What Are the Six Principles of Insurance?

From the insurer's viewpoint, writing you a policy may be as big a risk as the risk you're insuring against. You know more about your health or the value of your house than the insurer, which could make it easy to cheat them. The six principles of insurance reduce the risk of a company writing you a bigger check than you deserve.

In many business deals, the rule is "let the buyer beware." Insurance operates by the principle of "utmost good faith" instead. When you take out a policy, you have an obligation to be truthful with your agent about the value of what you're insuring and the risks of losing or damaging it. She has an obligation to tell you any restrictions or rules that might reduce the value of your coverage.

You can't insure something unless you have a vested interest in it. For example, you can insure your house, but you can't take out a policy on a stranger's home if the damage doesn't cause you a financial loss. Legally, taking out insurance on something you don't own is closer to gambling than insurance -- you're making a bet on something happening to the house.

The insurer's job is to pay you enough to compensate for your loss -- but no more. If your house suffers $5,000 of damage, the insurer will indemnify you up to that amount so that you're in exactly the same position as you were pre-damage. This principle has several exceptions: for example, when you die, life-insurance coverage isn't limited to the immediate financial loss this causes your spouse.

Insurance protects against some perils -- types of damage -- but not others. If your home is caught in a hurricane, for instance, your homeowners insurance protects against wind damage but not flooding: If the proximate or primary cause of damage was floodwater, your insurer will refuse to pay. If you prove the proximate cause of the damage was the wind, you can collect.

If a third party damages your property -- ramming your car, for instance -- and you collect from your insurer, your insurer can then sue the other driver. Subrogation says when you accept an insurance settlement, the insurer gets your right to sue the third party. That prevents you collecting twice for the same damage and gives the insurer a way to recoup its losses.

The contribution principle states that if you can hold more than one insurer liable for your losses, they have to share the loss. If you take out two policies on your car, you can't collect from both insurers. One company would pay you and then collect from the second, or both companies could cut you a check for part of the loss.