CHAPTER 4

THE CONCEPT OF
INSURANCE

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Learning Outcomes
Explain the fundamentals of insurance.
Identify the attributes of insurable risks.
Explain the legal concepts in insurance.

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 1.0 Fundamentals of Insurance
Definition of insurance
The undertaking of risks by an insurance company (insurer)
who agree to indemnify the insured (the risk transferor) for
specified losses upon their occurrence, subject to the
payment of insurance premiums by the insured.
The owner of an insurance policy - policyholder
Subject matter (person) that is to be protected under the
insurance - the insured.

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 1.0 Fundamentals of Insurance
Basic features of
insurance

Payment of Indemnification
Pooling losses Transfer of risks
furtuitous losses of losses

Fig. 1: Basic features of Insurance

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Basic features of insurance

(i) Pooling losses

• Pooling risks: insurance companies combine the
expected losses of a group of people so that the risk is
spread out and the average losses will be close to the
actual loss.
• By pooling losses, insurers reduce the probability of
an occurrence of a large loss.
(ii) Transfer or risk
• Risk transfer: transferring an insurable risk from the
insured to the insurer via an insurance policy
contract.

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 Basic features of insurance

(iii) Payment of forfuitous losses

• Forfuituos loss: loss that occurs by accident or by
chance, a loss that occurs unintentionally and
unexpectedly.
• E.g.: fire that is caused by a leakage in a gas pipe would
result in forfuitous loss.

(iv) Indemnification of losses

• The insured is compensated by the insurer by an
amount that reinstates his position to the original
situation prior to the incidence of loss.
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Types of insurance

1. Life insurance
• A type of insurance that pays out a certain amount of
compensation to the beneficiary(ies) in the occurrence of
death of the insured.
• The main objective : to create a fund that would be
available to the next of kin (or beneficiary) in the event the
insured passes away.

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 Types of insurance

2. General insurance
• All other insurance that do not fall under the category of life
insurance
• E.g.: motor insurance, fire insurance, houseowners and
householders insurance, medical and health insurance,
personal accident insurance, travel insurance.

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Types of insurance
Life insurance General insurance
Annuity Fire / Houseowners / Householders
Endowment Marine
Investment-Linked Medical and Health
Medical and Health Motor
Term Personal Accident
Whole life Travel
Worker’s Compensation

Table 1: Typical products under life insurance and general insurance

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2.0 Attributes of an Ideal Insurable Risk

Pure risk
Large
Legal subject
number of
matter
exposure

Appropriate
Attributes
Fortuitous
level of
premium
of Insurable loss

Risks
Calculable Definite and
probability of measurable
loss loss
No
Catastrophic
losses

Fig. 2: Attributes of Insurable Risks

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2.0 Attributes of an Ideal Insurable Risk
Pure risks
 Only a chance of loss or no loss.
 No chance of making gains or profits from pure risk
 Speculative risks are not insurable : possibility of loss, no
loss, and also a possibility of gain.

Large number of exposure

Reason: there is a pool sufficiently large to reduce the risk
borne by the insurer and so that the insurer would be able to
predict losses more accurately.

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2.0 Attributes of an Ideal Insurable Risk

Fortuitous Losses
Occurs by random chance, unintentional and unexpected.

Definite and measurable loss

E.g.:
1. Particulars of a car accident, such as its time, place and
cause must be established with certainty.
2. The loss must also be measurable in specific dollar
amounts

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 2.0 Attributes of an Ideal Insurable Risk

Calculable probability of loss

Insurers must be able to compute the probability of loss with
some degree of accuracy.

Appropriate level of premium

 The premiums that are charged by the insurer must be
appropriate relative to its potential loss.
 For perils that have high probability of occurring, the insurer
would usually charge a high premium due to its high risk.

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2.0 Attributes of an Ideal Insurable Risk

Legal subject matter

 Must not be against society’s interest and must be legal in
nature.
 E.g.: the contents of a container that carries illegal
weapons or drugs would not be insurable

No Catastrophic losses

Catastrophic losses: losses with high severity such as those
resulting from critical natural disasters are usually not
covered by insurers because they involve huge amounts of
losses on a large number of exposure units simultaneously.

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4.0 Legal principles of insurance
Principle of
Indemnity

Principle of Principle of
Proximate utmost good
Cause faith

Legal
Principles of
insurance
Principle of Principle of
Contribution Subrogation

Principle of
Insurable
Interest

Fig. 3: Legal Principles of Insurance

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 4.0 Legal principles of insurance

i. Principle of Indemnity
An insured will be compensated by an amount that reinstates his
or her financial position to one that existed prior to the
occurrence of loss.
Applies for general insurance policies:
motor vehicle, house owner’s and property insurance
The insurer will compensate the insured for the actual loss
suffered, provided that the amount in the insurance policy is
sufficient .
Does not apply on personal accidents, disability and death
coverage.

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4.0 Legal principles of insurance

ii. Principle of Utmost good Faith

Both parties to the insurance contract (i.e. the insurer and the
insured) bind into the contract in absolute good faith, belief and
trust.
The insured, especially, has to disclose all material facts about
the risk completely and accurately since he knows more about
the risk, compared to the insurer.
Any non-disclosure or misrepresentation of facts would breach
the principle of utmost good faith and render the insurance
contract void.

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4.0 Legal principles of insurance

iii. Principle of Subrogation

The transfer of rights from the insured to the insurer to take actions
against a third party that caused loss to the insured.
This is to allow the insurer to recover loss from the third party’s insurer
Is usually applicable in general insurance or contracts of indemnity (car,
property an medical insurance)

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4.0 Legal principles of insurance

iv. Principle of Insurable Interest

To have insurable interest is to have economic relevance
and/or financial dependence on the subject matter being
insured.
The absence of insurable interest could lead to malicious
intents and would deem the purchase of insurance
unenforceable.
A person must have insurable interest on the subject matter
to allow any purchase of insurance on a subject matter.

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4.0 Legal principles of insurance

v. Principle of Contribution
A person has taken up more than one insurance policy to cover
the same loss.
When the policyholder files a claim from one insurer, that insurer
has the right to call upon other insurers that are also liable to
share the cost of an indemnity.
Usually applies to general insurance.

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4.0 Legal principles of insurance

vi. Principle of Proximate Cause

In the event a loss is caused by more than one peril, the nearest
and most dominant (i.e. most proximate and direct) cause
should be taken into consideration in determining the liability of
the insurer.
The insured is responsible to prove the cause of the loss.

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