Underinsurance: why getting your sums insured right matters

Underinsurance can leave a business funding part of a major loss. Learn why sums insured, business interruption and replacement values need regular review.

Insurance is designed to help a business recover after an insured loss. But if the values declared under the policy are too low, the amount available at claim time may also be lower than expected.

That is the risk of underinsurance.

Underinsurance can arise when buildings, stock, machinery, equipment or business income are insured for less than the amount required under the policy. It is particularly easy for this to develop gradually as construction costs rise, businesses grow and replacement costs change.

What does underinsurance mean?

A sum insured is generally the maximum amount available under a particular section of a policy, subject to its terms, conditions, limits and exclusions.

The problem arises when that amount no longer reflects the value that should have been declared.

According to Steadfast, some common areas where businesses can become underinsured include:

• buildings, stock and contents
• removal of debris following an insured event
• equipment and machinery
• gross profit and additional increased costs under business interruption insurance.

For regional businesses and farms, the replacement cost of machinery, sheds, commercial buildings, specialist equipment and stock can move significantly between renewals.

Why simply rolling over last year's values can be risky

One of the easiest mistakes to make at renewal is accepting the previous year's sums insured with only a small adjustment, or sometimes no adjustment at all.

But the business itself may have changed.

You may have renovated or extended a building, purchased machinery, increased stock levels, added equipment or experienced significant growth. At the same time, the cost of construction materials, labour, freight and replacement equipment may have moved considerably.

Steadfast identifies carrying forward sums insured without a proper review as one of the common causes of underinsurance.

A renewal review should therefore look beyond the premium and ask whether the values themselves still make sense.

Replacement value is not necessarily market value

For buildings and business assets, insurance values commonly need to reflect the basis required by the policy, which may be very different from what an asset could be sold for.

Rebuilding a commercial property following a major fire can involve demolition, debris removal, professional fees, updated building requirements and significantly higher labour and material costs.

Similarly, replacing machinery or specialist equipment may involve freight, installation and long lead times.

The appropriate basis will depend on the particular policy, so the method used to determine the sum insured should be checked rather than assumed.

How underinsurance can affect a claim

Some commercial insurance policies contain an underinsurance or co-insurance clause.

Where it applies, being underinsured may affect more than a total loss. It can also reduce the amount payable for a partial loss.

The Steadfast presentation gives the example of a commercial building insured for $1.5 million when its assessed replacement cost was $2 million. Using an 80% co-insurance basis, a $500,000 insured loss resulted in a calculated insurer payment of $468,750, leaving a $31,250 shortfall for the insured.

That is why understanding the policy's co-insurance provisions matters. The percentage, calculation and circumstances in which a clause applies vary between policies and insurers, and 80% is only one commonly used figure.

“Underinsurance does not necessarily become apparent only after a total loss. Depending on the policy wording, an inadequate sum insured can also affect the settlement of a partial claim.”

Business interruption deserves the same attention

Property values are only one part of the issue.

Business interruption insurance is intended to help protect the financial position of a business following insured damage, subject to the policy wording.

The declared figures need to reflect the basis required by the policy and the expected trading position over the relevant period.

If the business has grown but its business interruption values have not been updated, the cover may no longer reflect its current operations.

Is your indemnity period long enough?

The indemnity period is another important part of business interruption insurance.

It is the maximum period over which insured business interruption losses may be measured or covered, subject to the policy terms.

Twelve months can sound like a long time until a major loss occurs.

Rebuilding may involve demolition, engineering, planning approvals, builders, specialist equipment, replacement machinery and supply-chain delays. Regional businesses can also face additional challenges sourcing trades and equipment.

Steadfast specifically identifies staff shortages, council approval times and domestic and international supply delays as factors businesses should consider when determining whether the indemnity period remains adequate.

For some businesses, 12 months may not provide enough time to return to normal operations.

When should sums insured be reviewed?

Renewal is the obvious time, but it should not necessarily be the only time.

A review may be worthwhile when:

• you purchase or replace major machinery
• buildings are extended, renovated or upgraded
• stock levels materially increase
• the business expands or revenue changes significantly
• replacement costs rise sharply
• you change premises
• new equipment is installed
• rebuilding costs in your area change following a major weather event
• your current indemnity period may no longer reflect realistic recovery times.

A significant change during the policy period should also be discussed rather than automatically waiting until the next renewal.

How an insurance broker can help

Determining appropriate sums insured can involve more than simply increasing last year's figures by a percentage.

Depending on the business and assets involved, a broker can help identify where valuations may be required, discuss the basis of cover, review machinery and stock values, consider business interruption information and examine whether the selected indemnity period still reflects a realistic recovery timeframe.

The objective is not to predict exactly what every future claim will cost. It is to make sure the information provided to insurers and the values selected are properly considered and reflect the business as it operates today.

If your buildings, machinery, stock or business operations have changed since your insurance was last reviewed, contact RMA Insurance Brokers to review whether your current sums insured remain appropriate.

Adapted from Steadfast Group's presentation Are You Underinsured? An insight into how a claim could be affected when insuring your business.