In insurance, indemnification is a legal principle that means your insurer agrees to compensate you for covered losses in amounts equivalent to what was lost. Below, we take a thorough look at what indemnification means and how it may affect you as a policyholder.

What Is Indemnification?

Indemnification is the act of being compensated by your insurer for a loss that restores you as closely as possible to your financial position before the loss. "Indemnity" is a similar term you might see that also has the same overall meaning.

Your insurer agrees to take on losses stemming from covered accidents or property damage when you’re a policyholder. Instead of you paying out of pocket for liabilities or property replacements, the insurance company picks up the tab to reestablish your financial standing to a state similar to what it was before the incident. If it’s an event where there’s another party involved, such as a car accident, your insurance company may sue the other party to recover damages.1 

How Does Indemnification Work?

Your insurer indemnifies (compensates you for your loss) after a covered claim. With car insurance, the insurance company shifts the financial responsibility from you to itself for costs arising from an accident or other covered event. This could mean paying for vehicle repairs, medical treatments, and attorney fees or judgments in a lawsuit. Without your policy and its indemnification provision, you’d be responsible for these bills. The process and principles are the same for other types of insurance, such as homeowners and commercial property insurance.

What Is the Role of Depreciation in Indemnification?

Policyholders sometimes run into problems with indemnification because of depreciation. Depreciation is an item’s loss in value due to all causes, such as age and condition. It can be cause for concern because if you total an older or high-mileage car, your insurer’s payout may not be enough to replace it.

Depreciation plays less of a role in some parts of homeowners insurance because most policies today have replacement cost coverage for structural damage. If you have to completely replace a damaged roof or other structure in your home, paying the full cost for a new roof of the same kind is the only practical option for the insurer.

However, it’s essential to check your homeowner's policy to verify your coverage type. Older homes may have a modified replacement cost policy so that special features like hardwood floors are replaced with standard building materials. Moreover, unless you have replacement cost coverage for your belongings, the insurer may indemnify them for only their actual cash value (ACV or depreciated value), not what it would cost to buy new items.2

Indemnification vs. Indemnity Insurance

Indemnification is not the same as indemnity insurance (also known as professional liability insurance).

As mentioned, indemnification is an agreement by your insurer to return you to an equivalent financial standing after a covered loss. Indemnity insurance is a supplemental liability insurance designed to protect service providers or other professionals who counsel, give their expertise, or provide specialized services. This type of insurance provides coverage that protects professionals from claims filed against them for negligence or failing to perform their duties, and the resulting litigation costs or other financial losses.

Typical types of indemnity insurance in the business setting may include malpractice, Errors and Omissions (E&O), and Directors and Officers (D&O) insurance.