8.1 The Principle of Indemnity and Settlement
Key Takeaways
- Indemnity means the insurer agrees to restore the insured to the financial position they were in immediately before the loss, no more and no less
- Indemnity prevents profiting from insurance, deters deliberate loss (moral hazard), and reinforces public policy against wagering on loss
- The four main methods of settlement are cash payment, repair, replacement, and reinstatement; the insurer selects whichever is reasonable in the circumstances
- Most general insurance is a contract of indemnity; life insurance is a valued (benefit) policy because a life cannot be indemnified and a fixed sum is paid on death
- Personal accident cover may be valued (agreed sum for specified injury) or indemnity-based (actual financial loss such as lost earnings)
What Is Indemnity?
Indemnity is the defining principle of general insurance. Under a contract of indemnity, the insurer agrees to restore the insured to the financial position they were in immediately before the loss occurred — no more and no less. If a storm damages a roof insured for £40,000 and the repair cost is £6,000, the insured receives £6,000. They do not receive £40,000, because that would put them in a better position than they were in before the storm.
The principle is sometimes expressed as the insured being "placed in the same position as if the loss had not happened" — but only insofar as money can achieve that. Indemnity is measured in money, not in sentiment, and a market-value indemnity will not always buy an identical replacement, particularly in a rising market.
Why Indemnity Matters
Indemnity performs three foundational functions in English insurance law and public policy:
| Function | Explanation |
|---|---|
| Prevents profit from loss | The insured cannot recover more than their actual financial loss, so insurance cannot become a source of gain. |
| Deters moral hazard | If the insured could profit from a loss, the incentive to prevent or cause loss would be distorted. Indemnity removes that incentive. |
| Distinguishes insurance from wagering | A wager pays out on the occurrence of an event regardless of loss; indemnity pays only the actual loss suffered. This reinforces the public policy against gambling on loss. |
Because indemnity limits recovery to actual loss, it works hand in hand with insurable interest (which caps the recovery at the insured's financial interest in the subject matter) and with the corollaries of subrogation and contribution (covered later in this chapter), which prevent the insured from recovering twice.
The Measure of Indemnity
The measure of indemnity depends on the subject matter and the basis of cover agreed in the policy:
- Property (indemnity basis / actual cash value): The indemnity is the cost of repair, or — for a total loss — the market value of the property immediately before the loss. Depreciation is reflected, so an old roof is indemnified at its depreciated value, not the cost of a brand-new roof.
- Property (reinstatement basis): The indemnity is the cost of repairing or rebuilding the property as new, without deduction for depreciation, subject to the reinstatement conditions in the policy (e.g. the work must actually be carried out within a reasonable time).
- Liability: The indemnity is the amount the insured is legally liable to pay to a third party, plus claimant's costs and the insured's own defence costs as defined by the policy.
- Business interruption: The indemnity is the financial loss sustained (gross profit lost plus increased cost of working) measured over the indemnity period, subject to the policy's basis of settlement.
Exam trap: Indemnity is not the same as the sum insured. The sum insured is the cap on the insurer's liability; the indemnity is the actual loss, which may be lower (and, if average applies, lower still).
Methods of Settlement
Indemnity does not always take the form of a cash cheque. The insurer may settle a claim by whichever method is reasonable in the circumstances, and the policy wording usually reserves the right to choose. The four recognised methods are:
Cash Payment
The most common method. The insurer pays the amount of the loss (or the agreed proportion of it) in money. Cash is appropriate where the insured has already paid for the repair or replacement, where the item is irreplaceable (so replacement is impossible), or where the loss is a liability payment to a third party.
Repair
The insurer arranges for, or reimburses the cost of, repairing the damaged property so that it is restored to its pre-loss condition. Common in motor and household claims. The insurer may use an approved repairer network to control cost and quality. Repair must not put the insured in a better position than before the loss — so a five-year-old damaged panel is replaced with a panel of equivalent condition, not a brand-new upgrade, unless the policy specifically offers "new for old."
