Insurance Principles Wealth Management Compilation: Krupesh Thakkar

Bibliography

There has been reproduction of the exerts and text from the below mentioned
sources for the purpose of academic clarification and easy explanation. The
material is for strictly for internal circulation and not meant for any re‐publication
and for distribution.

• CFP Materials by IMS Proschool

• CFP Materials by Mandar Professional Excellence

• IRDA Text Book – Life Insurance - IC32

• Risk Management and Insurance Planning

by Jatinder Loomba - Prentice-Hall of India Pvt. Ltd

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Insurance Principles Wealth Management Compilation: Krupesh Thakkar

THE PRINCIPLES OF INSURANCE

1. Principle of Utmost Good Faith

The proposer has an unfair advantage over the insurer since he has greater knowledge about the
subject matter of the contract. For this reason, the law imposes a greater duty on the proposer of an
insurance contract than in other commercial contracts. This is called the “Utmost good Faith”. This
means that all parties to an insurance contract must deal in good faith, making a full declaration of all
material facts in the insurance proposal. This contrasts with the legal doctrine of caveat emptor (Let
the buyer beware).
For instance, if a person suffers from a serious disease but does not disclose this fact while getting
his life insured, the insurance company can avoid the contract. Similarly, the insurer must exercise
the same good faith render the contract voidable ab initio at the discretion of the aggrieved party. A
material fact is a fact which would influence the mind of an insurer in deciding whether he should
accept the risk, on what terms and what premium he should charge. The utmost good faith says that
all material facts should be disclosed in true and full form. It suggests that the facts should be
disclosed in that form in which they really exist. There should be no false statement and no half truth
nor any silence on material facts.

Breach of Duty of Utmost Good Faith:

It arises due to following:

i) Misrepresentation: It happens when the proposer does not reveal the facts accurately.
ii) Non Disclosure: It happens when the proposer omits to report the material facts. If the proposer
deliberately hides that he knows to e material, it is called “concealment”.

2. Principle of Insurable Interest:

A person has an insurable interest in something when loss or damage to it would cause that person
to suffer a financial loss or certain other kind of losses.
For example: if the house you own is damaged by fire, the value of your house has been reduced,
and whether you pay to have the house rebuilt or sell it at a reduced price, you have suffered a
financial loss due to fire. By contrast if your neighbour’s house, which you do not own, is damaged by
fire, you may feel sympathy for your neighbour, but you have not suffered a financial loss from the
fire.
A basic requirement for all types of insurances is that the person who buys a policy must have an
insurable interest in the subject of the insurance.

Essentials of Insurable Interest:

• There must be some property right, interest, life, limb or potential liability capable of being
insured;
• The above mentioned property, rights etc. should be the subject matter of the insurance;
• The insured must have a relationship with the subject matter of insurance whereby The benefits
from the safety, wellbeing or freedom from liability and would be adversely affected by its loss,
damage or existence of liability; and
• The relationship between the insured and the subject matter of insurance should be recognised
by law.

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Insurance Principles Wealth Management Compilation: Krupesh Thakkar

Creation of Insurable Interest:

By common law: When the element of insurable interest is automatically present, it is said to have
arisen through common law.
By Statute: An act of parliament may create an insurable interest by granting some benefit to a
person or imposing some duty.

By Contract: Insurable interest arises by virtue of a contract entered into. Example; the landlord is
normally responsible for maintenance of the property, but a lease may make a tenant responsible for
maintenance of the property.

Duration of Insurable Interest:

It is not necessary that the insured may have insurable interest in the subject matter if insurance at all
the time. In different types of insurance, insurable interest is required to exist at different times as
below:
Life: required at the inception of insurance. Not required at the time of claim under the policy.
General: Required both at inception and at the time of loss.

3. Principle of Assignment:

Assignment is a method by which a policyholder transfers his rights in the life insurance policy to
another entity. The entity can be a family member, relative, friend and a lending institution like a bank
or a non-banking finance company.
Assignment due to Operation of Law:
Transfer of insurable interest takes place due to operation of law; in such cases, the insurance in
normally transferred in the name of the new insured.

Assignment of Life Insurance Policies:

Under the life policy, the assured does not receive the benefit of the policy until it matures. Therefore,
the risk profile for the insurer does not change by the change in the assignee. For this reason, the
policies are freely assignable.

4. Principle of Nomination:

It is a right conferred on the life insurance policyholder to appoint a person or persons to receive the
policy monies in the event of the policy becoming a claim due to death. Any policyholder who is
major, and the life insured under a policy, can make a nomination.
A nominee is the person designated by the policyholder to receive the proceeds of an insurance
policy, upon the death of the insured.
A life policyholder may appoint a nominee to receive the policy proceeds becoming payable in the
event of his/her death during the term of the policy.
Unlike an assignee, a nominee does not have any right to sue the insurer, except if he has not
received the policy proceeds payable to him from the insurer. The policyholder may change the
nominee at any point of time without consulting the insurer or the nominee.

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Insurance Principles Wealth Management Compilation: Krupesh Thakkar

5. Principle of Indemnity:

An insurance contract is a contract of indemnity. It means the insurer will indemnify the insured to the
extent he suffered the financial loss. Insurance contracts promise to make good the loss or damage.
However, payments for loss or damage are limited to the actual amount of the loss or damage subject
to the sum insured.
The principle of indemnity arises under common law which requires that an insurance contract should
be a contract of indemnity only and nothing more. This means that the loss or damage must be made
good in such manner that financially the insured should be neither better off nor worse off as the
result of the loss. The object of the principle is to place the insured after a loss in the same financial
position as far as possible, as he occupied immediately before the loss. The effect of this principle is
to prevent the insured from making a profit out of his loss or gaining any benefit or advantage.
If it were possible to make a profit out of the happening of loss or damage the insured would be
tempted to deliberately cause the loss or damage. It would also tend to make the insured careless in
maintaining the property in good conditions and in preventing the loss.

Indemnity and Insurable Interest.

Indemnity is closely related with the insurable interest. As per the concept of insurable interest, the
amount of the loss that a person suffers due to any event is limited to the insurable interest that he
has in the asset/property. Therefore, in the event of claim, the amount of indemnity cannot exceed the
insurable interest that the insured has in the subject matter.

Methods of providing Indemnity

There are various methods of providing indemnity. The right to choose the method of providing
indemnity is vested with the insurer. Accordingly, the method chosen is the one that is convenient in
the circumstances, always keeping cost in mind.

Cash: This is the most common method of indemnification under which the insurance company
simply pays the cheque for the amount payable under the policy and gets discharge of their liabilities.
When the insurer is satisfied in regard to the cause and extent of loss, as ascertained from the claim
form and other enquiries and also in large losses, report from independent surveyors, the loss is
settled by cash payment that is by cheque.
Repairs: Instead of making cash payments, the settlement of claims for loss or damage may be
effected by repair. This practice is followed for motor damage claims. The procedure is that at time of
intimation of the accident to the vehicle, insured is required to submit the detailed estimate of the
repair to the insurer who will arrange an inspection of the damaged vehicle to see that repairs are
necessary or not and at the reasonable cost. Thereafter, the insurer wills authorise the repair of the
vehicle. On receipt of the final bill of repairs and a satisfaction note from the insured, the repairer is
paid.
Reinstatement: This method is mostly used in fire insurance for building or machinery where the
insurance company undertakes to repair the damage or reconstruct the building. Generally, insurers
would resort to this method when the insured claims an amount far in excess of the cost of
reinstatement or they suspect fraud which cannot be proved. Once this method is chosen by the
insurers they cannot subsequently withdraw and offer cash settlement. Under this method, the
responsibility for the way in which reinstatement is carried out with that of the insurers.
Replacement: Insurers may undertake the replacement of the damaged item, for example, a broken
plate glass window in a showroom.

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Insurance Principles Wealth Management Compilation: Krupesh Thakkar

Factors Limiting Payment

A number of factors may limit the amount payable under an insurance policy. Some of them are:
Sum Insured: Every policy of insurance contains a sum insured which is the maximum limit of liability
under the policy. This amount is not the agreed value of the property nor is it the amount which will be
automatically paid in event of loss or damage. The amount payable under the insurance contract is
the actual loss or the sum insured whichever is less.
Exception: At times, in marine insurance policies, some loss minimisation expenses such as sue and
labour charges, loss minimisation expenses are paid even in excess of sum insured.
Depreciation: The value of an asset decreases over time due to constant use. So the amount
towards depreciation due to war and tear is generally deducted.
Salvage: Property which is partially saved from the loss or damage is called salvage. If a motor car
is damaged to such an extent that it is not worthwhile to repair to repair it, because the cost of repair
would exceed the sum insured or its value, in such cases insurers will settle it as a constructive total
loss and take over the salvage. If the salvage is left to the insured to that extent he would be
benefited, which is against the principle of indemnity.

