The Basic Principles of Insurance
The Basic Principles of Insurance can be viewed as answers to four basic questions or issues, which if they were to be summarized in a single word each, could be called the questions of ‘Who,’ ‘How Much,’ ‘ When and Why,’ ‘What’
First, we are confronted by the question of ‘Who’? Who can take an insurance policy? Can ‘Anyone’ or only the Owner of a property purchase insurance? Or, can ‘Others’ who claim to be affected also do so? Who, then, is entitled to collect compensation for a loss insured by an Insurance Policy? The answer to this question is called the ‘Principle of Insurable Interest.’
Second, before us is the question of ‘How much’? For how much value should insurance be taken, and for what value would the compensation be paid. Is there a relationship between the value insured and the amount paid as compensation? The ‘Principle of Indemnity,’ and its’ corollary, the ‘Principle of Subrogation and Contribution’ provide the answer.
Third, the question arises whether any and every loss is payable under a policy? ‘Which’ losses are payable? In what circumstances’ is a loss not payable under the contract? Is short, why is a particular loss payable, and another not payable. The answer to this dilemma is provided by the ‘Principle of Proximate Cause.’
Fourth, what must the Insured and Insurer do to uphold the spirit of their contract? It is well known that all contracts are founded on ‘Good Faith.’ Yet, contracts of insurance are somewhat different, and given their unique features, the contracting parties are bound by reciprocal rights and duties which go beyond the requirements of ‘good faith’ demanded under ordinary contracts. The conduct of the Insured and Insurer must be based on ‘Utmost Good Faith.’ The ‘Principle of Utmost Good Faith’ lays down the guiding operational principle behind their various reciprocal rights and duties.
At one glance these questions appear quite simple, and their answers obvious, and neither would seem to require consideration at any great length. A little bit of ‘common sense’ is all that seems to be required to provide solutions. Yet, as the saying goes, ‘Common Sense is anything but common, and often events are a jumble of occurrences not easy to segregate and disentangle into distinct features. Basic Principles, common sense, rigorous application of logic, and established business conventions provide the basis for correct decisions. We shall now discuss these ‘Basic Principles’ in detail.
The Principle of Insurable Interest
Consider the first question posed a little earlier. Who can buy an insurance policy? It is tempting to offer the immediate response that anyone could buy one if they were willing to pay for it. That is correct, but only part of the truth. If we keep the ‘purpose’ of insurance in mind, the answer to this question becomes obvious.
The purpose of insurance is to offer financial protection against an accidental loss. Who would suffer a loss if some property were damaged? Obviously the ‘Owner’ of the property would stand to lose. In addition so would any person who has the responsibility for its safety and maintenance, or a contractual duty to compensate the owner for its loss. Such a person is called a ‘Bailee.’ Likewise a Bank or Financial Institution may have mortgaged the property and advanced a loan against it to the owner, and they too would suffer a loss if the property were damaged and the owner unable to pay back the loan. The Bank or Financial Institution are ‘Mortgagors’ and have an insurable interest to the extent of their loan. Owners, Bailees and Mortgagors are said to have an ‘Insurable Interest’ in specific property which can be protected through insurance.
We can define Insurable Interest as “the interest of a person in some property, life or asset where damage or loss to such property, life or asset would lead to a financial loss to the person, and the continued preservation of the same would result in financial benefit.”
A few examples will help illustrate the meaning of Insurable interest better. A person who buys a Car, or inherits a house has an insurable interest in it as the legal owner. Other family members may benefit from the use of the asset, may be emotionally attached to it, but have no ‘insurable interest’ as they have no legal relationship with it and would not suffer any financial loss if it were damaged. A parent bears legal and financial responsibility for their dependent children, and therefore has insurable interest in their health and wellbeing. The parent therefore has an insurable interest in the children which can be protected through insurance. Similarly, an individual has an insurable interest in their spouse.
An employer, whether a small shop owner or a large industrial conglomerate, is responsible for the safety of his employees while at work. Employers are also liable at law to compensate employees for injuries or deaths suffered during the course of employment, and therefore have an insurable interest in the person of their employees.
Not just the Owner, but even a Tenant or Licensee, conceivably, has an insurable interest in the property occupied by them under the terms of a contractual agreement which holds them responsible for the continued maintenance of the occupied property and its eventual return in good condition to the owner. The tenant who occupies a house, or a hirer who uses a machine, may become liable to pay for the accidental damages to the rented or hired property. This creates an interest, the contractual responsibility, which can be insured against specified accidental damages.
