Underinsurance: Are you sure you're adequately protected?

Underinsurance remains a big challenge for many businesses as well as the insurance companies and brokers who handle the aftermath. When something bad happens, people often ask themselves, "Am I covered? And even if I am, do I have enough coverage?" The most challenging situation arises when you realise that your insurance policy does not fully cover everything you have lost or only provides partial coverage. This can leave you facing significant out-of-pocket expenses and financial stress during a time when you are already dealing with the consequence of a loss.

So, what exactly is underinsurance? How does it happen, and what kind of problems does it create? We will talk about all that before diving into the consequences, related costs, and examples that really show how underinsurance can impact you.

The cost of underinsurance

Simply put, underinsurance happens when the amount of insurance you have purchased is less than the correct value that it should be insured for.

In property insurance, insurance companies apply a rule called the Average Clause to figure out how much they'll pay you if you make a claim and you're underinsured. Here's how it works: If your property is insured for less than its actual value, the insurance company will reduce the payout accordingly. For instance, if your property is insured for half its actual value, the insurer might only cover half of your claim if something happens to it.

This principle is to encourage people to purchase enough insurance to cover the full value of their property. Otherwise, they will be stuck with a smaller payout than they need to rebuild or replace what had been lost.

Even if you have an approved fire alarm and other methods designed to protect your business and satisfy your insurers, if the value submitted in the first place is inadequate, then there could be trouble in store in terms of meeting your rebuilding and recovery costs. 

The tricky part is that you might not realise you are underinsured until you need to file a claim. This could lead to a big financial shock. 

Having gone through the ordeal of this happening to your business and hearing from your insurer that they won’t fully cover your claim might feel like they are adding insult to injury. But the insurer is not doing this to be difficult or ruin your livelihood – it’s one of the fundamental principles of how insurance works.

Why under-insurance happens

A common cause of underinsurance is simply not fully understood what needs to be insured. Additionally, asset valuations can be outdated and fail to account for inflation and other changes over time. Incorrect initial calculations, changing circumstances, and the challenging conditions in today's market also contribute to under-insurance.

There’s also the common pitfall of people thinking that “It’ll never happen to me, so why waste money on something so unlikely?”. This is where some may skimp on insurance by purchasing inadequate coverage or remaining un-insured altogether. This mindset can leave individuals and businesses vulnerable in the event of a loss.

How to avoid being under-insured

Property 

Property under-insurance is becoming more problematic due to steep inflation rates in recent years. The construction materials, cost of replacing machinery and equipment and transportation and labour costs have risen significantly as compared to a few years ago. 

In addition, there may have been additional installations within the building that have not been accounted for. Not accurately declaring the correct sum insured when you first set up your policy can lead to significant issues, leaving you with a financial gap in your business account due to being underinsured.

It’s advisable to get a professional valuer to assess how much it would cost you to rebuild your property. This is known as a Reinstatement Cost Assessment (RCA). Between these assessments, you may have to adjust your sum insured values based on an inflation index to ensure that the coverage taken up remains adequate.

While for most business owners, determining stock level is something that should almost come as second nature, the continuing global supply chain interruptions mean that many people are increasing their product and parts orders, so they’re not left short. And this makes for a sound business decision… unless an incident wipes out all your stocks and your insurance hasn’t been correctly adjusted for the changes you’ve experienced throughout the year. Again, this all hinges on declaring the full value of your required cover and making sure that if it fluctuates, your policy reflects this. 

Business interruption

Following a loss event, will your business grind to a halt or is there a back-up plan for business recovery, together with insurance to help you cover the costs? 

The business will need to temporarily relocate and rent, and bills will need to be paid on temporary premises, plus there will be delays in fulfilling orders or finishing jobs, which may incur penalties in unpaid invoices. Your insurance cover may only protect your business for a limited amount of time when a business interruption event occurs, but the disruption may last much longer than imagined. It’s therefore important that you set the correct level of sum insured and indemnity period for this area of cover. If insuring on a Gross Revenue or Gross Profit basis, then you’ll need to ensure it allows for growth throughout the policy and indemnity period. This is just one example of what business interruption insurance cover is built for. But if you’ve underpaid on this, then you’re still underinsured.

Take proactive steps to safeguard your business

Underinsurance can be avoided. Taking the time to review your policies and being realistic about any area that is uncovered may just be the saviour for your business in extreme or unwanted circumstances. It may not just be a roof burning down that leaves your business exposed. Your insurance policies need to keep pace with your business growth. Partnering an insurance broker like Howden will help you immensely with these reviews. We can provide tailored advice and solutions to ensure your policies are up-to-date and adequately cover all aspects of your business's operations.