a contract of indemnity. All the claims of the assured are adjusted only for the actual loss sustained by him. Thus it is implicit in every contract that the assured, in case of a loss against which the policy is made, shall be fully indemnified but shall never be more than fully indemnified. However, the insurer limits its liability to the extent of the sum assured. This is to say that in case of a loss, the sum assured is all that the insured is entitled to even if the actual loss suffered far exceeds that. The intention is to bring back the insured at the same financial level (to the extent possible) at which the insured was before the specified incident happened. However, this principle does not apply to life insurance as human life cannot be fully compensated.

Insurable Interest. It means that a person must have a monetary interest in life, property, or an event legally entitling that person or business to insure it. Unless the insured will suffer financially in the event of a loss, he does not have an insurable interest and is not legally entitled to insure that particular risk.

Utmost Good Faith. It implies that both parties in an insurance contract are obliged to act in good faith in their dealings with each other.

Contribution. This refers to the right of an insurer to call upon other insurers, similarly but not necessarily equally, liable to compensate the same insured to share the loss of an indemnity payment. The principle of contribution thus allows the insured to make a claim against one insurer who then has the right to call on other insurers liable for the loss to share the claim payment.

Subrogation. As per the principle of subrogation, the insurer acquires legal rights to pursue recoveries on behalf of the insured. In other words, the insurance company reserves the right to legally pursue a third-party responsible for the damages caused to the insured. The insured grants the insurance company this right for recovery of the money paid by the insurer a claim for damages.

Proximate Cause. It refers to the immediate and effective cause of the loss though not necessarily the last event in a chain of circumstances, which leads naturally and directly to the loss. Though being the first event in a series that results in a claim, it may not always be the one that is nearest in time to the event.

By failing to prepare, you prepare to fail!

Dr Swati Dhawan
Dr Swati Dhawan

A SRCC & FMS alumni, Dr. Swati Dhawan has a rich teaching & training experience of more than 17 years in the area of Accounting and Finance with institutes of repute like IIM Rohtak, IIM Raipur, IIM Sirmaur, Faculty of Management Studies, Shri Ram College of Commerce, IMT Ghaziabad, TERI University, etc. Also, she has been an academic consultant & corporate trainer in management development programmes at GAIL and Alchemist. Her book on Merchant Banking & Financial Services has been published by McGraw Hill.

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