Underinsurance can affect organisations of any size or sector, and the COVID-19 pandemic has prompted many to re-examine their cover in a more challenging commercial environment. In this article we explore the pitfalls of being underinsured and how to identify and mitigate this risk in your organisation.
Does your insurance cover really tick the box?
For some of us arranging insurance is simply a tick-box exercise. It can be a time consuming task to drill down into the finer details of your property, assets and business activities to achieve accurate valuations. And once you have this information additional time and effort is often required to examine and compare insurance policies to determine the levels of protection offered.
Even if you are confident you know what cover you need, is it acceptable to renew your cover based on your assessment or otherwise review last year’s cover and make a rule of thumb increase? Ultimately, the test of your insurance cover is when you come to make a claim on your policy. If the scope of your insurance doesn’t cover what you need, it’s too late to go back and do the homework.
The insurance market is changing
Before we explore the challenges of underinsurance, it is appropriate to take into consideration the prevailing market. This past 12-18 months has seen significant structural challenges to the insurance market – some things expected, others unpredicted. Brexit, a hardening insurance market, and the challenges associated with the global pandemic and lockdown restrictions carried an impact. As the government continues to transition the UK out of lockdown, the future remains uncertain or unclear for many businesses particularly within sectors hit hardest such as hospitality, leisure and tourism.
One approach is to consider the worst case scenario. An estimate or inaccurate valuation can translate a tick-box renewal exercise to a severe financial headache.
What is underinsurance?
Put simply, underinsurance is when a policyholder has inadequate insurance cover for their needs. In the event of a claim this could mean a claim amount exceeding the maximum limit that can be settled by the insurance company. This could result in a shortfall for the policyholder, potentially leading to a serious financial loss for the organisation. Common areas of underinsurance are typically property, stock and contents, plant & equipment, business interruption, and cyber liability.
What can lead to being underinsured?
There are a number of reasons a policyholder may be underinsured. In many cases, it happens when valuations are out of date, roughly estimated, or incorrectly calculated. It can also be caused by insufficient limits in the policy.
While underinsurance may be due to an oversight by a policyholder, it may also reflect action taken by the policyholder to reduce their premium by not declaring their sums insured accurately. Doing this not only increases the risk of financial loss, it can also void insurance cover altogether.
Your business premises may be your highest value asset, and integral to the smooth running of your day-to-day operations. And yet, many businesses have an element of underinsurance on their commercial properties.
Here are some of the common pitfalls:
Out-of-date valuations: If a property has not been professionally valued for insurance purposes there may be a shortfall in cover, even if the premises have not been altered or improved. If you have made alterations or extended the property, and/or changed its use then you should let your broker or insurer know as soon as these changes are made rather than waiting until your policy is due to be renewed.
COVID-19 and change of use: Many businesses have changed the layout of their premises or made adjustments to how certain areas are used to remain compliant for their COVID-19 risk assessments. For example, work stations may be socially distanced, one-way systems put in place, or fire doors propped open to allow for air flow within a building. Other buildings or areas not normally occupied might now be used to accommodate employees to achieve adequate social distancing. All these things should be taken into consideration for insurance and risk management purposes.
Market value versus reinstatement costs: Another common oversight for business owners is to insure for the market value when the sum insured should be the rebuild cost. Not only can the market value fluctuate but it is not an accurate reflection of the total cost to rebuild the premises from scratch. While materials and labour are obvious considerations, you should also consider factors such as professional fees (architects, legal, planning), demolition or make-safe costs, and total fit-out costs. In some cases, there is also potential for rebuild planning permission to be refused – for instance where your site may now be deemed too close to a residential area built since your property was constructed.
Rebuild/repair of listed buildings: When considering the original construction of the building a number of factors will determine the reinstatement cost such as whether the building is listed, the nature of materials it is built from, and the age of the building. Listed or heritage buildings, for example, typically have higher rebuilding costs than other properties as they must adhere to traditional forms of construction and specialist materials. This is where a professional valuation is an important consideration.
In addition to ensuring you do not have gaps in your property insurance, you should also think about the indemnities for the business if operations are interrupted due to an incident involving property damage.
Reinstatement cost valuations
Buildings insurance reinstatement cost valuations should be carried out by qualified building surveyors, whose activities are regulated by the Royal Institution of Chartered Surveyors (RICS), following the guidance contained within their current Practice Standards.
Stock and contents
When determining the cover required for the contents in the business (both on and off the premises) and the stock you hold, it is important to bear in mind how an insurer will view this. For a policyholder it may appear that selecting a cover amount is their choice based on how much cover they think they may need should an insured event occur. However, insurers are seeking to establish the total level of risk they will be taking on their books. Therefore, rather than simply selecting what you feel is an appropriate amount of cover, it is important to determine the cost of replacing all contents and stock on a new-for-old basis.
Given the current supply chain disruptions, we have seen some businesses deciding to increase their stock levels. In this particular case it is vital that the levels of cover for stock are reflective of the actual value should full replacement be required.