Replacement
The insurer replaces the damaged or stolen item with an equivalent new item. Common for contents policies offering "new for old" cover. The insurer will typically replace through a supplier with whom it has a discount arrangement, which is cheaper than paying the insured the retail price of a new item. If the insured insists on a cash settlement instead of replacement, the insurer will usually pay only what it would have cost them to replace the item — not the higher retail price the insured might pay.
Reinstatement
Used mainly for buildings and commercial property. Reinstatement means rebuilding or repairing the damaged property as new, without deduction for depreciation, provided the sum insured is adequate and the reinstatement conditions are met (e.g. the work is carried out within a reasonable time, the policy may require reinstatement rather than a cash payment). Many commercial property policies are on a reinstatement basis with a reinstatement condition requiring the insured to actually rebuild; if the insured chooses not to rebuild, the basis of settlement may revert to indemnity (market value), which can be substantially lower.
Choosing the Method — A Comparison Table
| Method | Typically used for | Key feature |
|---|---|---|
| Cash payment | Liability claims, total losses, irreplaceable items, items already replaced by the insured | Money equal to the loss (or agreed proportion) |
| Repair | Motor damage, household damage, damaged machinery | Restore to pre-loss condition; insurer often uses approved network |
| Replacement | Contents (new for old), small high-value items | New equivalent item; cash alternative limited to insurer's replacement cost |
| Reinstatement | Buildings, commercial property | Rebuild as new, subject to reinstatement condition and adequate sum insured |
Indemnity vs Valued (Benefit) Policies
Most general insurance is a contract of indemnity: the payment equals the actual loss. There are, however, important exceptions where the principle of indemnity does not apply, and the policy instead pays an agreed fixed sum on the occurrence of an insured event. These are called valued policies or benefit policies.
Life Insurance
Life insurance is a valued (benefit) policy, not a contract of indemnity. The reason is foundational: a human life cannot be indemnified — it is impossible to place a monetary value on a life in the way one values a house or a car, and impossible to "restore" the deceased to their pre-loss position. A life policy therefore pays the sum insured (the agreed fixed amount) on the death of the life assured, regardless of the actual financial loss suffered by the dependants.
A life policy for £250,000 pays £250,000 on death — whether the deceased's future earning potential was £50,000 a year or £500,000 a year. The sum is agreed at inception and is not adjusted to reflect actual loss. This is why insurable interest for life cover is required only at inception and not at the time of the claim (see Chapter 5).
Personal Accident Insurance
Personal accident cover may be written on either basis:
- Valued (benefit) basis: A fixed sum is paid for a specified injury — for example £50,000 for loss of a limb, £25,000 for loss of an eye. The payment does not depend on actual financial loss.
- Indemnity basis: The policy pays the actual financial loss suffered, such as lost earnings or medical expenses, up to the policy limit. This is closer to a conventional indemnity contract.
The IF1 exam will often test the distinction: life is always valued; personal accident may be either.
Key Takeaways
- Indemnity restores the insured to their pre-loss financial position — no more, no less — and is the foundation of general insurance.
- It prevents profit from loss, deters moral hazard, and reinforces the public policy against wagering on loss.
- The four settlement methods are cash, repair, replacement, and reinstatement; the insurer selects whichever is reasonable.
- Life insurance is a valued (benefit) policy, not a contract of indemnity, because a life cannot be valued or restored; a fixed sum is paid on death.
- Personal accident cover may be valued (fixed sums for specified injuries) or indemnity-based (actual financial loss), depending on the policy wording.
A homeowner has buildings cover on an indemnity (actual cash value) basis. A storm damages the 15-year-old roof and the replacement cost of a brand-new equivalent roof is £8,000. The insurer assesses the depreciated value of the old roof at £5,000. What is the correct indemnity payment, ignoring any excess and assuming the sum insured is adequate?
Which of the following is the best explanation of why life insurance is a valued (benefit) policy rather than a contract of indemnity?
A contents policy offers 'new for old' replacement cover. The insured's stolen television cost £600 three years ago and the equivalent new model now retails at £700. The insurer can replace the television through its approved supplier at a cost of £520. The insured demands a cash settlement of £700. What is the insurer most likely to pay if the insured insists on cash?