The principle of indemnity regulates the financial compensation to be made to the insured by the insurer following the loss experienced by the insured.
This principle exposes what amount would an insured be entitled to in the event of claim. Is an insured entitled to the current value of the damage property done by the insured peril? If not, what measure is used in arriving at what he (insured) will be entitled to? A mechanism by which insurer provides financial compensation in the attempt to place the insured in the same position after the loss as he enjoyed immediately before the loss is known as indemnity. This principle is related to the principle of insurable interest because insurable interest recorded only the insurance policy which covers an interest of the insured in the subject matter of the insurance.
Insurance policies based on person’s life are not subject to the principle of indemnity at the time of the claim because it is difficult to determine the financial worth of someone’s life. Therefore policies such as life assurance and personal accident insurance are not considered as contract of insurance that fall within the contract of indemnity. The sum payable in the event of claim would have been determined at the inception of the policy which will depend on the ability of the assured to afford the premium.
The essence of this principle is to know how much an insured is to receive when an event he has been insured against occurs. For example, a car owner bought a car for N500,000 seven years ago and insured it. If the car costs N750,000 today, how much should he receive if there is a valid claim under the policy of insurance considering the premium charged is based on the value of the car as at the time of taking up the insurance policy and the fact that no party under the insurance contract is expected to make profit. Remember that insurance exists to put back the insured to the position he was before the loss.
According to Lord Justice Brett in the case of Castellain Vs Preston (1883), he said that “indemnity was the main controlling principle in insurance law”.
WHAT IS INDEMNITY?
A dictionary definition of indemnity is “the protection or security against damage or loss or security against legal responsibility”. In literary sense, indemnity is the restoration of the insured to same financial position after a loss as he enjoyed immediately prior to the loss. That is, in insurance “Indemnity is the mechanism by which insurers provide financial compensation to the insured in an attempt to place him in the same position after the loss as he enjoyed immediately before the loss”.
The principle of indemnity was clearly expounded by Brett. J in the case of Castellain Vs Preston (1883) where he said: “The very foundation in my opinion of every rule which has been applied to insurance law is this, namely, that the contract of insurance contained in the marine or fire policy is a contract of indemnity and of indemnity only and this contract means that the insured in the case of a loss against which the policy has been made, shall be fully indemnified but shall never be more fully indemnified. That is the fundamental principle of insurance. And if ever a preposition is brought forward which is at variance with it, that is to say, which will prevent the insured from obtaining a full indemnity or which will give the insured more than a full indemnity, that preposition must definitely be wrong”.
INDEMNITY AND INSURABLE INTEREST
There is a direct link between indemnity and insurable interest. The provision of indemnity for a total loss will be in line with extent of insurable interest in existence which is measurable in financial term. The indemnity payable would be equal to the insurable interest at the time of the loss. With life and personal accident policies, there is normally an unlimited interest, which means an indemnity can never be given.
Since indemnity principle ensures that the insured does not make profit from his misfortune, the principles of subrogation and contribution are thus its corollaries. In indemnifying the insured, the guiding principle is usually “the sum insured or the market value, which ever is less.Thus for full indemnity to be provided, the sum insured must be adequate to represent the full value at risk, else it will be subject to average in event of partial loss to reduce the amount of claim.
METHODS OF PROVIDING INDEMNITY
Four basic methods of providing indemnity are:
- Cash Payments: This is the most popular method of claims settlement in insurance industry. This involves the insurance company giving cheques for the amount admitted by the insurer under the reported claims. It is very easy to execute.
- Repair: An object adequately repaired constitutes a full indemnity. This is the method applied by an insurer in settlement of motor and other property insurance claims. The repairer handling the repairs is authorized to effect repairs on vehicles or other property damaged by the insured perils.