Why is this important? If you were to insure only part of the total value of your stock or contents on the basis that a complete loss of your stock seems unlikely, this overlooks the fact that the total figure is required by your insurer. Policyholders may believe they can claim up to that limit, however this is not necessarily the case. This is due to the ‘average clause’ within a policy wording that allows insurers to pay a lower claim amount if a policyholder has underestimated the declared value of stock and/or contents.
If you have made significant changes to your property, assets, stock or business activities, let your broker know straight away – don’t wait until renewal.
What is the Average Clause?
Where a business is underinsured, the insurer can apply the average clause. This is a clause in the insurance policy stating that the policyholder must bear a proportion of any loss if assets were insured for less than their full replacement value. If the insurer finds the business has taken out inadequate insurance, it can reduce the settlement by the same percentage the asset is underinsured – so you may not get the pay-out you expect.
In short, taking out insufficient insurance cover will essentially mean any claim will be insufficiently covered.
Average Clause example:
If a property has a reinstatement value of £1.8 million on an insurance policy, and needs to claim £240,000 for repairs due to flood damage, it would be assumed that cover was adequate. However, if the insurer can establish the total cost to rebuild the property is actually £2 million, they can claim that the policyholder had inadequate cover in place (in this case cover amounts to 90%, so there is a 10% shortfall or ‘underinsurance gap’). Under the Average Clause the insurer can then reduce the claim amount by the same proportion as the amount of underinsurance (10%) – so a £240,000 claim becomes £216,000, leaving the business financially liable for the £24,000 difference – even though they had £1.8 million of insurance in place.
The average clause in an insurance policy is there to encourage policyholders to declare honest values when insuring their assets. It also helps to ensure a fair premium is always contributed into the pool of premiums from which insurance claims are paid.
Insurers do understand, however, that valuations can vary during a policy period – particularly where the claim involves property. Some insurers will counteract this by applying a Special Condition of Average which states that the average clause will only be applied if the sum insured falls below a certain percentage. For instance, if the percentage was stated as 75%, the average clause example we have used here would not apply and the policyholder should receive their full pay-out.
We recommend talking to your broker if your policy has a Special Condition of Average included as not all insurers will apply this. The important point to note is that you should ensure to the best of your ability that you are declaring the total reinstatement value of your assets – then the average clause is less likely to come into play.
Plant, machinery and equipment
When valuing plant and machinery for insurance purposes it is important to take the ‘new for old’ approach, even if your machinery is not the most up to date on the market, or if a certain piece of equipment is not frequently used. Whether you own or hire the equipment, you should look to insure it for its current replacement value to avoid an underinsurance gap which could mean receiving a pay-out that is less that your claim – even if you are just claiming for one machine.
For some sectors, plant and machinery can be the backbone of their business and an unexpected event can hold up production. This can very quickly have a knock-on effect on fulfilment of existing orders as well as taking on new ones, and may lead to customers looking elsewhere.
If you have specialist equipment that would take a significant amount of time to replace, this could carry greater impact and disruption to the normal running of your business.
When ‘business-as-usual’ trading is affected or interrupted, there will most likely be a financial impact. Therefore, considering a realistic time frame to get back up and running after an insured event is an important aspect of a business continuity plan, taking into account scenarios including physical events such as a fire or flood or the disruption caused by a cyber-attack.
According to the Chartered Institute of Loss Adjusters (CILA) 43% of business interruption insurance demonstrate underinsurance, with the average shortfall 53%.1
A common oversight with cover for business interruption is that the period of cover selected to protect the business financially turns out to be far shorter than the actual period of disruption. This then leaves the business with ongoing losses after the insurer stops paying – for example if you need to continue renting business premises beyond this indemnity period.
The recovery process may take longer than you think – even small, straightforward businesses can need longer than 12 months’ protection. If you are rebuilding premises for example, you may require planning permission which can often take months before any rebuilding works can even begin.
For your insurance policy to provide an effective response in the event of a claim, consider and present a true picture of the time and resources your business needs to achieve pre-loss turnover levels. A business continuity plan can help you achieve this.
43% of business interruption policies demonstrate underinsurance1
Business Interruption insurance cover and the definition of profitability
Another accidental cause of underinsurance within business interruption policies is the confusion around the definition of profit.
Standard accounting says that gross profit is sales minus the costs of production but the insurance definition is different. Business interruption insurance generally defines gross profit as turnover less the cost of raw materials and other expenses directly variable with turnover.
However, some costs may not fall in proportion. For example, if you suffer a major incident but you forward-buy materials under contract at a fixed price over time, those costs won’t change proportionately despite the drop in turnover you might experience directly after the incident. Having sufficient cover for business interruption in place can cover you for those contracted commitments.
When Gallagher carried out a poll involving 1,000 businesses, the vast majority of respondents (82%) did not have specialist coverage despite 39% of senior decision-makers citing cyber-attacks as among their biggest concerns2. Despite this fewer than one in five (18%) companies have a standalone cyber insurance policy to cover them against the costs and impact of an attack.
