1.1.

Principles of General Insurance

The main motive of insurance is Co operation. Insurance is defined as the

equitable transfer of risk from one Entity to another in exchange of Premium.

The basic principles insurance are as follows:

1.8.1. Nature of Contract

Nature of contract is a fundamental principle of insurance contract. An

insurance contract comes into existence when one party makes an offer or
proposal of the contract and the other party accepts the proposal.

The contract should be simple to be understood by each party. The person

entering into the contract should enter with his free consent.
1.8.2. Principle of Utmost Good Faith

In the case of a contract both the parties to the contract are required by law to
observe good faith.

However, in general transactions, say a transaction where a person has gone

to a store to buy some products, the buyer is supposed to satisfy himself
about the features of the product that he is buying. The seller is supposed to
disclose all material facts about the product and also the facts so disclosed
should not be misleading. However the is not obliged to disclose each and
every fact of the product. This casts a responsibility on the buyer to satisfy
himself about the quality and other features of the product.

If after the purchase of the product the buyer is not satisfied by it, he does get
a legal right to go back to the seller and return the goods. Now the discretion
is with seller whether to accept the goods or not. The seller would be well
within his right to refuse the return of goods on the contention that the buyer
had satisfied about the quality and other relevant features of the product
before buying the product.

This principle is known as Principle of ‘Caveat Emptor’ which means that let
the buyer beware. This principle is applicable to all commercial contracts.

However Insurance Contracts are different from General Contracts. While

general contracts work on the principle of ‘simple good faith’ insurance
contracts work on the principle of ‘utmost good faith’. The principle of
utmost good faith is also known as principle of Uberrima Fides’.

Let us now see as to why the insurance contracts must follow the principle of
utmost good faith and not simple good faith.

a. In an insurance contract the seller is the Insurer and the buyer is the
insured. In this case the buyer or the insured has the full knowledge of
the property being insured and the seller is ignorant about it. This is a
situation which is opposite of a general purchase contract. In a general
purchase contract it is the seller who would have full knowledge and
details of the property and not the buyer.

Thus in case of insurance contracts the seller would be dependent upon

the buyer to provide complete information about the property. In view
of this there is a need of
 utmost good faith of the insurer on the insured that the later has
provided full information of the property.

It could be argued here that the insurer has the option to examine the
property. But such examination may not bring forth all facts and
especially the history of the property.

Let us examine a situation where a person is seeking medical

insurance. In such a case the Insurance Company would insist on the
medical examination of the said person to know full facts about the
health and the medical history of that person i.e. past illness, accidents
etc.

However, such medical examination may not reveal the complete

medical history of the said person. Hence notwithstanding the medical
examination, the insurance company would expect the proposed
insured person to disclose full details about his medical condition so
that the insurance company is able to take a prudent decision on firstly
whether to provide insurance cover and if so, at what cost i.e. should
be the premium.

b. Insurance is an intangible product. It cannot be seen or felt. It is simply

a promise on the part of the Insurer to make good the loss incurred by
the insured if and when it occurs.

Hence, while the insured must disclose all information about the
property for which he is seeking insurance. It is also the duty of the
Insurance Company not to make any false promises during negotiation.

The Insurer must exactly appraise the insured about the circumstances
in which and the extent to which it would be compensated by the
Insurance Company in case of damage.

For instance in the case of earthquake in Gujarat (Latur) a number of

disaster victims failed to get any relief from the Insurance Company as
the risk of earthquake was not covered.
 Thus the term ‘Utmost Good faith’ can be defined as ‘ A positive duty
to voluntarily disclose accurately and fully all facts material to the risk
being proposed whether requested for or not.

In an Insurance contract utmost good faith means that ‘each party to

the proposed contract is legally obliged to disclose to the other all
information which can influence the others decision to enter the
contract.

In case it is found that full and true disclosures were not made at the
time of the contract the effected party will have the right to regard the
contract as void.

From the above we can arrive at the following conclusion:

 Each party is required to tell the other the truth and the
whole truth and nothing but truth.
 Failure to reveal information even if not asked for gives the
aggrieved party the right to regard the contract void.

1.8.3. Principle of Insurable Interest

One of the essential ingredients of a Insurance Contract is that the insured

must have insurable interest in the subject matter of the contract.

A person is supposed to have Insurable Interest in something when the loss or

damage to that thing would cause the person to suffer financial or any other
kind of loss. Thus insurable interest means that the Insured must stand to
suffer a direct financial loss if the event against which the insurance policy is
taken does actually occur.

The insurable interest is generally established by ownership, possession or direct

relationship. For example people have insurable interest in their own houses
and vehicles and not in neighbour’s houses and certainly not that of
strangers.

For an insurance company the insurable interest is the basic reason for
issuing a legal insurance cover to an insured (or the beneficiary) as it gives
legal right to enforce an insurance claim.
There are four essential components of Insurable interest:

 There must be some property, right, interest, life, limb or potential

liability which is capable of being insured.
 Any of the above i.e. property, right, interest etc must be subject matter of
insurance.
 The insured must have a formal or legal relationship with the matter
which is the subject of insurance.
 The relationship between the insured and the subject matter of
insurance must be recognized by law.

