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

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