The reason for being underinsured was the assumption that a standard business insurance policy is enough, when in fact it is unlikely to offer cyber protection. A data breach or other cyber event has the potential to cause substantial losses for a business, so it is vital to understand and secure the appropriate level of cover, particularly as many employees are now working remotely.
Fewer than 1 in 5 companies have a standalone cyber insurance policy2
2. Gov.uk - Department for Digital, Culture, Media and Sport (Cyber Security Breaches Survey 2021)
Void policies and prosecution
Being out of pocket due to underinsurance is one thing, but having your policy voided and not receiving any pay-out altogether is another. This is where unintentional and intentional underinsurance can differ in its consequences with some businesses facing prosecution for deliberate non-disclosure of total values.
Under the Insurance Act 2015, as a policyholder you have a duty of fair presentation of risk that requires you to disclose every material circumstance you know, or ought to know. This means you must conduct a reasonable search for, and disclose, material information that is available to you.
If an insurer believes underinsurance is the consequence of a deliberate or reckless breach of this duty, it can refuse to pay the claim in its entirety, or void the policy altogether, with no return of premium. It may even look to prosecute if it believes the sums insured were deliberately understated.
Non-disclosure of previous claims
Another pitfall is non-disclosure – essentially, failing to disclose a previous insurance claim to the insurer. Even if you have accurately valued the total reinstatement cost of all of your property and assets and paid the relevant premium, omitting a previous insurance claim could undo all of your efforts to avoid underinsurance.
Insurance providers have the means to validate a policyholder’s claims history and check records of reported incidents. So, even if the non-disclosure is unintentional, your policy can be cancelled for failing to declare relevant information that is later revealed.
In summary: tips for preventing underinsurance
By considering all aspects of your business, from your assets to your staff and customers, it is possible to identify areas and help remove the risk of underinsurance.
Rebuild: Your overall sum insured is the most you would need to rebuild and replace from absolute scratch. Consider a professional valuation by a RICS qualified valuer.
Limits: Are the policy limits insufficient? Check them against the needs of your organisation.
Values: Update the new-for-old replacement values of plant, assets and premises for your organisation annually.
Recovery: Set a realistic indemnity period within Business Interruption insurance that gives your business enough time to recover from an insured event. Your sum insured should reflect the anticipated business growth and not just past performance.
Review: Conduct an annual review of all relevant policies with your broker, based on your changing valuations, so you have suitable cover. Remember areas such as Employers’ Liability, Public Liability and Professional Indemnity: as your circumstances change, so does your risk.
Inflation: Check if your insured sums have automatically been index-linked to inflation. The cost of materials for re-build or replacement of goods will change from one year to the next.
Ultimately, managing the risk of underinsurance is about doing the groundwork to provide an accurate valuation to the insurer and being aware of what could happen if you fail to fulfil your duty of disclosure. Any audits or valuations made should be carried out by an independent professional. Working with a broker provides an extra set of eyes to ensure you have a clear, in-depth picture of cost, value and liability.
In a more challenging insurance market it can be more difficult for businesses to secure cover as insurers may be more selective of the risks they will take on. Remember when reviewing your existing cover and ascertaining your up-to-date valuations, you should not take for granted renewal on the same terms as the previous year. This is where an insurance review from a dedicated broker can help you prepare for renewal in order to secure adequate cover.
Risks change so businesses need to constantly reassess what could affect them. We can help you ensure you have sufficient cover for your organisation in a shifting risk landscape.
How can Gallagher help?
Call us today to discuss the benefits of a full insurance health check to ensure that adequate protection is in place across your business and navigate any underinsurance pitfalls. As well as helping you to secure the most appropriate cover at renewal, we offer dedicated support throughout the policy year should you need to make any amendments to your policy if your cover requirements change.
In the event of a claim, our in-house claims team and loss adjusters will work closely with you to help you maximise your chances of success. We also offer business continuity planning advice to protect your business stability in the event of disruption.
For more information or to book an insurance review please speak to your local Gallagher representative.
Conditions & Limitations
This note is not intended to give legal or financial advice, and, accordingly, it should not be relied upon for such. It should not be regarded as a comprehensive statement of the law and/or market practice in this area. In preparing this note we have relied on information sourced from third parties and we make no claims as to the completeness or accuracy of the information contained herein. It reflects our understanding as of 5th May 2021], but you will recognise that matters concerning COVID-19 are fast changing across the world. You should not act upon information in this bulletin nor determine not to act, without first seeking specific legal and/or specialist advice. Our advice to our clients is as an insurance broker and is provided subject to specific terms and conditions, the terms of which take precedence over any representations in this document. No third party to whom this is passed can rely on it. We and our officers, employees or agents shall not be responsible for any loss whatsoever arising from the recipient’s reliance upon any information we provide herein and exclude liability for the content to fullest extent permitted by law. Should you require advice about your specific insurance arrangements or specific claim circumstances, please get in touch with your usual contact at Gallagher.