6 Requirements Of An Insurance Contract [Explained]

Requirements of Insurance Contract

Insurance companies normally insure only pure risks but all risks are not insurable. For insurance certain requirements must be fulfilled before a pure risk can be insured.

From the insurer i.e. insurance company point of view, there are usually six requirements or essentials of the insurance contract. They are mentioned below:

A Large Number of Exposure Units

To insure against risks, a significant number of exposure units must be present and categorized into groups that share similar risks from one or more perils.

While not necessarily identical, these groups should be large enough to allow for accurate loss predictions through the application of the law of large numbers.

As an example, a sizeable collection of nighttime bus routes in the United States could be considered a suitable exposure unit for property insurance purposes.

By accumulating data on losses over an extended period, the insurer can make reasonably reliable forecasts about potential losses for the entire group.

Accidental and Unintentional Loss

For insurance to be effective, any losses incurred must be accidental and unintentional, beyond the control of the insured, and unforeseen.

This requirement is essential for two reasons. Firstly, if insurance is paid out for intentional losses, it can increase moral hazard, leading to a rise in premiums. This could result in fewer people being willing to take out an insurance policy, which in turn would reduce the number of exposure units, making it difficult for the insurer to accurately predict future losses.

Secondly, the law of large numbers, which forms the basis of insurance risk assessment, relies on the randomness of events. If an event is intentional, it cannot be considered random, and it becomes impossible to accurately predict future losses.

Determinable and Measurable Loss

One of the essential requirements of an insurance contract is that any loss incurred must be both measurable and determinable. This means that the loss must be clear and specific in terms of its reason, place, time, and amount.

In the case of life insurance policies, this requirement is relatively easy to fulfill, as the cause and timing of the insured person’s death can typically be determined.

However, in the case of fire or marine insurance, expert technical assessment is often necessary to determine the cause and extent of the loss.

The primary purpose of this requirement is to enable the insurer to accurately determine the amount of loss and subsequently pay out the appropriate amount to the insured.

No Catastrophic Loss

An essential criterion for insurance contracts is that losses should not be catastrophic. This means that a substantial number of exposure units should not suffer losses simultaneously.

If all units in a given class incur a loss at the same time, then the pooling technique becomes unworkable, leading to a sharp increase in premiums. This situation occurs when losses are spread across the entire group, even when only a few units experience them.

While insurers aim to avoid catastrophic losses, they do occur periodically due to natural disasters such as floods, earthquakes, and forest fires. To address such events, insurers may take measures such as reinsurance with other insurance companies, spreading coverage over large geographical areas, and so on.

Calculable Chance of Loss

A crucial requirement for an insurance contract is the ability to calculate the probability of loss accurately. The insurer must be able to determine both the average frequency and average severity of potential losses with reasonable precision.

Frequency pertains to the rate at which events are likely to occur over time, while severity concerns the magnitude of the resulting loss.

This requirement is critical for establishing appropriate premium amounts for the policy, ensuring that they are sufficient to cover claims and operating expenses while also generating a profit during the policy period.

Economically Feasible Premium

The primary requirement for insurance policies is that the premium must be economically viable, meaning that the insured party should be able to afford the premium payment.

To make insurance an attractive option, the premium paid by the insured party should be significantly less than the face value or amount of the policy.

Achieving an economically feasible premium requires a relatively low probability of loss. However, accurately estimating the likelihood of loss can be challenging, making it difficult to calculate appropriate premiums.

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