Examples of Insurable Interest

a. If the house you own is damaged by fire, the value of your house has

been reduced by damages sustained in the fire. Whether you pay to

have the house re built or you end up selling it at reduced price, you
have suffered a financial loss from the said fire.

On the contrary if your neighbor’s house which you don’t own is

damaged by fire you may feel sympathetic for your neighbor and you
may also be emotionally upset, but the fact is that you have not
suffered any financial loss from the fire. You have insurable interest in
your own house but in this example you do not have an insurable
interest in your neighbor’s house.

b. In Life Insurance everyone is considered to have an insurable interest

in his own life and that of his spouse.

c. At times the insurable interest may be subjective. For instance the

Employer has an insurable interest in the lives of their employees.

The reason for this is that if the employee dies or becomes
incapacitated due to an accident there will be a cost of training of the
employees who would replace the existing employees who has expired.
In such case the amount of insurable interest cannot be exactly
determined but it should be reasonable and proportionately related
with the salary of the employee. Insurable interest is one of the
foundations of insurance business because in its absence the
insurance contract would not constitute a binding contract. Absence of
Insurable Interest would make the contract of Insurance Null & Void.
1.8.4. Principles of Indemnity

Indemnity according to Cambridge International Dictionary means

‘Protection against possible damage or loss. Thus Indemnity means security,
protection and compensation given against damage, loss or injury.

In context of Insurance indemnity is defined as ‘Financial Compensation

sufficient to place the Insured in the same financial position after the loss as
he enjoyed immediately before the loss was incurred’.

Thus under the principle of indemnity the insured should be compensated

only for the loss that has been incurred by him as a result of the event in
respect of which the insurance has been taken.

It will not be in order if the Insured should make any profit out of such event
(such as fire, motor accident etc.)

Since the compensation of loss, and only the loss, is the basic factor under
the principle of indemnity, it will be essential that the evaluation of loss is
done as precisely as possible. Though the financial evaluation of loss is
possible in most of the cases, in case of loss of life and disablement it may
not be precisely possible to determine the loss in monetary terms.

In certain cases the amount of compensation given by the Insurer may be less
than the actual loss that has been incurred. However under no circumstances
the compensation to the Insured should be more than the loss that has been
incurred. This is more adequately explained by the following two examples:

a. “A” has insured his bike for Rs 50,000. Unfortunately he meets with an

accident and the bike is extensively damaged. This results in total loss
of the bike. Though ‘A’ must get a compensation of Rs 50,000 as his
bike has been totally destroyed in the accident but this may not always
be the case.

There could be a possibility that either he has estimated the value of

the bike at a higher price than its real value or that the prices of the
bile have been reduced.
 In both the cases Insurer will pay compensation of an amount that is
equal to the value of the bike at the time of Insurance. In such case if
the Insurer finds that a bike of the same make and model and in the
same condition as existed immediately before the loss is available for
Rs 30,000, he will be liable to pay only Rs 30,000 and nothing more
than this.

b. Suppose in the case mentioned above in the said accident the bike is

only partially damaged & can be adequately repaired to bring it back to

its condition immediately prior to the loss. However during the process
of repairs certain parts are replaced. Assuming that the bike was two
years old. In such case the parts that need to be replaced would have
suffered wear and tear.

In this if the Insurer gives the value of the new part as compensation to
the Insured, it would mean that the Insured is making a profit out of it.
This will be against the Principle of Indemnity.

Hence in this case the Insurer will make a suitable deduction from the
cost of the new part in respect of wear and tear of the part that has been
damaged and accordingly pay the balance amount to the Insured.

Exceptions

However there are certain exceptions to the ‘Principles of Indemnity’.

These are as follows:

a. As discussed above in case of Life and Personal Accident (ie

accident to an individual) Insurance it is not possible to make

financial evaluation of the loss.

Hence the Principle of Indemnity cannot be strictly made

 applicable to this case.

b. There are certain Insurance Policies called ‘Agreed Value

Policies’. In case of such policies at the time of entering into

contract the Insurer agrees that it will accept the value of the
property as stated in the contract of insurance or the Insurance
Policy as the true value and indemnify the insured to this extent
in
 case of total loss. Such type of policies is obtained for Jewellery,
Antiques, and valuable pieces of Art etc. This amount will be the
sum assured.

In this case also the Principle of Indemnity cannot be strictly followed.

c. There is another type of policy where the principle of indemnity

cannot be strictly followed. Such policies are called

‘Reinstatement Policies’ issued for Fire Insurance etc.

In case of such a policy Insured is required to insure the property

for its Replacement Value i.e. the value at which it will be
replaced.

In this case the Insurer agrees that in the event of a total loss he
shall replace the damaged property with new one or shall pay for
the replacement of the same.

Except for the exceptions stated above the principle of indemnity

is strictly followed in Insurance.

1.8.5. Principle of Subrogation

The Principle of Subrogation is basically a corollary or an offshoot of the

Principle of Indemnity.

