The essentials of insurance: how it actually works
It’s universal knowledge that life is full of unexpected events. Some are good, but some can be difficult, like a car accident, a fire in the house, or a sudden illness. These bad surprises can cost a lot of money. This is where insurance comes in. It is like a safety net for your finances.
But have you ever wondered how insurance companies can promise to cover such huge losses for so many people? The answer is that the entire system of insurance is built on a few important rules. These are called the “Principles of Insurance.” They are like the rules of a game that both you (the customer) and the insurance company must follow for the system to work fairly for everyone.
Understanding these principles will help you see insurance not as a complicated product, but as a simple promise based on trust and shared responsibility.
The principle of having a good faith is paramount
This is the most important principle. In simple English, it means “complete honesty.”
When you apply for insurance, the company needs to know certain things to decide the price (premium) and whether to insure you at all. They will ask you many questions about your health, your car, your business, etc.
Your Duty: You must answer every question truthfully and to the best of your knowledge. You cannot hide any important information. For example, if you are a smoker applying for life insurance, you must say so. If you have a old car with a bad engine, you must tell the motor insurance company.
The Company’s Duty: The insurance company must also be completely clear with you. They must explain the terms and conditions of the policy in simple language. They cannot hide any important clauses or make false promises.
Why is this important? If you lie or hide information, the insurance company can later refuse to pay your claim. This principle ensures that both sides start the agreement on a foundation of trust.
The Principle of Insurable Interest
This principle says that you must have a financial loss if the insured event happens.
In other words, you can only insure something if its damage or loss would cause you direct financial pain. You cannot insure something just because it might get damaged.
Examples:
- You have an “insurable interest” in your own car because if it is damaged, you have to pay for repairs.
- You have an “insurable interest” in your own house for the same reason.
- A business has an “insurable interest” in its factory or its key employees.
What you CANNOT do: You cannot insure your neighbour’s car or a famous celebrity’s life. Why? Because if their car is damaged or something happens to them, you do not suffer a direct financial loss. This principle stops insurance from becoming a form of gambling where people bet on bad things happening to others.
You must have this insurable interest at the time of taking the policy and, most importantly, at the time of the loss.
The Principle of Indemnity
“Indemnity” is a big word, but it simply means “to restore someone to the same financial position they were in before the loss occurred.”
This is a key principle for most insurance policies (like home, car, or business insurance). The goal of the insurance company is not to let you make a profit from a loss, but to cover your actual loss.
Example: Imagine you have a 5-year-old television that you insured. If it is destroyed in a fire, the insurance company will not pay for a brand new television of the latest model. They will pay you the current market value of your 5-year-old TV. This way, you are put back in the same financial position you were in before the fire—you have the value to buy a similar 5-year-old TV.
This principle prevents “moral hazard,” which is the temptation to cause a loss on purpose to get a big payout.
Exception: Life insurance and personal accident insurance are not contracts of indemnity. You cannot put a price on a human life. So, in these cases, the insurance company pays the full, agreed-upon amount.
The Principle of Contribution
This principle is related to indemnity. It comes into play if you have more than one insurance policy for the same thing.
Example: Suppose you have a valuable diamond ring. You insure it with Company A for $10,000 and, by mistake, also with Company B for $8,000. If the ring is stolen, you cannot claim $18,000 from both companies—that would be a profit, which goes against the principle of indemnity.
Instead, you can only claim the actual value of the ring, say $10,000. The two insurance companies will then “contribute” to this loss in proportion to the amount they insured. So, Company A would pay a larger share, and Company B would pay a smaller share.
The main point is: you cannot make a profit by claiming from multiple policies for the same loss.
The Principle of Subrogation
This is another principle that supports indemnity. “Subrogation” means “stepping into the shoes of another.”
After the insurance company has compensated you for your loss, they take over your legal right to claim against the third party who caused the loss.
Example: Imagine you are in a car accident that was 100% the other driver’s fault. Your insurance company pays for the repairs to your car. Now, the principle of subrogation gives your insurance company the right to sue the other driver (or their insurance company) to recover the money they paid you.
Why is this important? It ensures that the person who is ultimately responsible for the loss pays for it. It also prevents you from getting paid twice—once from your own company and once from the guilty party.
The Principle of Proximate Cause
Sometimes, a loss is caused by a chain of events. The “proximate cause” is the most direct and effective cause of the loss. The insurance company needs to find this root cause to decide if the loss is covered under the policy.
Example: A ship sinks during a storm (which is covered by the policy). But an investigation finds that the ship sank because it was not maintained properly and had a hole (which is not covered). The insurance company will look for the “proximate cause.” If the hole was the main reason, the claim may be rejected. If the storm was the main and active reason, the claim will be paid.
This principle helps in settling claims fairly when the cause of loss is not straightforward.
The Principle of Loss Minimization
This is a common-sense duty placed on you, the policyholder. It says that you must take all necessary steps to minimize the loss when it happens.
Insurance is not an excuse to be careless. You have a responsibility to act like a prudent person even if you are insured.
Example: If a fire breaks out in your kitchen, your first duty is to call the fire brigade and try to put out the fire with an extinguisher. You cannot just stand outside, watch the house burn, and say, “It’s okay, the insurance company will pay.” If it is found that you did nothing to control the fire, your claim could be reduced or even rejected.
Conclusion
Insurance is not magic. It is a carefully designed system based on fairness and shared risk. These seven principles work together to keep the system stable and honest. They protect the insurance company from fraud and irresponsible behavior, and they also protect you by ensuring that the company will be there to support you when a genuine loss occurs.
The next time you buy an insurance policy, remember that you are entering a contract based on “utmost good faith.” By being honest and understanding your responsibilities, you make the whole system stronger and more reliable for everyone. It is a partnership where everyone plays by the rules to create a safety net for life’s uncertainties.