Fundamentals of Insurance and Risk Management: Pure Risk, Pooling and the Governing Principles
Domain 1 checks whether you can separate risk that can be insured from risk that cannot, and how the technical principles of insurance turn a pool of premiums into a claim payment. The paper is definition-heavy but also asks 'which principle applies here' and simple numerical items.
Risk: pure, speculative and how it is treated
- Risk is uncertainty about loss. A peril is the cause of loss (fire, flood, theft); a hazard increases the chance or the size of loss. Hazards are physical (a timber godown), moral (deliberate arson) or morale (careless storage of oily rags).
- Only pure risk - loss or no loss - is insurable. Speculative risk (share trading, launching a new product) has gain as well as loss and is not.
- Risk management runs identify → evaluate → treat. Treatment options are avoidance, loss control, retention or self-insurance, sharing, and transfer. Insurance is only the transfer option.
Principles that decide claims
- Insurable interest - a legal or financial loss if the event occurs. In property it must exist at the time of loss; in life at inception.
- Utmost good faith - the proposer discloses every material fact; the insurer discloses the policy terms.
- Indemnity - the insured is restored to the pre-loss financial position, never better off.
- Subrogation - after paying, the insurer steps into the insured's right to recover from the negligent third party.
- Contribution - two policies on the same interest share the loss pro rata.
- Proximate cause - the nearest effective cause decides whether a peril is covered.
Worked example
A shopkeeper's stock worth ₹10,00,000 is insured for ₹10,00,000. A short circuit starts a fire and ₹3,00,000 of stock is destroyed. The insurer pays ₹3,00,000, not the sum insured, because of indemnity. It then sues the contractor whose faulty wiring caused the fire - that is subrogation. If a second policy also covered the same stock, the two insurers would pay ₹1,50,000 each under contribution.
Traps that cost marks
- Writing that 'insurance reduces risk' - it pools and transfers risk, it does not remove the peril.
- Applying subrogation or contribution to a life policy; life insurance is not a contract of indemnity.
- Mixing hazard and peril in the same sentence.