What Is Indemnity Insurance? How It Works and Examples

What Is Indemnity Insurance?

The term indemnity insurance refers to an insurance policy that compensates an insured party for certain unexpected damages or losses up to a certain limit—usually the amount of the loss itself. Insurance companies provide coverage in exchange for premiums paid by the insured parties.

These policies are commonly designed to protect professionals and business owners when they are found to be at fault for a specific event such as misjudgment or malpractice. They generally take the form of a letter of indemnity.

How Indemnity Insurance Works

Indemnity is a comprehensive form of insurance compensation for damages or loss. In a legal sense, it may also refer to an exemption from liability for damages. The insurer promises to make the insured party whole again for any covered loss in exchange for premiums the policyholder pays.

Indemnity insurance is a supplemental form of liability insurance specific to certain professionals or service providers. Insurance professionals provide counsel, expertise, or specialized services. Also referred to as professional liability insurance, indemnity insurance is nothing like general liability or other forms of commercial liability insurance that protect businesses against claims of bodily harm or property damage.

Indemnity insurance protects against claims arising from possible negligence or failure to perform that result in a client’s financial loss or legal entanglement. A client who suffers a loss can file a civil claim. In response, the professional’s indemnity insurance will pay litigation costs as well as any damages awarded by the court.

As with any other form of insurance, indemnity insurance covers the costs of an indemnity claim including but not limited to court costs, fees, and settlements. The amount covered by insurance depends on the specific agreement, and the cost of the insurance depends on many factors including the history of indemnity claims.

Typical examples of indemnity insurance include professional insurance policies like malpractice insurance and errors and omissions insurance (E&O). These special insurance policies indemnify or reimburse professionals against claims made as they conduct their business.

Special Considerations

Certain professionals are strongly advised to carry indemnity insurance. These professionals include those involved in financial and legal services, such as financial advisors, insurance agents, accountants, mortgage brokers, and attorneys. When dispensing financial or legal advice, these professionals are potentially liable for negligence or inadequate performance despite the intent of goodwill.

In the financial industry, a professional who provides financial advice that results in the purchase of an insurance or investment product can purchase errors and omissions insurance, to protect themselves, if the advice given causes damages. For example, accountants may be found negligent for advising a client on tax matters that in turn result in a penalty or additional taxes.

In the medical field, malpractice insurance is a form of professional indemnity insurance. Malpractice insurance protects medical practitioners from civil claims arising from negligence that results in physical or mental harm to patients. Medical malpractice insurance is required in some states, but optional in most.

Many executives purchase indemnity insurance to protect their deferred compensation plans against company claims or bankruptcy. Other professions, such as contractors, consultants, and maintenance professionals, carry indemnity insurance as a practical matter due to their exposure to failure to perform claims.

Professional indemnity insurance provides a critical layer of protection for service providers. Often these professionals might also need other forms of liability coverage such as general liability insurance or product liability coverage. Those purchasing indemnity policies can also add endorsements. An endorsement is an add-on that expands or enhances the coverage in some way.

Indemnity Insurance vs. Life Insurance

Both indemnity and life insurance policies provide coverage for losses to an insured party in exchange for premiums up to a certain limit. Life insurance, though, provides a lump-sum payout to the named beneficiaries when an insured party dies. Unlike indemnity insurance, the payout, referred to as a death benefit, is the full amount of the policy—not for the amount of a claim itself.

Here's a simple example of how life insurance works. Let's say Mr. Brown takes out a life $250,000 life insurance policy and names his wife as the beneficiary. He pays monthly premiums on the policy to the insurance company. A decade later, Mr. Brown dies in a car accident.

After processing the paperwork, the insurance company issues Mr. Brown's wife a payout for the policy amount—$250,000. She may also receive extra money since he died in an accident if the policy has a clause with an accidental death benefit, or if a rider for one was added.

The Bottom Line

Indemnity insurance represents an important protection for businesses and professionals. In the event that a customer is dissatisfied with the company's work, this type of insurance will pay for the insured's legal defense and defray any settlement costs. This type of insurance is frequently used by doctors, lawyers, and other experts to protect against claims of negligence or malpractice.