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.
Example –
Mr. A 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. A stands to gain from the loss.
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:
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 methods:
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
Continued….
PVS (Prashant V Shah) 