Underinsurance

If you fail to insure your property correctly, you may find yourself underinsured. So what does this mean?

Your insurance premiums are calculated using a variety of factors – one of which is the replacement or rebuilding cost of the items you are insuring. For example – if you want to insure commercial business premises that would cost £10,000 to rebuild you would expect to pay less than if you insured neighbouring premises that would cost £1,000,000 to rebuild.

It is important to accurately state the sum insured (or rebuild/replacement cost) needed to ensure that the premium you have paid is proportionate to the risk the insurer has accepted. If you fail to do so, you may only be entitled to a lower claim settlement (or in certain instances, you may invalidate your insurance policy).

In cases where a property is underinsured, insurers use the principle of average. A clause covering the principle of average can be found in most commercial insurance policies and some home insurance policies. There are different ways insurers calculate average but the most common method is called ‘pro-rata’ average. This is a calculation that works out how much you have underinsured the property by and applies the same figure to the amount of the loss incurred to give an amount the insurer will pay you.

A simple example of underinsurance and the result can be found below:

John runs a plumbing business and covers his premises on a commercial insurance policy for a rebuild cost of £50,000 with a policy excess of £250. The building is damaged in a fire causing £5000 worth of repairs. The insurer sends a loss adjuster to inspect the damage who discovers the actual rebuild cost of the premises is £100,000. The building is only insured for 50% of its rebuild cost and so, using the principle of average, the insurer will only pay out 50% of the costs of the repairs (£2500), minus the policy excess (£250) giving a settlement of £2250

In the example above the policyholder will be left with a personal cost of £2750 to complete the repairs to his building.

This may seem unfair to some people, however, don’t forget that the insurer has only received the premium equivalent to 50% of the property they were insuring and one of the fundamental aspects of insurance is that you can only receive a settlement for what you have insured.

In the event of a catastrophic fire resulting in a total loss of the building, the insurer will pay out the sum insured, this will still penalise the policyholder – in the example above John would receive a settlement of £50,000 meaning he has to find £50,000 to complete the cost of rebuilding his premises.

Underinsurance can be costly and is also relevant to contents insurance. Policyholders should not think about the sum they want to insure but instead should concentrate on the actual cost of replacing the items they want covering.

For example – Sarah owns a design company and has a package insurance policy covering her office building and contents. She has 10 staff, each with a tablet costing £1000. Sarah decides that the chances of all tablets being stolen or destroyed at once are small and so only insures 5 of these for a sum insured of £5000. The insurer will view this in the same manner as John’s building in the earlier example. The tablets are underinsured by 50% of their actual value and therefore is one tablet is stolen then Sarah would only receive a settlement of £500 (minus the policy excess). The insurer in this example is facing double the possibility of a tablet being stolen as there are 10 tablets, not 5 and the insurer will not know which 5 of the 10 tablets are covered and which are not.

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