Insurance is a transfer of risk of loss from an individual or business entity to an insurance company, which spreads the costs of unexpected losses to many individuals.
Real-World Example: Imagine you own a home worth $300,000. If a fire destroyed it, you'd have to pay $300,000 out of pocket. But with insurance, you pay a small annual premium (say $1,500), and the insurance company takes on the risk of that $300,000 loss.
Know This for the Exam!
Insurance is the transfer of risk of loss. The cost of an insured's loss is transferred to the insurer and spread among other insureds.
The insured must have an insurable interest in the person or property covered. In property insurance, this means the insured would incur a financial loss if the insured property was damaged.
A monetary interest in the property or person
A relative (family relationship)
A business partner relationship
Who Has Insurable Interest?
Critical Exam Point!
In property and casualty insurance, insurable interest must exist at the time of the loss.
The Setup:
John owns a home insured for $400,000. On Monday, he sells the house to Maria and the sale closes. John still has his old homeowners policy active (he forgot to cancel it).
What Happens:
On Wednesday - two days after the sale - a fire destroys the house. John thinks "Great, I still have insurance!" and files a claim on his old policy.
The Result:
CLAIM DENIED! John no longer has insurable interest. He sold the house on Monday - he doesn't own it anymore, so he suffers no financial loss from the fire. The insurance company pays him nothing.
Lesson: Insurable interest must exist AT THE TIME OF LOSS, not just when the policy was purchased.
Risk is the uncertainty or chance of a loss occurring. There are two types of risk, but only ONE is insurable.
Situations that can only result in a loss or no change. There is NO opportunity for financial gain.
Examples:
Involves the opportunity for either loss OR gain.
Examples:
Know This for the Exam!
Only pure risks are insurable. Insurance companies will NOT accept speculative risks.
Perils are the causes of loss insured against in an insurance policy.
Insures against financial loss caused by premature death of the insured
Insures against medical expenses and/or loss of income caused by sickness or accidental injury
Insures against loss of physical property or loss of its income-producing abilities
Insures against loss/damage of property and resulting liabilities
Common Property Perils: Fire, wind, hail, lightning, explosions, theft, vandalism, smoke damage
The Setup:
Tom has an older home with outdated electrical wiring from the 1960s. The wiring frequently overheats when too many appliances run at once.
What Happens:
One evening, the faulty wiring sparks and causes a fire that damages the kitchen, causing $50,000 in damage.
Breaking It Down:
The PERIL (Cause of Loss):
FIRE - This is what actually caused the damage
The HAZARD (Increased Probability):
Faulty wiring - This INCREASED THE CHANCE of fire occurring (Physical Hazard)
Remember: The peril CAUSES the loss. The hazard makes the loss MORE LIKELY to happen.
Hazards are conditions or situations that increase the probability of an insured loss occurring.
Remember the difference: A peril CAUSES the loss. A hazard INCREASES THE CHANCE of the loss happening.
Arising from material, structural, or operational features of the risk
Examples:
Intentional dishonesty - applicants who lie or submit fraudulent claims
Examples:
Carelessness or indifference because insurance exists
Examples:
Memory Trick: MorAL = Active dishonesty (intentional fraud) | MorALE = Apathy (careless attitude)
MORAL Hazard (Intentional Fraud)
Setup: Dave's business is failing badly. He has a $500,000 fire insurance policy on his warehouse.
What He Does: Dave intentionally sets fire to his own warehouse at night, planning to collect the insurance money and pay off his debts.
Why It's MORAL Hazard: This is intentional, deliberate fraud. Dave is actively trying to profit from insurance through dishonesty. This is criminal!
MORALE Hazard (Careless Attitude)
Setup: Sarah has comprehensive auto insurance on her new car parked downtown.
What She Does: She leaves her car unlocked with valuables visible, thinking "If it gets stolen, insurance will pay for a new one anyway."
Why It's MORALE Hazard: Sarah isn't committing fraud - she's just careless because she knows insurance exists. She doesn't WANT a loss, but she's not careful to prevent one.
Exam Tip: If the person is LYING or INTENTIONALLY causing damage = MORAL. If they're just CARELESS or INDIFFERENT = MORALE.
Indemnity (sometimes called reimbursement) means that in the event of loss, an insured is permitted to collect only to the extent of the financial loss - you cannot profit from insurance.
Purpose of Insurance = Restore, NOT Profit
Brenda has a health insurance policy for $20,000.
After hospitalization, her medical expenses totaled $15,000.
Insurance pays: $15,000 ✓
NOT $20,000 - only the actual loss!
Brenda has a homeowners policy for $200,000.
After her home was destroyed, rebuilding costs totaled $150,000.
Insurance pays: $150,000 ✓
NOT $200,000 - only the actual loss!
Know This for the Exam!
Indemnity means insureds cannot recover more than their loss.
Subrogation is the insurer's legal right to seek damages from third parties after it has reimbursed the insured for the loss.
Someone else causes damage to your property (e.g., a driver hits your parked car)
Your insurance company pays you for the damage
Your insurer "steps into your shoes" and sues the at-fault party to recover what they paid you
Your neighbor's tree falls and damages your fence, causing $5,000 in damage.
Why Does Subrogation Exist?
It's based on the principle of indemnity - it prevents the insured from collecting on the loss TWICE (once from their insurer and once from the party that caused the damage).
Insurance
Transfer of risk of loss
Insurable Interest
Financial, Blood, Business - must exist at time of loss
Pure Risk
Only loss or no change - INSURABLE
Speculative Risk
Gain or loss - NOT insurable
Peril
Cause of loss (fire, theft, etc.)
Hazard
Increases chance of loss
Physical Hazard
Material/structural conditions
Moral Hazard
Intentional dishonesty/fraud
Morale Hazard
Carelessness/indifference
Indemnity
Restore to pre-loss, not profit
Subrogation
Insurer recovers from at-fault party