Principle of Indemnity
What is the principle of indemnity?
The principle of indemnity is an insurance concept which states the purpose of insurance is to make an insured (policy owner) whole again after a loss. It also states insurance is not for profit.
How does it ensure the policy owner is made “whole” again?
Well, we are talking about financially “whole”. So, let’s use health insurance as an example of how the principle of indemnity works. First off, this principle states, the insured’s policy will never pay more than the policy limit. However, an insured’s claim could be for less than the policy limit. With this in mind, it is true to say that most insurance policies will pay the insured’s loss, or the policy limit, whichever of the two is less.
Say an insured has a health procedure completed and the cost is $5,000. They have health insurance that covers this procedure, but the policy only covers this procedure up to $4,000. How much will the policy pay? $5,000? NO! The policy will pay the loss or the policy limit, whichever of the two is LESS. Let’s change that up a little bit. Say the procedure costs $5,000, and the policy covers it up to $10,000. How much will the insurer pay? $10,000. NO! The principle of indemnity states the insured cannot profit from their loss. In this situation, they will receive reimbursement of the expense ($5,000).
You can think of the insured’s finances as a pie. If the insured has to pay for a unexpected surgery, this loss would take a piece out of their financial pie. This is where the statement, “make the insured whole again”, comes from. The insurance is there to make the insured financially whole again. Filling in the missing piece of their financial pie.
How does the principle of indemnity apply to property insurance?
It is very similar to the example given above with health insurance. How about this though, what if I purchase multiple policies covering the same property. For example, I purchase three fire insurance policies on the same property which each have a policy limit of $100K. However, the property I am insuring only needs to be insured for $100K. I figure, if the house burns down, I will receive $300K, use $100K to rebuild the property, and use the other $200K to take a cruise around the world. Wooo!!! Nope! This is exactly what the principle of indemnity prevents. Now, in order to prevent this situation, the insurers (insurance companies) had to get creative and think up additional provisions they could add to policies, such as the other insurance clause, which applies if an insured has more than one policy covering the same property. This provision was created to prevent profit when purchasing property insurance and reinforces the principle of indemnity.
Do the terms indemnity or indemnify mean the same thing?
Almost. Indemnity is a contractual obligation of one party to compensate for the loss incurred by the other party. To indemnify simply means to compensate someone for a loss.
Do all insurance policies follow the principle of indemnity?
No, they don’t. For example, you can purchase as many life insurance policies as you want and they all pay in addition to each other. Life insurance does not follow the principle of indemnity.
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