Indemnity in Insurance; Meaning and Principle

Indemnity in insurance meaning

Indemnity refers to the security or protection against financial liability which usually occurs in the form of a legal agreement that takes place between parties whereby one party agrees to pay the other party in an event of loss or damage suffered. The definition of indemnity in insurance is the financial compensation that the insurer makes to the insured if a loss occurs. When it comes to corporate law, the aim of an indemnity agreement is to grant a company’s executives and board directors safety from personal liability that may arise if anyone sues the company or suffers damages.

A practical example is in the insurance sector where the insurer agrees to pay the insured if any loss or damage occurs in a particular period of time. This takes place in exchange for a periodic payment called the premium. Indemnity in law refers to an exemption from liability for damages.

It is on the basis of the amount they agreed upon in the contract that the insurance company (the Indemnitor) promises to pay the insured (the indemnitee). This aspect of the contract is what matters the most to the insured, which states that the insured is entitled to financial compensation in an event of a loss or damage. Here, there is a direct relationship between the indemnity and the amount of loss. That is, the insurer can pay up to the amount of loss or the insured amount that was collectively agreed upon by both parties in the contract.

In essence, the concept of indemnity in insurance guarantees to compensate the insured party if any unexpected loss or damage occurs, up to a certain limit. In other words, in case of a loss, the indemnity provision in insurance policies provides compensation to the policyholder. This limit is usually the level of financial loss itself. With this, insurance companies make provision for coverage in exchange for the premium that the insured pays. The aim of this policy is to protect business owners and professionals especially when they default for a specific event such as malpractice and misjudgment. Generally, they take the form of a letter of indemnity.

Methods of providing indemnity in insurance

1. Cash
2. Replacement
3. Repairs
4. Reinstatement

In the form of cash

The cash method is the usual way of making claims payment as it is simpler, easier, and less stressful.
In the form of replacement
In an event where there is a total loss, the insurers may replace the insured property with another one that has the same standard, age, and quality.

In the form of repair

The insurers can repair the loss to pre-loss condition as far as practicable. So rather than making a cash payment, the insurers will decide to repair the loss.

In the form of reinstatement

Reinstatement is considered with respect to the damage or destruction by fire.
This is usually considered with regard to buildings damaged or destroyed by fire

In the form of replacement

Usually, in the case of a total loss, the insurers may replace the subject matter or property with another one that possesses the same standard, quality, and age.

The principle of indemnity in insurance

The principle of indemnity in insurance law affirms that in an event of a loss, the insurer will place back the insured back in the same financial position as he used to be immediately prior to the loss. In other words, the insured will get neither more nor less of the actual amount of loss sustained. Of course, this is usually subject to the limit of the sum insured as well as subject to certain terms and /conditions that are contained in the policy.

To elaborate on the rule of indemnity in insurance, if an event of a loss takes place, the insurers will make efforts to put back the insured in the same financial position that the insured was before the occurrence of the loss only if there is a proper arrangement of the insurance on full value insurance.
In under-insurance and restrictive terms of the policy, the insurer may preclude the insured from getting the actual loss. On the other hand, if the sum insured exceeds the actual value of the subject matter of insurance or property, the insured will not be entitled to getting more than the actual loss.
Indeed, this principle is very important in keeping the insurance business on track as well as keeping it free from wagering.

This principle also puts to checks the moral hazard of a man as well as allows him to get the actual amount of loss incurred but certainly not more than that.

Considering a proposition through over-insurance, the insured is allowed to make more than the actual amount of loss. This case can bring about a temptation to deliberately create an insured event of a loss in order to make a profit out of a loss.

Therefore, the principle of indemnity states that the insurer may not indemnify the insured in an amount that exceeds the economic loss of the insured. In this contract of indemnity, it is very important to select a proper sum insured as this is always the limit within which the insurer considers indemnity. The word indemnity symbolizes protection or security against loss. With this, the aim is to give protection to the insured against loss.

