An Overview of a Contract of Indemnity
Contracts of indemnity are an important component within the insurance industry. Like any other contract or legal document, they have their own particularities that must be understood. The legal definition of a contract of indemnity, the classification and its role for financial service institutions are key concepts to be mindful of as an insurance professional or consumer.
A contract of indemnity is defined as "a contract, by which one party promises to save the other from loss caused to him by the conduct of the promisor himself or by the conduct of any other person". There are a number of elements that are indispensable for a contract of indemnity: Contracts of indemnity may be defined to fall into two different classifications: Within the world of finance , the role of a contract of indemnity can be explained as such; "Every insurer in the course of business of effecting contracts of indemnity shall be deemed to be an agent, in respect of such contracts, of every insured under such contracts". This further illustrates how powerful a contact of indemnity can be – even containing the role of an agency with the ability to bind certain parties together. Contracts of indemnity also significantly impact the insurance industry. The Indian Insurance Act of 1938, governs this, defining an "insurance contract" as "a contract of indemnity, that is to say, a contract whereby one party agrees with another to indemnify the other against loss caused to him by the happening of an uncertain future event".
Distinctive Attributes of Insurance Contracts as Contracts of Indemnity
Insurance contracts are classified as contracts of indemnity at common law. This is a consequence of the operation of the rule in Bainbridge v. Postel [1842] 10 M & W 14, which provides that a party to a contract cannot sue for a loss which the other party is contractually obliged to indemnify. This general principle applies to insurance contracts, e.g. those contained in the AIG American International Group policy wording and the Institute Cargo Clauses.
The following are the main features of insurance which distinguish it as an indemnity agreement:
It is the purpose of the insurance indemnity that ‘the insured should be made whole as regards his loss’. However, it is not the purpose of a contract of indemnity to pay for damages or losses that may accrue to the insured over and above the actual damage/loss suffered. The insured can therefore only bring a claim against an insurer in respect of the actual amount of the damage/loss suffered. The valuation of the loss/damage will take place on the basis of the ‘value of goods at destination, plus insurance and freight’, i.e. any consequential losses would be insulated, provided that they were not caused by the insured’s own negligence or failure to take all reasonable care of the goods. Since an insured is not in the position to sue only for the total damages for which it has been held liable, a claim for indemnity by an insured will be for the amount of loss/damage suffered by the insured as a result of being held liable. This will exclude, for example, the claim by the insured set out above, i.e. $5000, business interruption costs, legal costs incurred as a result of the lawsuit, and the additional $2000 in costs, where the insured has suffered pure economic loss.
However, there are some exceptions to this rule. A claim for the cost of insurance undertaken by the insured could be included as part of the loss suffered by the insured.
The standard wording provided in the AIG American International Group marine policy (italics) for claims for consequential losses indicates the limits of recovery from the insurer. In practice, it would be extremely difficult to separate the costs of mitigating the loss from the $5000 of damages awarded to the plaintiffs in the Tort case. It is also highly unlikely that the court would be persuaded to make a reduction of the damages award because of unsuccessful mitigation by the insured. In China Ocean Shipping Co Ltd (COSCO) (Hong Kong) Ltd v. First New Hampshire Indemnity Co [1993] 2 All ER (Comm) 285, the Court of Appeal made it clear that damage mitigation costs are recoverable under a policy of indemnity. Accordingly, as a matter of underwriting practice, sellers will wish to insure together with purchasers to ensure that they are reimbursed for all losses suffered by them as a result of a breach of contract.
Categories of Insurance Products and their Nature of Indemnity
Property Insurance: Property insurance is designed to provide a safety net for policyholders against the financial consequences of property damage or loss caused by covered events such as theft, fire, or natural disasters. The principle of indemnity is applied in that the insurance payout is typically limited to the lesser of the actual cash value of the lost or damaged property (after depreciation) or the policy limit. This ensures that the policyholder is compensated without getting more than the monetary value of the loss or damage, which would violate the principle of indemnity by creating a moral hazard where the policyholder might be incentivized to create a loss.
Liability Insurance: Liability insurance provides protection for policyholders against claims resulting from injuries or damages to other parties. The principle of indemnity applies in that policyholders are usually compensated for liabilities up to the limit of their policy, but no more than that. The idea is that they can get protection without having access to the wealth or assets of the insurer, and that they are not more wealthy just because they have purchased an insurance policy.
Health Insurance: Health insurance also demonstrates the principle of indemnity, although to some extent it creates a kind of moral hazard. That is, it promises to cover all medical costs up to the limit of the policy, no matter what the cost might be. So the policyholder is generally covered without considering whether he will be made less wealthy or not for a particular medical procedure.
Disability Insurance: Disability insurance is also a contract of indemnity. The insurer promises to make up for the loss of income up to a certain amount if the policyholder becomes unable to work. The principle of indemnity applies here also because while policyholders are compensated for the monetary loss, they do not receive more than the monetary value of the loss, or its perceived value, and they do not get wealthy simply because of a purchase of an insurance policy.
