The problem of underinsurance and how it can be solved.
When disaster strikes, businesses rely on their insurance arrangements to respond so they can recover the full amount of the loss. After all, they buy an insurance product for that very purpose. Why then do some business insurance arrangements fall short when it really matters? In this article we explore the perennial problem of underinsurance; how it can lead to some businesses failing, but, more importantly, how it can be addressed, so that the insurance cover responds fully enabling a business to survive and thrive after the unexpected disaster.
Firstly a bit about underinsurance. When a policy is taken out, an insurer expects to be paid a premium that reflects the value at risk. So if you insure a building at £500,000, and the premium is £500, the insurer would expect a higher premium of say £1000 if the true reinstatement value, was £1,000,000. To protect their position, insurers include an average condition in the policy which allows for a proportionate reduction in claims payment should the true value exceed the insured value. So in this hypothetical example, you would be looking at a reduction in the claims settlement of 50%. It's therefore easy to see how this can have a devastating impact on a business if not addressed. Other areas where underinsurance can occur include not selecting a long enough indemnity period under the business interruption cover and inadequate liability indemnity limits.
Common situations where mistakes happen:
1) Buildings - Market value v reinstatement value. The vast majority of buildings are insured on a reinstatement basis. Therefore the building sum insured needs to represent the cost to rebuild the property allowing for construction costs, demolition and debris removal costs, architect and surveyors fees, public authority and planning costs and VAT (if applicable). This can be markedly different to the market value of the property and will cause issues if the reinstatement value exceeds the market value. It may seem obvious, but this mistake still happens on a regular basis.
2) Business Contents/Machinery - Again, most modern policies are on a reinstatement (new replacement) basis rather than an indemnity settlement (used/second hand) basis. Your sum insured should represent the cost to replace the machine or equipment with a new item. Common errors occur where second-hand values are used or where the "written down" values are used from the company's balance sheet. If you are sourcing equipment from abroad, it also important to regularly review the cost of replacement to allow for currency fluctuations, such as the fall in the pound against the euro following the Brexit vote.
3) Business Interruption - accountants definition of Gross Profit v insurance definition of Gross Profit. This is the "old chestnut" and is the area where I personally come across the most mistakes. An insurance policy has a specific definition of gross profit that will be paid in the event of insured damage so you must ensure that your insured gross profit is calculated in line with the definition in the policy. A very common issue arises when businesses utilise the gross profit figure in their accounts. This leads to serious underinsurance as it is not in line with the policy definition. It's customary for accountants to deduct manual labour when arriving at the gross profit number, which can lead to a big difference between the number in the accounts and what should be insured under the policy definition causing big problems in the event of a claim. Remember if the number is at 60% of where it should be, not only will the policy only pay up to the 60% figure, the claims settlement will be reduced proportionally in line with the average condition.
4) Inadequate business interruption indemnity periods - businesses sometimes underestimate the time it can take to return to the trading position they were at prior to the loss. Allowance has to be made for debris removal, construction, planning issues, lead times on machinery and time taken to rebuild the customer base. In a serious fire, demolition and site clearance can take several weeks. It is therefore important that the maximum indemnity period is taken to ensure the business can continue and recovers fully after the loss.
The serious bit:
The consequences of underinsurance can severely hit the trading position of the business with the need to self-fund a proportion of the claim. In severe cases, where business interruption cover is inadequate, this can lead to failure of the business. It is estimated that 40% of businesses do not have enough business interruption cover in place.
How the problem can be solved:
1) Seek professional reinstatement valuations of buildings and machinery to ensure you have the correct values insured from the outset. Whilst, there may be a minor cost implication on the business initially, the potential benefit of having the correct level of cover in place and having a claim settled in full far outweigh this initial outlay.
2) Review your values regularly to allow for inflation and currency fluctuations where overseas purchases are involved. Consult with manufacturers on key items of machinery.
3) Consult with the broker to ensure the correct calculation is used to arrive at the insured gross profit. Allow for potential growth and the length of the indemnity period.
4) Arrange business interruption cover on a declaration-linked gross profit basis - this really is a "no-brainer". It includes an automatic 33.3% uplift on your gross profit estimate and there is no average clause. Yes, that's right, no average clause and generally it does not cost any more premium!
5) Make sure you allow an adequate indemnity period under the business interruption cover. Better to allow for more time to bring you back to the position you were in prior to the loss. Unexpected delays can occur outside your control. Remember it takes time to clear the site, consult with professionals, rebuild and reinstate machinery. If there is a long build period, it will likely take longer to regain market-share and your customer base.
So in conclusion, underinsurance is still a problem, and this is especially true in the SME sector. However, with the understanding of the common pitfalls, and talking to a professional insurance broker, it can be solved.
John Baty ACII - Director - Cheviot Insured