Fundamental Principles of Insurance

5. Fundamental Principles of Insurance

Every valid contract of insurance is governed by a set of fundamental principles. The first three below apply to all types of insurance; the last three (indemnity, subrogation and contribution) apply fully to general (non-life) insurance, which is based on indemnity, but not to life insurance, which is a contract of assurance rather than indemnity.

1. Principle of Utmost Good Faith (Uberrimae Fidei). An ordinary commercial sale follows the rule "let the buyer beware" — each party looks after its own interest. An insurance contract is different: it requires both parties, but especially the insured, to disclose every material fact relevant to the risk, honestly and completely, even if not specifically asked. A material fact is any fact that would influence the insurer's decision to accept the risk or the premium it would charge (for example, a serious existing illness in a life proposal, or a history of fire losses in a fire proposal). If a material fact is concealed or misrepresented, the policy becomes voidable at the insurer's option, whether or not that fact actually caused the eventual loss. The reason is simple: only the proposer truly knows the full facts about the risk, so the law places a special duty of honesty on them.

2. Principle of Insurable Interest. The insured must have a genuine, legally recognised financial interest in the subject matter of the insurance — such that they would suffer a real financial loss if the insured event occurred, and would gain nothing if it did not. A person has an automatic insurable interest in their own life, and in the life of a spouse; a business has insurable interest in its own property and stock, and in the life of a key employee. As seen in the previous section, insurable interest is the very feature that makes insurance a valid contract rather than a wager. An important point of timing: in life insurance, insurable interest need only exist at the time the policy is taken out; in fire insurance it must exist both when the policy is taken out and when the loss occurs; in marine insurance it must exist at the time of loss.

3. Principle of Indemnity. Under a contract of indemnity, the insured is compensated only to the extent of the actual financial loss suffered — never more — so that insurance never becomes a source of profit. If a property worth a certain amount is destroyed, the insured recovers that amount (subject to the sum insured), not the full sum insured if the loss was smaller. This principle applies to fire, marine, motor and most other general insurance, but does not apply to life insurance, because a human life has no measurable market value at which a claim could be capped, and death (or survival) is a certain event rather than a possible loss.

4. Principle of Subrogation. Subrogation is a corollary of indemnity. Once the insurer has indemnified the insured in full for a loss, the insurer steps into the insured's legal position and acquires the insured's right to recover the same loss from any third party who was actually responsible for causing it (for example, a careless driver who damaged the insured vehicle). This prevents the insured from being paid twice over — once by the insurer and again by the party at fault — for the very same loss, and again keeps insurance from becoming a source of profit. Like indemnity, subrogation applies to general insurance, not life insurance.

5. Principle of Contribution. Contribution is another corollary of indemnity, applying where double insurance exists — that is, where the same subject matter is insured against the same risk with more than one insurer. If a loss occurs, the insured cannot recover the full loss separately from each insurer (which would breach indemnity by producing a profit). Instead, each insurer contributes to the loss in proportion to the sum it has insured, and the insured recovers the actual loss only once in total. An insurer that has paid more than its rateable share can claim the excess back from the other insurers. Contribution too is confined to indemnity (general) insurance. …