THE CONCEPT OF INSURANCE

MEANING OF INSURANCE
From a functional point of view, insurance can be defined as a social device or mechanism to spread
losses caused by a particular risk over a large number of people who are exposed to it and who
agree to come together and contribute funds to cover themselves against the risk. Insurance serves
as a mechanism for transferring losses falling on an individual or his family to a large number of
persons each bearing a nominal expenditure and feeling secure against heavy loss. It is the equitable
transfer of the risk of a loss, from one entity to another, in exchange for a consideration. In a
contractual sense, insurance can also be defined as a contract in which a sum of money known as a
premium is paid in consideration of the insurer’s incurring the risk of paying a large sum upon the
occurrence of a given risk.

Insurance is a contract in which one party (usually an insurer) agrees to pay another party (usually
the insured) or his beneficiary a certain sum upon the occurrence of a given risk. The insurer is
usually a company selling the insurance. Insurance relies on the law of large numbers which states
that “when a large number of units are used in an experiment, the actual experience will closely
approximate the underlying theoretical probability or experience” this law is critical to insurance
and is critical for its operations and practicability.

Insurance is a device that:-

(i) Spreads risk over a large number of persons who are exposed to it and are willing to cover
themselves against the risk.
(j) Transfers each member’s individual risk to all the members of the large group.
(k) Enables each member’s individual loss to be borne by all the members of the group.
(d) Allows for each member’s loss to be compensated for by the contributions of all the members.
(e) Ensures that a certain sum called the premium is charged in consideration.
(f) Provides for the payment to depend upon the value of loss due to the particular insured risk
provided insurance is there up to that amount.

The main assumptions in insurance are:-

(1) That a large number of units are exposed to the risk.
(2) That it is possible to accurately predict the number of units that will suffer loss within a
specified period of time.
(3) That only a few of the units exposed to the risk will actually suffer loss within a specified period
of time.
(4) That the losses of the unfortunate few who suffer losses are compensated for by the
contributions of the fortunate many

CONDITIONS NECESSARY INSURANCE

1. There must be a large number of homogeneous, similar and independent exposure units. The
vast majority of insurance policies are provided for individual members of very large classes. For
insurance to work, a large number of units must have been exposed to the risk in the past over a
period of time. Large numbers make it possible to examine and observe how the risk has caused
losses in the past which then make it possible to statistically estimate expected future losses
accurately. It is pointless to estimate future losses based on large numbers and then insure only a
few units. In such a situation the actual loss experience will not closely approximate the estimated
loss and the insurer will be problems. A large number of units must be insured if the actual loss
experience is to be roughly equal to the estimated loss.

The large number of units must be homogenous. This means that they must be roughly equal in
value and structure. High value units should not be placed in the same group with low value units as
the loss of one high value unit will be equivalent to the loss of many low valued units in the group.
The impact will be the same as if many units have suffered loss within the same specified period of
time. This is contrary to the basic assumption in insurance that only a few of the units exposed to
loss will suffer loss within a specified period of time.

The large number of units must be independent of each other. This means that the loss of any one
unit in the group must not influence the loss of any other unit or units within the same group. If this
were to happen, the loss of one unit will lead to the loss of another unit which will also lead to the
loss of another and another. In the end many of the units will suffer loss within the same period of
time.

2. The Loss must be definite in time, place and value. The event that gives rise to the loss that is
subject to insurance should, at least in principle, take place at a known time, in a known place, and
from a known cause. It must also have a known value. Proof that a loss has occurred is only
possible if the place in which the loss occurs, and the time that the loss occurred can be confirmed
beyond any doubt. Without these two, a loss could be an imaginary loss. Insurers only compensate
for confirmed losses. Insurers normally compensate for the value of the loss suffered. This is
normally in financial terms. It should be possible to quantify or measure the loss in monetary value.
It is not possible to value sentimental losses such as loss of love in financial terms. It would be
impossible to determine how much the insurer should for such losses in monetary value. The insurer
only compensates for losses proximately caused by a peril that is insured in the policy. It must
therefore be possible to determine the proximate cause of the loss. It must be possible to confirm the
cause of the loss. Ideally, the time, place, value and cause of a loss should be clear enough that a
reasonable person, with sufficient information, could objectively verify all four elements.

3. The loss must be accidental. The event that causes the loss should be fortuitous, or at least outside
the control of the beneficiary of the insurance. The occurrence of the loss must be purely a matter of
chance and not the deliberate act of the insured. Insurance does not cover losses intentionally
caused in the hope of obtaining financial gain from the insurer. Events that contain speculative
elements, such as ordinary business risks, are generally not considered insurable.

4. It must be economically feasible. It must make economic sense to insure. For this to happen,
certain things are necessary. First, the potential size of the loss from the risk must be large enough
to cause financial hardship to the insured if it does cause a loss. It is not economical to insure
against a risk whose potential loss is negligible and can be comfortably be absorbed by the insured
without any stress. Secondly, the insurance premiums charged need to cover both the expected cost
of losses, plus the cost of issuing and administering the policy, adjusting losses, and supplying the
capital needed to reasonably ensure that the insurer will be able to pay claims. It is not economical
from the insurer’s point of view to provide cover where the premium charged is not enough to cover
the cost of insurance. Thirdly, the premium payable must be affordable. It is not economical from
the insured’s point of view if the premium charged is nearly as large as the potential loss from the
risk covered. It is only economical where the premium payable is relatively very small compared to
the size of the expected loss. Finally, the chance of a loss occurring must be reasonably. It not
economical to insure against a risk that has no chance of causing a loss. It may also be
uneconomical to insure against a risk which has an unreasonably very high chance of loss together
with a very large potential loss from the risk. There is no point to insure if the policy has no
financial to both the insurer and the insured to both the insured and the insurer.

5. There should be no catastrophically large losses or hazard. An insurance scheme cannot work
in a situation where most of the insured units suffer loss within a specified period of time. If the
same event can cause losses to numerous policyholders of the same insurer, the ability of that
insurer to compensate for all the losses will be limited. Or where the loss from one single event
would be extraordinarily large, the insurer’s ability to compensate for it and other exposures. It is
possible to find risks whose total potential loss is well in excess of any individual insurer’s capital
reserves.

6. There must be insurable interest. Insurable interest is essential for the validity of any contract
of insurance. Insurance contracts cannot be enforced in any court of law where insurable is lacking.
It is a necessary requirement for insurability.

BENEFITS OF INSURANCE
(i) Insurance eliminates uncertainty.
Insurance provides certainty of payments at the uncertain of loss. The uncertainty of loss can be
reduced by better planning and administration. But the insurance relieves the person from such
difficult tasks. Moreover if the subject matters are not adequate, the self- provision may prove
costlier. There are different types of uncertainty in a risk. The risk will occur or not, when it will
occur, how much loss will be there? In other words there are uncertainty of happening of time and
amount of loss. Insurance removes all these uncertainty and the assured is given certainty of
payment loss. The insurer charge premium for providing the said uncertainty

(ii) Insurance provides protection.

The main benefit of the insurance is to provide protection against the probable chances of loss. The
time and amount of loss are uncertain and at happening of the risk the person will suffer loss in
absence of insurance. The insurance provides safety and security against the loss on a particular
event. In case of life insurance payment is made when death occurs or when the term of insurance
expires. The loss to the family at a premature death and payment in old age are adequately provided
by the insurance. In other words security against premature death and old age suffering are provided
by life insurance. Similarly the property of the insured is secured against on a fire in fire insurance.
In other insurance too, this security is provided against the loss at a given contingency. The
insurance provides safety and security against the loss of earning at death or in old age against the
loss at fire, against the loss at damage, destruction or disappearance of property, goods, furniture
and machines etc.

The insurance guarantees the payment of loss thus it secures and protects the assured from
sufferings. Insurance cannot check the happening of risks but can provide for losses at the
happening of the risk.

(iii) Insurance affords Peace of Mind

The security wish is the motivating factor. This is the wish which tends to stimulate to more work, if
wish is unsatisfied it will create a tension which manifests itself to the individual in the form of an
unpleasant reaction causing reduction in work. The security banishes fear and uncertainty, fire,
windstorm, automobile accident, damage and death are almost beyond the control of the human
agency and in occurrence of any of these events may frustrate or weaken the human mind. By
means of insurance, however, much of the uncertainty that centers about the wish for security and
its attainment may be eliminated.

(iv.) Risk Sharing

The risk is uncertain and therefore the loss arising from the risk is also uncertain. When risk takes
place the loss is shared by all the persons who are exposed to the risk. The risk sharing in ancient
times was done only at time of damage or death but today on the basis of probability of risk the
share is obtained from each and every insured in the shape of premium without which protection is
not guaranteed by the insurer.
(iv.) Prevention of loss
The insurance joins hands with those institution which are in preventing the loses of the society
because reduction in losses causes lesser payment to the assured and so more saving is possible
which will assist in reducing the premium. Lesser premium invites more business and more
business cause lesser share to the assured. So again premium is reduced to which will stimulate
more business and more protection to the masses. Therefore the insurance assists financially to the
health organization, fire brigade, educational institutions, and other organizations which are
engaged in preventing the losses of the masses from death and damage.

(v) It provides capital

The insurance provides capital to the society. The accumulated funds are invested in productive
channel. The dearth of capital of the society is minimized to a greater extent with the help of
investment of insurance. The industry, the business and the individual are benefited by the
investments and loans of the insurers.

(vi) It improves efficiency

The insurance eliminates worries and miseries of losses at death and destruction of property. The
carefree person can devote his body and soul together for better achievement. It improves not only
his efficiency but the efficiency of the masses are also advanced.

(vii) It helps economic progress

The insurance by protecting the society from huge losses of damage, destruction and death,
provides an initiative to work hard for the betterment of the masses. The next factor of economic
progress, the capital, is also immensely provided by the masses. The property, the valuable assets,
the man, the machine and the society cannot lose much at the disaster.

(viii) Insurance eliminates dependency

At death of the husband or father the destruction of family need no elaboration. Similarly at
destruction of property and goods the family would suffer a lot. It brings reduced standards of living
and suffering may go to any extent of begging from relatives, neighbors or friends. The economic
independence of the family is reduced or sometimes lost totally. What can be more pitiable
condition than this that the wife and children are looking others more benevolent than the husband
and the father in absence of protection against such dependency? The insurance is here to assist
them and provides adequate amount at the time of sufferings.