- Replacement: This is a method used by the insurer to replace an article lost due to the insured perils instead of making cash payment available to the insured. This may be possible with such items as jewelry and furs where depreciation will be very negligible and which the insurer could easily get a discount from a good dealer. It is assumed that the insured would be comfortable with the replacement made which is almost equivalent to the lost item.
- Reinstatement: This is a method commonly used in fire insurance claims whereby the insurer promises to effect settlement through reinstating or rebuilding of subject matter of insurance to the position it was before the fire. An insurer that elected to reinstate a damaged building is not allowed to make alteration. There are a lot of difficulties encountered in reinstatement that most insurers do not ordinarily and frequently exercise the option to reinstate.
MEASUREMENT OF INDEMNITY
The payment of exact financial compensation to the insured for the loss depends on the nature of the insurance involved. The life assurance and personal accident insurance contract involves payment of liquidate damages (which means that the amounts to be paid are known before the happening of the loss). In that the amount payment in the event of the claim are already determined at the inception of the policy. In case of property, liability and other non-life insurance policies, they deal with inliquidated damage, where the amount payable in the event of the claim will only be determined at the occurrence of the event. The indemnity payable in respect of different classes of insurance are calculated as stated below:
1) Marine insurance policies: The measure of indemnity will be determined based on the form of loss suffered, either a total loss or partial loss. In the event of total loss, the measure of indemnity is fixed by the policy. Where there is partial loss of goods, a settlement is made of a proportion of agreed value according to the amount of depreciation. In the event of partial loss of ship, the indemnity is represented by the cost of repairing the damage.
2) Building: In the case of loss or damage to building, the measurement of indemnity will be based on the cost of repairs or reconstruction at the time of loss. This will exclude any betterment, thus comply with the avoidance of a party making profit at the time of the claim. Betterment could take two forms:
- The replacement or repairing of a damaged or lost property can bring about new for old; this will result to putting the insured to a position above the level he was prior to the loss. Examples are “New electrical wiring, new plumbing, decorative.
- Betterment can arise where the repaired or replaced articles are better than how the original one was when it was new. For example, extra storey added to a building or sprinkles are installed during the reconstruction. The insured entirely bear the cost of betterment in case of second form of betterment.
Measuring indemnity with regards to building can be done in the following ways:
- If the insured intends to repair or reinstate the property in its previous form, then the indemnity is the cost of that work less an allowance for depreciation.
- If the insurer contends that the insured does not intend to reinstate, the onus is on the insurer to provide it and in the absence of such proof, indemnity will be the reinstatement cost less depreciation. If the insurer contends that market value is the measure of indemnity, the onus is to prove that there is a market for such a building and the level of value in that market.
3) Machinery: The measure of indemnity in the case of damage to machine depends on the availability of second market for such property, which in most cases isnot available. Where the machine is disposed of, it is destroyed or sold as crap and the insured cannot purchase a replacement on second hand. The cost of indemnity is usually the cost of repair or replacement less allowance for wear and tear.
For example, a machine was insured for 35m and the machine suffers total loss after 10 years of usage. A depreciation of 5% on straight line is charged per year on the value of the machine. What is the expected indemnity to be paid to the insured?
4) Manufacturer’s stock in trade: It includes raw materials, work in progress and finished products. The indemnity in respect of raw materials is the cost of replacing the destroyed raw materials with the cost of delivery while the indemnity in respect of workin-progress and finished products is the cost of raw materials along with other costs such as labour charge, production cost which are to be based on the market price at the time of loss representing the cost of production of the goods fully or partially.
For example, Mr. Olutola is a manufacturer of a brand of milk called “Tola Milk” and the warehouse of Olutola was stocked with finished products. Upon a spark of electrical installation during a switch from generating set to electrical power, fire erupted that burnt down 20,000 units out of 200,000 units stored in the warehouse. Mr. Olutola has a fire policy that covers the loss. He has prepared a claim estimate which he did as follow:
The goods were to be sold at 20% of the above cost and anything short of this calculation, Mr. Olutola threatened to go to court. Advise Mr. Olutola by calculating the:
a) Total cost.
b) Total revenue expected.
d) Indemnity value.
