What is Principle of Contribution in Insurance?
Principle of Contribution in Insurance is one of the fundamental principles in Insurance. Principle of Contribution comes into play when there are multiple insurance policies which are insuring the same asset.
As per the Principle of Contribution, if multiple Insurance Policies insure the same subject matter, the Insured cannot recover his loss from all the Insurance Companies. The Insured is not allowed to make profit out of his Insurance Policy. So, in case multiple Insurance Policies are covering the same subject matter, in such a case, the insurance companies will only pay the proportionate portion of the loss.
Principle of Contribution in Insurance ensures 2 things:
- The Insured does not profit by making separate claims from different insurance companies for the same loss.
- Each Insurance Company only pays its proportionate share of loss.
Principle of Contribution is related to Principle of Indemnity in that the Principle of Contribution only applies to Contract of Indemnity, that is, General Insurance Policies. Principle of Contribution is not applicable to Life Insurance and Personal Accident Policies since they are benefit products and not indemnity products.
In case of an Insurance Claim, where the Policyholder has insured the same subject matter with multiple Insurance Policies for the same perils, the Insurance Companies will contribute to the claim in proportion to the cover taken by the Insured.
How does the Principle of Contribution work and what are the conditions necessary for Principle of Contribution to apply?
The following conditions must be satisfied in order for the Principle of Contribution to come into play:
- There must be more than one Insurance Policy which is in force at the time of the loss. If only 1 Insurance Policy is in force at the time of the loss, then that Insurance Policy will bear the whole loss.
- The Insurance Policies must insure the same subject matter. Principle of Contribution is not applicable if the Subject Matter Insured under the Insurance Policies is different even though the Policyholder is the same.
- The Insurance Policies must insure the Subject Matter for the same perils. If the Insurance Policy is covering different perils, then Principle of Contribution will not be applicable.
- All the Insurance Policies must cover the same interest of the same insured. If the Insurance Policies are insuring the same interest but of different insured, then again, the Principle of Contribution will not be applicable. Consider an example where Mr XYZ has purchased a vehicle with a loan from Bank ABC by keeping the vehicle as collateral. Here, both Mr XYZ and Bank ABC have Insurable Interest in the vehicle and can make an Insurance Claim in either of their Insurance Policies.
If the above 4 conditions are satisfied, then the Principle of Contribution is applicable.
Example of Principle of Contribution
Consider a situation where Mr XYZ has insured his factory assets with a Factory Insurance Policy from 2 different Insurance Companies for a Sum Insured of Rs1 Crore and Rs1.5 Crores.
The Factory was damaged in a Fire Accident and the losses were assessed by the Surveyor at Rs1 Crore.
The Insurance Company would indemnify Mr XYZ by paying him his loss Rs1 Crores by contributing to the Claim in proportion (2:3) to the cover taken by Mr XYZ from the Insurance Company. According to the Principle of Contribution, the first Insurance Company would contribute Rs40 lakhs while the second Insurance Company would contribute Rs60 lakhs to make good the losses of Rs1 Crore.
Mr XYZ cannot earn a profit out of his Insurance Policies by making an Insurance Claim of Rs1 Crore under both the Insurance Policies.
How is the Claim Amount Payable by the Insurance Companies calculated under the Principle of Contribution?
Once it is determined that the Principle of Contribution is applicable, the next step is to calculate the pro-rata portion of claim payable under each of the multiple insurance policies.
The formula to calculate the pro-rata portion of claim payable is
(Sum Insured under each Policy/Total Sum Insured under all Policies)*Loss Amount.
In the above example where Mr XYZ had suffered a loss of Rs1 Crore which was insured under two insurance policies with a Sum Insured of Rs1 Crore (Policy 1) and Rs1.5 Crore (Policy 2), the loss is calculated as follows:
Loss payable under Policy 1 = (Sum Insured under Policy 1/Total Sum Insured under all Policies)*Loss Amount
Loss payable under Policy 1 = (Rs1 Crore/Rs2.5 Crore)*Rs1 Crore = Rs40 Lakhs
Loss payable under Policy 2 = (Sum Insured under Policy 2/Total Sum Insured under all Policies)*Loss Amount
Loss payable under Policy 2 = (Rs1.5 Crore/Rs2.5 Crore)*Rs1 Crore = Rs60 Lakhs
The objective of Principle of Contribution in Insurance is that the Insured should not earn profits out of his Insurance Policies. The Principle, thus, serves to eliminate Moral Hazard in Insurance whereby the Insured is not tempted to commit fraud in order to profit out of his Insurance Policy.