To summarize, anyone who will suffer a financial loss if the insured asset is damaged or destroyed, is said to have an ‘Insurable Interest’ in it, and can take an insurance policy to protect it. In addition, someone who is responsible for the maintenance and safety of the property and can be held liable if it is destroyed, with a responsibility to pay compensation, has an insurable interest in the property at least to the extent of his liability.
The Principle of Indemnity
The idea behind the principle of Indemnity can be best understood if we remember the basic purpose of insurance which is to provide adequate compensation for a loss. A person who suffers a loss must be restored to the same financial position in which he was placed before the loss occurred. Insurance professionals like to say that the objective of insurance is to “make good the loss.” The loss, it is said, should be reimbursed in full, but no one should make a profit from the loss, by gaining an amount that is greater than the value of the loss suffered. Equally, the purpose is not achieved if someone only gets partial compensation. Then, the idea of insurance itself would have failed, since that individual would have suffered a loss despite the activity of ‘insuring’ the risk. Therefore, Indemnity can be described as adequate compensation, which creates neither a profit nor a loss for the Insured. We are now in a good position to formulate a definition of the principle of indemnity.
The Principle of Indemnity states that through the medium of insurance, an Insured should be able to obtain such measure of compensation that he is restored to the same financial position as he was in before the event of loss occurred, achieving in the end neither a profit nor a loss as result of the mishap.
The principle of indemnity is one of the five pillars which together uphold the edifice of insurance, but by itself it is not enough to achieve the goal of adequate compensation. Think of a situation in which an Insured person first obtained the full compensation from the Insurance Company, and then proceeded to sue the person who had caused the damage. He would be entitled to sue under the Law of Torts, and the Courts may award him some amount as Damages. If this were to happen then this Insured person would have got not only the full compensation from the Insurance Company, but also some additional compensation through legal action. Over and above all this, the Insured could also sell the ‘Salvage’ which is the scrap or damaged item for whatever value it could fetch. All told, he would have received more than he lost, and would now be making a profit. This is something which is against the objective of insurance. The Principle of Subrogation is designed to prevent this from happening.
The Principle of Subrogation and Contribution Subrogation
Subrogation should be described as the legal right of one person, after having indemnified another person due to a contractual obligation to do so, to stand in the place of the latter and avail of all the rights and remedies of the latter, whether enforced or not. Therefore, Subrogation lies in assuming the legal rights of a person for whom expenses or a debt has been paid. The person who pays for the damages of some other also automatically acquires all the rights and obligations which the latter person had regarding the damaged property.
Typically, in insurance, subrogation occurs when an insurance company pays a claim to the Insured, or admits liability to pay it. The Insurance Company is now said to be ‘subrogated’ to the rights of the claimant. It has now automatically got the legal right to sue and recover whatever was due to the Insured from any third parties who may have been responsible for the loss. The Insurance Company also has the right to take over the damaged property, or ‘salvage,’ and sell it to realize the best price possible
In legal terms, the Insurance Company is the Subrogee, while the Insured is the Subrogor, and
the person responsible for the damage, and who has to be sued, is the Tortfeasor.
The operation of subrogation will become clearer through the example below.
Example: ABC Ltd., Mumbai, sends cargo to its buyer XYZ Ltd., Chennai, by Road, through TUV Ltd., a Road Transport Company. ABC Ltd. takes In-land Transit All-Risks Cargo Insurance from RGIC, Mumbai. The Cargo is delivered in a damaged condition. XYZ Ltd., which refuses to accept damaged goods and asks ABC to replace the damaged items. ABC has suffered a loss, and it makes a claim on RGIC under its’ policy. Now ABC has a legal right to recover damages from the carrier TUV Ltd. RGIC will pay the claim to ABC, and then, by the law of Subrogation, all the rights of ABC accrue to RGIC, which will be entitled to recover due amount from the Carrier, TUV Ltd.
The principle of Subrogation states that after a claim has been paid or liability to pay it has been accepted under the contract of insurance, the Insurance Company becomes entitled to all the rights and remedies which were originally available to the Insured, whether to sue and recover damages from third parties responsible for the loss or to sell the damaged article as salvage.
