Insurance Principles and Risk Management Fundamentals
This domain tests the foundation of insurance: how risk is identified, measured, and financed, and the legal principles that make a policy enforceable. Expect questions on insurable interest, indemnity, utmost good faith, subrogation, contribution, and proximate cause, plus the risk-management process.
Core rules
- Risk is uncertainty about loss. Pure risk has only loss or no-loss outcomes and is generally insurable; speculative risk involves gain or loss and is generally not insurable.
- Insurable risks are measurable, fortuitous, definite in time and place, and spread across a large pool of similar exposures.
- Risk management follows identify, measure frequency and severity, select control or financing techniques, implement, and monitor. Control includes avoidance, prevention, and reduction; financing includes retention and transfer.
- Indemnity restores the insured to the pre-loss financial position, not better. Actual cash value is replacement cost minus depreciation.
- Insurable interest must exist at the time of loss for property and at inception for life insurance.
- Utmost good faith requires disclosure of material facts. Material misrepresentation can void coverage or affect a claim.
- Subrogation transfers the insured's recovery rights to the insurer after payment. Contribution shares a loss among concurrent policies to prevent double recovery.
- Proximate cause is the dominant, efficient cause of loss, not necessarily the last event.
Worked example
A building has a replacement cost of 200,000, depreciation of 40,000, and a 5,000 deductible. The actual cash value claim is 200,000 minus 40,000 minus 5,000, or 155,000. If replacement-cost coverage applies and the insured repairs, payment may be based on replacement cost less the deductible, subject to policy conditions. The reasoning is that indemnity uses actual cash value unless replacement cost is purchased and its conditions are met; the deductible then reduces the payable amount.
Traps that cost marks
- Treating market value as actual cash value.
- Assuming every risk is insurable.
- Confusing subrogation with additional insurance.
- Missing the timing rule for insurable interest.