Key Takeaways
- The Law of Large Numbers allows insurers to predict losses accurately — more exposures = more predictable results
- The Principle of Indemnity guarantees restoration to pre-loss position without profit — insureds cannot gain from insurance
- Insurable interest must exist at BOTH policy inception AND time of loss for property insurance (unlike life insurance)
- Subrogation allows insurers to recover payments from negligent third parties — 'stepping into the shoes' of the insured
- Utmost Good Faith requires complete honesty from both parties — concealment or misrepresentation can void coverage
Principles of Insurance
Insurance operates on several fundamental principles that have been established through centuries of practice and legal precedent. Understanding these principles is essential for the P&C exam.
The Law of Large Numbers
Definition: As the number of observations increases, the average of the results converges toward the expected value.
In Plain English: The more people you insure, the more accurately you can predict how many will have losses.
How It Works
- 1 homeowner: Impossible to predict if they'll have a fire
- 100 homeowners: Still unpredictable for any individual
- 1,000,000 homeowners: Can predict with high accuracy that approximately X% will have fires
Insurance Application
| Pool Size | Prediction Accuracy |
|---|---|
| 100 policies | Low — actual losses vary wildly from expected |
| 10,000 policies | Moderate — closer to expected losses |
| 1,000,000 policies | High — actual losses very close to predicted |
Example:
- 1,000 people each pay $1,000/year = $1,000,000 collected
- Based on history, 90 people will need $10,000 each = $900,000 in claims
- Insurer profit: $100,000
- This works because of large numbers — with only 10 insureds, one unexpected loss could bankrupt the insurer
Principle of Indemnity
Definition: Insurance guarantees to restore the insured to their pre-loss financial position — no better, no worse.
Key Rules
-
Payment is the lesser of:
- Actual amount of loss, OR
- Policy limit
-
Insured cannot profit from a loss
-
Compensation cannot exceed actual financial harm
Example
| Scenario | Result |
|---|---|
| Car worth $10,000, damaged $3,000 | Insurer pays $3,000 (actual loss) |
| Car worth $10,000, total loss | Insurer pays $10,000 (ACV) |
| Car insured for $15,000, worth $10,000, total loss | Insurer pays $10,000 (can't exceed actual value) |
Why This Matters: Indemnity prevents moral hazard — if people could profit from losses, they'd be tempted to cause them.
Insurable Interest
Definition: A financial stake in property or a person such that loss would cause financial harm to the interested party.
Critical Timing Rule
| Insurance Type | When Interest Must Exist |
|---|---|
| Property & Casualty | At policy inception AND at time of loss |
| Life Insurance | Only at policy inception |
Exam Alert: This timing difference is frequently tested. For P&C insurance, you need insurable interest at BOTH times!
Types of Insurable Interest
- Ownership — You own the property
- Secured creditor/Mortgagee — Bank has interest in mortgaged property
- Bailee — Dry cleaner has interest in customer's clothes
- Contract right — Buyer under purchase contract
- Legal liability — Anyone legally responsible for property
Example: Why Timing Matters
Mark sells his house to Susan on Monday. Fire destroys the house on Tuesday before insurance is cancelled.
- Mark cannot collect — he no longer has insurable interest at time of loss (he doesn't own it)
- Susan cannot collect — she has no policy yet
Result: Neither party can recover. This illustrates why the timing requirement exists.
Subrogation
Definition: After paying a claim, the insurer has the right to "step into the shoes" of the insured and pursue recovery from any negligent third party.
How It Works
- You're injured in a car accident caused by another driver
- Your insurer pays your claim
- Your insurer then sues the at-fault driver to recover what they paid you
- You are "subrogated" — insurer takes your place in pursuing the claim
Priority of Recovery
When the negligent party pays, funds are distributed in this order:
- First: Insured recovers uninsured losses
- Second: Insurer recovers their claim payment
- Third: Remaining funds go toward insured's deductible
Why Subrogation Exists
- Prevents insured from collecting twice (from insurer AND negligent party)
- Holds negligent parties accountable
- Helps keep insurance premiums lower
- Reinforces the indemnity principle
Principle of Contribution
Definition: When multiple policies cover the same risk, each insurer pays a proportionate share.
Example
- Policy A limit: $100,000
- Policy B limit: $200,000
- Total: $300,000
- Loss: $60,000
Calculation:
- Policy A pays: ($100,000 / $300,000) × $60,000 = $20,000
- Policy B pays: ($200,000 / $300,000) × $60,000 = $40,000
- Total: $60,000
Purpose: Prevents insured from profiting by collecting full amounts from multiple policies.
Utmost Good Faith
Definition: Both insurer and insured must be completely honest with each other.
Insurance contracts require a higher standard of honesty than typical contracts because the insurer relies heavily on information from the applicant.
Three Components
| Component | Definition | Example |
|---|---|---|
| Representation | Statements believed true to best of knowledge | "I've had no accidents in 3 years" |
| Warranty | Strict promise that must be absolutely true | "Smoke detectors are installed and operational" |
| Concealment | Failure to disclose material information | Not mentioning a previous arson conviction |
Consequences of Violation
If material information is false or concealed:
- Insurer can void the contract
- Insurer can deny claims
- Even if premiums were paid in full
Material means information that would have affected the insurer's decision to issue the policy or set the premium.
For property insurance, when must insurable interest exist?
Your insurer pays your $10,000 auto damage claim after another driver hit you. The insurer then sues the at-fault driver. This is an example of:
An applicant fails to mention a previous arson conviction on their property insurance application. This is an example of:
1.4 The Insurance Contract
Continue learning