CHAPTER 2
PRINCIPLES OF INSURANCE
Chapter Introduction
In this chapter, we shall learn about the basic principles that govern the working of insurance. The chapter is divided into two sections. The first section deals with the elements of insurance and the second section deals with the special features of an insurance contract.
Learning Outcomes
A. Elements of insurance
B. Insurance contract – legal aspects
C. Insurance contract – special features
After studying this chapter, you should be able to:
1. Define the various elements of insurance
2. Define the features of an insurance contract
3. Identify the special features of an insurance contract
A. Elements of insurance
We have seen that the process of insurance has four elements
Asset
Risk
Risk pooling
Insurance contract
Let us now look at the various elements of the insurance process in some detail.
1. Asset
Definition
An asset may be defined as „anything that confers some benefit and has an economic value to its owner‟.
An asset must have the following features:
a) Economic value
An asset must have economic value. Value can arise in two ways.
a) Income generation: Asset may be productive and generate income.
Example
A machine used to manufacture biscuits, or a cow that yields milk, both generate income for their owner. A healthy worker is an asset to an organisation.
b) Serving needs: An asset could also add value by satisfying one or a group of needs.
Example
A refrigerator cools and preserves food while a car provides comfort and convenience in transportation, similarly a body free of illness adds value to oneself and family also.
b) Scarcity and ownership
What about air and sunlight? Are they not assets?
The answer is „No‟.
Indeed, few things are as valuable as air and sunlight. We cannot live without them. Yet they are not considered as assets in the economic sense of the term.
There are two reasons for this:
Their supply is abundant and not scarce.
They are not owned by any one individual but are freely available to all.
This implies that an asset must satisfy two more conditions to qualify as such - its scarcity and its ownership or possession by someone.
c) Insurance of assets
In insurance we are interested in economic losses that arise from unexpected and fortuitous events, not losses arising as a result of natural wear and tear. Insurance provides protection only against financial losses arising from unexpected events and not natural wear and tear, of assets due to usage over time.
We must note that insurance cannot protect an asset from loss or damage. An earthquake will destroy a house whether it is insured or not. The insurer can only pay a sum of money, which would reduce the economic impact of the loss.
Losses can arise in the event of breach of an agreement.
Example
An exporter would lose a great deal if the importer on the other side refused to accept the goods or defaulted on payments.
d) Life insurance
What about our lives?
There is indeed nothing as valuable to us as our own lives and those of our loved ones. Our lives can be seriously affected when subjected to an accident or an illness.
This can impact in two ways:
Firstly there are costs of treatment of a particular disease.
Secondly there may be loss of economic earnings, both due to death or disability.
These kinds of losses are covered by insurances of the person or personal lines of insurance.
Insurance is possible for anyone who has assets that have value [i.e. which generate income or meet some needs]; the loss of which [due to fortuitous or accidental events] cause financial loss that can be [measured in terms of money].
Thus these assets are commonly referred to as subject matter of insurance in insurance parlance.
2. Risk
The second element in the process of insurance is the concept of risk. We shall define risk as the chance of a loss. Risk thus refers to the likely loss or damage that can arise on account of happening of an event. We do not usually expect our house to burn down or our car to have an accident. Yet it can happen.
Examples of risks are the possibility of economic loss arising from the burning of a house or a burglary or an accident which results in the loss of a limb.
This has two implications.
i. Firstly, it means that that the loss may or may not happen. The chance or likelihood of loss can be expressed mathematically.
Example
One in a thousand chances that a house will catch fire = 1/1000 = 0.001.
Three in a thousand chances that Ram will have a heart attack = 3/1000 = 0.003
Risk always implies a probability. Its value always lies between 0 and 1, where 0 represents certainty that a loss will not happen while 1 represents certainty that it will happen.
ii. Secondly, the event, whose occurrence actually leads to the loss, is known as a peril. It is the cause of the loss.
Example
Examples of perils are fire, earthquakes, floods, lightning, burglary, heart attack etc.
What about natural wear and tear?
It is true that nothing lasts forever. Every asset has a finite lifetime during which it is functional and yields benefits.
At some future date its value becomes nil. This is a natural process and we discard or change our mobiles, our washing machines and our clothes when they are worn out. Therefore losses arising out of normal wear and tear are not covered in insurance.
i. Exposure to risk: Occurrence of a peril need not necessarily lead to a loss. A person staying in Mumbai does not suffer any loss due to a flood in coastal Andhra. For loss to happen the asset must be exposed to the peril.
Example
In giving protection against a car accident, an insurer would be interested in a population of cars that are „exposed to the peril called accident‟ during a certain year. A car regularly used for racing purposes cannot be part of this population. It must form part of a separate group of „racing cars‟ whose chances of accident are higher than ordinary cars.
Exposure to risk alone is not enough ground for insurance compensation.
Example
A fire may break out in factory premises without causing actual damage.
