The Principle of Indemnity: Meaning and How it Works in Insurance

Insurance is an agreement between two parties and has to be governed by certain principles to ensure that everyone is treated fairly.

As the insured party, you want to know that the insurance company will honour their end of the bargain and give you what you’re due. In the same way, the insurance company wants to protect itself from being exploited during insurance claims.

For this reason, indemnity is one of the essential principles of insurance. Whether your property is damaged or you need your car insurance to pay out, the principle of indemnity will ensure that you are fairly compensated.

Keep reading to learn more about what indemnity means, how different types of insurance policies can affect it, and how it can play out when a company indemnifies you.

Principle of Indemnity: Definition and Explanation

The principle of indemnity states that the insured will receive enough compensation to return them to the same financial position they were in before the loss occurred.

This means that the insurance company will reimburse you the exact amount you lost when your insured property was damaged. You will not receive any more or any less money.

Of course, this also depends on the sum you are covered for and the conditions of your insurance policy. If you are under-insured, the insurance company will only pay you the amount you are covered for, even if the losses were higher.


Example of Indemnity Insurance

Say, for example, you were in a car accident and the repairs to your car cost R10 000. Even if you insured your car for R15 000, the insurance company will only pay for the actual damages of R10 000. You will not receive the full R15 000, because it is more than the amount needed to return you to your original financial position before the loss.

Also keep in mind that the principle of indemnity cannot help you receive more than you are covered for. If you under-insured your car for only R8 000, you will not receive the full R10 000 that you lost, since that was not the agreement of your insurance policy.

What is the Reason for the Indemnity Principle?

Insurance indemnity allows you to be fairly compensated for a loss, while at the same time ensuring that no one takes advantage of their insurance.

This principle protects companies from insurance fraud and moral hazard. Some people might deliberately damage their property so that they can collect the insurance money and make a profit.

However, under the indemnity principle, they will only be given back the amount they lost and not gain anything more.


Types of Indemnity Insurance Policies

Life and medical insurance are not contracts of indemnity, since we cannot place monetary value on a person. But all other insurance policies obey the principle of indemnity. This includes burglary, car, fire, and employers’ liability insurance.

There are also two different types of insurance policies that might affect how the indemnity principle works. These are valued and first loss policies.

Valued Policies

In valued policies, the value of your property is decided beforehand. Your property is then insured for the agreed-upon sum of money.

If a total loss occurs, the full amount will be paid out to you, even if it is more than the actual cost of the damage. This is an exception, then, where the insured might make a profit from their insurance.

These cases are rare, however, since most losses are partial and not total. In the case of a partial loss, the insurance company will not pay you the full amount for which you are insured, but only enough to indemnify you.

First Loss Policies

In this type of policy, the property is insured for less money than its actual value. The reasoning behind this is that total loss is almost impossible because of the nature of the item. For example, if there is something in your house that is very heavy and won’t likely be carried off during a burglary.

If a partial loss occurs under such a policy, you will be indemnified in full. But if a total loss occurs, you will receive less money than the loss that occurred. These situations are rare, however, and the policies aren’t commonly used.


Different Ways Insurance Companies Can Indemnify You

Being indemnified means to be “made whole”, or brought back to the financial state you were in before the occurrence of a loss.

There is usually a written contractual agreement between you and the insurance company which states how much and in which way they will indemnify you in the case of a loss.

There are various ways in which you can be indemnified after a loss:

  • Cash payment. This is the easiest and most common way to receive payment after a claim.
  • Repair. The insurance company pays to have the damaged property fixed after a partial loss.
  • Replacement. The insurance company gives you a new item of the same type and quality as the one you lost, usually after a total loss occurred.
  • Reinstatement. If the insured property was a building, the insurance company pays you the amount it would cost to rebuild.

Note that the insurance company makes the choice of how to indemnify you and you might not have a say in the method chosen.


Final Thoughts on Indemnity in Insurance

The principle of indemnity is an important part of any insurance contract. It is your guarantee that you will be fairly compensated if your insured property is damaged or destroyed.

Indemnity is an agreement between you and the insurance company that you will receive no less and no more than you need to restore your economic loss. You will either be given money to make up for your loss, or the property itself will be fixed or replaced.

Different types of policies can have an impact on how the principle of indemnity plays out. But even though there can be slight changes, indemnity is always a fundamental part of insurance contracts.




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