What is underinsurance?
Underinsurance occurs when the sum insured is not adequate to cover the full cost of rebuilding, repairing, or replacing all items as new. In the event of a claim, this may result in a policyholder not receiving the full amount necessary to rebuild, repair or replace items as new. Underinsurance can occur for many reasons, often as a result of a miscalculation of the rebuild or replacement costs or when new items or changes are made and not accounted for.
How does underinsurance occur and how could it affect your business?
Underinsurance can occur when the amount you have insured your business property for is not enough to cover the full cost of rebuilding or replacing that same property. In the event of a claim, there is an “average clause” applied by the insurance company. This means that where a business (policyholder) is deemed to be underinsured, the insurance company can reduce the sum it must pay in proportion to how much the policyholder is underinsured. For example, if you insure your building for €1,000,000 but the real cost of reinstating it is actually €2,000,000, then in the event of damage to that building totalling €250,000, the insurance company will only pay out €125,000. This is because the buildings were insured for only 50% of their true value, hence the insurance company will only pay 50% of any claim. It is important to point out that it is not the market value you need to insure for, it is the cost of rebuilding the property to include the cost of additional items like site clearance, demolition, professional fees and VAT.
It is therefore vital that your business has the correct sums insured in place. This has become a problem for businesses in recent years due to the rising costs of construction. Whilst the rate of increase in prices in the construction sector is showing signs of easing, it is coming off the back of all-time highs. The average price of a project tendered for in December 2022 was 11.5 per cent higher than the same month in 2021 according to the Society of Chartered Surveyors Ireland (SCSI) index. This is on top a 13% increase when comparing December 2021 with December 2020. The increases have been driven mostly by increases in the price of energy and materials against the backdrop of rising demand and lingering supply chain bottlenecks from the Covid-19 pandemic. In addition, the war in Ukraine has further pushed up energy prices and caused shortages of raw materials. Figures published by the Central Statistics Office (CSO) reveal that construction material prices increased by 16.2 per cent in the 12 months to the end of 2022.
Underinsurance is a problem for businesses because it leaves them financially vulnerable and exposed to significant risks in the event of unexpected events or losses. Inadequate insurance cover means that a business may not have sufficient funds to recover from a major loss. In addition, underinsurance can leave a business ill-equipped to handle the costs associated with disruptions to operations due to events like natural disasters, flooding, or other unforeseen circumstances. Without adequate insurance cover, the financial burden of rebuilding and recovery can be overwhelming, and a business may struggle to resume normal operations and suffer a prolonged loss of income or in extreme cases, bankruptcy.
When asked to comment, Stephen Patterson Director at LHK Group stated: “The soaring building construction costs in recent years mean that the costs of reinstatement in the event of a buildings claim have risen dramatically. Businesses need to distinguish between market value and building reinstatement costs. If the building reinstatement sum insured is too high the business will end up paying unnecessarily high insurance premiums. The key is to strike a balance to ensure adequate insurance cover whilst minimising premiums. It is therefore essential to engage with a professional insurance broker.”
What steps can your business take to prevent underinsurance?
If you haven’t increased your building sums insured on your property insurance policies in recent times, you are quite likely to be underinsured. To mitigate the risks associated with underinsurance, businesses should talk to their insurance broker, conduct a thorough risk assessment, and ensure they have the appropriate cover for their unique needs and potential risks. Whilst an insurance broker cannot put a value on building reinstatement costs themselves, they can advise and recommend experts in this area. A professional insurance broker will regularly engage with its clients to review sums insured and levels of cover. As the business evolves it is crucial to maintain adequate protection cover, particularly in times of high inflation.