Insurance comes into play only if there is an actual economic (financial) loss as a result of a peril.
ii. Degree of risk exposure: Two assets may be exposed to the same peril but the likelihood of loss or the amount of loss may vary greatly.
Example
A vehicle carrying explosives can yield far greater loss from fire than tanker carrying water.
Similarly, the probability of a person having a respiratory problem is high in a polluted city or the individual engaged in horse racing has a higher risk of accidental injury than one who sits in a shop.
Insurers are mainly concerned with the degree of risk exposure. When it is very high we say that it is a bad risk.
Basis of risk classification
a) Extent of damage likely to be suffered
This is given by the degree of loss and its impact on an individual or business. On this basis one may identify three types of risk events or situations:
i. Critical or Catastrophic
Where losses are of such a magnitude; that may result in total loss or bankruptcy.
Example
An earthquake that completely destroys a village
A major fire that completely destroys a multi crore installation
A situation like the terrorist attack of 9/11 on World Trade Centre which caused injuries to many people
ii. Major
In which the possible losses may result in serious financial losses, compelling the firm to borrow in order to continue operations.
Example
A fire in the plant of a large multinational company at Gurgaon destroys inventory worth Rs 1 crore. The loss is heavy but not so high as to lead to bankruptcy.
A major kidney transplant operation whose cost is prohibitive.
iii. Marginal/Insignificant
Where the possible losses are insignificant and can be easily met from an individual or a firm‟s existing assets or current income without imposing any undue financial train.
Example
A minor car accident results in the side being slightly grazed due to which some of the paint is damaged and a fender is slightly bent.
An individual suffering from common cold and cough
b) Nature of risk environment
Another basis for classifying risks is by the nature of the environment.
i. Static risks
Static risks refer to events taking place within a stable environment. They have a regular pattern of occurrence over time and can be reasonably predicted. They are thus easier to insure. Typically such risks are caused by natural events.
Examples are fire, earthquake, death, accident and sickness.
ii. Dynamic risks
Typically refer to perils that affect the social environment and result from economic and social factors. They are called dynamic because they don‟t necessarily have a regular pattern of occurrence and cannot be predicted like static risks. Again these risks often have vast national and social consequences and may affect a large section of people.
Examples are unemployment, inflation, war and political upheavals. Insurance companies in general do not insure dynamic risks.
c) Who is affected?
A third way of classifying risks may be provided by considering who is affected by a particular peril or loss event.
i. Fundamental risks: affect large populations. Their impact is widespread and tends to be catastrophic.
Examples of fundamental or systemic risks are wars, droughts, floods and earthquakes and terrorist attacks.
ii. Particular risks: affect only specific individuals and not an entire community or group. In this case the loss is borne only by particular individuals and not the entire community or group.
Examples of particular risks are burning of a house or an automobile accident or hospitalisation following an accident.
Commercial insurance is available to cover both fundamental and particular risk.
d) Result / Consequence / Outcome
i. Speculative risk describes a situation in which the consequence can be either a profit or a loss. Typical examples of taking such risk are gambling on horses or stock market speculation. One assumes such risk deliberately in the hope of a gain.
ii. Pure risk on the other hand involves situations in which the outcomes can result only in loss or no loss, but never in gain.
For example, a flood or a fire either occurs or does not occur. If it happens there is a loss. If it does not happen there is neither loss nor gain. Similarly, a person may or may not fall seriously ill.
Insurance only applies in case of pure risks, where it protects against loss that may arise. Speculative risks cannot be insured.
Examples of pure risk:
Chemical – Fire, Explosion
Natural – Earthquake, Flood, Cyclone
Social – Riots, Fraud, Thefts
Technical – Machinery Breakdown
Personal – Death, Disability, Sickness
Hazard
We have seen above that mere exposure to a peril need not cause a loss. Again, a loss need not be severe. The condition or conditions which increase the probability of a loss or its severity, and thus impact(s) the risk is known as hazard. When insurers make an assessment of the risk, it is generally with reference to the hazards to which the asset is subject.
Let us now give some examples of the link between assets, peril and hazards
| Asset | Peril | Hazard |
| Life | Cancer | Excessive Smoking |
| Factory | Fire | Explosive material left Unattended |
| Car | Car Accident | Careless driving by driver |
| Cargo | Storm | Water seeping in cargo and spoiling; Cargo not packaged in waterproof containers |
Important
Types of hazards
a) Physical hazard is a physical condition that increases the chance of loss.
Example
i. Defective wiring in a building
ii. Indulging in water sports
iii. Leading a sedentary lifestyle
b) Moral hazard refers to dishonesty or character defects in an individual that influence the frequency or severity of the loss. A dishonest individual may attempt to commit fraud and make money by misusing the facility of insurance.
Example
A classic instance of moral hazard is purchasing insurance for a factory and then burning it down to collect the insurance amount or buying health insurance after onset of a major ailment.
c) Legal hazard is more prevalent in cases involving a liability to pay for damages. It arises when certain features of the legal system or regulatory environment can increase the incidence or severity of losses.
