Breaking the rule of indemnity

The rule of indemnity, or the indemnity principle, says that an insurance policy should not confer a benefit that is greater in value than the loss suffered by the insured. Indemnities and insurance both guard against financial losses and aim to restore a party to the financial status held before an event occurred. It is important to understand the difference between the two to protect your business.

Indemnities are used in commercial contracts to allocate risk between parties, usually by altering the common law or statutory rights of the parties. One party typically accepts some or all of the risk of loss that the other party may suffer in a given situation.

There are generally three types of indemnity:

1. Broad indemnity: makes the indemnitor responsible for its own negligence, and for the negligence of a third party. In certain states/countries, indemnitees cannot transfer damages from their own negligence to an indemnitor.
2. Intermediate indemnity: indemnifies a party for negligence unless it was completely at fault. Intermediate indemnity is a preferred method in construction contracts. It holds the property owner harmless from claims caused by the contractor during construction. Basically, it is all-or-nothing indemnification.
3. Comparative indemnity: makes each party responsible for its own actions. The indemnitor is not liable for negligence directly committed by the indemnitee. Typically, common law determines this responsibility.

Conditions outlined in a business contract determine how much indemnity one party will assume on behalf of the other. A proper contract will indicate the indemnity necessary based on the transaction.

Captive readers are generally familiar with the concept of insurance. An insurance policy transfers a risk from one party to another in exchange for payment. It protects the insured party against loss for the insured risk. Risk transfer always comes at a price.

The rule of indemnity says an insurance policy should not confer a benefit greater in value than the loss suffered by the insured, but do all insurance contracts follow this indemnity rule?

Breaking the rules

A life policy is of little or no benefit to the person listed on the policy. Life insurance benefits the beneficiary, with a premium paid that has little to do with the perceived value or replacement of the person who died. The payout is more of a reflection of the premiums paid and the dollar value on the policy.

Parametric (index-based) insurance is another example of an indemnity rule-breaker. It has been around for 20 years but has gained popularity recently as organisations look for new and creative risk transfer options for cyber and pandemic exposures and to replace traditional property coverage as rates increase.

Parametric coverage does not indemnify pure loss, but issues a set payment upon the occurrence of a triggering event, such as an earthquake of a certain magnitude or a hurricane of a specific intensity.

Parametric coverage enables companies to deliver insurance more efficiently and avoids lengthy claim investigations. When an index is triggered, a payout is made, with no questions asked and no disputes. These independent triggers include hail meters/sensors, satellite images and government data such as earthquake magnitude or wind speed.

Parametric cover is now receiving serious consideration for cyber and pandemic exposures. The World Bank issued and triggered pandemic catastrophe bonds for the COVID-19 pandemic. The market is hoping to use parametrics to find sufficient limits at reasonable pricing for these emerging exposures. The marketplace is also looking for policy triggers that are easily understood.

The COVID-19 pandemic has raised a lot of policy disputes over business interruption (BI) coverage, which compensates insureds for lost income during a given period, to repair or restore the physical damage of the covered property. Endorsements to these BI policies, such as communicable disease—which can include pandemics depending on the policy language—have existed for years. However, to qualify, your entire operation must be shut down, and the closure must be either ordered or recommended by a governmental authority.

Many insureds hoped and expected that the COVID-19 quarantine would qualify them for cover. However, in many instances the closure must be the result of an outbreak at the premises. Very few businesses either purchased this endorsement or were open at the time of the quarantine. This BI endorsement is most common in children’s camp and private school policies. Schools closed before there was a problem, or camp had not started yet: it is no surprise policyholders have felt frustration.

Indemnities and insurance both guard against financial losses. Purchasers of these covers really do not care what the Internal Revenue Service (IRS) or other governmental bodies think about the rule of indemnity—they want protection for their business and objective coverage triggers they can understand.

Greg Lang is the founder of Reinsurance and Insurance Network. He can be contacted at: glang@rainllc.com