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Principles of agreement

Insurance is governed by maxims that set the legal and ethical benchmark for the parties concerned. Here's what you should know before you buy insurance.

Print Edition: January 22, 2009

Insurance is a contract between two parties, wherein one party pays the other to insure itself against certain specified, measurable risks. Before considering the modalities of this agreement between the insurer and the insured, let us consider three of the six fundamental principles that govern the act of insurance.

Utmost good faith: By law, the greatest degree of good faith is expected from the proposer, or the buyer, of insurance as well as the insurer. It is the buyer's duty to disclose all facts related to the risk to be covered. For instance, when going in for a fire policy for your business establishment, you should provide information related to the construction of building, the type of occupancy and the nature of goods stored. Similarly, it is the insurer's duty to inform you of all the terms of the contract.

Principle of insurable interest: It states that the buyer must have a monetary interest in the entity that he wants to insure. In other words, he would be liable to suffer financially if the insured object is lost or damaged. For instance, you have an insurable interest in your house, because you may lose financially if the house burns down or is burgled, but you can't insure your neighbour's house for the same reason.

While the main purpose of insurable interest is to measure the extent of loss, it also aims to prevent gambling and reducing moral hazards. So you cannot take a policy for an entity not linked to you because it would indirectly amount to profiting from its loss.

It is important to understand that a quantifiable value of loss has to be arrived at to have an insurable interest. This implies that the loss has to affect the business financially and it is to this extent that it needs to be covered. This is also in keeping with the spirit of the principle of indemnity.

Principle of indemnity: The purpose of insurance is to restore the insured person to approximately the same financial position that existed prior to the loss. The operative words here are 'approximately the same' and the reason for this is to prevent the insured from profiting from insurance and to reduce moral hazards.

For instance, if your car meets with an accident, only the damaged parts are covered—that too at depreciated value, not actual value—even though the whole car is insured. This is to discourage people from deliberately making such claims and to ensure that the payment does not exceed the actual loss, thereby reducing the temptation to be dishonest.

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