Example
The enactment of law governing workmen‟s compensation in the case of accidents can raise the amount of liability payable considerably.
A major concern in insurance is the relationship between risks and associated hazards. Assets are classified into various risk categories on this basis and the price charged for insurance coverage [known as the premiums] would increase if the susceptibility to loss, arising as a result of the presence of associated hazards, is high.
3. Mathematical principle of insurance (Risk pooling)
The third element in insurance is a mathematical principle that makes insurance possible. It is known as the principle of risk pooling.
Example
Suppose there are 100000 houses exposed to the risk of fire that can cause an average loss of Rs 50000. If the chance of a house catching fire is 2 in 1000 [or
0.002] it would mean that the total amount of loss suffered would be Rs
10000000 [=50000 x 0.002 x 100000].
If an insurer were to get the owners of each of the hundred thousand houses to contribute Rs 100 and if these contributions were to be pooled into a single fund, it would be enough to pay for the loss of the unfortunate few who suffered from the fire.
The required amount of individual contribution is evident from the calculation below
100000 x 100 = Rs 10000000
To ensure that there is equity [fairness] among all those being insured, it is necessary that the houses should all be similarly exposed to the risk.
a) How exactly does the principle work in insurance?
Example
Mr. Shyam, who has a factory, with plant, machinery and inventory worth Rs 70 lakhs, wants to insure them with an insurer. The chance that there would be loss or damage to the factory and its contents from fire or other insured perils is 7 out of 1000 [0.007]. Both Mr. Shyam and the insurer are aware about this.
How are their positions different and why does Shyam want to insure?
Mr. Shyam‟s position
The probability of loss (0.007) is of little use to Mr. Shyam since it only suggests that on average about 7 out of 1000 factories like his, would be impacted by the loss. He does know whether his factory would be one among the unfortunate seven? In fact nobody can predict if the particular factory would suffer a loss.
Shyam may be said to be in a state of uncertainty. Not only does he not know the future, he cannot even predict what it will be. It is obviously a cause for anxiety.
Insurer‟s position
Let us now look at the insurer‟s position. When Shyam‟s risk of loss is combined and pooled with that of thousands of others, who are exposed to similar situation, it now becomes finite and predictable.
The insurer need not worry about Shyam‟s factory as much as the latter does. It is enough that only seven out of thousand factories be subjected to the loss. So long as the actual losses are same or nearly same as the expected, the insurer can meet them by drawing money from the pool of funds.
It is by pooling number of risks of all the insured similarly placed and exposed to possibility of loss due to a peril that the insurer is able to assume that risk and its financial impact.
b) Risk pooling and the law of large numbers
The probability of damage [derived as 7 out of 1000 or 0.007 in the example above] forms the basis on which the premium is determined. The insurer would face no risk of loss if the actual experience was as expected. In such a situation the premiums of the numerous insured would be sufficient to completely compensate for the losses of those who have been affected by the peril. The insurer would however face a risk if the actual experience was more adverse than expected and the premiums collected were not sufficient to pay the claims.
How can the insurer be sure about its predictions?
This becomes possible because of a principle known as the “Law of large numbers”. It states that the larger the size of the pool of risks, the actual average of losses would be closer to the estimated or expected average loss.
Example
To give a simple illustration, the probability of getting heads on a toss of the coin is ½. But how sure can you be that you will actually get 2 heads if you toss the coin four times?
Only when the number of tosses gets very large and closer to infinity, the chance of getting heads once for every two tosses will become closer to one.
It follows that insurers can be sure of their ground only when they have been able to insure a large number of insured. An insurer who has insured only a few hundred houses, likely would be worse affected than one who has insured several thousand houses.
Important
Conditions for insuring a risk
When does it make sense to insure a risk from the insurer‟s point of view?
Six broad requirements for a risk to be considered insurable are given in the box below.
i. A sufficiently large number of homogenous [similar] exposure units to make the losses reasonably predictable. This follows from the law of large numbers. Without this it would be difficult to make predictions.
ii. Loss produced by the risk must be definite and measurable. It is difficult to decide the compensation if one cannot say for sure that a loss has occurred and how much it is.
iii. Loss must be fortuitous or accidental. It must be the result of an event that may or may not happen. The event must be beyond the control of insured. No insurer would cover a loss that is intentionally caused by the insured.
iv. Sharing of losses of the few by many can work only if a small percentage of the insured group suffers loss at any given period of time.
v. Economic feasibility: The cost of insurance must not be high in relation to the possible loss; otherwise the insurance would be economically unviable.
vi. Public policy: Finally the contract should not be contrary to public policy and morality.
4. The insurance contract
The fourth element of insurance is that it involves a contractual agreement in which the insurer agrees to provide financial protection against specified risks for a price or consideration known as the premium. The contractual agreement takes the form of an insurance policy.
Test Yourself 1
Which one of the following does not represent an insurable risk?
