How insurance works

1.1 What insurance really is

Insurance is a way of sharing the cost of losses. Many people each pay a small, predictable amount (the premium) into a pool. When something bad happens to a few of them, the pool pays for their losses. Each person swaps a small certain cost for protection against a large uncertain one. This swap is called risk transfer.

Insurers can predict losses for a big group even though they can't predict them for one person. This is the law of large numbers: the more similar risks an insurer has, the more accurately it can forecast total claims, and the more stable its prices can be.

Insurers only want to cover risks that suit this model. An insurable risk generally has these features:

• It's a pure risk: the only outcomes are loss or no loss. Gambling and business investments are speculative risks (you might win), so they aren't insurable.
• The loss is accidental and outside the insured's control.
• The loss can be measured in money.
• There are many similar exposures, so losses can be predicted.
• The loss is not catastrophic to the whole pool at once, and the premium is affordable.

1.2 Peril, hazard and loss

These three words are easy to mix up, and the exam loves them.

• A peril is the cause of a loss: fire, theft, windstorm, collision.
• A hazard is a condition that makes a loss more likely or more severe.
• A loss is the reduction in value that results.

There are three kinds of hazard:

• Physical hazard: a physical condition, such as old knob-and-tube wiring, oily rags in a garage or an icy walkway.
• Moral hazard: dishonesty, or a motive to profit from a loss. A struggling shop owner who suddenly raises his stock limit before closing is a moral hazard.
• Morale hazard: carelessness because insurance exists, such as leaving the door unlocked because "the insurance will pay".

1.3 Managing risk

Insurance is only one way to deal with risk. Brokers are expected to think about all five techniques and recommend the right mix.

• Avoidance: don't do the risky thing at all. Example: a café decides not to offer deep-fried food. The exposure disappears completely.
• Loss prevention: lower the chance of a loss. Example: storing solvents in a separate fire-rated room, or training staff on grease fires.
• Loss reduction: lower the size of a loss when it happens. Example: sprinklers, fire extinguishers, a monitored alarm.
• Retention: accept the loss yourself. A deductible is a form of retention. It suits small, predictable losses.
• Transfer: shift the cost to someone else, either by contract (a lease that makes the tenant responsible, or requiring suppliers to add you as an additional insured) or by buying insurance.

1.4 The core principles of insurance

Indemnity. Insurance should put the insured back in the same financial position as just before the loss, with no profit. Pure indemnity pays actual cash value (ACV): the replacement cost minus depreciation. Replacement cost coverage pays "new for old", which goes beyond pure indemnity. Insurers allow it by agreement, but usually only once the property is actually repaired or replaced. If the client doesn't rebuild, the insurer pays ACV.

Insurable interest. You can only insure something if you would suffer a financial loss when it is damaged. An owner, a mortgage lender and a tenant (for their contents) all have insurable interest. A neighbour buying a fire policy on your house does not. In property insurance, insurable interest must exist at the time of the loss. Each insured recovers only for their own interest, which is why co-owners should both be named.

Utmost good faith. Both sides must be honest. The applicant must disclose every material fact, meaning anything that would affect the insurer's decision to accept the risk or the price. Hiding or misstating a material fact is misrepresentation and can void coverage.

Subrogation. After paying a claim, the insurer "steps into the shoes" of the insured and can sue the person who caused the loss. Example: the insurer pays a fire claim, then sues the contractor whose torch started the fire. This stops the insured from collecting twice.

Contribution. When two policies cover the same loss, the insurers share it, usually in proportion to their limits. The insured still can't collect more than the loss.

Proximate cause. The cause of a loss is the dominant, effective cause that started an unbroken chain of events, not necessarily the last thing that happened. Windstorm knocks a tree onto a power line, which starts a fire: the windstorm is the proximate cause. When a covered peril and an excluded peril act together (for example sewer backup and overland water), this is concurrent causation, and coverage can be disputed.

Two quick examples. Two insurers cover the same building for $600,000 and $400,000: on a $100,000 loss they pay $60,000 and $40,000 (contribution). An insurer pays a fire claim caused by a faulty product, then sues the manufacturer to get its money back (subrogation).

1.5 The insurance contract

An insurance policy is a legal contract. Like any contract, it needs four elements:

1. Offer and acceptance: usually the client's application is the offer, and the insurer accepts it.
2. Consideration: something of value on both sides. The insured pays premium; the insurer promises to pay covered losses.
3. Legal capacity: the parties must be legally able to contract (for example, of age and of sound mind).
4. Legal purpose: the contract can't be for something illegal.

Insurance contracts also have special features:

• Contract of adhesion: the insurer writes it and the client accepts it as written. Because of this, courts read any unclear wording in favour of the insured.
• Aleatory: the amounts exchanged are unequal. A client might pay $1,500 and collect $400,000, or nothing.
• Conditional: the insurer pays only if the insured meets the policy conditions, such as giving notice of a loss.
• Personal: it insures a person's interest, not the property itself, so it usually can't be assigned to a new owner without the insurer's consent.

A binder is temporary coverage put in place before the policy is issued. It follows the terms of the policy that will be issued, including its exclusions.

Representations and warranties. A representation is a statement made to get insurance. It needs to be substantially true. A warranty is a promise written into the contract that must be strictly kept, such as "the alarm will be on whenever the store is closed". Breaking a warranty can void coverage.

1.6 How a policy is organized

Almost every policy has the same building blocks. Knowing where to look saves time with clients and on the exam.

A deductible is the part of a covered loss the insured pays. It keeps premiums down and removes small claims.

Refunds when a policy is cancelled. If the insurer cancels, the refund is pro rata: the client gets back the exact unused portion. If the insured cancels, the refund is usually short rate: a little less than the unused portion, because the insurer keeps some for its costs.

Cancelling at the client's request. The insured can end a policy at any time. Cancellation takes effect when the insurer or broker receives the written request (or a later date the client names). Waiting for the refund doesn't delay it.

Some clauses change how much the insured is paid for a covered loss: the deductible, coinsurance (Chapter 9) and contribution with other insurance (1.4). Administrative details such as the policy number don't.

1.7 Liability basics

Liability insurance pays when the insured is legally responsible for injury to someone else or damage to their property. Most liability comes from negligence, which is failing to take reasonable care. To win a negligence claim, the injured person must generally prove four things:

1. The defendant owed them a duty of care.
2. The defendant breached the standard of care.
3. The breach caused the injury.
4. They suffered real damages.

Other kinds of liability you need to recognize:

• Vicarious liability: being responsible for someone else's actions because of your relationship. An employer is liable for an employee driving a company van on a delivery.
• Strict liability: liability without proof of fault. In Ontario, the Dog Owners' Liability Act makes dog owners liable for bites and attacks.
• Contractual liability: responsibility you take on under a contract, such as a lease.
• Occupiers' liability: under Ontario's Occupiers' Liability Act, people who control a property must take reasonable care to keep visitors safe. It is not automatic liability.

Ontario law is based on common law (rules built up through court decisions plus statutes). Quebec's private law is based on a civil code, and Quebec has its own regulator and licensing. Ontario practice can't simply be assumed to apply there.

1.8 Words the exam expects you to know

These legal and business terms turn up in questions without being explained. Learn them in pairs.