MODULE 3
PRINCIPLES OF INSURANCE
In this module we will learn about basic principle of Insurance contract.
Learning Outcome
1. Offer [Proposal] and Acceptance
2. Consideration (Premium)
3. Insurable Interest
4. Material Facts
5. Utmost good faith and duty of disclosure
6. Indemnity
7. Subrogation & contribution
8. Proximate cause
Insurance contract [Policy] is an agreement between Insurer and Insured enforceable by
law. The Indian contract act 1872 governs all contracts in India, including insurance
contracts.
1. Offer [ proposal ] and Acceptance
1.1 Proposal [Offer] is an application for taking an insurance. Generally a person who needs
insurance makes the proposal.
1.2 When an insured approaches insurance company to insure his life or his property he is
required to fill up a form called Proposal form. In proposal form the questions are asked,
depnding on type of insurance sought for.
Examples:
a)In case of insurance of life, generally questions about age, gender , health conditions,
occupation, income etc are asked.
b) In case of property insurance – say for insurance of a house – questions related to type of
construction, age of the building, distance from river etc are asked.
1.3 Depending upon the details given in the proposal insurers decide about acceptance or
rejection of the proposal. If they accept the proposal as it is , it is called “accepted as
proposed”.
1.4 In many cases insurers may be willing to accept the proposal but for lesser covers or
modified terms.
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E.g. If Shyam approaches an insurance company to insure his life against death and disability,
the insurer may not be willing to grant disability cover but may be prepared to grant only
death cover. In this case the proposal is not accepted but what is done by the insurance
company is called issue of a “ Counter Offer”
1.5 When a counter offer is made, the proposer has to decide whether he will accept the
counter offer or not. If he accepts, then it amounts to acceptance.
1.6 Many a times an insurance company also may approach a prospective client and make
an offer to insure his propeerty in that case the offer is made by the insurer and the client
has to decide whether he will accept it or not.
Example: ABC insurers approach a big farmer and offer to insure the crop in his 25 acre field.
Here insurers are making an offer and acceptance lies on the farmer.
2. Considerations [Premium]
2.1 Once an offer is accepted it becomes an agreement. But only agreement is not sufficient
to make an insurance contract valid. Other conditions are also to be fulfilled. An important
condition is about payment of premium. After acceptance if the agreed premium is paid
then only the insurance contract will come to existence.
Premium is the consideration, which is to be paid by the proposer to the insurer, at the
beginning of the period for which the Insurance is being provided.
2.2 Under the provisions of the Contract Act the provision is ‘No consideration no contract’.
If premium is not paid it amounts to absence of consideration and the insurance contract
will not come in to existence. The right to insurance cover depends on payment of
subsequent installments of premium [if any] at the beginning of each period.
Of Importance
Please note life insurance policy has a cooling off period of 15 days after the date of
intimation of underwriter’s acceptance. The proposer has the right to decide to
reject the insurer’s offer, within 15 days of receipt of the policy.
Example: A proposal for insurance was accepted by the insurer on 15th April 2011.
Confirmation about the acceptance was received by the proposer on 15 th May 2011.
The latter, sent a letter intimating that he wanted to cancel the policy. The letter was
sent on 17th of May and reached the insurer on 20th May. Can the proposer cancel the
policy contract?
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3. Insurable Interest
3.1 Insurable interest is said to exist when the insured stands in such a relationship to the
subject matter of insurance that he or she stands to benefit from its existence and suffers
financial loss in the event of its damage or destruction.
3.2 The relationship of insured with the subject matter should be direct and not indirect. In
life insurance one can insure own life, lives of dependent children, spouse, etc. but one
cannot insure brothers, sisters or distant relatives.
Of Importance
Three essential elements of insurable interest:-
1. There must be property, right, interest, life or potential liability capable of being insured.
2. Such property, right, interest, life or potential liability must be the subject matter of
insurance.
3. The insured must bear a legal relationship to the subject matter such that he stands to
benefit by the safety of the property, right, interest, life or freedom of liability. By the same
token, he must stand to lose financially by any loss, damage, injury or creation of liability.
Example: Shyam stays in a house which was purchased by his father ten years ago, with his
wife and brother. He can take a life policy on his life and also on the life of his wife but he
cannot insure his brother’s life. House is owned by his father so Shyam cannot insure it.
3.3 Life policies: For policies covering life insurance, personal accident and sickness
insurance, disability insurance etc.- insurable interest is required when the proposal to
insure is made.
3.4 Property insurances; insurable interest is required at both the times –when policy is
taken and when the loss occurs.
3.5 Absence of insurable interest makes the contract Void or an unenforceable contract. It
is treated as a gambling transaction and payment of any claim under that is illegal.
4. Material facts
4.1 ‘Material Fact’ is a fact which influences a prudent underwriter’s decision to accept the
risk or not. If he decides to accept the risk, at what rates, terms and conditions.
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4.2 In other words, material facts help an underwriter to decide about the acceptance of an
insurance proposal and its terms.
4.3 Examples of material facts:-
Life Insurance: age, health conditions, income, occupation, details of previous policies etc.
Fire insurance: construction of building, occupation, age of the building etc
Crop Insurance: type of crop being grown, acerage of the field, data about yield etc
Motor Insurance: year of manufacture, purpose for which vehicle is being used etc
5. Utmost good faith and duty of disclosure.
5.1 The principle of Utmost Good Faith is a concept which is unique to insurance contracts.
This relates to duty of disclosure of material facts by the proposer. If material facts are not
disclosed or incompletely disclosed, the insurance company can cancel the policy and/or
reject the claim on this ground. This duty of disclosure of material fact lies on the proposer.
