Understanding the Principle of Indemnity

Indemnity is arguably the most fundamental principle of insurance. This principle plays a critical role in general insurance. Indemnity is easily applied to losses that are quantifiable. Indemnity is monetary compensation that aims to return the insured to the same financial position he enjoyed before the loss occurred. Life insurance and personal accident policy are therefore not contracts of indemnity. A dollar value cannot be easily placed on life and limb. However, the idea behind indemnity is used for financial underwriting where life insurance is concerned.

Insurance in general covers pure risks. Pure risks differ from speculative risks in that they do not involve gain. Financial underwriting in life insurance is a means of ensuring that people do not acquire life coverage that is significantly higher than their future economic value. As such life insurers limit the amount of coverage you can have, based on your income. The coverage amount is typically thirty times one’s annual income. This is one way the underlying principle of indemnity influences life insurance coverage, even though it is not directly applied to it.

With contracts of indemnity, a claim must not exceed the actual loss. Even further to that, a claim cannot exceed the extent of your insurable interest in the insured asset. Let’s assume that two people are co-owners of a property. The property is shared equally. One owner is not entitled to insure more than half the value of the property under normal circumstances. That occurs because one owner’s interest in the property is limited by his share of ownership.

Where indemnity is concerned, the insurer has leverage in choosing the method of reimbursement. The options available, where indemnity is concerned, include cash, repair, replacement or reinstatement. Indemnity is limited by policy limits and the level of the sum insured. The application of excess and average help maintain the integrity of the indemnity principle.

The application of average dictates that a settlement must be proportional to the ratio between the sum insured and the total value of the risk covered. It is a technique used to combat under-insurance. Assume that you insure your home for $500,000.00 and the market value is $1,000,000.00. If a loss estimated at $200,000.00, the insurer would not reimburse the full extent of the loss with the application of average. The settlement would be $100,000.00, since only half the value was insured. Excesses perform the same role as deductibles in health plans. An excess is an amount of each claim that is borne by the insured and not covered by a policy.

In some cases, those who do not understand the fundamental principle of indemnity feel unfairly treated during the claims process. However, the application of this principle maintains the integrity of insuring pure risks. The fact remains that no one should gain from insurance, even where life insurance concerned.