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.
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