Principles of Indemnity and Insurable Interest – This is one of important insurance concepts.
The principles underlying risk and insurance are reflected in the design of insurance
contracts. Two key concepts are the principles of indemnity and insurable interest.
Under the principle of indemnity, insurers should not profit from a covered
loss but should be restored to no better than their financial position prior to
the loss (Rejda, 2005).
If an insured was fully indemnified, he or she
would be restored exactly to his or her prior financial condition. In practice,
many insurance contracts do not provide full indemnification; i.e., the insured
will retain some portion of a loss or related costs that are not covered by
insurance.
The
objective is to ensure that insureds do not gain financially from losses and,
in turn, reduce moral hazard. If insureds could profit from insurance coverage
of a loss, they would have an incentive to cause losses and a disincentive to
take precautions to avoid losses. Most property and liability contracts are contracts
of indemnity. Losses in such contracts are typically settled on the basis of
actual cash value (i.e., replacement cost less depreciation) or fair market
value.
However,
there are some insurance contracts that constitute exceptions to the indemnity
principle. A valued policy pays the face amount of insurance regardless of the
actual cash value of the loss. Valued policies are sometimes used to insure
items for which it would be difficult to determine the actual cash value or
fair market value, such as rare antiques. Some states have valued policy laws
that require payment of the face amount of insurance in the instance of total
losses to real property from certain perils. Some insurers offer replacement
cost contracts, where the cost of replacing the insured property is paid with
no deduction for depreciation.
For such
contracts, insurers typically require a minimum ratio of the market value to
replacement cost (e.g., 70 percent) be met to diminish moral hazard. Finally,
life insurance contracts are not contracts of indemnity, but rather are valued
policies that pay a stated benefit in the event of the insured’s death.
The second
important concept is the principle of insurable interest. According to this
principle, the insured must suffer some form of loss or harm if the insured
event occurs (Rejda, 2005). The nature of the loss or harm could be financial
or psychological, as in the case of the death of a family member. Insurable
interest is necessary to prevent gambling, reduce moral hazard and measure the
insured loss. Otherwise, individuals could purchase insurance contracts as a
matter of speculation (e.g., insuring another home in which the insured does
not have a financial interest) and/or gain from causing a loss. The same principle
applies to life insurance contracts: Purchasing a life insurance policy on a
person with whom they have no family relationship or pecuniary interest raises
obvious questions about the insurance buyer’s intentions.
Insurance
contracts reflect a number of other concepts and contain certain standard
provisions. Rejda (2005) provides a more detailed discussion of these concepts
and provisions for the interested reader.
In short
words, insurance contracts embody various concepts, including the principles of indemnity and insurable interest. Under the principle of indemnity, in the
event of a loss, insureds should not gain financially from insurance and should
be restored to no better than their prior position. Under the principle of
insurable interest, the insured must suffer some harm or loss if the insured
event occurs.