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General insurance

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asked Jun 22 in BUS 1003H - Introduction to Financial Risk by anonymous

In the 2015 test 2 question paper.

2.(iv) 

A cellphone insurance policy which replaces a stolen cellphone with a used cellphone of similar value follows the principle of indemnity, while one that gives the policyholder a voucher to buy a new phone of the same kind as was stolen does not. 

True or False, and why?

1 Answer

+1 vote
answered Jun 23 by Rowan (2,480 points)
selected Jun 23 by Rowan
 
Best answer

False.

This is because the principle of indemnity involves returning the policy holder to the same position as they were in before the event, from a financial point of view.

Therefore, regardless of  whether the insurer replaces the phone itself or  they give the monetary value of the phone in the form of a voucher, the principle of indemnity is still being followed.

commented Jun 23 by Mpumelelo (100 points)
edited Jun 23 by Mpumelelo

I fully understand where that reasoning comes from, However I answered True, because I looked at it this way:

lets say for example we have a car insurance policy, and they say that it gives the policyholder a voucher to purchase a new car of the same kind as was stolen, if it were to be stolen - And since we are assuming that it really does not matter how long the policyholder has been using the car - is it then false for me to say that the insurer does not necessarily follow the principle of indemnity because taking depreciation, damages to the car and so on to account, the car would have been worth a whole lot less then a new car that would be bought by the insurer. because the policyholder did not actually lose the whole amount of the car - when it was stolen, but rather the value of the car at that point in time?

thanks.

commented Jun 23 by Rowan (2,480 points)

Hi Mpumelelo.

From a purely technical point of view, the points you make are all correct and they open up an interesting avenue for discussion (Which is probably beyond the scope of the intros course).

In practice most general insurers operate on what is called a new-for-old basis. This means that they will replace something which has been damaged/lost with a new variant (as opposed to an old one). The primary reason for this is purely simplicity. It is much easier to simply get a new item, as opposed to trying to decide on the exact value of the old item and then trying to find a suitable used item which matches its value. The cost savings due to the simplicity outweigh the added cost of the new item vs. the used item.

This has led to it being generally accepted that providing the policy holder with a new item (or the value of a new item) still adheres to the principal of indemnity. This is because, even though strictly they are not in the same financial position, they are in a position which is better off, thus their original position is covered and they are indemnified from the loss.

commented Jun 23 by Mpumelelo (100 points)

Thank you for this explanation, because it really didn't make sense.

but now I understand!

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