Insurance Principles and Concepts
What insurance actually does
Insurance transfers pure risk (loss or no loss) from an individual to a pool; speculative risk (chance of gain) is not insurable. The law of large numbers lets the pool predict aggregate losses, which is what makes a rate credible. Adverse selection (only the worst risks buy) threatens the pool, so underwriters screen applicants. Moral hazard is dishonest behavior after coverage exists (arson, staged theft); morale hazard is carelessness because someone else pays.
The legal principles
- Insurable interest: for property it must exist at the time of loss; for life insurance, at inception.
- Indemnity: the insured should be no better off after the loss. Actual cash value = replacement cost minus depreciation; replacement cost coverage is an agreed exception. Valued policies (life, some fine art) pay a stated amount and ignore indemnity.
- Utmost good faith: representations, concealment, and warranties all matter.
- Contract of adhesion: the insurer drafts it, so ambiguity is construed against the drafter.
- Subrogation: the insurer steps into the insured's shoes but can never recover more than it paid.
Traps
Peril versus hazard (fire is a peril; oily rags are a hazard); proximate cause versus concurrent causation; and the coinsurance trap, where the penalty uses the required limit, not the policy limit.
Worked example
Building replacement cost $1,000,000; 80% coinsurance means $800,000 is required. The insured carries $600,000, suffers a $100,000 loss, and has a $1,000 deductible. Payment = ($600,000 / $800,000) x $100,000 = $75,000, minus $1,000 = $74,000. Carrying the full $1,000,000 would have paid the loss in full.