This principle is widely applied to property insurance and liability insurance, it does not apply to life insurance where it becomes difficult to measure financial loss.
The principle of indemnity is one of the fundamental principles of insurance because it is the aspect of the insurance contract that ensures the right of the insured to compensation and places limits on how much they can get.

Types of indemnity in insurance

1. Express indemnity
2. Implied indemnity

The above are the two basic types of indemnity in insurance.

Express indemnity

Express indemnity is a written agreement where the terms and conditions that the insurer and the insured must abide by are usually indicated.

Implied indemnity

The implied indemnity is an obligation of the insurer to indemnify the insured that is not based on a written agreement. However, this type of indemnity is rare in the insurance sector because most insurance agreements are in a written /form.

Selection of sum-insured in the principle of indemnity

In a contract of indemnity, the selection of proper sum insured is vital because it is usually the limit within which the insurer will consider indemnity. In this case, if the sum insured is restricted to an amount that is less than the value, then in an event of a total loss, the insured will end up getting the sum insured that does not indemnify him.

Even if it is not a total loss, the use of a policy condition known as average will help the insurer not to pay more than the proportionate loss, that is the loss that is corresponding to the ratio of the sum insured and actual value.

On the other hand, it is not a good idea .to arrange an excessive sum insured as the insured will never be entitled to getting more than the actual amount of loss. This will simply imply that the insured is making payment of excessive premium without any corresponding benefit. Therefore, the sum insured should always base on the actual market value of the property or subject matter of insurance at the time of putting the insurance policy to effect. By implication, the essential requirement of insurance is that it has to be full value insurance.

Application of the principle of indemnity to various branches of insurance

Life

With the exception of life and personal accident insurance, every insurance contract is a contract of indemnity. Life and personal accident insurance are not contracts of indemnity because one cannot value life or limb in terms of money.

In legal terms, these are the two types of insurances that have been outside the principle of indemnity. Theoretically, any individual can affect any number of policies for any amount. Also, at the time of claim, every of such policies must pay all the sum insured under all such policies.

Although this is the position of law, however, insurers would always try to place checks and balances on the moral hazard by placing restrictions with regard to the sum insured on a man’s financial capability and standing, that is, his continual premium payment capacity.

It should be noted that such a check that is being placed on the sum insured is purely an underwriting check in order not /to completely shatter the principle of underwriting. However, this check is not a legal check. This means that from the legal point of view, such policies are not contracts of indemnity and there is absolutely no reason why an individual cannot get any number of policies for any amount.

Non-life

All insurance policies aside from life and personal accident insurance policies are contracts of indemnity. These policies include fire, marine, auto, fidelity guarantee, engineering, agricultural insurance, burglary and theft, products liability, aviation, employers’ liability, etc. These are all contracts of indemnity.

Excess, franchise, and average in indemnity

As earlier stated, the insurer provides indemnity subject to certain terms and conditions contained in the policy. Therefore, excess, franchise, and average are important because they have an impact on the principle of indemnity.

Excess

This term means that with regard to any loss, the insurance company shall deduct a certain predetermined amount, and the balance if any of them shall be paid. Here, one will notice that because of a policy condition, the insured is not really placed back into the same initial financial position after the event of a loss.

From the perspective of underwriting, it is sometimes a requirement to adopt such treatment particularly to keep a check on moral hazard about an insured that has the habit of making constant claims that are trivializing. Therefore, another justification for excess is to eliminate trivial claims, considering the administrative expenses that are quite more often than the amount of claim itself.

Franchise

If an insurance policy is subject to a franchise, to get a claim, the extent of the claim has to reach the amount of franchise when the insured gets a full claim. If the amount of loss fails to reach the franchise, it means that the insured will not get anything. Therefore, a franchise is a prerequisite to acquiring a claim.

About the franchise, we would see that if the extent of loss does not reach the amount of the franchise, then nothing will be payable. This means that the insured will get no indemnity although he has suffered a loss.

