Introduction to Insurance
FIN-302:Spring 2025
Course Instructor
Sanjida Alam
Lecturer,
School of Business Administration
East Delta University
Gmail:sanjida.alam@eastdelta.edu.bd
Definition of Insurance
Contractual definition –The insurance, thus, is a contract whereby a) a certain sum,
called premium, is charged in consideration, b) against the said consideration, a
large sum is guaranteed to be paid by the insurer who received the premium, c)
the payment will be made in a certain definite sum, the loss or the policy amount
whichever may be, and d) the payment is made only upon a contingency.
Insurance
Contract
Large Sum Guaranteed
Insurance company
Insured
Premium payment
payment is made only upon a contingency.
Wants to insure
any subject matter
An Illustration of How Insurance Works
1. Health Insurance Example
Sarah works at a company that provides health insurance. She pays a monthly premium of $200 to an insurance
company the company will covers 80% of the cost. One day, she has a medical emergency and undergoes surgery,
which costs $50,000. Since she has health insurance, the company covers 80% of the cost, and she only pays
$10,000 instead of the full amount.
2. Life Insurance
John, a father of two children, buys a life insurance policy for $500,000. He pays a monthly premium of $50.
Unfortunately, after 10 years, John passes away in an accident. Since he had life insurance, the insurance company
pays $500,000 to his family.
3. Car Insurance Example
Lisa owns a car and buys comprehensive car insurance. One day, her car is stolen. Since she has insurance, the
insurance company pays her the value of the stolen car so she can buy a new one.
4. Property Insurance Example (Fire Insurance)
A shopkeeper, Mr. Khan, owns a small business. He buys fire insurance for his shop, paying an annual premium.
Unfortunately, a fire breaks out, and he suffers a loss of $100,000. Since he had insurance, the company
compensates him for the damages, allowing him to rebuild his business.
Case Study on how insurance works
Bright Future Ltd., a company with 500 employees, partners with XYZ Insurance to provide health
insurance. Each employee pays a monthly premium into a shared pool average $50. When Sarah, an
employee, falls ill and needs $10,000 for treatment, the cost is covered by the pooled funds, ensuring
she doesn’t bear the full financial burden alone. It also acts as a cooperative device, where many
contribute to help the few in need. XYZ Insurance assesses the value of risk by charging higher
premiums for older or higher-risk employees, ensuring fairness and sustainability. Payments are
made only at the time of a contingency, such as illness, and the large number of insured employees
(500) ensures the system remains stable and capable of covering claims. Through this process, Sarah
receives financial support, other employees gain peace of mind, and Bright Future Ltd. maintains a
healthy, financially secure workforce.
Insurance characteristics
Sharing of Risk – Insurance is a mechanism that distributes financial risk among multiple
policyholders. The insured transfers the risk to the insurer, who spreads it among a large number of
people through premium collection.
Co-operative Device – Insurance operates as a collective approach where individuals facing similar
risks contribute to a common pool, ensuring financial protection in case of a loss. This cooperative
approach helps in stabilizing economic conditions.
Value of Risk – The risk is assessed based on potential losses. The higher the chance of loss, the
higher the premium charged. The insurer evaluates the probability and magnitude of potential loss
before determining the premium amount.
Payment at Contingency – Insurance provides financial compensation only if the insured event
(like death, accident, or fire) occurs. If there is no loss, no payment is made, ensuring that insurance
serves its intended purpose.
Amount of Payment – The compensation provided is based on the actual loss suffered by the
insured. The principle of indemnity applies, ensuring that the insured does not profit from the
insurance policy but is only compensated for the actual loss.
Large Number of Insured Persons – The principle of law of large numbers applies in
insurance. A large number of policyholders contribute premiums, which helps insurers
predict risk accurately and maintain financial stability.
Insurance is Not Gambling – Unlike gambling, which creates risk artificially, insurance
manages existing risks. Gambling is based on speculative gain, whereas insurance is a
protective measure against unforeseen losses.
Insurance is Not Charity – While charity provides help without expecting anything in
return, insurance requires the insured to pay a premium. The insurer compensates only
when a loss occurs, making it a contractual agreement rather than a voluntary donation.
Insurance contract
The insurance contract involves- the elements of general contract, and the elements of
special contract relating to insurance.
1. General Contract:
The valid contract must have the following essentialities:
i. Agreement (offer and acceptance)
ii. Legal consideration
iii. Competent to make contract
iv. Free consent
v. Legal object
1. General Contract
i. Agreement (offer and acceptance)
Offer – The person who wants insurance (the proposer) submits an application to the insurance company. This
application acts as an offer to buy insurance. Acceptance – The insurance company reviews the application. If they
agree to provide coverage, they issue a policy or send a confirmation. This is acceptance, and once accepted, the
contract is legally binding.
ii. Legal consideration
The promiser to pay a fixed sum at a given contingency is the insurer who must have some return for his
promise. Premium being the valuable consideration must be given for starting the insurance contract.
iii. Competent to make contract
Every person is competent to contract who is a) of the age of majority according to the law, b) of
sound mind, and c) not disqualified from contracting by any law to which he is subject. A minor is not
competent to contract. Also, an alien enemy, an undischarged insolvent and criminal cannot enter into contract.
1. General Contract
iv. Free consent
Parties entering into the contract should enter into it by their free consent. The consent will be free when
it is not caused by – a) coercion, b) undue influence, c) fraud, or d) misrepresentation, or
e) mistake. If it is not made on free consent, then it becomes voidable.
v. Legal object
In order to make a valid contract, the object of the agreement should be lawful. An object that is a) not
forbidden by law, or b) is not immoral, or c) opposed to public policy, or d) which does not defeat the
provisions of any law, is lawful.
In proposal form, the object of insurance is asked which should be legal and the object should not be
concealed. If the object of an insurance, like the consideration, is found to be unlawful, the policy is
void.
Insurance contract
b) The elements of special contract relating to insurance:
2. Insurable interest
3. Utmost good faith
4. Indemnity
5. Subrogation
6. Proximate cause
7. Return of premium
2. Insurable interest
For an insurance contract to be valid, the insured must possess an insurable interest in the subject matter of
insurance. The insurable interest is the pecuniary/financial interest whereby the policy-holder is
benefited by the existence of the subject-matter and is prejudiced by the death or damage of the subjectmatter. The essentials of a valid insurable interest are the following:
i.
ii.
iii.
iv.
There must be a subject-matter to be insured.
The policy-holder should have monetary relationship with the
subject-matter.
The relationship between the policy-holder and the subject- matter should be recognized by law.
This financial relationship should be such that the policy- holder is economically benefited by
the survival or existence of the subject matter and/or will suffer economic loss at the death or nonexistence.
Note: The subject-matter is life in the life insurance, property and goods in property insurance,
liability and adventure in general insurance.
3. Utmost good faith
The doctrine of disclosing all material facts is embodied in the important principle ‘utmost good faith’
which applies to all forms of insurance, where both parties of the contract must disclose all the material facts
truly and fully.
There should not be any misrepresentation, non-disclosure or fraud concerning the material facts.
In case of life insurance, the material facts are age, residence, occupation, health, income etc., and in
case of property insurance, it would be use, design, owner and situation of the property.
4. Principle of indemnity
The Principle of Indemnity ensures that the insured is compensated for the actual financial loss incurred due to a
covered event, but no more than the loss amount. The purpose is to restore the insured to their pre-loss financial
position without allowing any profit from the insurance claim.
Example 1 (Car Insurance)
Suppose your car is insured for $10,000, and it gets into an accident, causing damage worth $5,000. The insurance
company will pay only $5,000, because that’s your actual loss. They won’t pay the full $10,000, as that would be a
profit.
4. Principle of indemnity
Conditions for this principle
The following conditions should be fulfilled in full application of this principle:
i.
The insured has to prove that he will suffer loss on the insured matter at the time
of happening the event and the loss is actual monetary loss.
ii. The amount of compensation will be the amount of insurance.
Indemnification
cannot be more than the amount insured.
If the insured gets more amount than the actual loss, the insurer has right to get the
extra-amount back.
iv. If the insured gets some amount from third party after being fully indemnified
by
insurer, the insurer will have right to receive all the
amount paid by the third party.
5. Doctrine of subrogation
The doctrine of subrogation in insurance refers to the legal principle where an insurer, after
indemnifying the insured for a covered loss, acquires the insured’s rights to recover the
amount of the loss from a third party responsible for causing the damage. This principle
ensures that the insured does not receive double compensation and helps the insurer
mitigate its losses by recovering from the at-fault party.
Example: Suppose John's car is damaged in an accident due to Mike’s reckless driving. John
files a claim with his car insurance company, which pays for the repairs. Under subrogation,
the insurance company can then sue Mike or his insurer to recover the money it paid to John.
This prevents John from receiving double compensation (one from the insurer and another
from the responsible party) and ensures the actual wrongdoer bears the financial
responsibility.
6. Proximate cause
The principle of proximate cause states that when a loss occurs due to multiple causes, the
closest or most dominant cause should be identified to determine the insurer's liability. The
insurer will compensate only if the proximate cause of the loss is covered by the insurance
policy.
Example: If a fire breaks out in a house and the fire leads to a gas explosion, the primary
cause (proximate cause) of damage is the fire, not the explosion. If the insurance policy
covers fire-related damage, the claim will be valid.
7. Return of premium
Ordinarily the premium once paid cannot be refunded. However, in the following
cases the refund is allowed:
i. By Agreement in the Policy:If the policy itself contains a provision for a refund
under specific circumstances, such as early termination or non-acceptance of risk
by the insurer.
ii. For Reasons of Equity: If fairness and justice demand a refund, the insurer may
provide a partial or full refund.Example: If the insured cancels a long-term policy
shortly after paying the premium, a proportionate refund might be issued after
deducting administrative costs.