(ix) Life Insurance encourages saving

The element of protection and investment are present only in case of life insurance. In property
insurance, only protection element exists. In most of the life policies elements of saving
predominates. These policies combine the programs of insurance and savings. The saving with
insurance has certain extra advantages:
i. Systematic saving is possible because regular premiums are required to be compulsory paid. The
saving with a bank is voluntary and one can easily omit a month or two and then abandon the
program entirely.
ii. In insurance the deposited amount cannot be withdrawn easily before the expiry of the term of
the policy. As contrast to this the saving which can be withdrawn at any moment will finish with
no time.
iii. The insurance will pay the policy money irrespective of the premium deposited while incase of
bank deposit only the deposited amount along with interest is paid. The insurance thus provide the
wished amount of insurance and the bank provides only deposited amount.
iv. The compulsion or force to premium in insurance is so high that if the policy holder fails to pay
premiums within the days of grace he subjects his policy to lapse and may get back only a nominal
portion of the total premiums paid on the policy. For the preservation of the policy he has to try his
level best to pay the premium. After a certain period it would a part of necessary expenditure of the
insured. In absence of such forceful compulsions elsewhere life insurance is the best media of
saving.
(x) Life Insurance Provides Profitable Investment
Individuals unwilling or unable to handle their own funds have been pleased to find an outlet for
their investment in life insurance policies. Endowment policies, multipurpose policies differed
annuities are certain better form of investment. The elements of investments i.e. regular savings,
capital formation and return of capital along with certain additional returns are perfectly observed in
life insurance. In India the insurance policies carry a special exemption from income tax, wealth
tax, gift tax and estate duty. An individual from his own capacity cannot invest regularly with
enough of security and profitability. The insurance fulfills all these requirements with a lower cost.
The beneficiary of the policy holder can get a regular income from the life insurer, if the insured
amount is left with him.
(xi) Life Insurance Fulfils the Needs of a Person
The needs of a person are divided into:
A. Family needs
B. Old age needs
C. Re adjustments needs
D. Special needs
E. The clean up needs

(A) Family needs

Death is certain but the time is uncertain. So there is uncertainty of time when the sufferings and
financial stringencies may befall on the family. Moreover every person is responsible to provide for
the family. It would be a more pathetic sight in the world to see the wife and the children of a man
looking for someone more considerate and more benevolent than the husband and the father who
left them unprovided. Therefore the provision for children up to their reaching earning period and
for widow up to long life should be made. Any other provision except life insurance will not
adequately meet this financial requirement of the family. Whole life policies are the better means of
meeting such requirements.

(B) Old Age Needs

The provision for old age is required where the person is surviving more than his earning period.
The reduction of income in old age is serious to the person and his family. If no any other family
member starts earning they will be left with nothing and if there is no property it would be more
piteous state. The life insurance provides old age funds along with the protection of the family by
issuing various policies.

(C) Re-adjustments Needs

At the time of reduction in income whether by loss of employment, disability or death adjustments
in the standard of living is required. The family members will have to be satisfied with the meager
income and they have to settle to lower incomes and social obligations. Before coming to lower
standards and to be satisfied with that they require, certain adjustments income so that the primary
obstacles may be reduced to minimum. The life insurance helps to accumulate adequate funds.
Endowment policy, anticipated endowment policy and guaranteed triple benefit policies are deemed
to be good substitute for old age needs.

(xii) Special Needs

There are certain special requirements of the family which are fulfilled by earning member of the
family. If the member becomes disabled to earn due to old age or death those needs may remain
unfulfilled and the family will suffer:
(i) Need for Education
There are certain insurance policies and annuities which are useful for education of the children
irrespective of the death or survival of the father or guardian.

(ii) Marriage
The daughter may remain unmarried in case of father’s death or incase of inadequate provision for
meeting the expenses of marriage. The insurance can provide funds for the marriage if policy is
taken for the purpose.

(iii) Insurance Needs for Settlement of Children

After education settlement of children takes time and in absence of adequate funds the children
cannot be well placed and all the education will go to waste.

(E) Clean up Funds

After death ritual ceremonies payment of wealth taxes and income taxes are certain requirements
which decrease the amount of funds of the family member. Insurance comes to help for meeting
these requirements. Multipurpose policy, education and marriage policies, capital redemption
policies are the better policies for the special needs.

USES TO BUSINESS
The insurance has been useful to the business society also. Some of the uses are discussed below:

1. Uncertainty of business Losses is Reduced

In world of business, commerce and industry a huge number of properties are employed. With a
slight slackness or negligence the property may be turned into ashes. The accident may be fatal not
only to the individual or property but the third party also. New construction and new establishments
are possible only with the help of insurance. In absence of it uncertainty will be to the maximum
level and nobody would like to invest a huge amount in the business or industry. A person may not
be sure of his life and health and cannot continue the business up to longer period to support his
dependants. By purchasing policy he can be sure of his earnings because the insurer will pay a fixed
amount at the time of death.

