The Investor’s Guide to Understanding Indemnity Clauses

Key Takeaways

• Indemnity is basically protection against loss or damage when a contract is breached.

• Also known as indemnity clauses, indemnity agreements are often included in contracts to discourage parties from violating contractual provisions.

• Depending on the agreement’s terms, indemnity may be paid in cash or in the form of replacement or repairs.

Indemnity is a key component of contracts because it is crafted to discipline the party who breaches the pact, and to make the aggrieved party whole. But just what is indemnity? Here is its definition, its different types, and examples.

What is Indemnity?

Indemnity is basically protection against loss or damage when a contract is breached. The idea is to restore the damaged party to the financial state they would be in were it not for the contract breach or nonperformance.

Also known as indemnity clauses, indemnity agreements between two parties are often included in contracts to discourage parties from violating contractual provisions. When a contract is breached, the indemnity agreement dictates the compensation the nonperformer must legally pay the aggrieved party.

Note that the indemnity agreement’s wording is very important as the clause can also serve as an exemption from liability from damages.

Contractual situations in which indemnity clauses are common include supply agreements, commercial contracts, leases, loans, promissory notes, and licensing agreements.

Who is Involved in an Indemnity?

With indemnity, one party agrees to compensate the other for prospective damage or losses. In a typical indemnity contract, the indemnitor is the insurer, and the indemnitee is the insured.

How Does an Indemnity Work?

The coverage and scope of an indemnity clause depends on how it is used. Such agreements are common between individuals and businesses such as automobile insurers. On a larger scale, they also can apply to relationships between a government and businesses or between multiple countries.

There are also times in which a business, government, or whole industry will absorb, on behalf of the public, the costs of larger issues such as disease outbreak. In 2014 and 2015, for example, U.S. lawmakers authorized $1 billion to combat a bird flu epidemic that did great harm to the nation’s poultry industry. Of that money, the Agriculture Department spent $200 million on indemnity payments to farmers who had to kill their birds to impede further viral spread.

In general, every indemnity clause will contain a period of indemnity – a specific time period for which indemnity payment is valid. Some pacts include what is called a letter of indemnity, which ensures that both parties will comply with stipulations to avoid triggering indemnity status.  

Depending on the agreement’s terms, indemnity may be paid in cash  or through replacement or repairs. For example, a homeowner pays an insurance company premiums in exchange for the knowledge that indemnification is forthcoming if the house is damaged by fire, natural disaster, or anything else stipulated in the insurance agreement. 

There are also indemnity clauses in property leases. For example, with rental property, the tenant must stipulate that they will take care of damage resulting from negligence, and may be subject to fines and attorney fees, depending on the agreement.

Key Elements of an Indemnity Agreement

There are a few essential components of indemnity agreements in general, including:

Scope of indemnification. The agreement should plainly state the scope of coverage involved. In other words, it should spell out the extent of protection the indemnitee can claim if necessary.  

Notification requirements. An indemnity agreement should state the manner in which the indemnitee will give the indemnitor notice of a dispute or claim. In addition, the pact should detail how the indemnitor can defend the claim.

Enforcement provisions. Further, the agreement should explain how, if the indemnitor will not fulfill their obligation, the indemnitee can enforce the agreement.

Indemnification exceptions. Here, the contract states, where applicable, any condition under which the indemnitor will not protect the indemnitee.

Duration requirements. This element of the contract sets forth how long the obligations and rights between the parties will exist.

Types of Indemnity

There are various types of indemnity, including insurance and loan indemnity.  

Insurance. Here, the insurer agrees to pay the other party for any losses or damage in exchange for premiums paid to the insurer by the insured.

Loan indemnity. In the business-to-business (B2B) space, loan indemnity protects against a borrower’s sudden inability to repay a loan or mortgage. In such a case, loan indemnification kicks in to pay off the obligation. 

Limitations and Special Considerations

Indemnity insurance

Companies and individuals use indemnity insurance to protect against indemnity claims. Even if the holder has, in fact, caused the indemnity, the insurance protects the holder from having to remit the entire indemnity sum.

Because lawsuits are common, many companies require indemnity insurance. Examples include errors and omissions insurance as well as malpractice insurance. Further, some companies pay what is called deferred compensation indemnity insurance, which protects from litigation money the companies anticipate getting in the future. 

Indemnity vs. Insurance

Both indemnity and insurance guard against financial losses and seek to restore a party to their previous financial status. However, the two terms are not the same: one can have indemnification without insurance, but one cannot have insurance without indemnification, because the purpose of insurance is to shift risk from one party to another.  With indemnity, losses are transferred through a contract from one party to another.  

Indemnification in Legal Finance

Indemnities are a significant part of litigation finance, which basically involves a third party investing in a lawsuit in exchange for a share of the profit. These days, it is easier than ever to invest in legal finance through popular alternative platforms such as Yieldstreet, which links investors with plaintiffs and law firms that have strong cases and require capital. To date, Yieldstreet has funded more than $400 million in the vertical, with loan sizes of between $5 million and $50 million.

Adding litigation finance to one’s investment portfolio also serves to diversify holdings, necessary for successful long-term investing. Diversification can decrease overall portfolio risk, reduce volatility, and protect against inflation.

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

There are a number of contractual situations in which indemnity is necessary as insurance against loss or damage, or exemption from liability. Remember that indemnification does play a prominent role in legal finance, which could provide steady returns in addition to portfolio diversification.