What Does Principle of Indemnity Mean?
To indemnify someone means to “make someone whole.” The principle of indemnity is one of the fundamental principles of insurance because it is the part of an insurance contract that ensures the insured has the right to compensation and sets limits on how much they can get.
The principle of indemnity states that an insurance policy shall not provide compensation to the policyholder that exceeds their economic loss. This limits the benefit to an amount that is sufficient to restore the policyholder to the same financial state they were in prior to the loss.
In other words, the principle of indemnity ensures that the insured gets made whole from their loss but will not benefit, gain, or profit from an accident or claim. Nor will you get less than what is necessary to restore you to the same financial position.
For example, if you suffer a loss to your home due to a fire and it is estimated that it would cost $50,000 to repair the damage, then that is what you would get from the insurance company subject to limits of insurance selected and other terms and conditions of the insurance policy.
If you are underinsured however - as in you did not purchase a high enough limit of insurance to allow yourself to be fully “made whole”, this principle still holds as you are not profiting from your insurance policy.
The principle of indemnity only applies to property and casualty insurance policies and not life insurance as the value of a human life cannot be quantified in monetary terms.
Insuranceopedia Explains Principle of Indemnity
The principle of indemnity is a central, regulatory principle in insurance that applies to most policies, except personal accident, life insurance, and other similar policies. This exception is because it is impossible to accurately quantify a human life in monetary terms.
According to the principle of indemnity, the insured would get enough money to be “made whole” or to return them to the same financial position they were in prior to the loss. In other words, they would be compensated based on the actual amount of loss sustained subject to limits of insurance selected by the insured and other policy terms and conditions.
This basic tenet ensures the policyholder receives an amount in benefits equivalent to their actual losses so they do not make a profit from it. Because of this, it is linked to another central insurance principle, that of insurable interest, as the policyholder cannot receive a sum that goes beyond their insurable interest.
Here are some basic examples to help illustrate this principle:
If an insured purchased a limit of insurance of $50,000 on his car and got into a crash. After taking it to a certified body shop, the mechanic estimates it would cost $10,000 to repair the damage and return the car to its original condition. In that case, according to the principle of indemnity, the insured would only be entitled to $10,000 in compensation (or “indemnity”) from the insurer as that is what is required to return them to their pre-loss financial position. No more, no less. Just because they had purchased $50,000 of insurance does not mean they will get $50,000 in compensation every time. Payment is made by the insurance company based on the actual amount of loss you have sustained.
There are caveats as the principle of indemnity can be overwritten by other terms and conditions. If the insured purchased a limit of $10,000 on his car and got into a crash that is estimated to cost $15,000 to repair, the insured would only be entitled to $10,000 in indemnity from the insurer even though the principle of indemnity is supposed to guarantee them $15,000 (the amount required to make him whole). This is because the principle of indemnity is subordinate to the limit of insurance purchased or other terms like coinsurance penalties.
The rationale behind this principle is to protect insurance companies by eliminating moral hazard. Insureds won’t be as tempted to commit insurance fraud if there was no way to profit from a claim as all they would get back is what they lost.