The law of subrogation takes care of one loophole which could have resulted in a claimant legally earning profit out of a loss. Due to the act of Subrogation the right to recover damages and sell salvage belongs to the Insurance Company after it has paid a claim to the Insured. Without the operation of ‘Subrogation’ the Claimant would be able to sell the Salvage and recover ‘Damages’ through legal process even after having collected full compensation from the Insurer. The amount collected as salvage and for damages would be a profit over and above
the sum received as compensation. However, one more loophole still remains. What if an insured takes multiple policies from different companies to cover the same property against the same risks? For example, suppose the owner of a small garment factory decides to insure the factory building valued at one crore rupees (INR 1,00,00,000/-) by taking four different policies from different companies. Each policy insures the building for one crore. If the factory building was totally destroyed, the factory’s owner would be in a position to collect a claim of one crore under each of the four policies and walk away with a sum of four crore rupees against a loss of only one crore, except for the Principle of Contribution.
Contribution
The ‘Contribution’ condition which is a part of all insurance policies is a corollary to the Principle of indemnity. In its absence an insured could obtain more than one policy covering the same risk, and he would be able to recover the same loss from more than one source. The Contribution condition stops this from happening. It ensures that each policy pays only a portion of the loss that is equal to its share of the total value of insurance by all the policies. Otherwise a Insured could recover multiple amounts from different policies and would wind up making a profit, out of a calamity like a loss. This would defeat the spirit and purpose of Insurance.
The example of the Garment Factory can be used to illustrate the workings of the principle of ‘Contribution.’ The Owner had taken out four Fire Insurance policies A and B for Rs.1,00,00,000/(one crore) each, and C and D for Rs. 50,00,000/(fifty lac each) to insure the factory building.
suppress information or misrepresent facts. The Insurer, who draws up the contract, must ensure that the policy is free from ambiguity in covering the risk in the same manner in which the Insured proposes to cover it. In simple words, ‘no window dressing of facts’ by the Insured and ‘no sugar coating of the conditions’/ ‘no fine print in the policy’ by the Insurer must guide their contractual relationship. Non-disclosure or misrepresentation by the Insured make the policy void or voidable, and would allow the Insurer to not pay a claim. Similarly, any ambiguity in the policy conditions would result in the benefit of the doubt going to the Insured.
Usually most people do not find it difficult to think of a ‘cause’ for events and actions they come across in their daily lives. In fact human beings are conditioned by years of habit and education to believe that nothing happens without a reason and everything has a cause. They view their lives through the cause-effect paradigm, and with a little effort can usually come up with a probable cause, right or wrong, for what happens around them. People sometimes say they missed a train or could not catch a flight because they got caught in a traffic jam. In their view the ‘Traffic jam’ is the cause for the missed flight. Yet, in a different view, it is not the traffic jam but the lack of adequate planning to account for such eventualities, the last minute delays or detours, which could be the reason for not reaching the airport on time. Sometimes it is quite easy, and at others quite difficult, to tell the real cause for what happened as we shall see a little later in this discussion.
It is important to know the real ‘cause’ for both good and harmful actions, if for no other reason then, at least to ensure that mistakes are not repeated and the right actions are always taken. In terms of the business of insurance it is vital to know with certainty the ‘real’ or ‘actual’ cause for any particular event that leads to a loss. Losses that are caused by perils insured by an insurance policy are payable to the policyholder, and It is therefore important to establish a simple and unambiguous methodology for determining the cause of loss or event. We need a defined, universally accepted, way of deciding upon the ‘cause.’ This need is fulfilled by the principle of ‘Proximate Cause.’
The classical definition of ‘Proximate Cause’ describes it as the active and efficient cause
[13:01, 8/29/2021] bjaydev334: and burn strongly, and the blaze had spread before the Fire Brigade managed to control it. In this example it is not difficult to identify the proximate cause of the fire which destroyed the General Store. The carelessly thrown cigarette butt was the proximate cause. Even if the fire in each shop is treated as a separate and distinct event, the proximate cause for each shop, other than the General Store, can be easily identified as the fire which was burning in the neighbouring store.