I. Fire
II. Stolen goods
III. Burglary
IV. Loss of goods due to ship capsizing
B. Insurance contract – legal aspects
1. Legal aspects of an insurance contract
We will now look at some features involved in an insurance contract and then consider legal principles that govern insurance contracts in general.
We have already seen that one of the elements of insurance is that it involves a contract between insurer and insured.
A contract is an agreement between parties, enforceable at law. The provisions of the Indian Contract Act, 1872 govern all contracts in India, including insurance contracts.
2. Elements of a valid contract
The elements of a valid contract are:
a) Offer and acceptance:
Usually, the offer is made by the proposer, and acceptance is made by the insurer.
b) Consideration
This means that the contract must involve some mutual benefit to the parties. The premium is the consideration from the insured, and the promise to indemnify, is the consideration from the insurers.
c) Agreement between the parties
Both the parties should agree to the same thing in the same sense.
d) Capacity of the parties
Both the parties to the contract must be legally competent to enter into the contract. For example, minors cannot enter into insurance contracts.
e) Legality
The object of the contract must be legal, for example, no insurance can be had for smuggled goods.
Important
i. Coercion
Involves pressure applied through criminal means.
ii. Undue influence
When a person, who is able to dominate another, uses her position, influence or power to obtain undue advantage.
iii. Fraud
When a person induces another to act on a false belief that is caused by a representation he or she does not believe to be true. It can arise either from deliberate concealment of facts or through misrepresenting them.
iv. Mistake
Error in judgement or interpretation of an event. This can lead to an error in understanding and agreement about the subject matter of contract.
Test Yourself 2
Which among the following cannot be an element in a valid insurance contract?
I. Offer and acceptance
II. Coercion
III. Consideration
IV. Legality
C. Insurance contract – special features
Let us look at the special features of an insurance contract.
1. Indemnity
The principle of indemnity is applicable to Non-life insurance policies. It means that the policyholder, who suffers a loss, is compensated so as to put him or her in the same financial position as he or she was before the occurrence of the loss event. The insurance contract (evidenced through insurance policy) guarantees that the insured would be indemnified or compensated up to the amount of loss and no more.
The philosophy is that one should not make a profit through insuring one‟s assets and recovering more than the loss. The insurer would assess the economic value of the loss suffered and compensate accordingly.
Example
Ram has insured his house, worth Rs. 10 lakhs, for the full amount. He suffers loss on account of fire estimated at Rs. 70000. The insurance company would pay him an amount of Rs. 70000. The insured can claim no further amount.
Consider a situation now where the property has not been insured for its full value. One would then be entitled to indemnity for loss only in the same proportion as one‟s insurance.
Suppose the house, worth Rs. 10 lakhs has only been insured for a sum of Rs. 5 lakhs. If the loss on account of fire is Rs. 60000, one cannot claim this entire amount. It is deemed that the house owner has insured only to the tune of half its value and he is thus entitled to claim just 50% [Rs. 30000] of the amount of loss. This is also known as underinsurance.
The measurement of indemnity to be paid would depend on the type of insurance one takes.
In most types of non-life insurance policies, which deal with insurance of property and liability, the insured is compensated to the extent of actual amount of loss i.e. the amount of money needed to replace lost or damaged property at current market prices less depreciation.
Indemnity might take one or more of the following modes of settlement:
Cash payment
Repair of a damaged item
Replacement of the lost or damaged item
Restoration, (Reinstatement) for example, rebuilding a house destroyed by fire
Diagram 1: Indemnity
But, there is some subject matter whose value cannot be easily estimated or ascertained at the time of loss. For instance, it may be difficult to put a price in the case of family heirlooms or rare artefacts. Similarly in marine insurance policies it may be difficult to estimate the extent of loss suffered in a ship accident half way around the world.
In such instances, a principle known as the Agreed Value is adopted. The insurer and insured agree on the value of the property to be insured, at the beginning of the insurance contract. In the event of total loss, the insurer agrees to pay the agreed amount of the policy. This type of policy is known as “Agreed Value Policy”.
a) Subrogation
Subrogation follows from the principle of indemnity.
Subrogation means the transfer of all rights and remedies, with respect to the subject matter of insurance, from the insured to the insurer.
It means that if the insured has suffered from loss of property caused due to negligence of a third party and has been paid indemnity by the insurer for that loss, the right to collect damages from the negligent party would lie with the insurer. Note that the amount of damage that can be collected is only to the extent of amount paid by the insurance company.
Important
Subrogation: It is the process an insurance company uses to recover claim amounts paid to a policy holder from a negligent third party.
Subrogation can also be defined as surrender of rights by the insured to an insurance company that has paid a claim against the third party.
Example
Mr. Kishore‟s household goods were being carried in Sylvain Transport service. They got damaged due to driver‟s negligence, to the extent of Rs 45000 and the insurer paid an amount of Rs 30000 to Mr. Kishore. The insurer stands subrogated to the extent of only Rs 30000 and can collect that amount from Sylvain Transports.