Again the owner of the business might foresee contingencies that would bring great loss. To meet
such situation they might decide to set aside annually a reserve but it not be accumulated due to
death. However by making an annual payment to secure immediately insurance policy can be taken.

2. Business efficiency is Increased with Insurance

When the owner of a business is free from the botheration of losses he will certainly devote much
time to business. The carefree owner can work better for maximization of profit. The new as well as
the old businessmen are guaranteed payment of certain amount with insurance policies at death of
the person, at damage, at destruction or disappearance of the property or goods. The uncertainty of
the loss may affect the mind of the businessmen adversely. The insurance removing the uncertainty
stimulates the businessmen to work hard.

3. Key Man Indemnification

Key man is that particular man whose capital, expertise, experience, energy, ability to control
goodwill and dutifulness makes him the most valuable asset in the business and whose absence will
reduce the income of the employer tremendously and up to that time when such employee is not
substituted. The death or disability of such valuable lives will in many instances prove a more
serious loss than that of fire or any hazard. The potential loss to be suffered and the compensation to
the dependents of such employee require an adequate provision which is met by purchasing an
adequate life policy. The amount of loss may be up to the amount of reduced profit, expenses
involved in appointing and training of such persons and payment to the dependents of the key man.
The term Insurance Policy or Convertible term Insurance Policy is more suitable in this case.

4. Enhancement of Credit
The business can obtain loan by pledging the policy as the collateral for the loan. The insured
persons are getting more loan due to certainty of payment at their deaths. The amount of loan that
can be obtained with such pledging of policy with interest thereon will not exceed the cash value of
the policy. In case of death the cash value can be utilized for settling of the loan along with the
interest. If the borrower is unwilling to repay the loan and the interest the lender can surrender the
policy and get the amount of loan and interest thereon repaid. The redeemable debentures can be
issued on the collateral of capital redemption policies. The insurance properties are the best
collateral and adequate loans are granted by lenders.

5. Business Continuation
In any business particularly partnership business may discontinue at death of any partner although
the surviving partners can restart the business, but in the cases the business and the partners will
suffer economically. The insurance policies provide adequate funds at the time of death. Each
partner may be insured for the amount of his interest in the partnership and his dependents may get
that amount at the death of the partner. With the help of property insurance the property of the
business is protested against disasters and the chance of closure of the business due to tremendous
waste or loss.

6. Welfare of Employees
The welfare of the employees is the responsibility of the employer. The former are working for the
latter. Therefore the latter has to look after the welfare of the former which can be provisions for
early death, provisions for disability and provisions for old age. These requirement are easily met
by the life insurance, accident and sickness benefit, and pensions which are usually provided by
group insurance. The premium for group insurance is generally paid by the employer. This plan is
the cheapest form of insurance for the employers to fulfill their responsibilities. The employees will
devote their maximum capacities to complete their jobs when they are assured of the above benefits.
The struggle and the strife between the employers and employees can be minimized easily with the
help of such schemes.

USES TO THE SOCIETY

Some of the uses of insurance to the society are discussed in the following sections:

1. Wealth of the Society is Protected.

The loss of a particular wealth is protected with insurance. Life insurance provides loss of human
wealth. The human material if it strong, educated and carefree will generate more income. Similarly
the loss of damage of property at fire, accident etc, can be well indemnified by the property
insurance; cattle, crop, profit and machines are also protected against their accidental and economic
losses. With the advancement of the society, the wealth of the property of the society attracts more
hazardous and so new types of insurances are also invented to protect them against the possible
losses. Each and every member will have financial security against old age, death, damage,
destruction and disappearance of his wealth including the life wealth. Through prevention of
economic losses, insurance protects the society against degradation. Through stabilization and
expansion of business and industry, the economic security is maximized. The present, future and
potential human and property resources are well protected. The children are getting expertise
education, working classes are free from botherations and other people are guiding at ease. The
happiness and prosperity observed everywhere with the help of insurance.
2. Economic Growth of the Country
For the economic growth of the country insurance provides strong hand and mind, protection
against loss of property and adequate capital to produce more wealth. The agriculture will
experience protection against losses of cattle, machines, boilers and profit insurances provide
confidence to start and operate the industry. Welfare of employees create a conducive atmosphere to
work: adequate capital from insurers accelerate the production cycle. Similarly in business too the
property and human materials are protected against certain losses, capital and credit are expanded
with the help of insurance. Thus the insurance meets all the requirements of the economic growth of
a country.

3. Reduction in Inflation
The insurance reduces the inflationary pressure in two ways: first, by extracting money in supply to
the amount of premium collected and secondly by providing sufficient funds for production narrow
down the inflationary gap. With reference to Indian context it has been observed that about 5.0
percent of the money in supply was collected inform of premium. The share of premium contributed
to the total investment of the country was about 10.0 per cent. The two main causes of inflation,
namely increased money in supply and decreased production are properly controlled by insurance
business.

3. Insurance Protects Mortgaged Property

At death of the owner of the mortgaged property the property is taken over by the lender of the
money and the family will be deprived of the uses of the property. On the other hand the mortgagee
wishes to get the property insured because at the damage or destruction of the property he will loose
his right get the loan repaid. The insurance will provide adequate amount to the dependants at the
early death of the property owner to pay off the unpaid loans. Similarly the mortgagee gets adequate
amount at the destruction of the property.

