Insurance Principles and the Business of Insurance
Core principles
Insurance transfers pure risk from an insured to a pool of policyholders. The contract rests on indemnity, insurable interest, utmost good faith and proximate cause. Indemnity restores the insured to roughly the pre-loss financial position, no better and no worse; actual cash value and replacement cost are different ways to measure it. Insurable interest is a financial relationship to the subject matter: property insurance requires it at the time of loss, life insurance at inception. Utmost good faith requires a proposer to disclose material facts a prudent insurer would want, even if no question asks for them; concealment or material misrepresentation can let the insurer avoid the contract. Proximate cause is the dominant, effective cause of a loss, not merely the last event.
Business mechanics
- Insurers pool risks, underwrite, price, invest reserves and buy reinsurance; reinsurance is a contract between insurers and does not give the original insured direct rights against the reinsurer.
- Subrogation lets an insurer that has paid a claim stand in the insured's shoes against a responsible third party. It cannot be used against the insurer's own insured, and a waiver of subrogation can extinguish it.
- Contribution applies when two or more policies cover the same loss; they usually share pro rata, subject to conditions.
- Adverse selection, moral hazard and correlated losses shape underwriting and exclusions.
Worked example
A homeowner's kitchen fire causes $40,000 damage. The insurer pays the claim, then discovers the tenant's faulty appliance caused it. The insurer may subrogate against the tenant, but the insured cannot also recover the same $40,000 from the tenant and keep both payments; the insured's deductible may be recovered first. If the insured had waived subrogation in the lease, the insurer's recovery right is impaired, so underwriters ask about waivers.
Traps
Insurance is not a guarantee against all loss, and speculative risk is not insurable. A material fact does not become immaterial because the insurer failed to ask. Replacement cost does not automatically override the policy limit. Reinsurance does not make the reinsurer a party to the insured's policy.