Indemnity insurance

Insurance contracts come in two shapes, and this is the first one.

An indemnity policy makes good what was actually lost. The workbook takes the plain meaning of the word: a duty to make good any loss, damage or liability incurred by another. An insurance contract, it says, is a classical contract for indemnity.

One consequence follows immediately. The loss has to be worked out before anything is paid. Bills, estimates, a surveyor. No figure, no claim.

Health insurance that reimburses hospital costs is the workbook's own example. So is fire cover on a building and own-damage cover on a car.

The other shape is defined benefit insurance. That pays a sum fixed in advance and does not ask what the loss was. A life policy works that way.

Behind both sits the principle of indemnity — insurance restores your position, it does not improve it.

The test. Any indemnity policy requires a determination of the actual loss suffered by the insured before a claim is paid. It is that requirement, not the type of risk, that makes a policy an indemnity policy.

Table 1.1 of the workbook sorts the common products.

One policy can be both. A mediclaim policy reimbursing hospital bills is indemnity; a daily hospital cash rider inside the same policy is defined benefit.

Three mechanics attach only to indemnity policies.

1. Contribution — where more than one policy covers the same risk, one insurer may claim a proportionate share from the other. The workbook states it applies only to indemnity policies, because the total claim cannot exceed the ascertained loss. Its example: two flood policies of Rs 5 lakh each with insurers A and B, ascertained loss Rs 30,000, so A may require B to chip in Rs 15,000.
2. Subrogation — after paying, the insurer steps into the insured's shoes and recovers from whoever was at fault. A policy without subrogation rights would be more expensive for the insured.
3. Co-pay and deductible — both reduce what the insurer pays out of an ascertained loss, and both reduce premium.

Why multiple indemnity policies rarely help. Section 3.2 says multiple health policies make very little sense, because the total claim cannot exceed the sum insured across them all. Multiple defined benefit policies all pay in full, however many there are.

One IRDAI override worth knowing. In health insurance, where the insured has covered the same risk with more than one company, it is the insured who chooses which insurer to claim from, and the chosen insurer cannot apply contribution if the claim is within that policy's sum insured.

Mr Bhalla holds two indemnity covers. A householder's fire policy on his Pune flat with a sum insured of Rs 40,00,000, and a mediclaim policy with a sum insured of Rs 5,00,000 carrying a Rs 10,000 deductible.

The fire claim. A kitchen fire causes assessed damage of Rs 6,20,000. The insurer pays Rs 6,20,000, not the Rs 40,00,000 sum insured. Indemnity pays the ascertained loss, capped by the sum insured, never more.

The health claim. A hospital bill of Rs 1,80,000 is submitted.

Subrogation in action. The fire began in a faulty geyser installed by a contractor. Having paid Mr Bhalla his Rs 6,20,000, the insurer sues the contractor in its own right and recovers Rs 4,00,000. Mr Bhalla neither gains nor loses from that recovery — he was already made whole.

Contribution in action. Suppose he also held a second fire policy of Rs 20,00,000 with another insurer. On the workbook's proportionate approach, the Rs 6,20,000 loss would be shared in the ratio of the sums insured, 40 to 20, so Rs 4,13,333 and Rs 2,06,667. He still receives exactly Rs 6,20,000 in total, which is the whole point.

Contrast a defined benefit payout. Had he held two life policies of Rs 50,00,000 each, both would pay Rs 50,00,000 on his death. Rs 1 crore in total, with nobody asking what the family actually lost.

Chapter 1 (Basics of Insurance), section 1.4(a), defines indemnity insurance; 1.4(b) and Table 1.1 set it against defined benefit insurance; 1.4(c) and 1.4(d) give subrogation and contribution with the Rs 5 lakh flood example. Chapter 3, section 3.2, applies it to multiple policies.

The reliable questions are classification questions straight out of Table 1.1, the contribution arithmetic, and the statement that contribution applies only to indemnity policies. Expect also the IRDAI health insurance override on who chooses the insurer.

• An indemnity policy pays the ascertained loss, not the sum insured. The sum insured is a ceiling. Answering with the full sum insured on a partial loss is the classic slip.
• Health insurance for hospitalisation is indemnity; critical illness is defined benefit. The exam pairs these two on purpose.
• Life insurance is not indemnity. The loss from a death cannot be measured exactly, so it is structured as defined benefit.
• Contribution applies only to indemnity policies. No indemnity, no proportionate sharing.
• Multiple indemnity policies do not multiply the payout. Multiple defined benefit policies do.
• One policy can carry both structures. The reimbursement leg of a health policy is indemnity while its daily cash rider is defined benefit.
• In health insurance the insured picks the insurer, and contribution cannot be forced on a claim that fits inside the chosen policy's sum insured.
• Do not treat indemnity insurance and the principle of indemnity as one headword. The principle is the doctrine that insurance must not be a source of profit; indemnity insurance is the contract structure that carries it out.