The expected amount by Mr. Olutola is N1,920,000 while the actual value is N1,600,000. It is advisable that Mr. Olutola does not go to court as he cannot receive more than the total cost of production for the damaged goods which is N1,600,000. The excess of N320,000 is regarded as profit which cannot be recovered under this cover.
5) Wholesaler’s and retailer’s stock in trade: The measure of indemnity is based on the wholesale price but not the selling price since the selling price would include profit.
For example, Sola, the retail seller of computer items buys at wholesale price of N300 per unit and discount of 5% was allowed for his prompt payment. At the time of fire in his shop, 2,000 units of the items were completely destroyed. Sola was expecting an indemnity of N800,000 since his selling price as at the time of the loss is N400 per unit. Can the insured recover the payment of N800,000? If not how much do you think the insurer will approve for payment?
To calculate the indemnity
= (Wholesale Price * unit destroyed) – discount
= (N300 x 2000) – (5/100 x (N300 x 200))
= N600,000 – 5/100 x 600,000
= N600,000 – 30,000
Measuring indemnity = N570,000 and not N800,000 proposed claim by the insured.
6) Farming stock: The indemnity payable in respect of livestock and farm produce is the local market price and where the farm produce is for sale, it is usually based on the market price less processing, handling or transportation cost which are saved from its destruction. Any cost property which is for consumption at the farm such as dairy cows, straw, feedstuffs, the indemnity is the cost of replacement which must take into account any additional cost that will ensure replacement of such farm stock at the farm.
7) Pecuniary insurance: The amounts of indemnity under this are not difficult to arrive at. The indemnity is ascertained through the actual financial loss suffered by the insured following the dishonesty to the insured staffs like cashier, accounts staff.
8) Liability insurance: The indemnity is the amount awarded by the court. This may be negotiated by out of court settlement in addition to other costs and expenses incurred while processing the claim.
The likely position of loss suffered in the event of the happening may be subject to the total or partial loss. Where there is total destruction of the subject matter, the issue of salvage does not arise. For instance, a vehicle damaged beyond economic repair or a shoe factory affected by fire where the shoes are damaged by smoke will be described as in the deteriorated conditions in which the insurer settles the claim in total loss basis. The insurer is allowed to take the possession of the damaged vehicle or shoes.
This is applicable only in marine insurance; this means that in certain circumstances, the insured can abandon the subject matter. It means that in the event of constructive total loss, the assured is entitled to abandon all the rights on the subject matter of the insurance and claim for a total loss. This may be due to the following reasons:
- The possibility of recovering the ship or goods is zero.
- The cost of recovering the ship or goods may be higher than their values.
It has to be understood that technically, a claim for total loss could not be possible until the breakup of the vessel, but the principle of abandonment has given the right to the insured to receive immediate policy money and the vessel becomes the property of the insurer.
FACTORS LIMITING INDEMNITY
1) Sum insured: This is the maximum obtainable by the insured in the event of the claim under an insurance policy, although this may not represent a full indemnity. Policies covering liabilities usually pay for legal costs in addition to the stipulated limit of cover, but the insurer cannot be compelled to pay more than the sum insured.
2) Average: This is a devise used by the insurance to discourage or combat under insurance by involving the insured in the sharing of loss with the insurer when it is discovered that the subject matter is insured for less than its actual value. The insured will be responsible for part of the amount at the time of the claim. This is calculated thus:
Sum Insured ÷ Actual Value at time of loss * Loss
The use of this formula will result to the insured receiving less indemnity in which he will be taken to be on his own for the balance not paid by the insurer.
Value of Property = N20,000
Sum Insured = N14,000
Loss = N10,000
The insurer will pay N7,000 out of N10,000; the insured will bear the remaining balance of N3,000.