6. Principle of Subrogation:
It is the right of one person (insurer), having indemnified another (insured) under a legal obligation to
do so, to stand in the place of that other (insured) and avail himself (insurer) of all the rights and
remedies of that other whether already enforced or not.
This principle is corollary to the principle of indemnity, in the sense that it prevents the insured to be
benefited by loss after receiving the loss from the insurer as well as the responsible third party. The
insured may recover the loss from another source after receiving the claim from the insurers, but that
additional money must be given to the insurer.
Subrogation applies only when there is a contract of indemnity. It is not applicable in life insurance
and personal accident insurance as there are not subject to the principle of strict indemnity.
If the insured has received the whole or part of his loss from a third party who was responsible for
causing the loss, then to that extent, the indemnity to be provided by the insurer will be reduced.

Extent of Subrogation rights:

This principle does not apply only to the insured but also to the insurer, as insurers are not entitled to
recover more than what they paid a claim. Just like the insured, the insurer must also not make any
profit out of an insurance claim.

7. Principle of Contribution:

When there is more than one policy may be in force on the same subject matter at the time of loss. In
those circumstances, each insurer would need to bear a proportion of loss. This is referred to as
contribution.
It is the right of the insurer to call upon others similarly liable to the same insured to share the cost of
an indemnity payment. If the insurer paid the indemnity in full, he can recover as equitable proportion
of the risk from other insurers.

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Insurance Principles Wealth Management Compilation: Krupesh Thakkar

Condition of Contribution arises when:

• Two or more policies indemnity must exists;

• The policies must cover the same interest;
• The policies must cover a common peril which gives rise to the loss;
• The policies must cover a common subject matter; and
• Each policy must be liable for loss.

Basis:

Sum insured under the policy

Liability under policy = ---------------------------------------------- x Loss
Total Sum Insured

8. Principle of Warranties:

• There are certain conditions and promises in the insurance contract which are called warranties.
• Warranties which are mentioned in the policy are called express warranties.
• There are certain warranties which are not mentioned in the policy, these warranties are called
implied warranties.
• Warranties which provide answers to the questions are called affirmative warranties.
• Warranties fulfilling certain conditions or promises are called promissory warranties.

9. Proximate cause:

Principle:

To determine if loss is payable by the insurer, the following two questions need to be answered.

(1) What is the root cause of the loss?

(2) Is the peril, identified above, specifically covered under the insurance policy?

(1) What is the root cause of the loss?

Sometime, the root cause of the loss may be straightforward. For example, two cars may have an
accident on the road. At other times, it may not be simply. For example, after a fire breaks out in a
building containing library which us swiftly brought under control by firemen. However, the water used
by the firemen damages the books. Here there is a need to find out the ‘proximate cause’ here it was
the fire and the water which caused the damage was the ‘immediate cause’.

Proximate cause means the direct, most dominant and the most effective cause of the loss. It is the
cause that is most closely and directly connected with the loss.

More formally, So the ‘Proximate cause’ is the active efficient cause that sets in motion a train of events
which brings about a result, without the intervention of any force started and working independently
from a new source.

(2) Is the peril, identified above, specifically covered under the insurance policy?

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Insurance Principles Wealth Management Compilation: Krupesh Thakkar

Once the proximate cause is identified, the next step is to determine if the causative peril is covered by
the insurance policy or not.

Insured Perils: These are perils that are covered by the policy insured. For example, fire, lightening,
theft etc.

Excepted or Excluded Perils: These are perils that are specifically stated as excluded. For example,
war and allied perils.

Uninsured or other Perils: These are perils that are not stated in either inclusion cause or exclusion.
For example, smoke and water may not be excluded or mentioned as insured in a dire policy.

Application in Practice:

In practice, losses caused only by the insured perils are payable under the policy. Losses where the
proximate cause is an excluded or uninsured peril are not payable, to entitle an insured to recover, the train
of events leading from the insured peril to actual financial loss suffered by the insured must be unbroken.
If the sequence of events from an insured is broken by train of events from an excepted or uninsured peril,
then only the loss up to the break is covered.

Example: Fire breaks out in a building insured against fire but not against an earthquake. About 50% of
building is damaged by fire and later because of earthquake the entire building is reduced to rubble. In such
a cause, only 50% of the building value is payable, since the rest of the damage was caused by the
uninsured peril, that is, the earthquake.

Types of Causes:

In real word, things are rarely simple. Losses may be incurred due to a single cause or by a sequence of
causes. To determine whether the loss is payable under the insurance, causes are classified into four
categories as below:

Single Cause: Where the happening of the insured peril is a single cause or the last in series of causes,
then the claim is payable under the insurance policy.

Concurrent Cause: If there are concurrent causes, but there is no excluded perils involved, the claim
is payable. If an insured peril and an excluded peril operate together to produce the loss, the claim is
not payable. If the effects of the insured, perils can be easily separated from the effects of the excluded
perils, then the claim is payable to the extent of the damage caused by the insured peril.