5.2 In insurance policies the duty of disclosure is at the time of making a proposal, and
continues till the proposal is completed. The duties of disclosure once again arise, [if a
policy lapses for nonpayment of premium] at the time of revival/ reinstatement in long
term policies.
However, in many nonlife policies, it is mentioned, whether changes in the conditions of
assets insured are required to be intimated or not.
5.3 An insurance policy becomes void when there is concealment with intent to deceive or
when there is fraudulent nondisclosure or misrepresentation.
5.4 Examples:
5.4.1 Ram replies, in his proposal for life insurance, to a question that he does not suffer from
cancer but in fact he is being treated for lung cancer. On his death when the insurer comes to
know about this sickness they can refuse to pay the claim.
5.4.2 For insurance of his tractor, Gautam replies to a question about year of manufacture
of tractor, that it is only two years old. In fact it was assembled by a local manufacturer and
is ten years old. When the tractor becomes “total loss” due to an accident this comes to light
and the insurance company rejects the claim because of non disclosure of material fact.
5.5 However, these duties of proposer/ policyholder cannot be taken advantage by insurers
for avoiding claims. To balance the principle of “Utmost Good Faith” and principles of
policyholder’s right, certain rules have been framed.
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5.5.1 The question of materiality is a question of facts; no straightforward answers can be
given. In real life, many a times this question is a matter of intepretation.
5.5.2 In life insurance policies, Section 45 of Insurance Act 1938 puts a limit on the
insurer’s privilege. In simple words, after two years of commencement of the policy the
insurer can cancel the policy/ reject the claim for breach of “Utmost Good Faith”, only if it
can establish
1. The statement made for obtaining the policy was false or inaccurate. and
2. Such statement was a “Material Fact”. and
3. The policyholder knew at time of making the statement, that the statement was false.
6. Indemnity
6.1 In insurance, to indemnify, means to make good the loss suffered by the insured.
6.2 If the insured suffers loss, due to a loss event, he can recover only the amount of loss
suffered by him and not more. He is not allowed to make any profit out of loss.
6.3 Example: Ramphal has insured his buffalo for Rs 50,000/- and the buffalo dies in an
accident. The market value of the buffalo is Rs 30,000. Insurance company will pay him Rs
30,000 and not Rs 50,000 though he may have paid an insurance premium for Rs 50,000.
6.4 The principle of indemnity is applicable only when there is a possibility of finding out
any definite value of subject matter insured. It is not applicable where there is no such
possibility like in life insurance policy. What is the value of a life? Nobody can say any
definite amount. So the principle of indemnity does not apply to life insurance policy.
7. Subrogation and Contribution
Subrogation and contribution are supplementary to principle of indemnity.
7.1 If insured has any other source of recovery for insured loss, the insurer pays for the
loss. The Insurer acquires the rights of recovery from a third party. This principle is known
as Subrogation. The insured is not allowed to make profit out of a loss, and the insurance
company is able to minimize losses.
Example: Ms. Mayuri had dispatched a consignment of cotton, valued at Rs. 50,000, through
Shyamji Transport service. The consignment was insured for Rs. 60,000. The consignment was
destroyed by fire, due to negligence of the driver, and resulted in total loss. The insurance
company will pay the claim to Ms. Mayuri of Rs. 50,000. At the same time it will acquire the
right to recover from Shyamji Transport Company.
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7.3 The principle of Contribution arises when the insured has taken many policies for the
same property.
Example: if Supriya has insured her farm house worth Rs 1,00,000 with ABC insurance
company for Rs 1,00,000 and with XYZ insurance company for Rs 1,00,000 in the event of loss
of Rs. 50,000/- both insurers will pay Rs 25000/- each and not more. This is done to ensure
that the insured does not make any profit out of the loss.
14.4 As stated earlier these principles support the principle of indemnity so they are not
applicable to insurances where the principles of indemnity is not applicable. They do not
apply to life Insurance policies.
8. Proximate cause
Many Insurance contracts provide indemnity only if losses are caused, by perils, mentioned
in the policy. The concept of proximate cause is used to determine, whether the cause of
loss is an insured peril or an excluded peril. If there are two or more causes for the loss,
whether operating simultaneously or in sequence, the cause which is most effectual in
contribution to the loss is the Proximate Cause. Note that the proximate cause need not
always be the immediate cause of the loss.
To understand the principle of proximate cause, consider the following situation:-
Example: Mr. Pinto, while riding a horse, fell on the ground and had his leg broken, he was
lying on the wet ground for a long time before he was taken to hospital. Because of lying on
the wet ground, he had fever that developed into pneumonia, finally dying of this cause.
Though Pneumonia might seem to be the immediate cause, in fact it was the accidental fall
that emerged as the proximate cause and the claim was admitted under Personal Accident
Insurance.
There are certain losses which are suffered by the insured but cannot be said to be
proximately caused by fire. In practice, some of these losses are customarily paid under fire
insurance policies. Examples of such losses are –
1. Damage to property caused by water used to extinguish fire.
2. Damage to property caused by a fire brigade in execution of its duty.
3. Damage to property during its removal from a burning building to a safe place.