We have already seen in the preceding sections that the purpose of indemnity
is to ensure that the Insured does not make any profit or gain in any way or as
a consequence of loss. He should, at the maximum, in the same financial
position which he had occupied immediately before the loss had been
incurred.
However, in case the Insured gets compensated for the loss by the Insurer
and, simultaneously or subsequently, also gets compensated, fully or partly,
for the same loss from a third party, the insurer is entitled to recover such
additional compensation from the insured.

In case the insured, after having received compensation for loss

(i.e.indemnity) from the Insurer also receives from another person any
amount towards such loss then he will be placed in a position of gain which
is against the Principle of Indemnity. Hence the Insurer will have the right to
recover the indemnity or the compensation paid to the Insured to the extent
the same has been received by the Insured from a person other than the
Insurer though limited to the compensation paid by the Insurer.

The theory discussed above forms the premise or the objective of the
‘Principle of Subrogation’.

Subrogation may be defined as ‘transfer of legal right of the Insured to

recover to the Insured’.

However there is a limitation to the right of the Insurer to recover the

compensation paid by it to the Insured. The Insurer can only claim the
amount of compensation paid by it to the Insured. If the Insured has received
an amount of compensation which is higher than the compensation paid by
the Insurer, the Insurer will get the right to recover the compensation given
by it and nothing over and above that.

The principle is that if the insured is not allowed to make profit the insurer is
also not allowed to make profit and he can only recover to the extent he has
indemnified the insured.
Exception
There is an exception to the ‘Principle of Subrogation’. This principle does
not apply to Life and Personal Accidents as in respect of these insurances the
‘Principle of Indemnity’ is not strictly applicable to these insurances.

In case the death of a person is caused by the negligence of another person

then the legal heirs of the deceased can initiate proceedings to recover from
the guilty party a compensation which will be in addition to the proceeds of
the Life Insurance Policy of the deceased.
In such case the Insurance Company providing the Life Insurance Policy
does not get the right to receive compensation from the legal heirs in respect of
such additional compensation.

1.8.6. Principle of Contribution

Contribution is also a Corollary or Offshoot of Principle of Indemnity.

An individual may have more than one policy for the same in respect in of
the same property and in case of a loss if the Insured is able claim
compensation for the said loss from all Insurers it is but obvious that he
would be making a profit from this loss. This is against the Principal of
Indemnity.

This situation is taken care of by the Principle of Contribution.

Contribution may be defined as the right of the Insurer who has for a loss to
recover a proportionate amount from other insurers who are also liable for
the same loss.

The condition of contribution will arise if the following conditions are met:

 Two or more policies should exist.

 The policies must cover a common interest.
 The policy must cover the same cause or event which results into a loss.
 The policies must cover a common subject matter i.e. the same property.
 All the policies must be in operation at the time of loss.

It may be noted here that it is not essential that the policies should be identical to
each other.

The essential condition for the principle of contribution to come into force is
that the two policies should overlap each other. The subject matter should be
common and the event causing the loss should be common and covered by
both the policies. The same principle will be applicable if there is more than
one policy.

The Insured has the right to recover the loss from any one insurer. The
Insurer who compensates the Insured for the loss will have the right to
recover proportionate amount from other insurers.
In order to make the Principle of Contribution enforceable the insurers
generally insert a clause in the policy that in the event of loss they shall be
liable to pay only ‘ Rate – able proportion’ of loss.

It means that each Insurer will pay only its share and if the Insured wants full
indemnity he should a claim with other Insurers also.

Let us try to understand this by the following example:

Westin Industries Ltd has taken three Insurance Policies to cover the risk of
fire in respect of the same office building.
The sum assured under these three insurance policies is as under:

Sum Assured Policy A Rs 10,00,000

Sum Assured Policy B Rs 20,00,000
Sum Assured Policy C Rs 30,00,000
Total Rs 60,00,000

Assuming that the claim is for Rs 6lacs, the same will be paid by each of the three
insurers in proportion of the sum assured by them.

The amount of claim to be borne by each of the three Insurers would be as follows:

A Rs 1,00,000
B Rs 2,00,000
C Rs 3,00,000
Total Rs 6,00,000

1.8.7. Principle of Causa Proxima (Proximity Clause)

Principle of Causa Proxima is a Latin phrase in English which means Principle of

Proximity.
The loss to a property can be caused by more than one cause. Under this
principle in such a situation the nearest or the closest or the most proximate
cause shall be taken into consideration to decide the liability of the insurer.
Example:
A cargo ship’s base was punctured due to rats. This resulted in the sea water
entering the ship and accordingly the cargo was damaged.

Here there are two causes for the damage of the cargo ship:
 The Cargo ship getting punctured because of rats.
 The sea water entering the ship through the punctures.

In this case the risk of sea water is covered but the first cause ie damage due
to rats is not covered. Since the nearest cause of damage is the sea water
which is insured, the insurer must pay the compensation.

However, in the case of Life Insurance, the principle of Causa Proxima does
not apply. Whatever be the reason of the death (whether natural or unnatural)
the insurer is liable to pay the amount of insurance