PRINCIPLES OF INSURANCE
The principles will act as a guideline both to person(s) who may want to persuade an insurance
company to bear on his or their own behalf the loss that may be incurred by a given risk and to the
insurance company that would as a result undertake the cover. The following is an outline of these
principles:

1. INSURABLE INTEREST
A contract of insurance affected without insurable interest is void. It means that the insured must
have an actual pecuniary interest and not a mere anxiety or sentimental interest in the subject matter
of insurance. The insured must be so situated with regard to the thing insured that he would have
benefit by its existence and loss from its destruction. The owner of a ship rubs a risk of losing his
ship, the chatterer of the ship runs a risk of losing his freight and the owner of the cargo incurs the
risk of losing his goods and profit. It is the existence of insurable interest in a contract of insurance,
which distinguishes it from mere watering equipment.

In relation to insurance the law the principle of insurable interest prevents people taking out an
insurable contract on someone else’s life (or someone else’s property) unless they have an insurable
interest in that life.

Valid forms of insurable interest include being a spouse being financially dependent on the person
or situations where there is joint ownership of real property or a business.

The concept of insurable interest was established to prevent:

• Gambling (on the lives of others), under the pretense of insurance.
 • The moral hazard of the people taking out insurance on someone’s life, and then “arranging”
for that person to die- so that they can claim on the policy.

WAYS IN WHICH INSURABLE INTEREST CAN ARISE

a) One’s own life - Life is the most valuable possession one could have. It’s priceless and therefore
its value can’t be quantified in monetary terms. There is therefore no financial limit to the insurable
interest that a person has in his life.

b) Husband-wife relationship - Spouses have insurable interest in each other’s life. This arises out
of biblical and common law concept that a man and his wife are one and the same person. Since
their lives belong to each other, this gives them insurable interest in each other’s life.

c) Creditor-debtor relationship - The creditor stands to suffer financial loss if the debtor dies
before paying the debt. This gives the creditor some insurable interest in the life of the debtor. The
insurable interest is limited to the total debt outstanding. He can therefore insure the debtor’s life on
any sum that does not exceed the debt outstanding. The debtor on the other hand cannot suffer any
financial loss if the creditor dies. He therefore has no insurable interest in the life of the creditor.

d) Partnership relationship - Business partners have insurable interest in each other’s life. This is
because the business stands to suffer financial loss if one partner(s) dies. This is as a result of
withdrawal of capital from the partnership to the dead partner’s estate. The surviving partners would
therefore have financial stress. This gives them insurable interest in each other’s life. The insurable
interest is limited to each partner’s financial involvement with the partnership.

e) Ownership - A person who is not the legal owner of a property stands to suffer financial if the
property is lost or damaged or incurs any liability. The extent of the loss would be limited to the
financial value of the property itself or the resulting liability. This gives the property owner
insurable interest in the property owned. He can insure such property for any sum not exceeding its
market or financial value.

f) Joint ownership - A partner has insurable interest in any property jointly with another or others.
The insurable interest is limited to the full financial value of the property jointly owned at its full
values, but he will be insuring on his own behalf and on the behalf of the other owner(s). it follows
then that the compensation will be made to all the owners if a loss occurs.

g) Bailee - A bailee is a person who is legally in possession of property or goods belonging to

another person. He is required by law to take care of the goods in his custody as if they were his
own. He can be held liable for any goods lost, damaged or which incurs liability while in his
custody. This gives him insurable interest in the goods in his custody. He can insure such goods for
a sum not exceeding their market value or financial liability that could arise.

h) Administrators, trustees and executors - These are people charged with the responsibility of
taking care of the estates of others. They have a legal duty to take care of the estates under their
charge as if they were their own. This gives them insurable interest in any property belonging to the
estate. They can insure such property at their full market or financial value, not on their own behalf
but on the behalf of the estate.

i) Potential liability - A person has insurable interest in any potential liability that could cause him
or her financial loss. He can insure for a sum that does not exceed the full financial extent of the
potential liability.
2. INDEMNITY
A contract of insurance where the insurable interest is limited and can be valued in financial terms
is a contract of indemnity. The object of every contract of insurance is to place the insured in the
same financial position as nearly as possible after the loss as if the loss had not taken place at all.
This means then that the insured in case of loss against which the policy has been insured shall be
paid the actual amount of loss he has suffered as a result of the operation of the insured risk but not
exceeding the amount of the sum insured in the policy. Indemnity therefore simply means what the
insured has actually lost is what he or she gets nothing more nothing less. It is exact financial
compensation for a loss suffered through a particular risk. Why is it not advisable to allow the
insured to obtain from the insurer a value that is greater than what he or she has actually lost? If the
insured could end up with more money than he has actually lost he would have made a profit out of
the occurrence of the risk. This would constitute a serious moral hazard as people would be tempted
to deliberately cause their own loss in order to get this profit. More losses would occur as more
people strive to make profits from their insurance contracts. The claims would overwhelm the
insurers who will find it impossible to compensate every one. It is therefore against the public
policy to allow an insured to make a profit out of his loss or damage.

