Insurance Principles and Concepts
Core principles
Insurance transfers pure risk (chance of loss only); speculative risk is not insurable. Insurers make the math work through pooling and the law of large numbers, and adverse selection is the enemy of that math. Insurable interest must exist at the time of loss for property, and at inception for life insurance. The principle of indemnity says the insured should be restored to roughly the pre-loss financial position and no better, which is exactly why subrogation exists: after paying, the insurer steps into the insured's shoes against a negligent third party.
Contract characteristics
A policy is a contract of adhesion (drafted by the insurer, so ambiguities are construed against the drafter), aleatory (unequal exchange of value), conditional (benefits depend on the insured's compliance with duties), and unilateral (only the insurer makes an enforceable promise). Utmost good faith underlies the application and the duty to disclose material facts.
Valuation
Actual cash value equals replacement cost minus depreciation; replacement cost pays new-for-old up to the limit. Commercial coinsurance penalizes underinsurance: recovery equals (limit divided by required limit) times the loss, capped at the limit.
Traps
- Moral hazard (dishonesty or intent) versus morale hazard (carelessness).
- Proximate cause: the dominant, efficient cause controls, and ensuing loss can be covered even when the initiating peril is excluded.
- Waiver and estoppel: an adjuster's informal assurance can bind the insurer, so be careful what you promise.
Worked example
A roof with a 20-year life is 10 years old and costs $20,000 to replace. Depreciation is 50%, so ACV is $10,000. Subtract a $1,000 deductible and $9,000 is payable - unless the policy settles on a replacement cost basis.