Legal Views on a Contract of Indemnity
The legal principles governing contracts of indemnity or insurance policies are generally summarised in terms of the principle of indemnity, the principle of subrogation, the principle of contribution and the principle of utmost good faith. Insurance policies are interpreted with reference to the authority of specific cases resulting in certain general legal propositions being applied. The legal principles mentioned above do not carry the force of law but rather provide conceptual frameworks for understanding indemnity and insurance. The general legal principles and some of their limitations are briefly discussed below.
The principle of indemnity refers to the process that the insured will be restored as closely as possible to the financial position it would have been in had it not been for the loss, accident, death, disability, destruction or damage insured against. Generally, the amount of indemnity will be agreed upon in an insurance policy and the insurer will pay the amount agreed upon in the event of the occurrence of an insured event giving rise to a claim.
The insured cannot profit from the agreement and must suffer a loss before the indemnity arises. If an asset is destroyed, the insured will merely recover the market value of the asset at the time of the indemnity event. That means the insured will not receive the replacement value of the asset, or the insured’s profit from such an asset, in the event of an insured event.
The principle of subrogation entitles an insurer to take the place of the insured, after compensation has been paid, in respect of any rights the insured may have against a third party who has caused or contributed to the insured event.
The principle of contribution allows an insured with more than one policy insuring the same risk to claim only the appropriately agreed amount from one insurer and then share the claim amongst the insurers. For example if A has two insurance policies each covering the risk of R500 000 and the insured loss is R1 million, the insured can only recover R1 million from one insurer or R500 000 from each insurer. In this manner the insured will not profit from having multiple policies but the policies will still cover the entire amount of the risk.
The insurer and the insured owe each other a full and honest disclosure by the insured during the life of the policy, the negotiation of the policy and the claims process according to the principle of utmost good faith.
Myths for Contracts of Indemnity in an Insurance Policy
As discussed above, indemnity has a particular legal meaning. As with many legal concepts, however, the terms used and what they mean under the law often contrast with the common understanding of those same words. The practical application of legal principles can sometimes be misleading, especially when the words we use in everyday life are far from the legal concept they are intended to express. Most people think of insurance as a safety net, because they believe that it provides them with financial protection in the event of a loss. Indeed, this is how insurance is often marketed. Some think that the purpose of life insurance is to provide the beneficiary with money in place of the deceased’s "lost life". Others may believe that auto insurance is intended to pay out the amount of a theft or collision, regardless of the actual value of the vehicle. Or that home insurance will pay out the cost of replacing a lost or damaged object, even if the market value of that object has gone down in the time since it was purchased. Other common misconceptions are explored in the infographic below.
An ‘indemnity’ policy will only restore an insured back to their pre-loss (or pre-damage) position to a reasonable extent and to the extent provided under the contract of insurance. In other words, the insurer compensates the insured for its loss instead of putting the insured in a better position.
Whether the term is permissive or mandatory, once a loss arises it should be expressed in terms of indemnity:
When looking at indemnity in the general terms as described above , we can now see where the misconception lies. However, the purpose of insurance is not to put the insured in a better position than they were before the loss. It is to compensate them for the loss suffered, up to a limit as agreed in the contract of insurance, to put them in the same position as they were before. It follows from this that, without a loss arising, the principle of indemnity does not apply. Further, the fact that there is a risk of an insured damage or loss occurring does not change the situation until the risk materialises. So, for example, if an insurance policy is written under a particular basis of settlement and a claim is made, the insurer may not contractually be required to respond in excess of the insured amount. Thus, an insurer would not automatically be required to pay the full amount claimed just because the claim has been made in good faith. In essence, indemnity is intended to compensate the insured if a loss occurs. Therefore, the purpose of insurance is not to provide a guarantee that the insured would receive the amount claimed from an insurer. This is particularly relevant where the loss claimed could comprise many claims, with considerable differences in the quality and nature of the cover without considering the indemnity basis expressly provided under the policy. Indemnity cover is intended to indemnify the insured for losses or damages that have already occurred, up to a limit. It does not provide the benefit of compensation for future losses.
