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Basics of Insurance Principles – The Modern Explanation

Basics of Insurance Principles - The Modern Explanation

Principle of Utmost Good Faith

The principle of utmost good faith is a basic and first primary principle of insurance. According to this principle, the insurance contract must be signed by the both parties (insurer and insured) in an absolute good faith, belief or trust and both parties should a good faith towards each other.

The person who is getting the insurance (insured) must willingly disclose and surrender to the insurer his complete true information regarding the subject matter of insurance.

On the other hand the insurer must disclose all facts regarding the insurance contract (complete, correct and clear information of subject matter and regarding terms and conditions of the contract) unless omitted, hidden, falsified or presented in a wrong manner to the insured.

Also insured must behave in the same way. This principle is applicable to all contracts of insurance such as life, fire, motor, marine and etc.

Principle of Insurable Interest

The insured must has insurable interest about the subject matter of insurance and it is a financial relationship recognized under the law, between the insured and the subject matter of the insurance.

A person has an insurable interest when the physical existence of the insured object gives him some gain but its non-existence will give him a loss.

It means, the insured person must suffer some financial loss by the damage of the insured object. This principle is applicable to all contracts of insurance.

– The owner of a garment factory has insurable interest in the garment factory, because he is getting income from it, but if he sells it, he will not have an insurable interest left in that garment factory.
– Every person has an insurable interest in his own life.
– A merchant has insurable interest in his business.
– A creditor has insurable interest in his debtor.

Principle of Indemnity

According to the principle of indemnity, an insurance contract is signed only for getting protection against unpredicted financial losses arising due to future uncertainties.

Insurance contract is not made for making profit and sole purpose of the insurance contract is to give compensation in case of any damage or loss. In here, the amount of compensations is paid in proportion to the incurred losses and the amount of compensations is limited to the amount assured (sum insured) or the actual losses, whichever is less.

Compensation is not paid if the specified loss does not happen due to a particular reason during a specific time period. Thus, insurance is only for giving protection against losses and not for making profit.

Under this, the insurer agrees to compensate the insured for the actual loss suffered. Also this principle is applicable to general insurance only and in case of life insurance, the principle of indemnity does not apply, because the value of human life cannot be measured in terms of money.

Principle of Contribution

According to the principle of contribution when the insured has taken out more than one policy on the same subject matter, the insured can claim the compensation only to the extent of actual loss either from all insurers or from any one insurer.

The insured claims full amount of compensation from one insurer then he cannot claim the same compensation from other insurer and make a profit. If one insurer pays full compensation, then that insurer can claim proportionate contribution from other insurers.

This principle is a corollary of the principle of indemnity. It is applicable to general insurance contracts only.


Mr. Kamal insures his property worth Rs. 100 000 with two insurers “X ” for Rs 60 000 and “Y” for Rs. 40 000. Kamal’s actual property destroyed is Rs. 30 000. Then he can claim the full loss Rs. 30 000 either from X or Y or he can claim Rs. 18000 from X and Rs. 12000 from Y.

Principle of Subrogation

This principle is corollary of the principle of indemnity and it is applicable to all contracts of general insurance. As per this principle after the insured is compensated for the loss due to damage to insured property, then the right of ownership of such property passes to the insurer.

This principle is applicable only when the damaged property has any value after the event causing the damage. The insurer can benefit out of subrogation rights only to the extent of the amount insurer has paid to the insured as compensation.

Eg: –

Mr. Kamal insures his car for Rs. 500 000. The car is totally destroyed by the negligence of Mr. Nimal. The insurance company shall settle the claim of Mr. Kamal for Rs. 500 000. At the same time, if Mr. Kamal can file a law suit Mr. Nimal for Rs. 600 000 the market value of the car. If insurance company wins the case and collect Rs. 600 000 from Mr. Nimal, then the insurance company will retain Rs. 500 000 plus other expenses such as court fees and the balance amount if any will be given to Mr. Kamal, the insured.

Principle of Proximate Cause

This Principle means when a loss is caused by more than one causes, the proximate or the nearest or the closest cause should be taken in to consideration to decide the liability of the insurer. It is not the latest cause, but the direct, dominant and efficient cause that must be regarded as proximate.


An earthquake overturned on an oil stove and the split oil caught fire from the burning wick. Then burning oil set fire to the building. Eventually the fire in this building was the proximate cause by the earthquake.

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