In banking, many transactions involve risk of loss, especially when banks issue guarantees, letters of credit, or act on behalf of customers. To protect themselves from such losses, banks often rely on contracts of indemnity. Under such contracts, one party agrees to compensate another for losses suffered due to specific events or actions.
The relationship between the parties in such contracts is known as the indemnifier–indemnified relationship. This concept is governed by the Indian Contract Act, 1872, and is frequently tested in JAIIB and CAIIB exams under legal and risk management topics.
Meaning of Indemnity
According to Section 124 of the Indian Contract Act, 1872, a contract of indemnity is a contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself or by the conduct of any other person.
In simple words, indemnity means protection against loss.
Who is an Indemnifier and Who is Indemnified?
- The indemnifier is the person who promises to compensate for the loss.
- The indemnified (or indemnity holder) is the person who is protected against the loss.
In banking practice:
- Customer is usually the indemnifier
- Bank is usually the indemnified
For example, when a bank issues a bank guarantee, the customer gives an indemnity to the bank to cover any loss the bank may suffer if the guarantee is invoked.
When Does Indemnifier–Indemnified Relationship Arise in Banking?
This relationship arises in several banking transactions, such as:
- Issue of bank guarantees
- Issue of letters of credit
- Duplicate demand drafts or fixed deposit receipts
- Collection of lost cheques
- Safe custody and custody services
- Surety arrangements
In all these cases, the bank requires an indemnity to protect itself from potential loss.
Rights of the Indemnified (Bank)
Section 125 of the Indian Contract Act provides certain rights to the indemnified once loss occurs.
The indemnified has the right to recover:
- All damages which he is compelled to pay in respect of any matter covered by the indemnity
- All costs reasonably incurred in defending or instituting a suit
- All sums paid under any compromise, provided it was not against the indemnifier’s instructions
These rights are important for exam questions.
Duties of the Indemnifier
The indemnifier has a legal duty to:
- Compensate the indemnified for losses covered under the contract
- Honour the indemnity when loss occurs
- Act in good faith and not avoid liability
Failure to honour an indemnity can result in legal action.
Nature of Indemnity in Banking
In banking, indemnity contracts are usually:
- Continuing in nature
- Unconditional
- Irrevocable
- Supported by security or margin
Banks carefully draft indemnity clauses to ensure full protection.
Difference Between Indemnity and Guarantee (Very Important for Exam)
Though both indemnity and guarantee protect against loss, they are legally different.
In indemnity:
- Only two parties are involved
- Liability is primary
- Loss may arise from promisor or third party
In guarantee:
- Three parties are involved (creditor, principal debtor, surety)
- Liability of surety is secondary
- Loss arises due to default of principal debtor
This difference is frequently asked in MCQs.
Bank Guarantee and Indemnity
A bank guarantee is based on an indemnity from the customer. If the bank pays the beneficiary under the guarantee, the customer must indemnify the bank for the amount paid along with costs and interest.
This explains why banks insist on indemnity bonds before issuing guarantees.
Termination of Indemnifier–Indemnified Relationship
The relationship ends when:
- The purpose of indemnity is fulfilled
- Contract expires
- Loss is fully compensated
- Contract is revoked by mutual consent
However, indemnity obligations often survive termination until all liabilities are settled.