General Insurance Principles
This chapter covers the foundations shared by all property and casualty insurance: how risk works, the special nature of an insurance contract, and the core concepts of insurable interest and indemnity. These principles are consistent nationwide.
Risk, Peril, and Hazard
Risk is uncertainty about loss. Insurers deal only with pure risk (a chance of loss or no loss, with no chance of gain), not speculative risk such as gambling. A peril is the actual cause of a loss (fire, wind, theft, collision). A hazard is a condition that increases the chance or severity of a loss: a physical hazard is a tangible condition (worn tires), a moral hazard involves dishonesty (arson to collect), and a morale hazard is carelessness because insurance exists (leaving keys in the car). Risk can be handled by avoidance, retention, reduction, sharing, or transfer; insurance is the transfer of risk to an insurer for a premium.
Law of Large Numbers and Adverse Selection
Insurance pools many similar exposure units so individual uncertainty becomes group predictability. The law of large numbers holds that the more similar, independent exposures an insurer covers, the more closely actual losses match predicted losses, which lets it set accurate rates. Adverse selection is the tendency of higher-risk applicants to seek insurance more aggressively than lower-risk ones; insurers counter it through underwriting, inspections, and appropriate pricing so the pool is not overloaded with poor risks.
Insurable Interest and Indemnity
To collect on property insurance, the insured must have an insurable interest, a genuine financial stake that would cause a loss if the property were damaged; in property insurance this interest must exist at the time of the loss. The principle of indemnity means the insured is restored to their pre-loss financial condition but not allowed to profit. Related concepts, actual cash value, deductibles, coinsurance, other-insurance clauses, and subrogation, all exist to enforce indemnity.
Special Features of Insurance Contracts
Insurance contracts are contracts of adhesion (written by the insurer and offered take-it-or-leave-it, so ambiguities are read against the insurer). They are aleatory (the dollar amounts exchanged are unequal and depend on chance). They are unilateral (only the insurer makes a legally enforceable promise). They are conditional (benefits are paid only if the insured meets conditions such as paying premium and filing proof of loss). They require utmost good faith from both parties. A valid contract also needs offer and acceptance, consideration, competent parties, and a legal purpose.