The principle of indemnity does not apply to life assurance contracts and personal accident
insurances where the insurable interest is unlimited and cannot be valued in monetary terms. It will
however apply to life assurance contracts where the insurable interest is limited and can be valued
financially such in the case of a creditor insuring the life of his debtor.

METHODS OF PROVIDING
i) Cash payments;
When the insurer pays for the cash value of the item lost or the cash value of the assessed reduction
in the value of an item as a result of the occurrence of the insured peril. This is the most common
method of providing indemnity.

ii) Replacement;
In this case the insurer replaces the items lost by providing the insured with another item of similar
financial value. This method is mostly used where the items was still brand new or doesn’t
depreciate in value over a period of time. For example; jewelry like gold ring, diamond etc.

iii) Repairs;
This method is mostly used in motor vehicle insurance where the insurer arranges for the damaged
vehicle to be repaired and pays for the cost of repairs with the garage concerned. Adequate repairs
constitute indemnity.

iv) Re-instatement;
This method is mostly used in fire insurance policies. The insurer rebuilds the premises which have
been damaged by fire. In ordinary circumstances the insurer prefers to pay cash to the insured for
the damaged premises so that the insured himself will undertake the building. This is because the
insurer would not like to be involved with the disagreement which will arise between him and the
insured when he undertakes to rebuild himself. The disagreement usually relate to either the quality
of the materials used in the rebuilding or the standard of the workmanship involved. However
where the insurer suspects the fire was caused by arson but have no adequate proof he may opt that
instead of providing cash for rebuilding he will undertake the rebuilding himself. This is because
the insured may have caused the fire for the purposes of obtaining money from the insurer and the
insurer is allowed by law to insist on rebuilding rather providing the cash.
CIRCUMSTANCES THAT HINDER FULL INDEMNITY
In practice it is sometimes possible that a person who has suffered financial loss as a result of an
insured peril may not be taken to the same financial position he was in immediately before the loss
occurred.

The following circumstances may operate to prevent the insured from obtaining full indemnity.
i) Sum insured
The maximum liability of the insurer in a contract of insurance is the sum insured. There is no
obligation on the part of the insurer to pay for sum which exceeds the sum insured. Therefore in a
situation where the insured, insured his property for a sum which is less than the market value or the
financial value of the property insured he may not be fully indemnified when a loss occurs as the
insurer will only pay the sum insured which will be less than the financial value of the loss.

ii) Where the insurance policy is subject to average;

Where the property is insured on the understanding that the sum insured is the financial value of the
property insured, the policy will become subject to average if it turns out that the property was
actually more than the sum insured. It will be understood that in such circumstances the insured did
not transfer the whole risk to the insurance company. The insured therefore retains part of the risk
and if the loss occurs the insurer will only compensate for the proportion of the loss that was
transferred to him. They therefore share the loss with the insured person.

iii) Policy Excess;

This is a statement or a clause in motor vehicle insurance policy which states that; if a loss occurs
and the insured want to make a claim for compensation he will pay a specified sum of money to the
insurer before his claim can be processed and paid. This clause serves to prevent the insured from
launching what is called petty or trivial claims. It results in less than the indemnity being paid.

iv) Policy Franchise;

A franchise policy is similar to the policy excess in that they serve the same purpose of eliminating
trivial or petty claims. The difference is only that in a franchise there is a clause stating that the
insurer will only compensate for a loss if total value exceeds a specified sum of money.
Compensation can only be paid where the value of the loss is greater than the franchise amount.

3. CONTRIBUTION
Contribution is the right of an insurer to call upon other insurers who have insured the same risk to
share in the cost of an indemnity payment. Where there are two or more insurers on one risk, the
principle of contribution comes into play. The aim of contribution is to prevent the insured from
making a profit by claiming in full from all insurers against the same loss. It achieves this by
distributing the actual amount of loss among the different insurers who are liable for the same risk
under different policies in respect of the same subject matter. Any one insurer may pay to the
insured the full amount of the loss covered by the policy and then become entitled to contribution
from his co-insurers in proportion to the amount which each has undertaken to pay in case of the
same subject matter.

The following conditions are necessary for contribution to apply.

(i) There must be at least two or more policies of indemnity existing.
(ii) The two or more policies of indemnity must cover the same peril or risk.
(iii) The two or more polices of indemnity must cover the same subject matter of insurance.
(iv) They must cover the same interest of the same insured.
(v) They must be in force at the time of loss.
METHODS OF CALCULATING CONTRIBUTIONS
There are two methods that can be used in calculating contribution. These include:

a) Sums insured method;

This method is used where the total of all the sums insured is either equal to or greater than the
financial value of the insured property. It applies where the whole risk is transferred to the insurers
and they therefore share in contributing for the whole loss. The formula for calculating the
contribution is:

sum insured by individual insurer X Loss sustained

Total of loss insured

b) Independent liability method;

This method is normally used when a policy is subject to average. This means that the whole risk
was not transferred to the insurer. The insured retained part of the risk. It is therefore applied where
the total of all sums insured by the different insurers is less than the market value of the subject
matter insured. The formula used is;

Sum insured by individual insurer X Loss sustained

Market or financial value of the property insured

In conclusion the principle of the contribution only applies to contracts of indemnity where the
insurable interest can be valued in monetary terms.