From the underwriting point of view, the aim of franchises is to treat moral hazards and trivial claims just like excess.

Average

The average is a method by which an insurance company defeats under-insurance. The norms of insurance always require that there should always be full value insurance. Under-insurance deprives the insurers of getting the actual premium even though they are liable to the payment for the occurrences of loss to the fullest extent, the sum insured is the only limit.

The outcome of under-insurance is that the experience gets unfavorable leading to enhancement of the premium which will be to the detriment of even those who usually believe in full value insurance. In order to handle this situation, the average was introduced to make the insured his part-insurer to the extent of under insurance.

3 types of average

1. Pro-rata condition of average
2. Special condition of average
3. Two-condition of average

Pro-rata condition of average

In this type of average, if at the time of loss, the insurance company finds out that the actual value of the property is more than the sum insured, that proportion of actual loss will be paid, that the sum insured bears to the actual value.

For example, if the sum insured is $10000, the actual value of the asset is $20000, and the loss is $1000. The calculation will be as follows;
10000/20000 x 1000 = $500
This implies that the insurance policy will pay $500 as indemnity to the insured for the loss incurred.

Special condition of average

Another name for the special condition of average is 75% condition of average. Under this type of average, if the insurance company at the time of loss finds out that the sum insured is less than 75% of the value of the property, the insurance company will pay the proportion of the loss that is born by the sum insured to the actual value. If the sum insured is to the extent of at least 75% of the actual value of the property, then no average will apply.

For example, if the sum insured is $7500, the actual value of the subject matter is $10000 and the loss is 1000, the insurance company will pay the actual amount of loss that is $1000.

Another example may be; If the sum insured is 7000, the actual value of the subject matter is $10000, and the value of the loss is $1000, then the calculation will be;
7000/10000 x 1000 = 7000

Therefore, the policy will pay $700 as indemnity.

This condition of average is usually applicable to properties like stocks where the possibility of violent and rapid fluctuations in price exists.

This condition is usually applied to those types of properties (e.g., stock) where there is a possibility of

Two-condition of average

Under this type of average, there is virtually no difference with the pro-rata condition, but it has two parts. The first part of this type of average is exactly the pro-rata average. The second part states that if the insurance company finds out that there is a policy that is more specific, that is covering the same loss, then it is the specific policy that will pay first pay for the loss. If there is still a balance of claim that is remaining, then only this policy will come forward to pay the balance of loss. Also, in the case of under-insurance, will be applicable in the usual manner on the balance.

For example; In the first instance, the sum insured in Policy A for property 1 and 2 is 1000, the value of property 1 is 1000, as well as the value of property 2, the sum insured in Policy B for Property 1, is $700. If a loss of $500 occurs on Property 1, Policy B will be the first to pay $500 as the sum insured fully covers the loss. While Policy A will pay nothing as the loss has been fully paid by Policy B.

In the second instance, if the loss on Property 1 is $1000, Policy B will pay first, $700 which is the limit of the sum insured. The balance of the loss is $300. Policy A will then pay 1000/2000 x 300 = 150. This implies that the insured will bear the balance of loss of $150.

Looking at these types of average, it is certain that if there is no proper arrangement of insurance on full value insurance, that is, if there is under insurance, the insured will not be entitled to full indemnity. However, it should be appreciated that this happens as a result of a defective arrangement of insurance for which one cannot blame the principle of indemnity.

Double indemnity in insurance

Double indemnity clauses may be unavailable to those with occupations that possess high levels of risks. Depending on the occupation, the insurance provider may decide to add a premium surcharge for the coverage. One can add this coverage to group-life insurance, standard life insurance, travel life insurance contracts, etc.

To receive double indemnity for a life insurance policy, it is critical for the beneficiary to prove that the death was accidental. Depending on the nature of death, it may be obvious physically, probably murder, car accident, etc. However, the insurer will still need to obtain records of the autopsy which will be adopted by medical professionals to prove that the death was unintentional and accidental.

FAQs on indemnity in insurance