Real-Life Instances of Indemnity in a Contract of Insurance
One can look at practical examples and case studies of this concept of indemnity in action from the insurer’s side of the equation. For example, liability insurance, which is perhaps the most commonly held form of insurance, provides for the defense of an insured in a legal matter and which pays to the third party any judgment or settlement amount that the insured becomes legally obligated to pay due to the loss-causing event. This is, in the truest sense, compensation for loss, as proposed by the concurrence in State Farm Fire and Cas. Co. v. Pash, 368 N.W.2d 276, 285 (Iowa 1985) where the court stated that the "purpose of an indemnity contract is that the indemnitor is to compensate the indemnitee for loss or damage settled by the latter" or as stated in Cresco Mut. Ins. Benefit Ass’n. v. Biereck, 203 N.W.2d 174, 176 (Iowa 1973) that liability insurance protected against "damages from claims . . . that might be asserted against the insured _________________________________________________________________ 1. See also, L. & R. Assocs., Inc.v. Continental Ins. Co., 726 F.Supp. 859, 863 (D. Mass. 1989) (stating that "if there is a loss that is covered by the policy, the insured shall receive reimbursement for those losses and, in that sense, the policy is an indemnification agreement.") as well as Steinmetz & Assoc. Mut. Ins. Co. v. Kaas, 482 F.Supp. 1375, 1380 (N.D.Ill. 1979) and Lajoie v. USS Agri-Chem, 293 N.W.2d 657, 661 (Iowa 1980).
The Future of Indemnity in Insurance
The future of indemnity as it secures the contract between insurer and insured will be influenced by technological developments and the subsequent transformations to customer behaviours and expectations. There are four future trends of significance:
1. Technology as a premium driver Evidently, artificial Intelligence ("AI") has already begun to drive down premiums by enabling high-volume underwriting in new lines. We expect AI to continue to reduce operational overheads, unless operational overheads are increased in response to stricter regulation in other areas such as anti-money laundering, fraud, data protection and network security. We expect the impact of these to not significantly raise operational costs in the short to medium term, except perhaps for those few insurers and insurance intermediaries who had extensive reliance on manual processes.
An important issue to be addressed relates to the appropriate level of insurance against cyber risk. There are a number of competing views about the amount of cyber insurance that an enterprise should have, with amounts ranging from 1% to 10% of total assets. At present, the Academics’ consensus is that the right amount of cyber insurance for corporates is approximately 3% of the business’ net assets; however this is likely to change with the prospect of a large-scale cyber incident. In the absence of sophisticated models, each organisation must assess the nature and extent of its risk appetite and vulnerability, before determining how much premium it is willing to spend. Given that cyber insurance can be offered on terms that both cover cyber-related risks and the reputational damage that may result from a cyber incident, it may yet prove to be a key way for insurers to expand their books of business. One thing is clear: the need for cyber insurance is becoming increasingly ubiquitous. This was highlighted by the Bank of England, which in its 2018 report "The 2018 Insurance Development Priorities" reflects a "potentially severe accumulation risk resulting from unmitigated cyber risk concentrated in London, potentially affecting the international reinsurance market". This is supported by S&P which released a report in August 2018 indicating that its research "shows that over the next two years, the most common use of technology-enabled services will be to generate additional premium income related to industrial internet of things (I-IOT)". The long- and short-term trends of the cyber insurance industry will be a determining factor in the decision of whether to purchase cyber insurance when signing a contract of insurance.
- Artificial Intelligence as a contract engine A 2018 report published by the World Economic Forum highlighted the use of data in a "data-driven economy" , where data is used to make decisions regarding prices, delivery schedules, discounts for bulk purchases and marketing messages. The use of algorithms to automate key business functions has already changed the nature and extent of the contract. For example: With ‘smart’ or distributed ledger technology, contracts will become the basis of transactions and will regulate themselves, ensuring compliance and performance. In the event of non-performance, smart contracts will automatically trigger payment of damages, or performance, if agreed.
- Self-insurance as a risk management tool The concept of self-insurance, whereby organisations will begin to rely more on in-house systems and resources to meet obligations, will influence the approach to contracts of insurance. This philosophy underpins the UK’s Insurance Act 2015, which aims to encourage commercial organisation to provide more information to insurers to ensure that policies and claims are tailored to their specific needs. It also leads to an evolution of the contract, which will be predicated on data analytics. Organisations will rely less heavily on brokers and underwriters to determine and provide the terms of the contract. Instead they will either: Accordingly, an increasing focus on the client’s in-house systems and processes will drive endorsements, which require representations, warranties and covenants to be made by the insured that go beyond the classic model requirements of the policy. Additionally, clients will have to provide evidence and deliverables through the life of the contract that demonstrate compliance with, and mitigate, indemnity claims.
- A changing risk landscape At the same time that companies are seeking to become smarter at managing their own data, technological companies are becoming increasingly transparent about the way in which they use and allow access to their customers’ data. This reflects a move by large technology companies to embrace the EU General Data Protection Regulation ("GDPR"), which contains stricter data protection rights, and the EU Directive 2016/680 (also known as "Police Directive"), which implements similar data protection rights in a criminal context. GDPR and the Police Directive are both designed to give EU citizens greater control over their personal data. However, they also create a greater risk of liability for large technology companies, which may be passed on, at least in part, to employees through the contract of insurance, or employers’ liability insurance. According to the CEO of one large technology company, such claims are likely to become the single most expensive loss risk over the next five years – overtaking corporate and commercial crime, tech errors and emissions and business interruption.