Insurance Principles and Concepts
Core principles
Insurance transfers pure risk (loss or no loss, never gain) from an individual to a pool; speculative risk is not insurable. The pool works because of the law of large numbers - more homogeneous exposure units yield a more predictable loss ratio - and because premium must cover expected losses, expenses, and a margin. Indemnity is the guiding promise: the insured is restored to roughly the pre-loss financial position, no better. That promise explains actual cash value, coinsurance, deductibles, and subrogation, which prevents double recovery by letting the insurer pursue a responsible third party.
Two distinctions confuse candidates. Insurable interest in property must exist at the time of loss; in life insurance it must exist when the policy is issued. Moral hazard is a dishonest tendency (arson, staged theft); morale hazard is indifference or carelessness (keys left in the car). Adverse selection - poor risks seeking coverage - is countered by underwriting, exclusions, and deductibles. Retention (deductibles, self-insured retentions) keeps small losses with the insured, and reinsurance protects the insurer, not the policyholder.
Traps
- Asking who holds insurable interest in a borrowed car, a shipped good, or a building under contract for sale.
- Confusing a valued policy (agreed amount paid on total loss) with replacement cost.
- Treating reinsurance as coverage that runs directly to the original insured.
Rule of thumb
Coinsurance: required limit = value × percentage; recovery = limit ÷ required × loss, minus deductible. A $400,000 limit at 80% on a $600,000 building requires $480,000; a $60,000 loss pays 400/480 × 60,000 = $50,000, less the deductible.