4. SUBROGATION
In insurance, subrogation is the right of an insurer to stand in the place of the insured and to avail to
himself all the rights and remedies available to the insured, whether such rights have been exercised
or not. It is a corollary to the principle of indemnity and applies only to contracts of indemnity. It
operates to prevent the insured from making a profit out of a contract of insurance by claiming
twice. Where the insured property is lost or damaged through the negligence of say a third party, the
insured can make a profit by claiming in full from both his insurer and the third party. This would
be contrary to the requirements of the principle of indemnity which prohibits parties from making
profits out of contracts of insurance. Subrogation only applies to contracts of indemnity where the
insurable interest is limited and can be valued financially. It does not apply to those life assurance
contracts and personal accident insurances where the insurable interest is unlimited and cannot be
valued in monetary terms.

Subrogation requires that when an insured has received full indemnity in respect of his loss, all
rights and remedies which he has against any third person will pass on to the insurer and will be
exercised for his benefit until he (the insurer) recoups the amount he has paid for the loss for which
he is liable under the policy and this right extend only to the rights and remedies available to the
insured in respect of the thing to which the contract of the insurance relates.

Subrogation is the same name given to the legal technique under the common law by which one
party (P) steps into the shoes of another party (X), so as to have the benefit X’s rights and remedies
against the third party (D). subrogation is similar in effect to assignment, but unlike assignment
subrogation can occur with any agreement between P and X to transfer X’s rights. Subrogation most
commonly arise in relation to policies of insurance but the legal technique is more of general
application. Using the designations above, P (the party seeking to enforce the rights of another) is
called subrogee. X (the party whose rights the subrogee is enforcing) is called the subrogor. In each
case because P pays money to X which otherwise D would have had to pay, the law permits P to
enforce X’s rights against D to recover some or all of what P has paid out.
A very simple (and common) example of subrogation would be as follows:
1. D drives a car negligently and damages X’s car as a result.
2. X, the insured party has comprehensive insurance and claims (ie asks for payment) under the
policy against P, his insurer.
3. P pays in full to have X’s car repaired.
4. P then sues D for negligence to recoup some or all of the sums paid out to X.
5. P receives the full amount of any amounts recovered in the action against D up to the amount to
which P indemnified X. X retains non of the proceeds of the action against D except to the extent
that they exceed the amount P paid to X.

If X were paid in full by P and still claim in full against D then P could recover “twice” for the same
loss. The basis of the law of subrogation is that when P agrees to indemnify X against a certain loss,
then X “shall be fully indemnified, but never more than fully indemnified …if ever a proposition
was brought forward which is at variance with it, that is to say, which will prevent X from obtaining
a full indemnity, or which will give to X more than full indemnity, that proposition must certainly
be wrong.” P will normally (but not always) have to bring the claim in the name of X. accordingly,
in situations where subrogation rights are likely to arise within the scope of a contract (i.e. in an
indemnity insurance policy) it is quite common for the contract to provide for that X as subrogor
will provide all necessary cooperation to P in bringing the claim.

Subrogation is an equitable remedy and is subject to all the usual limitations which apply to
equitable remedies. Although the basic concept is relatively straightforward subrogation is
considered to be a highly technical area of the law.

Types of subrogation
Although the classes of subrogation rights are not fixed (or closed) types of subrogation are
normally divided into the following categories:
i. Indemnify insurer’s subrogation rights
ii. Surety’s subrogation rights
iii. Subrogation rights of business creditors
iv. Lender’s subrogation rights
v. Banker’s subrogation rights

Although the various fields have the same conceptual underpinnings there are subtle distinctions
between them in relation to the application of the law of subrogation.

i) Indemnify insurer’s subrogation rights

An indemnity insurer in fact has two distinct types of subrogation rights. Firstly they have the
classic type of subrogation used in the example above; viz. the insurer is entitled to take over the
remedies of the insured against another party in order to recover the sums paid out by the insurer to
the insured and by which the insured would otherwise be overcompensated. Secondly the insurer is
entitled to recover from the insured and by which the insured is overcompensated. The latter
situation might arise if, for example an insured claimed in full under the policy but then started
proceeding anyhow against the tortfeasor, and recovered substantial damages.

ii) Surety’s subrogation rights

A surety who pays off the debts of another party is subrogated to the creditor’s former claims and
remedies against the debtor to recover the sum paid. This would include the endorser on a bill of
exchange. In relation to surety’s subrogation rights, the surety will also have the benefit of any
security interest in favor of the creditor of the original debt. Conceptually this is an important point,
as the subrogee will take the subrogor’s security rights by operation of law, even if the subrogee had
been unaware of them. Accordingly in this area of the law at least, it is conceptually improbably
that the right of subrogation is based upon any implied on them.

iii) Subrogation rights against trustees

A trustee or a trust that enters into a transaction for the benefit of the beneficiaries of the trust is
generally entitled to be indemnified by the beneficiaries for personal loss incurred, and has lien over
the trust assets to secure compensation. If for example the trustee conducts business on behalf of the
trust and fails to pay creditors then the creditors are entitled to subrogate to the personal and
proprietary remedies of the trustee against the beneficiaries and the trust fund. Where under the
terms of the trust instrument the trustees are permitted to trade in derivatives as part of the trust’s
investment strategy, then the derivatives document will also normally contain a subrogation clause
to bolster the common law rights.