Unbroken Sequence: Where several events occur in unbroken sequence and no excepted peril is
involved, the claim is payable. If an excepted peril precedes the happening of an insured peril, and the
insured peril can be said to be a reasonable consequences of the excepted peril no claim is payable.
For example, suppose a warehouse is insured against fire, but war and associated perils are excluded.
If the warehouse is destroyed due to fire caused by an incendiary bomb dropped by an enemy aircraft,
then no claim is payable, because the proximate cause – war – is an excluded peril.

Broken Sequence: If a new and independent cause arises, so that it breaks a chain of sequences,
the claim would be payable if the new cause is an insured peril. If the new cause is an excepted peril,
the claim would be payable only to the extent of the damage caused by the insured peril. For example,
the building damage caused by the fire and earthquake, the example showed earlier.

Burden of Proof:

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Insurance Principles Wealth Management Compilation: Krupesh Thakkar

In the event of loss, the burden of the proof is on the insured. He has to prove that the proximate cause of
loss was an insured peril.

If the insurance company argues that the loss was caused by an excepted peril, the onus of proof shifts to
them.

The doctrine is also modified by express policy conditions especially in fire and accident polices. The
condition is usually worded in such a manner that the loss caused proximately or remotely, directly or
indirectly, by an excluded peril is outside the scope of the policy.

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Insurance Principles Wealth Management Compilation: Krupesh Thakkar

THE INSURANCE CONTRACT

1. Essential Requirements of an Insurance Contract:

Insurance policies are based on the law of contracts. Each insurance contract must meet the following
essential requirements:
• Offer and acceptance;
• Consideration
• Competent parties
• Common intentions
• Legality of purpose

Offer and Acceptance:

As with all the legal contracts, in insurance contracts, there must be an offer and acceptance of its terms.
It should be remembered that in insurance contracts, the person seeking insurance makes the offer.
Therefore, he is also referred as the “proposer”. It is the insurance company or the insurer which accepts
or declines the offer.

Consideration:
It is the value that each party to the contract provides to the other. Without consideration there cannot be
any contract. In case of insurance contracts, the consideration for the insured is thee premium payments
and the agreement to abide by the terms of policy. For insurer, the consideration is the promise to make
payment of the sum insured on occurrence of specified event.

Competent Parties:
Each party to the insurance contract must be legally competent to enter into a contract. For the insured,
this means that the proposer should be an adult of sound mind. For the insurer, this means that the insurer
must have a valid license to do insurance business.

Common Intentions:
Parties to a contract are said to have a common intentions when they understand the same thing in the
same manner at the same time.

Legality of Purpose:
The purpose of the insurance contract should be legal. A terrorist cannot insure his weapons against theft
because the object of the contract is not legal and is contrary to the greater public interest.

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Insurance Principles Wealth Management Compilation: Krupesh Thakkar

2. Distinct Characteristics of an Insurance Contract:

• Aleatory contracts
• Unilateral Contracts
• Conditional Contracts
• Personal Contracts
• Contracts for adhesion

Aleatory Contracts:
There are where the value exchanged is not equal but depends on an uncertain event. Depending on
the occurrence of a chance event, one party to the contract may receive a value out of proportion to
the value that is given. For example in case of a motor vehicle insurance contract, an individual may
pay Rs. 5,000 as premium but collect Rs. 500,000 if the car is stolen or destroyed during the insurance
period. Similarly, there may be cases where the insured pays the premium but gets absolutely nothing
in return if no event causing any loss occurs.

Unilateral Contract:
Contract in which only one party makes a legally enforceable promise. In the case of insurance
contracts, only the insurer makes that promise. If the insured does not pay further premiums after the
payment of the first premium, he cannot be legally forced to pay the balance premiums. The insurer
can withhold payment of claims, if premium are not paid but cannot force the insured to pay the
premiums.
On the other hand, if the insured pays the premium, the insurer is under obligation to provide the
insurance promised under the contract. In general contracts, if one party fails to perform, the other party
can insist on performance or sue for damages because of breach of contract.

Conditional Contracts:
These are type of contracts which place certain restrictions or limitations on one or both parties. In
insurance contracts, the insured must comply with policy conditions, if he wants to collect payment for
his claims. In case of noncompliance of the policy conditions, the insurer can refuse the payment.

Personal Contracts:
An insurance contract is a personal contract. This means that the policy is personal to the insured. With
the exception of life insurance, it may not be assigned to anyone else without the approval of the insurer.

Contracts of Adhesion:
These are contracts that must be accepted in toto, with all their terms and conditions. In insurance
contracts, this means that the insured must accept the policy issued by the insurer as it is. The insured
cannot insist on any charges or modifications to the contract.

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