Next, consider a slightly more complex example. A man got up late in the morning. He had been working till late the night before, had finished some important work and wanted to reach his workplace early next morning to deliver the output. In the little time that he had he knew that he had to rush and somehow catch a train. As he reached the railway platform he saw a train about to depart and began to run to catch it. The surface of the platform was slippery for it has rained a little while ago and in his hurry the man lost his footing on the rain slicked surface. He twisted his ankle, fell down and broke his arm. The two injuries he suffered, a twisted ankle and a broken arm were the result of his fall on a slippery surface. Did he slip because he lost his footing, or because the surface was slippery? Was he a little less careful because he was in a hurry? What caused him to get up late that morning? Could he have finished his work more quickly in the night, and could he have got up a little earlier than he did? Was it ‘work’ or laziness that lay at the root of his lack of time? The questions and possible answers, the permutation and combination of possible factors is extremely large. The concept of proximate cause simplifies the whole issue of what caused the injuries. It was the loss of footing which caused the man to fall down and injure himself. The slippery nature of the surface, the rainfall which made it slippery, the man’s need to hurry and catch the train, may have added to the hazard and to the probability of a man losing his footing, but they are in the nature of independent sources or factors and cannot be considered ‘active’ or ‘efficient’ causes of the injuries. The act of accidentally slipping is the ‘active’ and ‘efficient’ cause that started the train of events which resulted in the man falling down and injuring himself. This is the proximate cause.
The concept of ‘proximate cause’ is very logical and fairly straight forward, and you may well wonder why an elaborate or formal definition of it is required at all. In fact there is a very good reason why such a definition is required. You will notice that more often than not individuals tend to blame something, anything, at times even everything, for whatever goes wrong. Usually this is a subjective exercise, a type of ‘blame game.’ For instance, in the second example mentioned above, people could consider ‘over work and fatigue,’ ‘lack of adequate rest,’ ‘haste, ‘slippery surface’ as root causes for the injuries. ‘Cause’ means different things to different people, but it is important to eliminate subjectivity from the process of decision making. At times, real life situations can also be more complex than these simple examples, and multiple factors can function at the same time to produce an event which is a chain of occurrences that are not easy to segregate. In such situations it becomes all the more necessary to deploy a standardized definition. A definition provides a standardized can easily find out through inspection and enquiry, then it is not necessary for a seller to provide that information. If the seller does not provide the buyer with complete information, or provides information which may not be completely accurate, but provides the buyer with full opportunity to obtain and verify such information, then he will have satisfied his duty of “Good Faith.”* Truly the buyer must ‘beware.’ Good faith requires all parties to achieve common understanding and intention, on the basis of information freely and fairly exchanged about facts which are either in the public domain or can be easily verified by them. Lack of Good Faith, or bad faith, arises when one party presents incomplete or incorrect information in a situation where the other parties are denied the opportunity or do not have the opportunity to fairly and independently verify it.
Insurance Contracts however require the parties to observe not just good faith, but ‘Utmost Good faith. Why? And, how is this to be achieved? Why is the condition of Good Faith adequate for all other types of contracts, but needs to be transformed into ‘utmost good faith’ when it comes to insurance contracts? Under an insurance contract there is a condition of information asymmetry. The ‘Insured’ or buyer of insurance knows much more about the risk, the history of loss experience, the condition of the property at risk, than the Insurer. Often the insurer may be at a distant location without any opportunity of physically inspecting the property, or knowing the exact conditions of, and hazard to which it is exposed. The Insurer has perforce to depend upon facts revealed to him by the Insured or Proposer as he is called at this stage of the transaction. The responsibility to provide adequate and accurate information in an insurance transaction rests even more firmly and heavily on the Insured than it would on a seller or buyer under an ordinary commercial contract. The Proposer, or Insured, must disclose to the Insurer all material facts that he knows or is expected to know, which would influence the decision of a prudent insurer to accept the risk and determine its pricing. A material fact is all information of the type which acts as a criterion for acceptance of risk by the Insurer and the price at which they would do so. The insurers, who issue the contract document, have the same duty to observe utmost good faith while issuing the policy and should ensure that there is no ambiguity in the contract wording and all conditions are adequately revealed to the Insured.
The essence of ‘Utmost Good Faith’ was perhaps first, and best, enunciated by Lord Mansfield, an English Judge from the 18 century while pronouncing judgment in the leading and often quoted case of Carter v Boehm (1766) 97 ER 1162, 1164. The Judge observed that
“Insurance is a contract of speculation... The special facts, upon which the contingent chance is to be computed, lie most commonly in the knowledge of the insured only: the under-writer trusts to his representation, and proceeds upon confidence that he does not keep back any circumstances in his knowledge, to mislead the under-writer into a belief that the circumstance does not exist... Good faith forbids either party by concealing what he privately knows, to draw the other into a bargain from his ignorance of that fact, and his believing the contrary.””
The Insured must disclose to the Insurer all ‘material’ facts. He must not withhold, deny,
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