Suppose, the claim amount is for Rs 45,000/, insured is indemnified by the insurer for Rs 40,000, and the insurer is able to recover under subrogation Rs
45,000/ from Sylvain Transports, then the balance amount of Rs 5000 will have to be given to the insured.
This prevents the insured from collecting twice for the loss - once from the insurance company and then again from the third party. Subrogation arises only in case of contracts of indemnity.
Example
Mr. Suresh dies in an air crash. His family is entitled to collect the full sum assured of Rs 50 lakhs from the life insurer plus the compensation paid by the airline, say, Rs 15 lakhs.
b) Contribution
This principle is applicable to only non-life Insurance. Contribution follows from the principle of indemnity, which implies that one cannot gain more from insurance than one has lost through the peril
Definition
The principle of “Contribution” implies that if the same property is insured with more than one insurance company, the compensation paid by all the insurers together cannot exceed the actual loss suffered.
If insured were to collect insurance money for the full value from all the insurers, insured would make a profit from the loss. This would violate the principle of indemnity.
Example
Scenario 1
Mr. Srinivas takes out a fire policy on his house valued at Rs. 24 lakhs with two insurance companies. He insures it for Rs.12 lakhs with each company. When the house is partially damaged in a fire, the loss is estimated at Rs. 6 lakhs. He claims Rs. 6 lakhs each from the two insurers. The two insurers decline to give him Rs. 6 lakhs each.
They take the position that since each of them are deemed to have shared in the insurance to the extent of 50%, each would pay 50% of the loss, viz., Rs.3 lakhs each, thus ensuring that the insured gets no more than the value of the actual loss.
Scenario 2
Rishi has taken two Mediclaim policies for self, Rs 2, 50,000 from X company and for Rs 1, 50,000 from Y company. Rishi has incurred an expense of Rs 1,
60,000 on hospitalisation following an ailment. This compensation of Rs 1,
60,000 will be shared and paid by both the companies on rateable proportion basis. The share of each company will be
X company: 1, 60,000 x2, 50000/ (2, 50, 000 + 1, 50, 000) = RS 1, 00.000
Y company: 1, 60,000 x 250,000/ (2, 50, 000 + 1, 50, 000) = Rs 60, 000
2. Uberrima Fides or Utmost Good Faith
There is a difference between good faith and utmost good faith.
a) Good faith
All commercial contracts in general require that good faith shall be observed in their transaction and there shall be no fraud or deceit. Apart from this legal duty to observe good faith, the seller is not bound to disclose any information about the subject matter of the contract to the buyer.
The rule observed here is that of “Caveat Emptor” which means buyer beware.
The parties to the contract are expected to examine the subject matter of the contract and so long as one party does not mislead the other and the answers are given truthfully, there is no question of the other party avoiding the contract
Example
Mr. Chandrasekhar goes to a TV showroom and is obsessed by a fanciful brand of TV with many features. The sales person knows from experience that the particular brand is not very reliable and has in the past given rise to problems for other customers. He does not reveal this for fear that it might jeopardize the sale.
Can he be charged of deceit?
Would the situation have been different if the sales man had been asked about the reliability of the brand and had replied that it was very reliable?
b) Utmost good faith
Insurance contracts stand on a different footing. The proposer has a legal duty to disclose all material information about the subject matter of insurance to the insurers who do not have this information.
Material information is that information which enables the insurers to decide:
Whether they will accept the risk
If so, at what rate of premium and subject to what terms and conditions
This legal duty of utmost good faith arises under common law. The duty applies not only to material facts which the proposer knows, but also extends to material facts which he ought to know.
Insurance contracts are subject to a higher obligation. When it comes to insurance, good faith contracts become utmost good faith contracts. The concept of "Uberrima fides" is defined as involving “a positive duty to voluntarily disclose, accurately and fully all facts material to the risk being proposed, whether requested or not."
What is meant by complete disclosure?
The law imposes an obligation to disclose all material facts.
Example
i. Misleading of facts by the insured
An executive is suffering from Hypertension and has had a mild heart attack recently, following which he decides to take a medical policy but does not reveal his true condition. The insurer is thus duped into accepting the proposal due to misrepresentation of facts by insured.
ii. Misleading of facts by the insurer
An individual has a congenital hole in the heart and reveals the same in the proposal form. The same is accepted by the insurer and proposer is not informed that pre-existing diseases are not covered for at least 4 years.
c) Material fact
Material fact has been defined as a fact that would affect the judgment of an insurance underwriter in deciding whether to accept the risk and if so, the rate of premium and the terms and conditions.
Whether an undisclosed fact was material or not would depend on the circumstances of the individual case and could be decided ultimately only in a court of law. The insured has to disclose facts that affect the risk.
