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Insurance principles: Indemnity

Updated on July 6, 2011

Definition

Insurance is based on a number of fundamental principles; in the sphere of general insurance, indemnity is a very important principle. Indemnity, as the word suggests, suggests compensation for losses that are measurable or determinable. It is monetary compensation that seeks to restore insured individuals to their financial standing before the loss occurred.

Application in insurance

Life insurance, health insurance and personal accident policies do not use the insurance principle because they are value contracts; loss of life and limb is not objectively determinable. However, indemnity suggests that insurance should not lead to profit.

Therefore, the spirit of the principle governs financial underwriting for ordinary long-term insurance contracts. For example, insurers tend to limit the amount of coverage on such plans – depending on the annual income of the insured.

With indemnity contracts, such as general insurance contracts, the claim amount must not exceed the loss. Whether the contract uses replacement cost or actual cost, the claimant is not supposed to make an actual cash profit. There are cases where this can happen in theory, but it is very rare.

The indemnity principle also mandates that an insured’s claim cannot exceed the extent of his insurable interest in the covered asset. For example, assume that two entities own a commercial property, which is shared equally. Typically, general insurers would only allow one entity to insure half of the value of the property. This is because that represents the extent of insurable interest – determined by ownership.

Insured individuals or entities that suffer losses may not always receive cash as compensation. The four compensation options are as follows:

  • Cash
  • Repair
  • Replacement
  • Reinstatement


The Principle of Indemnity in Marine Insurance Contracts: A Comparative Approach
The Principle of Indemnity in Marine Insurance Contracts: A Comparative Approach

This book discusses legal issues related to the principle of indemnity in marine insurance contracts as well as disputes that may arise in a representative sample of common and continental law jurisdictions. It offers a comparative examination of Australian, English, Canadian, French, Greek, Norwegian and U.S. law.

 

The extent of indemnity is restricted by policy stipulations and the coverage level. For example, the concepts of excess and average are integral in reinforcing this principle. The “average” concept mandates that that a settlement must be proportional to the ratio of the sum insured to the total value of the risk covered. This prevents persons who are underinsured from being fully compensated for damages/losses that are lower than the value of the sum insured. The excess is the amount of a claim that must be borne by the insured. The excess amount is outlined in the policy contract,

In the example where average is applied, it may seem as though the insurer is unfairly trying to pay less. However, understanding the principles of insurance, and indemnity in particular, reveals how these principles maintain the integrity of covering pure risks. The principle of indemnity and the concepts that reinforce it ensures that people do not profit from losses.


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