The Indemnity Principle: Evolution from a Financial to a Functional Paradigm

Journal of Risk Management & Insurance, Vol. 10, No. 30, 2005

16 Pages Posted: 7 Dec 2008

See all articles by Jeffrey E. Thomas

Jeffrey E. Thomas

University of Missouri at Kansas City - School of Law

Brad M. Wilson

affiliation not provided to SSRN

Date Written: December 4, 2008

Abstract

Although the indemnity principle is well-accepted, its customary meaning has not kept up with insurance practice. This paper explores the evolution of the indemnity principle in the context of property insurance in the United States. When property insurance was standardized in the 19th century, "indemnity" had a strict, financial meaning. An insured was only entitled to receive actual cash value for a loss, less depreciation. This ensured that insureds received a financial recovery equal to the value of their property prior to the loss. This approach to indemnity was developed in the context of concerns about the morality of insurance, its association with gambling, and the risk of moral hazard. In the 20th century, the financial approach for indemnity often left insureds without sufficient resources to rebuild. Courts and the insurance industry responded by providing replacement cost coverage, which became the standard in the U.S. property market by the 1960s. Replacement cost coverage, however, is inconsistent with the financial version of the indemnity principle. By replacing damaged property with new materials without regard for depreciation, the insured receives a financial benefit from the loss. This paper contends that this shift in the market represents a paradigm shift from the financial approach to a pragmatic, functional approach to indemnity. The consequences of this shift are that exclusions need to be reevaluated for their theoretical grounding, that innovative products may be more easily made consistent with the indemnity principle, and that moral hazard needs to be addressed independently of the indemnity principle.

Keywords: Indemnity, Customary meaning, Insurance, Property insurance, Replacement cost, Depreciation, Financial loss, Catastrophe, Moral, Contracts

JEL Classification: G22, K12, K20

Suggested Citation

Thomas, Jeffrey E. and Wilson, Brad M., The Indemnity Principle: Evolution from a Financial to a Functional Paradigm (December 4, 2008). Journal of Risk Management & Insurance, Vol. 10, No. 30, 2005, Available at SSRN: https://ssrn.com/abstract=1311433

Jeffrey E. Thomas (Contact Author)

University of Missouri at Kansas City - School of Law ( email )

5100 Rockhill Road
Kansas City, MO 64110-2499
United States

Brad M. Wilson

affiliation not provided to SSRN

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