Let us take a look at some of the types of material facts in insurance that one needs to disclose:
i. Facts indicating that the particular risk represents a greater exposure than normal. Examples are hazardous nature of cargo being carried at sea; past history of illness
ii. Existence of past policies taken from all insurers and their present status
iii. All questions in the proposal form or application for insurance are considered to be material, as these relate to various aspects of the subject matter of insurance and its exposure to risk. They need to be answered truthfully and be full in all respects
The following are some examples of material facts:
Example
i. Fire Insurance
Construction of the building
Occupancy (e.g. office, residence, shop, warehouse, manufacturing unit, etc.)
The nature of goods stored/manufactured, i.e., non-hazardous, hazardous, extra-hazardous etc.
ii. Marine Insurance
Method of packing i.e., whether in single gunny bags or double gunny bags, whether in new drums or second hand drums; etc.
The nature of goods (e.g. whether the machinery is new or second hand)
iii. Motor Insurance
Cubic capacity of engine (private car)
The year of manufacture
Carrying capacity of a truck (tonnage)
The purpose for which the vehicle is used
The geographical area in which it is used
iv. Personal Accident Insurance
The exact nature of occupation
Age
Height and weight
Physical disabilities etc.
v. Health Insurance
Any operations undergone
If suffering from Diabetes or Hypertension
vi. General Insurance
The fact that previous insurers had rejected the proposal or charged extra premium, or cancelled, or refused to renew the policy
Previous losses suffered by the proposer
Important
Facts that need not be disclosed [unless asked for by insurer]
It is also held that unless there is a specific enquiry by underwriters, the proposer has no obligation to disclose the following facts:
i. Measures implemented to reduce the risk
Example: The presence of a fire extinguisher.
ii. Facts unknown to the insured
Example: An individual, who suffers from high blood pressure but was unaware of it at the time of taking the policy, cannot be charged with non-disclosure of this fact.
iii. Facts which could be discovered, by reasonable diligence It is not necessary to disclose every minute material fact. The underwriters must be conscious enough to ask for the same if they require further information
iv. Matters of law: Everybody is supposed to know the law of the land.
Example: Municipal laws about storing of explosives
v. About which insurer appears to be indifferent [or has waived the need for further information]. The insurer cannot later disclaim responsibility on grounds that the answers were incomplete.
vi. Facts possible for discovery: Like when a medical examiner on behalf of an insurer takes BP measurements in a medical examination before taking of the policy.
d) Duty of disclosure in non-life insurance
In non-life insurance, the contract will stipulate whether changes are required to be intimated or not. When an alteration is made to the original contract affecting the risk, the duty of disclosure will arise. The duty of disclosing material facts ceases when the contract is concluded by issue of a cover note or a policy. The duty arises again at the time of renewal of the policy, if during the period of the policy; there is any change in the risk.
Example
A house owner has insured the building and its contents.
He goes on a holiday for a week - no material change in the facts.
However if he builds another floor above and starts a beauty parlour, it will considerably alter the risk.
e) Breach of utmost good faith
Let us now consider situations which would involve a breach of utmost good faith. Such breach can arise either through non-disclosure or misrepresentation.
i. Non-Disclosure
Insured is silent in general about material facts because the insurer has not raised any specific enquiry
Through evasive answers to questions asked by the insurer
Disclosure may be inadvertent [made without one‟s knowledge or intention] or because the proposer thought that a fact was not material. In such case it is innocent. When a fact is intentionally not disclosed it is treated as concealment. In this case there is intent to deceive.
ii. Misrepresentation
A statement made during negotiation of a contract of insurance is called representation. This may be a definite statement of fact or a statement of belief, intention or expectation.
When it is a fact, it is expected to be substantially correct.
When it concerns matters of belief or expectation, it must be made in good faith.
Misrepresentation is of two kinds:
Innocent Misrepresentation relates to inaccurate statements, which are made without any fraudulent intention e.g. an individual who occasionally smokes and is not a habitual smoker may not reveal the same in the proposal form as he does not think it has any bearing on the risk.
Fraudulent Misrepresentation are false statements made with deliberate intent to deceive the insurer or are made recklessly without due regard for truth. E.g. a chain smoker may deliberately not reveal the fact that he smokes.
An insurance contract generally becomes void when there is concealment with intent to deceive, or when there is fraudulent non- disclosure or misrepresentation. In case of other breaches of utmost good faith, the contract may be rendered voidable.
For e.g., parent at the time of covering their child in the family floater policy may not be aware that their child has a congenital problem. There is no intent to deceive.
3. Insurable interest
The existence of „insurable interest‟ is an essential ingredient of every insurance contract and is considered as the legal pre-requisite for insurance. Let us see how insurance differs from a gambling or wager agreement.
a) Gambling and insurance
Consider a game of cards, where one either loses or wins. The loss or gain happens only because the person enters the bet. The person who plays the game has no further interest or relationship with the game other than that he might win the game.
Betting or, wagering is not legally enforceable in a court of law and thus any contract in pursuance of it will be held to be illegal. In case someone pledges his house if he happens to lose a game of cards, the other party cannot approach the court to ensure its fulfilment.
Now consider a house and the event of it burning down. The individual who insures his house has a legal relationship with the subject matter of insurance – the house. He owns it and is likely to suffer financially, if it is destroyed or damaged. This relationship of ownership exists independent of whether the fire happens or does not happen, and it is the relationship that leads to the loss. The event [fire or theft] will lead to a loss regardless of whether one takes insurance or not.
Unlike a card game, where one could win or lose, a fire can have only one consequence – loss to the owner of the house.
The owner takes insurance to ensure that the loss suffered is compensated for in some way.
The interest that the insured has in his house or his money is termed as insurable interest. The presence of insurable interest makes an insurance contract valid and enforceable under the law.
Important
Three essential elements of insurable interest:
1. There must be property, right, interest, life or potential liability capable of being insured.
2. Such property, right, interest, life or potential liability must be the subject matter of insurance.
3. The insured must bear a legal relationship to the subject matter such that he stands to benefit by the safety of the property, right, interest, life or
freedom of liability. By the same token, he must stand to lose financially by any loss, damage, injury or creation of liability.
Example
Scenario 1
Mr. Chandrasekhar owns a house for which he has taken a mortgage loan of Rs 15 lakhs from a bank.
Does he have an insurable interest in the house?
Does the bank have an insurable interest in the house? What about his neighbour?
Scenario 2
Mr Srinivasan has a family consisting of spouse, two kids and old parents. Does he have an insurable interest in their well being?
Does he stand to financially lose if any of them are hospitalised?
What about his neighbour‟s kids? Would he have an insurable interest in them?
It would be relevant here to make a distinction between the subject matter of insurance and the subject matter of an insurance contract.
Subject matter of insurance relates to property being insured against, which has an intrinsic value of its own.
Subject matter of an insurance contract on the other hand is the insured‟s financial interest in that property. It is only when the insured has such an interest in the property that he has the legal right to insure. The insurance policy in the strictest sense covers not the property per se, but the insured‟s financial interest in the property.
Example
Consider the house which Mr. Chandrasekhar has brought with a mortgage loan of Rs 15 lakhs from a bank. If he has repaid 12 lakhs of this amount, the bank‟s interest would be only to the tune of the balance three lakhs which is outstanding.
Thus the bank also has an insurable interest financially in the house for the balance amount of loan that is unpaid and would ensure that it is made a co insured in the policy.
If one deliberately sets a fire to one‟s property and collects claims against losses under the policy, such claims are clearly fraudulent and could be justifiably rejected.
b) Time when insurable interest should be present
In case of fire and accident and health and travel insurance, insurable interest should be present both at the time of taking the policy and at the time of loss.
In case of health and personal accident insurance apart from self, family can also be insured by the proposer since he / she stands to incur financial losses if the family meets with an accident or undergoes hospitalisation. However, in marine cargo insurance, insurable interest is required only at the time of loss.
4. Proximate cause
The last of the legal principles, which applies only to non-life insurance, is the principle of proximate cause.
Non-life Insurance contracts provide indemnity only if losses that occur are caused by insured perils, which are stated in the policy. Determining the actual cause of loss or damage is a fundamental step in the consideration of any claim.
Proximate cause is a key principle of insurance and is concerned with how the loss or damage actually occurred and whether it is indeed as a result of an insured peril.
Under this rule, insurer looks for the predominant cause which sets into motion the chain of events producing the loss, which may not necessarily be the last event that immediately preceded the loss i.e. it is an event which is closest to, or immediately responsible for causing the loss.
Unfortunately when a loss occurs there will often be a series of events leading up to the incident and so it is sometimes difficult to determine the nearest or proximate cause.
For example, a fire might cause a water pipe to burst. Despite the resultant loss being water damage, the fire would still be considered the proximate cause of the incident.
Definition
Proximate cause is defined as the active and efficient cause that sets in motion a chain of events which brings about a result, without the intervention of any force started and working actively from a new and independent source.
To understand the principle of proximate cause, consider the following situation:
Example
Scenario 1
Ajay‟s car was stolen. Two days later, the police found the car in a damaged condition. Investigation revealed that the thief had banged the car into a tree. Ajay filed a claim with insurance company for the damages to the car. To Ajay‟s surprise, the insurance company rejected the claim. The reason given by the insurance company was that „theft‟ was the reason for the damage to the car and theft was an excluded peril in the insurance policy that Ajay had taken for his car and hence insurance company is not liable to pay the claim.
Scenario 2
Mr. Pinto, while riding a horse, fell on the ground and had his leg broken, he was lying on the wet ground for a long time before he was taken to hospital. Because of lying on the wet ground, he had fever that developed into pneumonia, finally dying of this cause. Though pneumonia might seem to be the immediate cause, in fact it was the accidental fall that emerged as the proximate cause and the claim was admitted under personal accident insurance.
There are certain losses which are suffered by the insured as a result of fire but which cannot be said to be proximately caused by fire. In practice, some of these losses are customarily paid by business under fire insurance policies.
