P&C General Insurance Principles 2 — Questions and Answers
Question 1: The principle of indemnity in insurance means:
- The insured should profit from an insurance claim
- The insured should be restored to the same financial position they were in before the loss, no better and no worse (Correct answer)
- The insurer must pay the maximum policy limit for every covered loss
- The insured must prove negligence before any payment is made
Correct answer: The insured should be restored to the same financial position they were in before the loss, no better and no worse
Indemnity means the insurance payment should restore the insured to their pre-loss financial position — not provide a windfall or a penalty.
The principle of indemnity underlies most property and casualty insurance. It prevents moral hazard by ensuring the insured cannot profit from a covered loss. Valuation methods such as actual cash value, replacement cost, and agreed value all attempt to implement indemnity at different levels. Life insurance and valued policies are notable exceptions where a stated amount is paid regardless of actual financial loss.
Question 2: 'Subrogation' in insurance allows the insurer to:
- Cancel the policy after paying a claim
- Recover money paid to the insured from the responsible third party (Correct answer)
- Increase the premium after a loss
- Deny coverage if the insured was partially at fault
Correct answer: Recover money paid to the insured from the responsible third party
Subrogation transfers the insured's right to sue a negligent third party to the insurer after the insurer pays the insured's claim, allowing the insurer to seek reimbursement.
Subrogation prevents double recovery — the insured cannot collect both from the insurer and from the responsible party. After the insurer pays a claim, it acquires the insured's legal rights against the at-fault party up to the amount paid. For example, if a contractor damages the insured's building and the insurer pays the repair bill, the insurer can pursue the contractor for reimbursement.
Question 3: What does 'insurable interest' require?
- The insured must be a licensed professional
- The insured must stand to suffer a financial loss if the insured event occurs (Correct answer)
- The insured must own the property outright with no mortgage
- The insured must reside in the covered location
Correct answer: The insured must stand to suffer a financial loss if the insured event occurs
Insurable interest requires that the policyholder would suffer a genuine financial loss if the covered property is damaged or the covered event occurs, preventing insurance from becoming a gambling instrument.
Insurable interest must exist at the time of loss for property and casualty policies. It can arise from ownership, a security interest (such as a mortgage lender's interest in a property), a contractual relationship, or potential legal liability. Without insurable interest, a policy can be voided as a wagering contract. Insurable interest prevents moral hazard by ensuring the insured has a genuine reason to want the property preserved.
Question 4: An 'aleatory' contract, such as an insurance policy, is one in which:
- Both parties exchange equal value
- One party may receive considerably more or less than they give, depending on chance (Correct answer)
- The terms are negotiated individually for each insured
- Performance is guaranteed regardless of events
Correct answer: One party may receive considerably more or less than they give, depending on chance
Insurance is an aleatory contract because the values exchanged are unequal and depend on an uncertain future event — the insured pays premium but may receive a large claim payment or nothing at all.
In an aleatory contract, the outcome depends on an uncertain event. An insured who pays $1,000 in premium may receive $500,000 if a major loss occurs, or may receive nothing if no loss occurs. This uncertainty distinguishes insurance from a service contract where the exchange of value is more predictable. The aleatory nature of insurance is the economic foundation for pooling risk across many policyholders.
Question 5: The 'law of large numbers' is the statistical principle that allows insurers to:
- Set premiums arbitrarily high to guarantee profit
- Predict losses with greater accuracy as the number of similar exposure units increases (Correct answer)
- Avoid paying large claims by spreading them across policyholders
- Guarantee that no policyholder will suffer a total loss
Correct answer: Predict losses with greater accuracy as the number of similar exposure units increases
The law of large numbers states that as the sample size increases, the actual loss experience approaches the expected (predicted) loss rate, giving insurers greater predictability.
Insurers rely on the law of large numbers to price policies accurately. With a large pool of similar risks, random variation in individual results averages out, and the insurer can predict aggregate losses with reasonable accuracy. This is why personal lines insurers seek high volumes of policyholders, and why niche or surplus lines risks are harder to price — the insurer lacks sufficient loss data for reliable predictions.
Question 6: A 'binder' in property and casualty insurance is:
- A permanent policy delivered by mail
- A written or oral agreement that provides temporary coverage until a formal policy is issued (Correct answer)
- A mandatory government certificate of insurance
- A multi-year policy that locks in the premium rate
Correct answer: A written or oral agreement that provides temporary coverage until a formal policy is issued
A binder is a temporary contract of insurance that provides immediate coverage while the formal policy is being processed and issued.
Binders are common in property and casualty insurance because there is often a gap between the application and issuance of the formal policy. A binder contains the essential terms — insured, insurer, coverage type, limits, and effective date — and is legally binding on both parties. Binders typically expire after 30 to 90 days or when the formal policy is issued, whichever comes first.
P&C General Insurance Principles 2
The principle of indemnity in insurance means: