Introduction to Insurance Questions and Answers [With PDF]

A house fire, a car accident, a ship lost at sea or an unexpected death can turn a family or a business upside down. Insurance is the system that lets many people share these risks, so that those who suffer a loss are compensated. This chapter explains what insurance is, the kinds of risk, which risks can be insured, the insurance contract and its basic principles (insurable interest, utmost good faith, indemnity, subrogation, contribution and proximate cause). Here are 30 important questions with clear answers, tables and worked examples, ready for exams, vivas and job interviews.

This is Chapter 1 of our Insurance course. Continue with Life Insurance afterwards.

Meaning, Features and Importance

Q1. What is insurance?

Insurance is a contract in which one party, the insurer (the insurance company), agrees to compensate the other party, the insured (the policyholder), for a specified loss, or to pay a fixed sum on a specified event, in return for a payment called the premium. In this way a person who is exposed to risk gets financial protection against loss of life or property.

Q2. What are the basic terms of insurance?

Q3. What are the features of insurance?

1. It is financial protection against risk.
2. It shares the risk among many people exposed to similar risks.
3. It covers risks to human life and property.
4. In return for the premium, the insurer takes on the risk.
5. The insurer must pay for a loss that falls within the terms of the policy.

Q4. What is the importance of insurance?

Q5. Why is insurance called a risk-sharing system?

Because many people exposed to the same kind of risk each pay a small premium into a common fund, and the few who suffer a loss are paid from that fund. The loss of one is spread over all.

Example: 10,000 houses, each worth 1,000,000, face a 1 in 1,000 chance of burning each year. On average 10 houses burn, so the loss is 10 x 1,000,000 = 10,000,000. Shared among 10,000 owners, each pays only 1,000 (plus a small amount for expenses), instead of one owner facing a loss of 1,000,000 alone.

Q6. How important is insurance in business?

Businesses face risks such as fire in the factory, shipwreck or accidents in transit, theft, robbery and the injury of workers. Insurance gives traders financial protection against these losses, so they can carry on and expand their business with confidence.

Risk and Its Types

Q7. What is risk?

Risk is the uncertainty about whether a financial loss will happen. In insurance, it refers to the possibility of loss of life or property.

Q8. What are the features of risk?

1. It is linked to uncertainty. The higher the uncertainty, the higher the risk.
2. In insurance, the uncertainty of financial loss is what counts as risk.
3. Its likelihood can be measured using probability and statistics.
4. It cannot be removed completely, but financial protection can be provided by spreading it among many people.

Q9. What are the types of risk?

Q10. What are financial and non-financial risks?

• Financial risk: a risk whose loss can be measured in money, such as a shipwreck, a factory fire or the theft of goods. Most financial risks are insurable.
• Non-financial risk: a risk whose loss cannot be measured in money, such as choosing a career, a marriage decision or a new food product disappointing customers. These are not insurable.

Q11. What are fundamental and particular risks?

Q12. What are pure and speculative risks?

• Pure risk: a situation with only two possible outcomes: loss or no loss. There is no chance of gain. Examples: a fire, theft or accident. Pure risks are insurable.
• Speculative risk: a situation with three possible outcomes: loss, no change or gain. Examples: investing in shares or starting a business. Speculative risks are generally not insurable.

Q13. What makes a risk insurable?

• It must be a pure risk (loss or no loss).
• The loss must be accidental and not caused deliberately by the insured.
• It must be measurable in money.
• There must be a large number of similar exposures, so the insurer can predict losses.
• The loss must not be catastrophic for the whole pool at once.
• The insured must have an insurable interest.
• The risk must be permitted by law.

Q14. What are insurable and uninsurable risks?

An insurable risk is one for which an insurer is willing to give cover, because it meets the conditions above. Examples: loss of life, fire, theft, motor accidents and marine losses. An uninsurable risk is one that insurers do not accept, because it is not measurable, not accidental, or too widespread. Examples: war, epidemics, economic depression and speculative business losses.

The Insurance Contract

Q15. What is an insurance contract?

A legal agreement in which the insurer promises to compensate the insured for a loss, or to pay a specified sum if a particular event happens, in exchange for a premium.

Q16. What are the features of an insurance contract?

1. It is a legal contract, not a bet.
2. It is normally in writing (the policy).
3. It gives financial protection against possible loss.
4. The premium paid is the price of the insurer taking the risk.
5. The insured must have an insurable interest in the subject.
6. It is based on trust between the parties (utmost good faith).
7. The terms of the policy must be specific.
8. The more policies an insurer has, the better the risk is spread.

Q17. What is the nature of an insurance contract?

1. It is a cooperative device for spreading risk.
2. It is a financial protection device.
3. A premium is paid against the risk.
4. It gives assurance or compensation.
5. Payment is made only on the contracted event or accident.
6. It is not gambling.

Q18. What are the essential elements of an insurance contract?

Principles of Insurance

Q19. What are the principles of insurance?

1. Insurable interest
2. Utmost good faith (fiduciary relationship)
3. Indemnity (financial compensation)
4. Proximate cause
5. Contribution (proportionate sharing)
6. Subrogation
7. Law of large numbers and probability
8. Minimizing the loss

Q20. What is insurable interest?

Insurable interest is the financial interest that a person has in the subject of the insurance: he benefits financially from its safety and suffers financially from its loss or damage. Without it, the contract cannot be enforced. A cannot insure B’s house unless A has a financial stake in it. If B’s house is mortgaged to A, A has an insurable interest to the extent of the loan.

Q21. Why is insurable interest important?

Without it, insurance would turn into gambling: someone could insure the property or life of a stranger and profit from the loss. Insurable interest ensures that insurance only protects real financial interests, and it removes the temptation to cause a loss deliberately.

Q22. Why is an insurance contract called a contract of utmost good faith?

Because the insurer cannot easily check the facts about the risk, so both parties must tell each other every important fact honestly (full disclosure). If the insured hides a material fact, the insurer may cancel the contract or refuse a claim. Example: a person with heart disease who hides it when taking life insurance can have his claim rejected later.

Q23. What is the principle of indemnity?

Indemnity means that the insured is compensated for the actual loss, so he is restored to his position before the loss, but he does not profit from it. The payment cannot be more than the actual loss or the sum insured, whichever is less. Example: a car worth 500,000 is insured for 700,000 and is destroyed. The insurer pays only 500,000.

Q24. Why is an insurance contract called a contract of compensation?

Property insurance (such as marine, fire and motor insurance) is a contract of compensation, because the loss is measurable and the insurer pays for the actual loss, total or partial. Life insurance is different: the value of a life cannot be measured in money, so the insurer pays the agreed sum assured. That is called a contract of assurance, not indemnity.

Q25. What is the principle of subrogation?

After the insurer has paid a claim in full, it takes over the insured’s rights over the damaged property and against any third party who caused the loss. This prevents the insured from recovering twice. Example: a ship insured for its full value sinks, and the insurer, after paying, becomes the owner of the wreck. Or a driver damages your insured car and you are paid by the insurer, which can then claim from the driver.

Q26. What is the principle of contribution?

If the same property is insured with more than one insurer, they share the loss in proportion to the sum each has insured. The insured cannot recover more than his actual loss in total. It applies only to property insurance.

Example: A insures his property with two companies for 250,000 each (500,000 in all). It suffers a loss of 200,000. Each company bears its share: 250,000 / 500,000 x 200,000 = 100,000 each. If A collects the whole 200,000 from one insurer, that insurer can claim 100,000 from the other.

Q27. What is the principle of proximate cause?

The insurer pays only if the loss is caused directly by an insured peril, the nearest, dominant cause of the loss, not a remote cause. Example: a fire (insured peril) breaks out in a house and the firemen flood it with water, causing further damage. The water damage is proximately caused by the fire, so it is covered. But if the damage had been caused by a flood, which is excluded, the claim would be rejected.

Q28. What is the principle of probability (law of large numbers)?

Insurers use statistics and experience to estimate how likely a loss is. The more similar risks they insure, the closer the actual losses are to the expected losses (the law of large numbers). Actuaries use this to decide premium rates and whether to accept a risk.

Classification and Premium

Q29. How is insurance classified?

Q30. How is a premium determined?

The premium is based on the expected loss, plus a margin for expenses and profit. Example: following Q5, the expected loss per house is 1,000,000 x 1/1,000 = 1,000. If expenses and profit add 20%, the premium is 1,000 x 1.20 = 1,200 per house. Higher risk, such as an older house or a high-crime area, means a higher premium.

Quick Revision Points

• Insurance: the insurer compensates the insured for a loss, in return for a premium.
• Pure risk = loss or no loss. Speculative risk includes a chance of gain.
• Fundamental risks affect many. Particular risks affect individuals.
• Principles: insurable interest, utmost good faith, indemnity, proximate cause, contribution and subrogation.
• Life insurance is a contract of assurance, not indemnity.

Test yourself with the chapter quiz below, then continue to Life Insurance.