Example of such losses can be –
Damage to property caused by water used to extinguish fire
Damage to property caused by fire brigade in execution of their duty
Damage to property during its removal from a burning building to a safe place
Test Yourself 3
Mr. Pinto contracted pneumonia as a result of lying on wet ground after a horse riding accident. The pneumonia resulted in death of Mr. Pinto. What is the proximate cause of the death?
I. Pneumonia
II. Horse
III. Horse riding accident
IV. Bad luck
Summary
a) The process of insurance has four elements (asset, risk, risk pooling and an insurance contract).
b) An asset may be anything that confers some benefit and is of economic value to its owner.
c) A chance of loss represents risk.
d) Condition or conditions that increase the probability or severity of the loss are referred to as hazards.
e) The mathematical principle, that makes insurance possible is known as principle of risk pooling.
f) The elements of a valid contract include offer and acceptance, consideration, legality, capacity of the parties and the agreement between parties.
g) Indemnity ensures that the insured is compensated to the extent of his loss on the occurrence of the contingent event.
h) Subrogation means the transfer of all rights and remedies, with respect to the subject matter of insurance, from the insured to the insurer.
i) The principle of contribution implies that if the same property is insured with more than one insurance company, the compensation paid by all the insurers together cannot exceed the actual loss suffered.
j) All insurance contracts are based on the principle of Uberrima Fides.
k) The existence of „insurable interest‟ is an essential ingredient of every insurance contract and is considered as the legal pre-requisite for insurance.
l) Proximate cause is a key principle of insurance and is concerned with how the loss or damage actually occurred and whether it is indeed as a result of an insured peril.
Key terms
a) Asset
b) Risk
c) Hazard
d) Risk pooling
e) Offer and acceptance
f) Lawful consideration
g) Consensus ad idem
h) Uberrima fides
i) Material facts
j) Insurable interest
k) Subrogation
l) Contribution
m) Proximate cause
Answers to Test Yourself
Answer 1
The correct option is II.
Stolen goods violate the principle of legality and hence do not represent an insurable risk.
Answer 2
The correct option is II.
Coercion is not an element of a valid contract.
Answer 3
The correct option is III.
The horse riding accident set things in motion that eventually resulted in Mr
Pinto‟s death and hence it is the proximate cause.
Self-Examination Questions
Question 1
Moral hazard means:
I. Dishonesty or character defects in an individual
II. Honesty and values in an individual
III. Risk of religious beliefs
IV. Hazard of the property to be insured
Question 2
Risk indicates:
I. Fear of unknown
II. Chance of loss
III. Disturbances at public place
IV. Hazard
Question 3
____________
means spreading one‟s investment in different kinds of assets.
I. Pooling
II. Diversification
III. Gambling
IV. Dynamic risk
Question 4
____________ is not an example of an asset.
I. House
II. Sunlight
III. Plant and machinery
IV. Motor car
Question 5
____________ is not an example of risk.
I. Damage to car due to accident
II. Damage of cargo due to rain water
III. Damage to car tyre due to wear and tear
IV. Damage to property due to fire
Question 6
____________ Earthquake is an example of: I. Catastrophic risk
II. Dynamic risk
III. Marginal risk
IV. Speculative risk
Question 7
____________ Select the most appropriate logical equivalence for the statement. Statement: Insurance cannot protect an asset from loss or damage. I. True
II. False
III. Partially true
IV. Not necessarily true
Question 8
____________ means transfer of all rights and remedies, with respect to the subject matter of insurance, from insured to insurer.
I. Contribution II. Subrogation III. Legal hazard IV. Risk pooling
Question 9
An example of a fact which need not be disclosed unless asked for is ____________ by the insurer.
I. Age of the insured
II. Presence of fire extinguisher
III. Heart ailment
IV. Other insurance details
Question 10
____________ is a wrong statement made during negotiation of a contract.
I. Misrepresentation
II. Contribution
III. Offer
IV. Representation
Answers to Self-Examination Questions
Answer 1
The correct option is I.
Moral hazard means dishonesty or character defects in an individual.
Answer 2
The correct option is II.
„Risk‟ indicates a chance of loss.
Answer 3
The correct option is II.
Diversification means spreading one‟s investment in different kinds of assets.
Answer 4
The correct option is II.
Sunlight cannot be classified as asset as it fails the test of scarcity and ownership.
Answer 5
The correct option is III.
Damage as a result of wear and tear cannot be treated as risk.
Answer 6
The correct option is I.
Earthquake is an example of catastrophic risk.
Answer 7
The correct option is I.
Insurance cannot protect an asset from loss or damage.
Answer 8
The correct option is II.
Subrogation means transfer of all rights and remedies, with respect to the subject matter of insurance, from insured to insurer.
Answer 9
The correct option is II.
Presence of fire extinguisher need not be disclosed while buying insurance, unless asked for.
Answer 10
The correct option is I.
Misrepresentation is a wrong statement made during negotiation of a contract.