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What are the principles of insurance?

FUNDAMENTAL (LEGAL) PRINCIPLES OF INSURANCE... 

Principles are fundamental truths. The violation of principles put the system in disorder. Therefore, they must be followed. There are some principles of insurance as well. They must be followed by both parties of the insurance contract. If they are not followed, the insurance business cannot survive. Since these principles are so fundamental, they have been incorporated in insurance laws and are known as fundamental legal principles of insurance. We describe these important principles of insurance below. 

Principle of Indemnity 


The principle of indemnity states that the insurer should not pay more than the 
actual amount of the loss. In other words, the insured should not profit from the loss. There are two objectives of this principle. The first one is to prevent the insured from profiting from a loss, and the second one is to reduce moral hazard. For example, if Ram’s motorbike is insured for Rs 150,000 and a . partial loss of Rs 50,000 occurs, the principle of indemnity is violated if Rs 150,000 were paid to him. The loss would profit Ram and encourage moral hazard.  

In order to keep up with the principle, the insured property is valued based on the concept of actual cash value. There are number of methods for calculating actual cash value. One simple method is replacement cost less depreciation. Under this method, the actual cash value is determined by deducting the amount of depreciation from the replacement value. To illustrate this method let us take an example. Your company owns a machine that is 5 years old and has been depreciated by 50 percent. Assume that it cost Rs 100,000 to replace the machine at present. In the event of loss of the machine, the insurance company pays you only Rs 50,000 (Rs 100,000-Rs 50,000) actual cash value only, not Rs 100,000. However, there are several important exceptions to the principle of indemnity. Some of them are as follows. 

Valued policy 

Valued policies typically are used to insure antiques, fine arts, rare paintings, etc. Under this policy the insured and the insurer agree on the value of the property when the policy is first issued. At the event of loss of the property the insured is paid the insured amount not the actual cash value. It is not only difficult to value such property when they are lost, but in many cases their value may appreciate over period. In such cases the principle of indemnity does not apply. 

Replacement cost insurance 

Under replacement cost insurance there is no deduction for depreciation in determining the amount paid for a loss. Replacement cost insurance is based on the recognition that payment of the actual cash value can still result in a substantial loss to the insured. Therefore, under replacement cost insurance the principal of indemnity is violated. 

Life insurance 


Life insurance is another exception to the principle of indemnity. The reason is obvious. Life of a person neither has replacement value nor does it depreciate. Therefore, a life insurance contract is not a contract of indemnity but is a valued policy. 

Principal of Insurable Interest 


You have insurable interest on your property because you loose financially if a loss occurs to your property; you do not have insurable interest on some others’ property because you do not lose financially if some others’ property is lost. The principle of insurable interest states that the insured must be in a position to loose financially if a loss occurs.You must prove that you have insurable interest on the property you wish to insure. Otherwise, the contract will not be legally enforceable. The question of insurable interest does not arise when you purchase life insurance on your own life. But you must have insurable interest if you wish to purchase a life insurance policy on the life of another person. 

The main purpose of principle of insurable interest is to reduce moral hazard and discourage gambling. If an insurable interest were not required, a dishonest person could purchase a property insurance contract on someone else’s property and deliberately cause a loss to receive the proceeds. 

Principal of Subrogation 


Assume that a negligent motorist hits your motorbike and causes a damage of Rs 10,000. If you have an insurance of your bike, the insurance company will pay for the repair. Now, can you collect for the damage from the negligent motorist? No, because if you collect from insurance company and also from the negligent motorist, the principle of indemnity is violated you profit from the loss. Subrogation means substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third person for a loss. It allows the insurer to take the place of insured and recover the loss from third party. In our example, after compensating to you the insurance company takes your place and claims for the loss from the negligent motorist. The principle of subrogation serves two basic purposes. One, it prevents the insured from collecting twice from the same loss. Two, it is used to hold the guilty person responsible for the loss. 

Principal of Utmost Good Faith


It is an important principle of insurance. The principle of utmost good faith demands a higher degree of honesty on both parties of the insurance contract. There should not be false representation and concealment of material facts. A fact is considerea material if it influences the judgment of prudent insurer in fixing the premium, or determining whether he will take risk. If there is false representation or concealment of facts, the contract is voidable at the insurer’s option. The duty of utmost good faith is defined as a positive duty to voluntarily disclose, accurately and fully, all facts material to the risk being proposed, whether asked for them or not (Holyoake and Weipers). For example, you apply for life insurance and state in the application that you have not visited a doctor within the last five years. However, six months earlier, you had surgery for gull stone. In this case, you misrepresented the fact and concealed the truth. Therefore, the policy is voidable at the insurer's option. 

Principle of Proximate Cause 


For events to happen there must be some cause. The cause may be proximate _ cause or remote cause. The proximate cause is the active and efficient cause that sets in motion a train of events which brings about a result. To illustrate the proximate cause let us take an example. Assume that ere are 10 cycles standing in the cycle stand with little space between them. If you knock the first cycle, it will fall against the second cycle and the second cycle fall on the third cycle and so on. This way all the cycles including the tenth cycle will fall. What is the proximate cause of the fall of the tenth cycle the ninth cycle or your knocking down the first cycle? Your action of knocking down the first cycle set motion a train of events (the falling down of remaining Cycles) to bring the final result (the falling down of the tenth cycle), hence your action of knocking down the first cycle is the proximate cause. To take another example, suppose, an earthquake overturned an oil stove. The split oil caught fire from the burning wick. The burning oil set fire to the building. The first building set fire to a second building and so on. This way several more buildings caught fire. What is the proximate cause of damage to the last building the fire or the earthquake? The earthquake set motion a train of events (the burning of houses), hence the earthquake is the proximate cause of the damage even to the last building. 

Insurers indemnify the loss caused by the peril stated in the contract. Therefore, it is neces ary to identify the peril when an event takes place. The principle of proximate cause is applied to identify the cause of loss or the peril. 

Principle of Contribution

Contribution means the right of an insurer to call upon other insurers who are liable to the same insured to share the cost of an indemnity payment. It means if a person insures his/her property for more than one insurance company, he/she will be Indemnified from only one insurance company. The insurance company which Indemnifies the insured will ask the other insurers to share the indemnity payment. 



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