PRINCIPLE OF INDEMNITY

Principle of Indemnity .

The dictionary meaning of ‘indemnity’ is ‘the protection or security against damage or loss or security against legal responsibility’. Indemnity may be referred to as a mechanism by which insurers provide financial compensation in an attempt to place the insured in the same pecuniary position after the loss as enjoyed just before it. The literal meaning of the term “Indemnity” is making good the loss. On the happening of the insured event for which the insurance policy is taken up the insured should be replenished the amount of loss. This principle sets the rule according to which insurance companies undertake to compensate the insured upon fulfillment of all the stipulations that are agreed upon in the insurance contract. The insurer charges a small amount as premium for undertaking the liability to cover the risk and in return promises to pay the value of the insurance policy or the amount of loss whichever is lower. The principle of Indemnity ensures that the insurer is liable to pay up to the amount of loss and not more than that. In other words it implies that the insured should not derive any unwarranted benefit from a loss. Normally the principle of indemnity applies to property and liability insurance contracts and it promises that the insured be restored to the same financial position that existed prior to the occurrence of loss. Whenever the insurance company indemnifies the insurer for the full value of the insurance policy (when the asset is completely damaged) the insurer takes possession of the damaged asset to realize the salvage value.

Importance of the principle of indemnity 1. The principle of indemnity is important in the sense that it ensures that the insured does not derive any undue benefit from the loss. Example – Mr. Kumar had insured his car for Rs. 5 lakhs. The car met with an accident and was damaged. The loss suffered was valued at Rs.1 lakh. As per the principle of indemnity the compensation to be paid will be based on the amount of loss, i.e. Rs. 1 lakh. In case the compensation exceeds Rs. 1 lakh, Mr. Kumar stands to gain from the loss.

The principle of indemnity also aims to control moral hazard. It is possible that the insured may try to secure the maximum amount through dubious and unfair means. For example he may: l Deliberately inflict loss upon the property to seek compensation l Resort to exaggerating the loss l Make false claims, etc. Such claims when accepted confer undue profits on the insured. The insured may try to inflate the value of the property and over insure it to seek profit. If the compensation to be paid by the insurer is limited to the market value of the loss or less, it would put a check on this avenue for undue gains for the insured. Thus the principle of Indemnity helps to eliminate this possibility. This is demonstrated in the following example: Example – Mr. Ajay owns a restaurant, which he had bought three years ago for Rs. 2 lakhs. He had bought fire insurance worth Rs. 1.6 lakhs (which is the written down value of his insured property). His restaurant caught fire and the amount of loss suffered was worth Rs. 90000. The amount of compensation to be paid by the insurance company = Rs. (sum insured/value of insured asset) * actual loss = Rs. (1.6 lakhs/2 lakhs) * 90000 = Rs. 72000

Indemnity in practice Even though the property is fully covered, all covered losses are not actually paid in full amount of loss since it would contravene the provisions and implications of the principle of indemnity. As per certain provisions in force the amount of compensation paid can be less than the loss suffered. They are: i. Actual Cash Value (ACV) The actual amount of payment to be made by the insurer for the loss is based on ACV of the property, which is insured. Usually ACV is determined using the following three methods: 1. Replacement cost less depreciation In this method ACV is the written down value of the property after taking into account the depreciation and inflation in the value of the property over a period of time.

Thus actual cash value = (replacement cost - depreciation) Example – Suppose a Machinery is purchased by A five years ago at a cost of Rs. 10 lakhs. The cumulative depreciation on the machine for the five years (@ 10% Straight Line Method) = Rs. 5 lakhs Replacement cost = Rs. 10 lakhs Hence ACV = Rs. (10 - 5) lakhs = Rs. 5 lakhs 2. Fair Market Value (FMV) FMV, which is the price that would normally be determined in a free market during a transaction entered into by a willing buyer and a willing seller, can be taken as ACV where replacement cost cannot be determined. The concept of fair market value can be better understood by the following case. X owns an independent house property purchased ten years ago for Rs. 15 lakhs. The Municipal authorities are developing a cremation ground on the uninhabited land near the property of Mr. X. Hence the market value of property has come down for the property due to lack of market interest in the property and the only prospective buyer is willing to pay Rs. 8 lakhs for the property.

In case of any loss to the property the fair market value will be considered to be Rs. 8 lakhs by the insurance authorities. 3. Broad Evidence Rule In this method ACV is determined scientifically applying techniques such as replacement cost less depreciation, FMV, discounting income streams derived from the property, taking the value of similar property, etc. Here the method of judgment and application of commonsense is resorted to by the experts to reach an agreeable value. ii. Other Insurance In case the insured has taken up two policies for the same property, the compensation will be paid proportionately according to ACV by both the insurers. Thus the insured cannot benefit by resorting to multiple policies for the same property.

Example – A stevedoring company owns an ocean steamer valued at Rs. 32 crores. The steamer has been insured with three different insurance companies A, B and C.The amount underwritten by A is Rs. 6 crores, by B is Rs 10 crores and by C is Rs. 16 crores. Thus the total sum insured amounts to Rs. 32 crores. The steamer meets with an accident and the loss is valued at Rs. 4 crores. Hence the liability of each individual insurer = (Amount underwritten by the insurer * amount of loss)/total sum insured So the liability of insurer A = Rs. (4 * 6)/32 = Rs. 75 lakhs The liability of insurer B = Rs. (4 *10) / 32 = Rs. 1.25 crore. The liability of insurer C = Rs. (4 * 16) / 32 = Rs. 2 crores.

How indemnity is provided Most of the general insurance policies contain the following wordings: The company may at its option indemnify the insured by payment of the amount of the loss or damage or by repair, reinstatement or replacement. In other words, indemnity is made in the following ways: Cash payment – for the amount payable under the policy Repair – most extensively used method of providing indemnity (motor claims) Replacement – commonly used in glass insurance Reinstatement – used in restoring or rebuilding machinery or building under engineering insurance policies Factors limiting the payment of indemnity The maximum amount recoverable under any policy is limited by the sum insured [or the limit of indemnity]. The actual amount payable to the insured is governed by a number of considerations: Average – this is applicable where an insured deliberately or otherwise underinsures his property. Application of this principle would make the insured his, own insurer to the extent of underinsurance [i.e. the difference between the value of the property and the sum insured]. Excess – it is the amount of each and every claim which is not covered by the policy. Excesses may be voluntary or compulsory. Most common in private car policies, where accidental damages could be insured for 80% or 90%.

Limits – refers to the limit in the amount to be paid for certain events, as mentioned by the wording in the policy. E.g. value of pictures, works of art restricted to 5% of the total sum insured in household policies. Deductible – refers to very large excess. Claims exceeding the deductible amounts become payable by the insurer. Principle of indemnity– Exception to the rule with respect to life insurance (In non-life insurance this covers Personal Accident Insurance and certain types of Health Insurance such as ‘Critical Illness’, ‘Hospital Cash’, etc., where the agreed amount is paid as claims without having to establish the actual spending by the policyholder). The life of a person is different from a material or property. The principle of valuing material property like replacement cost less depreciation and discounted cash flows cannot be applied to determine the monetary value of the life of a person. The value of life is broadly determined by certain qualitative factors and is subject to one’s opinion. The most important factor here is the earning capacity of the person and the insurable value is the value of the policy taken up by the person. A life insurance policy is not subject to the principle of indemnity but is a valued policy wherein the agreed upon amount in full is paid to the beneficiary in case of loss of life.