iv) Lender’s subrogation rights

Where the lender lends money to a borrower to discharge the borrower’s debt to a third party (or
which the lender pays directly to the third party’s to discharge debt), the lender is subrogated to the
third party’s former remedies against the borrower to the extent of the debt discharged. However if
the original loan was invalid (because for example it is ultra vires the borrower) then the lender
generally cannot enforce the third party’s claim against the borrower as this would indirectly
validate an invalid loan. However the claim can subsist in so far as the unlawfully borrower money
was used to discharge lawful debts, by inferring the legality of the use of funds to the right of
subrogation. However the law in this area has been subject to conflicting decisions.

v) Banker’s subrogation rights

Where a bank acting on what it believes erroneously to be valid mandate of its client, pays money
to a third party which discharges the customer’s liability to the third party, the bank is subrogated to
the third party’s former remedies against the customer.

5. UTMOST GOOD FAITH

Since insurance shifts risk from one party to another, it is essential that there must be utmost good
faith and mutual confidence between the insured and the insurer. In a contract of insurance the
insured knows more about the subject matter of the contract than the insurer. Consequently he is
duty bound to disclose accurately all materials facts and nothing should be withheld or concealed.
Any fact is material which goes to the root of the contract of insurance and has a bearing on the risk
involved. It is only when the insurer knows the whole truth that he is in a position to judge if he
should accept the risk and what premium he should charge.

If that were so the insured might be tempted to bring about the event insured against in order to get
the money. Generally the rule applicable to contracts of insurance is that of uberrime fides, which
means “of the utmost good faith” utmost good faith is therefore a rule that require that each party in
the contract of insurance is under the legal obligation to disclose all material facts affecting the
contract, whether such facts have been specifically requested for or not. A material fact is any fact
which would influence the judgment of a prudent insurer in deciding if to accept to insure or not, or
in determining the amount of premium to be charged.

Examples of material facts include:

b) The fact that a life proposed for insurance has been hospitalized for several times before or
suffers from known serious infection is regarded as a material fact.
c) In motor insurance the fact that the motor vehicle that is proposed for insurance will be driven on
a regular basis by someone else rather than the insured driver is regarded as a material fact.
Examples of non-material facts include:
a) Facts which the proposer does not know and which he cannot reasonably be expected to know. In
determining this, the level of education, the professional qualification and the experience of the
proposer will be taken into account.
b) Facts of law: Everyone is presumed to know the law and ignorance of the law is no defense. The
insurer is therefore expected to be aware of all legal provisions affecting the insurance operations.

6. PROXIMATE CAUSE
The rule of proximate cause means that the cause of the loss must be proximate or immediate and
not remote. If the proximate cause of the loss is a peril insured against, the insured can recover.
When a loss has been brought about by two or more causes, the question arises as to which is the
proximate cause, although the result could not have happened without the remote cause. But if the
loss is brought about by any cause attributed to the misconduct of the insured, the insurer is not
liable.

Proximate cause
The legal definition of ‘proximate cause’ is contained with the case Pawsey v Scottish Union &
National (1908): “Proximate cause means the active, efficient motion that sets in motion a train of
events, which brings about a result, without the intervention of any force started and working
actively from a new and independent source” Proximate cause is the dominant cause-it does not
have to be first. Life itself is full of events, sometimes occurring independently of each other or as a
result of another.

The principle, proximate cause identifies for insurance purposes, which event is the probable cause
of a particular event, leading to a loss and whether this event is insured. Usually, the first and last
event can be easily identified but it is any intermediate events and causes, which happen, that may
be trickier to determine. The event chain must be carefully considered at each stage, questions as to
whether that particular chain was broken by a new and intervening cause, using logic.

Remote causes
These are when an original event has occurred and started the motion towards loss, when another
new and independent cause occurs and the loss happens. Usually a period of time elapses between
the original causes of the remote cause.

Perils Relevant to Proximate Cause

There are three types of relevant perils, which are as follows:
i) Insured Perils
Those which are stated in the policy as insured, such as fire and lighting
ii) Exempted or Excluded perils
Those stated in the policy as excluded either as causes of insured perils, such as riot or earthquake
or as a result of insured perils
iii) Uninsured or Other Perils
Those not mentioned in the policy at all. Storm, smoke and water are not excluded nor mentioned as
insured in a fire policy. It is possible for water damage claim to be covered under fire policy, if for
example a fire occurs and the fire brigade extinguishes it with water.
iv) Indirect Causes
Some policies sometimes exclude a peril if it caused directly or indirectly by another one.
v) Concurrent Causes
These are losses whereby it is clear that more than one event has occurred at the same time,
contributing to the loss. If there is no expected peril involved and the causes cannot be identified or
the parts of the loss separated, then all the damage will be insured. If the losses can be filtered, then
the appropriate settlements will be made, if insured. If an expected peril is involved in loss
involving concurrent causes and the damage cannot be separated then none of the loss is insured. If
it can then only the insured part of the damaged is insured.