Basic Insurance Principles and Practice
Risk and the insurance mechanism
Insurance transfers the financial consequences of specified uncertain events from an individual or business to a pool of policyholders. The insurer needs a large number of similar, independent exposures so that actual losses approximate expected losses (the law of large numbers). Underwriting assesses frequency and severity; risk management reduces both. Moral hazard is behaviour changed by insurance; adverse selection is the tendency of poorer risks to buy cover.
Core legal principles
- Insurable interest: a financial interest in the subject matter. It is required at inception for life policies (Life Assurance Act 1774) and at the time of loss for indemnity covers (marine: Marine Insurance Act 1906 s.4).
- Indemnity: restores the insured to the pre-loss financial position, no better. Reinstatement or new-for-old is an exception. Underinsurance triggers average only where the policy contains an average condition.
- Utmost good faith is now codified: commercial insureds have a duty of fair presentation under the Insurance Act 2015; consumers are protected by CIDRA 2012.
- Proximate cause: the dominant, effective cause of loss, not merely the last event.
- Contribution and subrogation prevent profit. Contribution applies between indemnity policies covering the same interest and peril; subrogation gives the insurer recovery rights after paying a claim.
- Reinsurance protects the insurer; it does not change the insured's contract.
Worked example
A commercial property has a sum insured of £80,000, an actual replacement value of £100,000 and an average condition. A fire causes £20,000 damage; the policy excess is £250. The insured is underinsured by 20%. Claim = £20,000 × (80,000 ÷ 100,000) = £16,000, less £250 = £15,750. Without average, the insurer would pay £19,750, subject to the sum insured. Average is a proportional adjustment, not a penalty.
Traps that cost marks
- Treating the sum insured as the claim limit where a reinstatement basis and average apply.
- Confusing contribution with subrogation: contribution is between insurers, subrogation is against third parties.
- Saying consumers must disclose 'all material facts'; CIDRA requires reasonable care, not a perfect memory.
- Applying the commercial fair presentation rules to consumer contracts.
- Assuming reinsurance gives the insured a direct claim against the reinsurer.