Insurance: dangers of underinsurance
Don’t risk it
31 May 2017
James King warns of the dangers of underinsurance and provides advice for keeping cover accurate and up to date
Underinsurance is an issue for both the insurance sector and its customers. What are the factors driving underinsurance in commercial properties? Inertia and lack of awareness are the most obvious, but are there others?
Underinsurance has always been a feature of the commercial property sector when deciding on the declared value for the risk you wish to insure. Because underinsurance will only apply in the event of a claim rather than when the policy is taken out, it is imperative to ensure that the policy has the correct basis from the start and is updated as required.
As it looks likely that the UK will embark on protracted negotiations to leave the EU, many expect to see potential cost increases and imports to rise since a lot of building materials are EU-sourced, so it is crucial to ensure that properties are being insured for the correct sums.
The level of underinsurance in the commercial sector is of real concern, particularly for property owners, who are risking their investments. They are potentially exposing themselves to significant costs in the event of a rebuild, as their insurance may not cover the full costs of this, which may include demolition and site clearance, together with the related professional fees.
Another major concern is that if a property is subject to finance, the agreement will stipulate that it is fully insured and will remain so throughout the term of the loan. A regular review of the declared value is strongly recommended to safeguard against contravening the loan agreement.
Getting valuations right
Failure to conduct regular valuations is probably the most common reason for underinsurance. The valuation must be for the demise of the whole risk, not just the main structure. Typically insurers define a property risk as:
- landlord’s fixtures and fittings therein and thereon, including former property of tenants relinquished to the named insured
- outbuildings, annexes, extensions and substations
- walls, gates, fences, canopies and fixed signs
- ornaments and statues, but not where insured under machinery plant and all other contents, nor where the designation under which such property appears in the named insured’s books would require it to be insured under machinery, plant and all other contents, up to a limit of £500 for any one ornament or statue
- surfaces and foundations of car parks, yards, roads, pathways, pavements, patios, terraces, forecourts, driveways, service areas, pedestrian malls, associated lamp posts and other street furniture
- services, but not where insured under machinery plant and all other contents, nor where the designation under which such property appears in the named insured’s books would require it to be insured under machinery plant and all other contents
- building management systems, but not where insured under computer and telecommunication equipment, nor where the designation under which such property appears in the named insured’s books would require such property to be insured under computer and telecommunication equipment
- security lighting, cameras, other security devices and fire-protection devices
- telecommunication, television and radio aerials, satellite dishes, aerial fittings and masts
- foundations or footings unless otherwise excluded
- glass, including framework alarm strips or fittings and lettering thereon.
The declared amount to insure is made up of the full cost of reinstatement of the demise, and will also include the costs for the removal of debris, architects, surveyors’ fees and VAT where this is appropriate.
No professional insurance broker wants to find themselves in a situation where their client has a genuine claim that is covered only to discover that the sum insured is inadequate. Brokers have a duty to remind property owners of the benefits of regular valuations, the consequences of underinsurance and, more importantly, how they can take the appropriate actions in a cost-effective and efficient manner.
Insurance Act 2015
The Insurance Act 2015, which came into force in August 2016, contains important changes, and those in the property sector should be aware of these. Insurers do not need to rely on their policy wordings to reduce the costs of claims as they will be able to proportionately reduce these due to inaccurate disclosures. Therefore, the duty to provide a fair presentation of risk should be given the utmost care and consideration, to ensure that the property at risk is accurately presented to insurers to avoid any detrimental settlement adjustments.
Top tips for property owners
- Put in place a rolling programme of valuations by RICS-qualified surveyors, thereby spreading the costs.
- Take advantage of the preferred supplier rates on offer for valuations from brokers and insurers.
- Assess valuations annually using one of the many online calculators to pinpoint those properties most at risk from an erroneous valuation.
- Avoid the temptation to remove index-linking applied to sums insured by many insurers – the rate of increase is not plucked out of the air.
- Keep increasing the sum insured in line with rebuilding costs.
- Work with brokers who have specialist teams focusing on the property sector.
'Underinsurance' and 'average'
For buildings valuation, reinstatement is normally applied. It reflects the cost of replacing the building irrespective of its age, size or suitability. The reinstatement value should include the cost of demolishing and clearing away the existing structure and rebuilding it with modern materials, using modern techniques, allowing for professional fees and in accordance with any statutory requirements.
If the reinstatement value is incorrect then 'average' can be applied: this allows insurers to pay only a percentage of the loss if a building is underinsured. So if the building is only insured for half of what it would cost to rebuild, the payment will be half of the loss, and in certain circumstances the insurer will refuse to pay completely. 'Average' can be applied to any size of claim. Unfortunately, if the building is overinsured, the reverse does not apply and there is no profit, simply an overpayment of premium.
It is worthwhile ensuring that the reinstatement cost is correctly calculated. A leading UK insurer has commented that as many as 50% of claims for damage to buildings are being settled below the cost of reinstatement, which could have a significant impact on property owners who would have to fund the difference themselves (see Table 1 for an example).
Table 1: Sample payout for an underinsured property
'Declared value' and 'sum insured'
To check the figure for which your premises are insured, examine your insurance certificate or schedule. This may show two figures: one labelled declared value (DV), the other sum insured (SI).
The DV is the lower figure. This is the total cost for rebuilding your premises – including all fixtures and fittings, car parks, pavements and similar property for which you are responsible – at the inception or renewal date of your policy. It should include an adequate allowance for professional fees and debris removal costs as well. This figure must be adequate for full reinstatement of the property.
SI is the DV plus a percentage uplift, as provided free by insurers, to cover inflation, changes in the Building Regulations and increased costs for labour or materials. In insurance terms, this is known as a 'post-loss inflation protection'.
But why is this needed if the DV is correct? If the worst happens and a serious fire occurred on day 364 of your policy, then it took a year or more for new plans to be drawn and planning permission to be obtained, it could then take a further year to rebuild. By this time, the original DV would be more than 3 years out of date, and a shortfall in your claims payment could leave you out of pocket. Insurers know that it is impossible to rebuild on the same day as the loss, so the sum insured should allow full reinstatement at the later date. The sum insured will be the higher figure on your certificate, but this benefit is only available if the DV is correct.
For absolute clarity, the insurance premium is calculated using the lower figure of the two, the DV. As you are only paying a premium based on the DV, insurers will expect this figure to be adequate to rebuild your property on day one of the policy. So it is imperative that this is correct, as the higher sum insured figure will only cover inflationary factors and not underinsurance where the DV is set too low.
James King is a senior executive at chartered property broker Clear Insurance