What is an Indemnity Contract

There are many ways to define or categorise insurance contracts. Indemnity contracts and valued contracts represent one of several insurance dichotomies. While indemnity is based on compensation- and all insurance contracts involve compensation- not all insurance contracts are indemnity contracts.

An indemnity contract only seeks to compensate for actual losses incurred. An insured who suffers a loss covered by an indemnity contract should not profit from the claim payment. For this to happen, indemnity contracts cover only measurable losses. This is why insurance underwriters place high priority on the value of all insurable assets. The insured is supposed to get recognized valuations of insurable assets under an indemnity contract. In certain cases, the insurer only requires relevant documentation of the value of an asset- for example, jewellery.

The indemnity principle allows the insurer to pay less than the sum insured but never exceed the sum insured. If the replacement cost of an asset is less than the original cost, the insurer may only be liable to pay the replacement cost- even though it is less than the insured amount. However, if the replacement value were higher, the burden is on the insured. It is incumbent on the policy owner of an indemnity contract to insure assets adequately. Indemnity contracts that do not bear sufficient coverage can taint the insurance history of the policy owner as well.

Under a contract of indemnity, an insured cannot benefit beyond his insurable interest. For instance, assume that a person purchases full insurance on a commercial building that the said person co-owns (50% share). If an insured risk destroys the building, the co-owner is not entitled to seek full compensation from the insurer. The insurer may only provide compensation for 50% of the loss because that is the extent of the insured’s insurable interest in the property.

An indemnity contract is the opposite of the valued contract. The valued contract is based on an insured benefit- not on the value attached to a loss. This is because valued contracts- as life insurance is- cover priceless assets like life or limbs. Insurers have the options of choosing the method of indemnity under an indemnity contract as well. The insurer can provide cash, repair the asset, reinstate or replace it. Since the aim of an indemnity contract is to restore the owner to their previous status, the insurer has discretion in that process.

Indemnity is one of the most important principles of insurance. It helps to reinforce other principles like subrogation, insurable interest and good faith. An indemnity contract seeks to reimburse policy owners for actual, measurable losses. Even though not all insurance contracts are contracts of indemnity, the indemnity-based tenet of not profiting from insurance claims applies to all forms of insurance.