Risk and Insurance

Fundamental Principles of Insurance

Insurance is a contract of utmost good faith based on certain well-established principles. These principles govern the rights and duties of both the insurer and the insured and make the contract valid and enforceable. The fundamental principles are explained below.

1. Principle of Utmost Good Faith (Uberrima Fides) Both the insurer and the insured must disclose all material facts relating to the risk honestly and completely. A material fact is any information that would influence the insurer's decision to accept the risk or fix the premium. If either party conceals or misrepresents a material fact, the contract becomes voidable. For example, the insured must disclose existing diseases, past claims, or the true value of the property.

2. Principle of Insurable Interest The insured must have a legal and financial interest in the subject matter of insurance. Insurable interest means the insured would suffer a financial loss if the insured event occurs. Without insurable interest, the contract is a wagering agreement and is void. For example, a person has insurable interest in his own house, but not in a neighbour's house.

3. Principle of Indemnity Under this principle, the insured is compensated for the actual amount of loss suffered, neither more nor less. The aim is to restore the insured to the same financial position he enjoyed before the loss. This principle applies to fire and marine insurance but not to life insurance, which is a contract of assurance rather than indemnity.

4. Principle of Contribution When the same property is insured with more than one insurer against the same risk, each insurer shares the loss in proportion to the sum insured by each. The insured cannot claim the full amount from each insurer separately. This principle prevents the insured from profiting from multiple policies.

5. Principle of Subrogation After paying the compensation, the insurer acquires all the rights of the insured over the damaged property. The insurer can then recover the loss from a third party who caused the loss. This principle also supports indemnity by preventing the insured from recovering twice for the same loss.

6. Principle of Proximate Cause (Causa Proxima) The insurer is liable only if the proximate (nearest) cause of loss is an insured peril. If the nearest cause is excluded, the insurer is not liable, even if a remote insured cause also contributed to the loss.

7. Principle of Mitigation of Loss The insured must take all reasonable steps to minimise the loss after the insured event occurs. He cannot remain careless and expect the insurer to bear the entire loss. The insured must act as a prudent uninsured person would.

Importance of the Principle of Indemnity

The principle of indemnity is the backbone of most insurance contracts. Its importance can be discussed as follows:

1. Prevents Profit from Loss It ensures that the insured recovers only the actual loss and does not make a profit out of misfortune. This keeps insurance a genuine device of protection rather than a source of gain.

2. Restores the Original Position It aims to place the insured in the same financial position as before the loss. The compensation is measured strictly by the extent of damage.

3. Basis of Subrogation and Contribution The principle of indemnity gives rise to subrogation and contribution. Since the insured is fully compensated, the insurer can take over his rights against third parties and share losses among co-insurers.

4. Fixes the Limit of Liability It fixes the maximum liability of the insurer at the actual amount of loss or the sum insured, whichever is lower. This protects the insurer from excessive claims.

5. Discourages Fraud and Moral Hazard By linking compensation to actual loss, it discourages the insured from deliberately causing or exaggerating losses to gain money.

6. Ensures Equitable Premium Since claims are limited to actual loss, premiums remain reasonable and affordable for all policyholders.

7. Applies to Property Insurance It is the guiding principle in fire, marine, and other property insurances, where the value of the subject matter can be measured in money.

In short, the principle of indemnity makes insurance fair, practical, and financially sound by ensuring that compensation equals loss and no more.

Risk is the uncertainty that the actual outcome of an investment or decision will differ from what was expected, including the possibility of loss. Examples: a share price may fall below the price paid; a borrower may fail to repay a loan (credit risk); a fire may destroy a factory; a rise in interest rates may reduce the value of a bond.

(b) Possibility of loss or gain

Risk means uncertainty about the outcome — the chance that the actual result may differ from the expected one, so it carries the possibility of either loss or gain. Certainty of loss (a) is not risk but a known loss, and guaranteed profit (c) and absence of uncertainty (d) are the opposite of risk.

Functions of insurance

1. Providing certainty (risk transfer). Insurance removes the uncertainty of loss. In return for a small, fixed premium paid in advance, the insured transfers the risk of a large, uncertain loss to the insurer. The insured thus knows the exact cost of protection in advance and can plan business and personal affairs with confidence.

2. Protection against risks. Insurance gives protection to individuals and businesses against the financial loss arising from risks such as fire, theft, accident, marine perils and death. On the happening of the insured event, the insurer compensates the loss, so the insured is saved from ruin. For example, a fire insurance policy compensates a trader for the loss of stock and building due to fire.

3. Distribution of risk (sharing of losses). Insurance works on the principle of co-operation and pooling. The losses of a few unfortunate members are shared among a large number of members who pay premiums. In this way, a heavy loss falling on one person is distributed in small shares over a large number of persons, and no single member is financially destroyed.

4. Capital formation (savings and investment). The premiums collected from a large number of policyholders are invested by insurance companies in government securities, shares, debentures and other productive channels. Besides, life insurance encourages compulsory savings among people. The funds so mobilised add to the capital of the country and help in its economic development.

5. Aid to trade and industry (credit facility). Insurance facilitates trade and commerce by covering the risks of business. Insured goods and property can be mortgaged or used as security to obtain loans from banks and financial institutions, because the lender's risk is reduced. Marine and fire insurance protect goods in transit and in storage, and thus promote internal and foreign trade.

Other functions (any of these may also be written): it helps in the efficient use of capital by indemnifying losses, provides employment to a large number of persons, contributes to national income and revenue through taxes, and promotes social security and welfare.

Risk and uncertainty are both situations where the outcome of a decision is not known in advance, but they differ in whether the possible outcomes can be assigned probabilities.

Conclusion: Risk is a calculable situation in which the decision-maker knows the odds, whereas uncertainty is an incalculable situation in which the odds are unknown. In practice, when uncertainty is reduced by gathering information and experience, it becomes risk.

Meaning of risk

Risk is the uncertainty about the outcome of an event, which may cause a loss or a result different from what was expected. In finance and insurance it means the possibility that actual returns or outcomes will differ from the expected ones, usually with the chance of a financial loss, for example loss of property by fire or a fall in the price of a share.

Nature of risk

1. Uncertainty. Risk exists only where the future outcome is not known with certainty. If a loss is certain to happen, it is not a risk.
2. Possibility of loss. Risk involves a chance of loss or damage to a person, property or income. A loss may or may not occur.
3. Present in every activity. Every business and individual faces risk, whether in investment, production, trade, health or travel.
4. Related to the future. Risk concerns events that may happen later; past events are already known and carry no risk.
5. Measurable. Many risks can be estimated using probability and past data, such as variance or standard deviation of returns, and the death rate used by insurers.
6. Return and risk move together. Higher expected return is usually accompanied by higher risk.
7. Can be reduced or transferred. Risk cannot always be removed, but it can be managed by avoidance, loss prevention, diversification or transfer to an insurer.