How does the principle of indemnity function in insurance?

The principle of indemnity in insurance is designed to restore the insured to the financial position they were in before the loss occurred, without allowing for a profit from the situation. This principle ensures that when a loss is covered by an insurance policy, the compensation provided corresponds directly to the actual financial loss the insured has sustained.

By adhering to this principle, insurance policies prevent moral hazard, which could occur if individuals were incentivized to cause losses in order to receive a payout that exceeds their actual loss. The goal is to ensure that the indemnity payment equals the loss experienced, thereby effectively mitigating the economic impact on the insured.

This principle is foundational to insurance practices, ensuring fairness and maintaining the integrity of the insurance system. For instance, if a policyholder loses a valuable item, the insurance payout will reflect either the actual cash value or the replacement cost, not exceed it, aligning with the principle of indemnity.