Principle Of Indemnity

What Does Principle Of Indemnity Mean?

To indemnify someone means to “make someone whole.” The principle of indemnity is a core concept in insurance, ensuring that the insured has the right to compensation, while also setting limits on the amount they can receive.

The principle of indemnity states that an insurance policy will not provide compensation that exceeds the policyholder’s economic loss. It ensures that the compensation restores the policyholder to the same financial position they were in before the loss, without allowing them to profit from the claim.

In other words, the principle of indemnity guarantees that the insured is made whole after a loss but prevents them from benefiting, gaining, or profiting from an accident or claim. Likewise, the compensation will not be less than what is necessary to restore their financial position.

For example, if your home is damaged by fire and repairs are estimated to cost $50,000, that is the amount you would receive from the insurance company, subject to policy limits and conditions.

However, if you are underinsured—meaning you did not purchase enough coverage to fully restore your property—the principle still holds, as you will not profit from the policy.

The principle of indemnity applies only to property and casualty insurance policies, not life insurance since the value of human life cannot be quantified in monetary terms.

Insuranceopedia Explains Principle Of Indemnity

The principle of indemnity is a key regulatory concept in insurance, applying to most policies, with exceptions for personal accident, life insurance, and similar policies. This exception exists because it is impossible to quantify the value of human life in monetary terms.

Under the principle of indemnity, the insured receives enough compensation to be “made whole” or restored to the financial position they were in before the loss. This compensation is based on the actual amount of the loss, subject to the limits of insurance and the policy’s terms and conditions.

The principle ensures that the policyholder receives an amount that reflects their actual loss, preventing them from profiting from the insurance claim. It is closely linked to the concept of insurable interest, meaning the policyholder cannot receive more than their insurable interest in the property or event.

Here are some examples to clarify the principle:

If the insured purchased a $50,000 coverage limit for their car and had a crash, with repairs estimated at $10,000, the insured would only be entitled to $10,000 in compensation. This reflects the actual loss—the amount required to return the car to its pre-loss condition. Despite having $50,000 in coverage, the insured will only receive compensation based on the actual loss sustained, not the full coverage amount.

However, there are exceptions. If the insured had purchased a $10,000 limit on their car and the repairs were estimated to cost $15,000, the insured would only receive $10,000 in indemnity, not the full $15,000 needed to repair the car. This is because the indemnity is limited by the coverage purchased or by other terms, such as coinsurance penalties.

The rationale behind the principle of indemnity is to protect insurers by preventing moral hazards. If policyholders couldn’t profit from their claims, they would be less likely to engage in fraud or intentionally cause losses.