What is underinsurance?
Underinsurance arises when sums insured or limits of indemnity under a policy are insufficient to cover the risk. A recent survey by the Royal Institute of Chartered Surveyors (RICS) and the Building Cost Information Service (BCIS) suggested that 80% of small & medium enterprises (SMEs) in England & Wales were underinsured. (Bonus question – Are Scottish SMEs LESS likely to be underinsured, due to what Scottish former Chancellor of the Exchequer Gordon Brown would call “prudence”, or MORE likely to to be underinsured due to being, as Rod Stewart proudly proclaimed, “tight”? Answers on a five-pound note please.)
Take into account that over 99% of UK businesses are SMEs and you see the scale of the problem. The UK government’s definition of SME is fewer than 250 employees and less than €50 million (app £42.2m).
Why does underinsurance matter?
From its early beginnings in Edward Lloyd’s coffee shop in 1688, insurance was based on the principle of “utmost good faith”. Provided the insured gave the insurer all the relevant facts about a risk, the insurer undertook to pay valid claims. From time to time, important information would be overlooked and arguments arose over cover.
In recent years disputes over non-disclosure became fairly common as insurers baulked at claims where information they were unaware of came to light. To remedy the situation, the Insurance Act 2015 was introduced, effective from August 2016. In a nutshell, this requires insurers to specify the matters that are important to them for rating purposes. If they don’t ask, they can’t later decline a claim because they didn’t know.
Underinsurance matters because it usually doesn’t become apparent until there is a loss, by which time it is too late for the insured. It matters because policyholders recover less than they expected and counted on to get their business back to normal.
How does underinsurance affect claims?
The concept is straightforward. Most policies that have a sum insured or limit of indemnity will have a clause called a “condition of average”.
If a risk is insured for, say, three-quarters of its true value, then the insurers will pay only three-quarters of the claim value. If a factory is worth £1 million but is insured for £750,000, the owner may think the risk of underinsurance only arises if there is a loss over £750,000, but proportional payment applies to ALL claims. In the event of a £10,000 loss, the insurers would pay only £7,500 leaving the owner to bear the shortfall of £2,500.
A survey by insurers Royal & SunAlliance (RSA) found that 28% of SMEs would collapse if faced with a bill for £50,000. That would be the result of a 10% underinsurance on a £500,000 loss.
Less frequently, if values are liable to fluctuation or are difficult to assess accurately, a different clause may be substituted – a “special condition of average”. In this case, if the sum insured is more than a stated percentage of the full value at the time of loss, say 80%, then no deduction will be made for underinsurance.
Why is underinsurance so prevalent in the hospitality industry?
Given that underinsurance is so widespread, it’s hard to be certain that it particularly affects hospitality more than other sectors.
However, the industry tends to be highly seasonal, with fluctuations in wage bills and stock levels that may make it harder to assess appropriate values. If anything, this makes it more important to be aware of the issue and guard against it.
Even before the pandemic, there was evidence that some underinsurance was due to attempts at cost-cutting, in addition to the more traditional cause – under-stated valuations. Business owners may have legitimately reduced cover last year, but need to remember to restore cover when business picks up again.
What areas does underinsurance affect?
Underinsurance can potentially affect any policy reliant on valuations for premium calculation.
Buildings, contents, machinery and stock are usually all rated on valuations provided by the insured policyholder. Unless the valuations appear wildly out of line with expectations, the insurer is unlikely to have reason to query them at this stage.
Changes in practice may result in inadvertent underinsurance. For example, recent supply chain problems may have resulted in stockpiling or higher than normal levels building up at distribution centres.
Less obviously than in property classes of business, underinsurance is found in business interruption (BI) policies. Historically, businesses tend to overestimate how quickly they can be up and running normally after a loss or closure. This can result in selecting too short an indemnity period. In the current economic climate, supply chains have been badly affected by Brexit and Covid. These factors may hold up availability or delivery of materials, parts, plant or stock and impact how quickly a business can recover.
12 months is a very common indemnity period for BI, but a review by the Financial Conduct Authority (FCA) found that almost 25% of BI claims involved losses exceeding the 12 month indemnity period of the policy.
The same survey looked at 20 case studies. Of the 20, 12 cases had inadequate sums insured – 8 for material damage cover and 4 with inadequate 12 months BI indemnity.
How to avoid underinsurance?
Be aware of what insurance policies you have, but more importantly, what they cover, what they don’t cover and what are the limits of cover.
Carry out a review at least annually, preferably with your broker, and with your accountant on speed-dial.
Don’t guess at figures or use the proverbial “back of a fag packet”. Get proper valuations from experts. Property values should be full rebuilding costs plus demolition costs, local authority costs (building & planning control) and professional fees (architects, engineers, project managers etc). The Chartered Institute of Loss Adjusters (CILA) suggests these are typically 8-15% of project cost, with 10% as a rule of thumb.
For BI and cyber cover, a recovery plan is essential if you are to have an adequate indemnity period. Unless your business is very small or very simple, 12 months is probably not enough. Avoid the rookie error of setting the limit of indemnity at your annual turnover if you opt for a longer period – 24 months requires 2 x turnover.
Are there risks attached to over-insurance?
Insurance won’t pay more than replacement or rebuilding costs, regardless of whether the sum insured is higher, so there is nothing to be gained by overinsuring.
The real cost of over-insurance is simply that premiums will be higher than they need be. If in doubt, err on the side of caution and higher valuations for sums insured or limits of indemnity, but don’t overdo it.
Over insurance can occur inadvertently if the same risk is covered by more than one policy. Even if covered by multiple policies, losses can be recovered only once, with the insurers sharing the settlement in proportion to their respective sums insured.
It should be clear from the foregoing that underinsurance can be potentially disastrous, even fatal, for businesses. Also how important it is not to regard insurance as a costly drain, or as simply an adjunct to operations.