3) Policy excess: This is the compulsory amount the insurer and the insured agreed at the inception of the policy that the insured will be responsible for the event of each and every claim made. This amount is clearly stated in the insurance policy. This is known as excess. For example, if the policy is subject to N50 excess, it means that the policy holder is subject to the first N50 of each and every claim. Such excess may be compulsorily applied by the insurer or the insured may voluntarily agree to the provision. The effect is that whether the loss is below or above the amount of the excess (N50), the insured will bear the first N50 of the amount of the loss. This applies in almost all non-life insurance policies. This will automatically reduce the amount of indemnity payable.
4) Policy franchise: A franchise is similar to an excess. It is the amount the insured had agreed with the insurer to be responsible for in the event of each and every claim, but it is different from excess in the sense that if the amount of loss is less than or equal to the franchise, the insured will bear it all. But if the loss is greater that the franchise value, the insurer will settle the whole loss including the franchise value.
For example, if the franchise is N50, the insured will be responsible for any loss that is equal to N50 but if the loss is more than N50, the insurer is responsible for the loss. It is common in marine insurance, personal accident insurance, illness insurance and engineering interruption insurance policies.
5) Limit: This is the amount the insurance companies have agreed to pay in the event of claim following the loss of an article by insured peril. This is very common in theft insurance and house insurance policy where contents are covered with such policy containing wordings to that effect.
For example, a work of art valued at N800 being destroyed in a household fire, where the content sum insured was N6,000 subject to the insured not having intimated the insurer that he wishes the item covered. He would receive less than indemnity. At times, an insurance company may include in their theft insurance policy or household insurance policy, a wording that the company will only be responsible for 5% of the total sum insured in respect of an article lost by an insured peril. For example, a theft insurance policy with the total sum insured of N5,500,000 covered an article worth N500,000 and the policy contained a wording that the policy has a 5% limit per article which are to be calculated on the total sum insured. This implies that 5% of 5,500,000 which is 275,000 will be paid by the insurer if the article is lost. This will be different if the insured said the insurer should provide cover for the full value of the article at the inception of the policy and if such article should be lost as a result of the insured peril. The limit per article clause will not be applicable.
6) Deductibles: This is where the insured accepts a substantial excess and agrees to be responsible for smaller claim in order to obtain a useful serving in premiums cost. An industrialist insured may consider that it has the resources to meet fire claims up to N150,000 and in any one period of insurance and is confident on his own ability to prevent fire. They may approach an insurer and receive a discount from the premium. In the event of a claim they will not receive indemnity as they have decided that they will settle for less than indemnity in order to obtain a saving in premium.
MODIFICATION TO THE PRINCIPLE OF INDEMNITY
- Reinstatement: This is used to represent the amount of money that would be paid by an insurer in respect of claim without deduction of wear and tear and depreciation under a property insurance policy covering building and machinery. The insured can request that his policy should be subject to the reinstatement memorandum. This will mean that the settlement includes indemnity, plus wear tear and depreciation, plus the effect of inflation between date of loss and eventual date of reinstatement. But this would exclude betterment of the subject matter of the insurance. The insurer will ensure that the damaged property is returned to the same position it was before the loss. In case of replacing the damaged insured property with another similar property, the insured shall be made to contribute in the purchase.
- New for old: This is similar to the reinstatement cover and is found in different forms of different policies. At the inception of the policy, the insurer agrees to pay for reinstatement of contents if they are destroyed within a certain number of years of their purchase, about three to five years without the deduction of wear and tear. It provides the insured opportunity to replace the property of about 3 to 5 years damages by insured peril’s with new property. This form of arrangement attracts higher premium and it excludes clothing.
- Agreed additional cost: In property insurance, the insured often incurs additional cost as a result of a fire or other damage such as debris, removal expenses, cost of complying with public authority for rebuilding, architect’s fee and surveyor’s fees. These expenses can be included in the insurance cover and any payment relating to them will amount to more than strict indemnity.