Underinsurance & Average: Beware the Dangers

“It’s not really a problem if I get the sum insured wrong. If I end up underinsured, the worst that can happen is that any claim I make will be limited to the sum insured and I can live with that, right?”

Wrong.

Average

The effect of underinsurance and average is, perhaps, one of the most common misunderstandings we see from insureds in commercial insurance claims.

Most policies contain clauses, often headed “Average” or “Condition of Average”, which allow an insurer to reduce the sum paid out on a claim in proportion to the value insured where it is found that the assets covered by the policy were insured, whether deliberately or accidentally, for less than their full value. This is because the premium paid will have been calculated with reference to the value declared (i.e., the sum insured). If it is underinsured, a policyholder will only have paid part of the premium that would have been applied had the true value been declared and it should therefore only take the benefit of the proportion of cover for which it has paid. The effect of this for policyholders is that they can be left substantially out of pocket, even where the total value of the claim made is well below the sum insured under the policy.

For example, if a policyholder insured a factory premises on the basis that it would cost £2 million to rebuild if it was destroyed, it might think that it had more than enough cover to be paid out in full if a flood caused £500,000 of damage. However, if the insurer determined that the true reinstatement cost of the premises at the date the claim was made was, in fact, £2.5 million, it could rely on an average clause to reduce the sum paid out on that claim so that the policyholder would be left to bear the same proportion of the loss as the amount of the underinsurance. In other words, it could claim that only 80% of the true reinstatement value was insured and it was therefore only required to pay 80% of the claim, being £400,000. The policyholder would be left to cover the remaining 20% or £100,000 itself at a time when its business is likely to be under stress.

Where an appropriate clause is included in the policy wording, average can also be applied to business interruption claims where the gross revenue or gross profit of a business is found to be underinsured, because the sum insured is not properly reflective of the actual turnover or gross profits achieved.

The Insurance Act 2015

Even where there is no such express clause in the policy, an Insurer can rely on the Insurance Act 2015 to apply a proportionate remedy where it can demonstrate that a policyholder’s failure to disclose the true (higher) value of the property/risk insured amounted to a breach of its duty of fair presentation. This means that where an Insurer can show that it would have charged a higher premium but for that breach (i.e., had the correct sum insured been applied), it can reduce proportionately the amount paid on the claim and only pay a percentage of what it would otherwise have been required to pay under the terms of the policy.

For example, if the premium actually paid was £1,500, but the Insurer would have charged an increased premium of £2,000 had the correct (higher) sum insured been applied, the Insurer would only be required to pay 75% of any claim made under the policy (i.e., actual premium / higher premium x 100). This means that, whereas the policy might otherwise have obliged the Insurer to pay out £100,000 on a claim, the application of the proportionate remedy would only require it to pay out £75,000.

Comment

To avoid being underinsured, policyholders should carefully consider (both internally and with their insurance broker) whether the sums insured are properly reflective of the value of the assets/risk to which the cover will be applied when taking out or renewing an insurance policy. Thought should be given to how any changes or business growth may impact on the values/sums insured applied in previous years and policyholders should avoid relying on out of date valuations or historic data.

If your business is in the midst of an insurance claim, and the insurer has raised the question of average/underinsurance so as to reduce the amount it says you are owed, do get in touch with Indemnity Legal to see how we could help.

Emma Hockley
Indemnity Legal
26 April 2022

*The above should not be taken as legal advice or relied upon as such. If you have a legal issue on which you require advice, do get in touch with us.

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