Principle of Indemnity

The workbook states it in one sentence: the Principle of Indemnity implies that insurance will restore the financial situation of the insured to where it was before the event that caused the loss or damage. The intent of insurance should not be to make a profit or gain.

Its own illustration shows why. If a shopkeeper could insure against not making a profit from selling goods, there would be very little incentive to try to sell them — the insurance company would step in and pay anyway.

The principle sits alongside a requirement of every insurable risk: no prospect of gain or profit. Insurable risks must be pure risks, with only the possibility of full or partial loss. A speculative risk such as investing in the stock market, which can produce gain as well as loss, is not insurable.

Indemnity is defined as "a duty to make good any loss, damage, or liability incurred by another", which makes an insurance contract a classical contract of indemnity. Any indemnity policy requires a determination of the actual loss suffered before a claim is paid.

Not every policy is an indemnity policy. A defined benefit plan pays a fixed sum, based on a pre-estimated loss, when the covered event happens — used where the exact loss is hard to ascertain, or too small to be worth ascertaining.

Concepts that follow from indemnity:

• Contribution — when more than one policy covers the same risk, one insurer may get a proportionate share from another. It applies only to indemnity policies, because the total claim cannot exceed the ascertained loss.
• Subrogation — after paying, the insurer steps into the insured's shoes and recovers from the party at fault.
• Multiple indemnity policies make very little sense: the total claim cannot exceed the loss. Multiple defined benefit policies all pay, however many there are.

The workbook's contribution example. An insured takes two flood policies of Rs 5 lakh each from Company A and Company B. Floods cause an ascertained loss of Rs 30,000. The insured is paid Rs 30,000 in total — not Rs 30,000 from each — and if Company A pays, it may require Company B to chip in its proportionate Rs 15,000, based on the share in the sum insured.

The following case is illustrative.

Ravi, 45, is hospitalised for a heart procedure. The bill is Rs 4,20,000. He holds:

Ravi's total receipts can exceed his hospital bill without breaching the principle, because the critical illness and hospital cash policies are not indemnity contracts — they pay pre-agreed sums for losses, such as lost income, that cannot be measured exactly. What the principle forbids is collecting Rs 4,20,000 twice from the two mediclaim policies.

Under IRDAI rules for health insurance, Ravi chooses which company to claim from. Because the claim is below the chosen policy's sum insured, that insurer cannot apply contribution.

Chapter 1 (Basics of Insurance): section 1.2.1(e) on no prospect of gain and the Principle of Indemnity; 1.4(a) and (b) on indemnity versus benefit insurance, with Table 1.1; 1.4(c) subrogation and 1.4(d) contribution. Chapter 3 (Non-Life Insurance Products), section 3.2, applies it to multiple policies. Expect classification questions from Table 1.1 and the contribution arithmetic.

• Health insurance for hospitalisation is indemnity; critical illness is defined benefit. The exam pairs them deliberately.
• Life insurance is defined benefit, not indemnity — the loss from a death cannot be exactly measured.
• Contribution applies only to indemnity policies.
• Multiple indemnity policies do not multiply the payout; multiple defined benefit policies all pay.
• Speculative risk is not insurable. Only pure risk — loss or no loss — can be indemnified.
• In health insurance the insured chooses the insurer, and contribution cannot be applied if the claim is within that policy's sum insured.