BASIC PRINCIPLES OF LIFE INSURANCE :

Life insurance is based on several basic principles that apply to all types of insurance, and that form the foundation of the insurance contract. Understanding these principles will help one to understand better how life insurance works. Few of the Basic Principles of Life insurance are discussed below.

Risk Pooling

Risk pooling Life insurance is based on a concept called risk pooling, or a group sharing of losses. People exposed to a risk agree to share losses fairly or on an equitable basis. They transfer the economic risk of loss to an insurance company. Insurance companies collect and pool the premiums of thousands of people, spreading the risk of losses across the entire pool. By carefully calculating the probability of losses that will be sustained by the members of the pool, insurance companies can equitably spread the cost of the losses to all the members. The risk of loss is transferred from one to many and shared by all insured in the pool.

Example of Risk Pooling

Ten thousand males aged 35 contribute to a life insurance pool. If Twenty-one of them are expected to die this year and each of the 10,000 contributes `210 to fund death benefits (ignoring costs of operation), a death benefit of `100,000 could be paid for each of the 21 expected deaths.

The Law of Large Numbers 

The law of large numbers states that as the size of the sample (insured population) increases, the actual loss experience will more and more closely approximate the true underlying probability. This means that the insurer’s statistical group must be large enough to produce reliable results, and that the group actually insured must be large enough to produce results that are consistent with what probability predicts. Insurance relies on the law of large numbers to minimize the speculative element and reduce volatile fluctuations in year-to-year losses. The greater the number of exposures (lives insured) to a peril (cause of loss/death), the less the observed loss experience (actual results) will deviate from expected loss experience (probabilities). Uncertainty diminishes and predictability increases as the number of exposure units increases. It would be a gamble to insure one life, but insuring 500,000 similar persons will result in death rates that will vary little from the expected. A peril is a cause of a loss. In life insurance, the event against which protection is granted, death is uncertain for any one year, but the probability of death increases with age until it becomes a certainty. If a life insurance policy is to protect an insured during his or her entire life, an adequate fund must be accumulated to meet a claim that is certain to occur.

Principle of Utmost Faith 

Insurance contract is one of utmost good faith. The rule of caveat emptor [let the buyer beware] does not generally apply. This doctrine is supported by Representation through an application Concealment Warranty

The application and its interpretation

An application for life and health insurance is the applicant’s proposal to the insurer for protection and is the beginning of the policy contract. The proposed insured is required to give accurate answers to questions in the application relating to his personal and family history, habits, employment, insurance already in force, and other applications for insurance that either are pending or have been postponed or refused etc. A failure to do so leads the insurer being estopped [i.e., prevented] from denying the correctness or truth of information in the application. Insurers place great reliance on this information to issue the requested policy. This principle of insurance stems from the doctrine of “Uberrimae Fides” which is essential for a valid insurance contract. It implies that in a contract of insurance, the concerned contracting parties must rely on each other’s honesty. Insurance contracts are different from other contracts. Normally the doctrine of “Caveat Emptor” governs the formation of commercial contracts which means ‘let the buyer beware’. The buyer is responsible for examining the good or service and its features and functions. It is not binding upon the parties to disclose the information, which is not asked for.

However in case of insurance, the products sold are intangible. Here the required facts relate to the proposer, those that are very personal and known only to him. The law imposes a greater duty on the parties to an insurance contract than those involved in commercial contracts. They need to have utmost good faith in each other, which implies full and correct disclosure of all material facts by both parties to the contract of insurance.

The term “material fact” refers to every fact or information, which has a bearing on the decisions with respect to the determination of the severity of risk involved and the amount of premium. The disclosure of material facts determines the terms of coverage of the policy.

Any concealment of material facts may lead to negative repercussions on the functioning of the insurance company’s normal business. For instance life insurance companies normally segregate the quality of lives depending upon the state of health of the people. Healthy people are accorded a higher status in the table and different (lower) rates of premium are applicable to them since their risk of ill health is lower. If a person suppresses facts about his ill health and manages to buy a policy at rates applicable to the low risk group then other policyholders in the same group have to share his risk. This results in adverse selection.

Hence as per the principle of utmost good faith it is binding on the part of parties, the insured and the insurer, to expressly disclose all the relevant material facts pertaining to the contract. This doctrine is incorporated in insurance law and both the parties are expected to adhere to a high degree of honesty. Based on such faith, the insurer and the insured execute the contract of insurance. Thus each party believes that on fulfillment of the conditions for which the insurance policy was purchased, the other party would perform his duties as promised by him. Non-compliance by either party or any non-disclosure of the relevant facts renders the contract null and void.