What Does the Principle of Indemnity Means in Insurance?

What Is Principle of Indemnity?

The principle of indemnity ensures that the insured is restored to their previous financial position before their loss by the insurer in case of any insurance claims. For example, if your business suffers fire damage worth ₹5 lakh, in case of having fire insurance, your insurer will compensate you for the loss. The indemnity principle lets the insurer reinstate the insured to their original financial condition before they incurred a loss.

The indemnity principle is critical given the mounting risks businesses face. Be it the healthcare or manufacturing industry, businesses have always been exposed to risks worth crores. Let’s understand this in more detail below.

What Is The Idea of Indemnity?

The principle of indemnity in insurance states that the compensation provided by the insurer should equal the actual loss. Note that the insurer will compensate only if the claim lies within the policy's coverage limits. In real life, if a manufacturing company suffers damage to assets due to a third party, the principle lets the insurer compensate the manufacturing company.

However, this principle only applies if both parties have entered into an insurance contract, and the policyholders have raised a claim that is covered by the insurance contract.

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Example of Principle of Indemnity

Insurance works as a risk protection coverage to shield the company against major financial losses. The identity principle just makes sure that the insured who pays a fixed premium is fully compensated for their losses as per policy coverage.

Let’s consider thecase of Kia. Kia lodged an official complaint mentioning that the engines sourced from Hyundai are stolen. If Kia were insured with a commercial crime insurance, the company would have been completely secured against the loss. According to indemnity law, the insurer would have compensated Kia for its loss due to missing engines, and the company would not have incurred a loss of $2.3 million.

Main Features of the Principle of Indemnity

The principle of indemnity has several important features:

Needs To Have Insurable Interest

The policyholder needs to have an insurable interest in the asset or individual the insurance is levied on. For example, if a business insures only its employees, it has an insurable interest in only its employees, not anyone else, such as its clients.

Sum Insured Cannot Exceed Loss

The amount of loss for which the insurer will compensate cannot exceed the sum insured. In case of excess, the insured needs to compensate for that by paying from their own pockets.

Covers Only Proximate Cause

The insured will cover only those losses that are stated within the insurance policy. Losses that are excluded from the policy are not directed to be covered by the indemnity principle.

Reinstating To Original Position

The principle of indemnity does not promise to make the insured wealthier, nor does it improve their financial position. The only objective of indemnity is to restore the insured to their original position by compensating only for the loss.

Monetary Losses Covered

The losses must be measurable in monetary terms and not qualitative losses. For example, loss of reputation of the firm, which does not have a fixed qualitative number, is not compensated.

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Where the Principle of Indemnity Applies in India

Let’s study some of the real-life cases to understand the indemnity principle better.

Health Insurance

The insurer is liable to financially compensate the insured when the policyholder has raised a health claim. For example, if the total medical expenses of an insured amount to ₹2 lakh, the law of indemnity directs the insurer to compensate for the same amount.

Marine Insurance

Let’s take the case of an Indian exporter who is exporting cargo to Australia, while the cargo suffers flood damage mid-transit. If the exporter had already purchased marine insurance, all cargo loss would be completely covered. By the indemnity principle, the insurer becomes liable to recover the exact amount of cargo loss to the exporter.

Property insurance

If business property gets damaged by a third party, the principle allows the insurer to reimburse for the damaged property. All types of damages are covered under property insurance, which includes buildings, assets and stocks.

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Where Indemnity Principle Does Not Apply

There are certain cases where this principle is not applicable. These cases are those where the insurer cannot determine the value of loss in monetary terms, such as:

Term Insurance

Term insurance is excluded from this principle as loss of human life cannot be measured with money. Even if the nominee does not lose any money, they receive it upon the death of the nominee.

Antique Assets

The actual value of antiques and ancient artefacts depends on bidding value and always changes. This is why the principle does not apply here too, as these artefacts cannot be measured in monetary terms.

Personal Accidents

Indemnity does not cover any cases of personal accidents. The main reason is that personal accidents involve loss of life or physical injury, which cannot be measured in actual monetary terms.

Critical Illness Insurance

It also does not apply to specialized insurance covers such as a critical illness policy. In a critical illness policy, the insurer pays a lump sum to the insured on diagnosis, irrespective of actual expenses incurred.

Main Functions of the Principle of Indemnity

The principle of indemnity in insurance ensures continuity for business. Financial interruptions and setbacks are easily covered with this principle. The major functions of indemnity coverage are:

• Helps the insured to continue their business without major financial interruption
• Restores the insured to their original financial condition before the loss
• Develops transparency and trust between insurer and insured
• Preserves a balance to exist in the insurance industry by compensating the insured for only the loss amount
• Controls double compensation and maintains fairness in the insurance industry

Conclusion

The principle of indemnity acts as a legal promise where the insurer has to compensate the insured for the exact loss incurred. Without indemnity, insurers may increase premiums sharply, and the purpose of insurance as a safety net would be distorted. This law of indemnity makes sure that insurance is fair and transparent. For businesses of any size, indemnity allows them to resume their businesses even if they meet with a fatal financial disruption when they are insured.

A small error can drag your business into expensive lawsuits. Protect against expensive legal claims with professional indemnity insurance from Covrzy. Connect with our experts at [email protected] and book the quote that suits your team size.