The principle of indemnity is the cornerstone of general insurance contracts. In the broadest sense, indemnity is compensation. However, in the context of insurance, indemnity is much more than that. Measurement of loss is critical to an insurer’s application of indemnity. While it is true that the indemnity principle seeks to compensate for losses, it follows that not all insurance contracts are indemnity contracts.
An indemnity contract seeks to reimburse the insured for actual losses that occur. Critical to the indemnity contract is the cost of restoring the insured’s financial status before the loss. For instance, if you insured your house for one million but it costs only $500,000.00 to replace your house at the time of loss, then the insurer is concerned with the $500,000.00 figure- the actual replacement cost.
A valued contract, on the other hand, does not consider the actual replacement value. A valued contract states the benefit payable in the event of a loss. The benefit payable is also known as the face value or face amount of the policy. The face value arbitrarily connects to the loss, which is usually intangible. Life insurance and personal accident policies are valued contracts because one cannot attach a specific value to loss of life or limb.
Life insurance policies are valued contracts/ contracts of compensation or benefit. They seek to cover the loss of income for a household. The life insured has latitude in determining how much insurance to buy. It is more difficult to establish underinsurance with life and personal accident policies than with general insurance.
The death benefit in a life insurance contract reflects the earning potential of the life insured or the expenses that the life insured wants covered- not the actual value of your life or limb. The notion that you do not value your life if you do not have life insurance is arrant nonsense (usually spewed by insurance sales representatives and agents).
Health insurance contracts can be either valued contracts or indemnity contracts. Health plans that seek merely to reimburse medical expenses are contracts of indemnity. Those that provide a stated benefit, regardless of expenses incurred, are valued contracts. A critical illness plan that offers a stated value as a benefit- regardless of the loss incurred- cannot be an indemnity contract.
The concept of indemnity influences valued contracts to an extent, however. You cannot buy how much life insurance you desire without limits. Life insurance underwriters have guidelines under Financial Underwriting. Underwriters also scrutinize large amounts of life insurance carefully to ensure that illegal wagering on an insured’s life is not taking place.
Insurers also frown on those who take a sizeable amount of insurance on a low annual salary. They have their own method of determining how much is too much, which is generally reasonable. After all, one would not expect a man earning $30,000.00 a year to purchase a $2,000,000.00 life policy without a very good reason.
The principle of indemnity does not apply to life policies or personal accident policies but it may (or may not) apply to health policies. Instead, the ‘spirit’ of the principle of indemnity guides the face amount of valued contracts like life policies.