How underinsurance can leave businesses exposed
Navigating new forms of volatility
Author: Grant Pilkington, Director, Technical Excellence – Broking Commercial Risk Solutions
While many major economies are experiencing higher levels of inflation than they’ve been accustomed to, the outlook for inflation across Asia appears more complex. As consumer and producer prices escalate in certain Asian countries, in a property insurance context, rising inflation can lead to underinsurance – when the sum insured, valued and declared to insurers when the insurance incepts, is inadequate.
In the current environment, underwriters are scrutinising declared property values far more closely, and in many cases, are requiring professional annual valuations to consider renewing existing insurance policies.
In this article we explore:
- Inflation across the Asia region
- Potential consequences of underinsurance
- Common valuation mistakes
- Steps to limit underinsurance risk
A varied picture of inflation across the region
According to Taimur Baig, Managing Director and Chief Economist with DBS Group Research, we can expect inflation to impact Asian economies in a wide variety of ways. “If you were to look at Asia as an inflation heat map you would see all sorts of colours,” he says. “Some countries are very export dependent, relying on technology or commodities for their economic growth, for example. Others may be relying on imports of food and fuel and will be experiencing major price increases due to the Russia-Ukraine conflict. But even some of these countries will take a hit to their balance sheet by protecting their populations and not passing through the full cost of price increases to businesses and consumers.”
“In many Asian economies they’re quite used to seeing levels of inflation that might be alarming to central banks in other countries,” he adds. “For India, inflation of mid-single digits isn’t unusual. And other countries, like China and Hong Kong, have only recently seen the end of lockdowns that were dampening demand and haven’t reported significant changes to rates of inflation in 2022.”
Underinsurance - considerations for risk managers
Underinsurance is a recognised concern for the insurance industry and policyholders that can be exacerbated by high rates of inflation. When prices are rising, in the construction sector for example, this has the potential to impact organisations’ infrastructure costs and asset values across all industries and sectors. In major property markets, valuers and insurers estimate that a typical business that declared accurate property values in 2021, are probably at least 15% below an accurate valuation today. Adding a nominal 5 or 10% to last year’s valuation seems unlikely to provide an adequate correction and could potentially open businesses up to significant uninsured exposure.
Most commercial businesses will require property insurance covering all risks of physical loss, damage to, or destruction of buildings, plant, equipment and contents, and adequate business interruption cover. Declared property values are crucial to the underwriting decision in property insurance because premium is primarily calculated based on the true value of the risk.
Outdated property valuations may then leave businesses underinsured if the sum insured is less than the value of the property or the cost of its reinstatement or replacement. In a total loss scenario, underinsurance can act as its own balancing factor since the liability of insurers will ordinarily be limited to the sum underinsured if the policy limits are exceeded. The insured will necessarily bare the uninsured balance of the loss. In real life, though, partial losses are more frequent and insurers are required to pay the full amount of a partial loss, unless the policy is subject to the principle of average.
The principle of average - how much uninsured exposure is your organisation taking on?
In a situation of underinsurance, where there is a partial loss, the insurer may be able to rely on the principle of average. Commercial property insurance clauses generally contain average clauses – also known as ‘co-insurance’ clauses, depending on the specific policy form and terminology. The purpose of such clauses is to attribute risk between the insurer and the insured in the event of underinsurance.
The application of an average clause can have a severe impact on the settlement of a claim in the event of a partial loss. For example, if a building worth US$600K is insured, subject to average, for US$400K, the insured will be entitled to only two-thirds of the loss. A basic simplified calculation of the claim settlement would be: Sum Insured US$400K ÷ True Value US$600K x Loss US$120K = US$80K.
Given that property values declared by insureds are often understated, and in some cases, might represent only 50-75% of the true value at risk, the potential financial exposure to the insured’s business is significant. The business is effectively insuring itself for the difference between the declared value and true value of insured assets and will be liable for a proportionate amount of any loss in the event of a claim under the policy.
Quite apart from the application of average, where declared values are significantly understated, depending on the applicable governing law of the policy, insurers may be entitled to avoid the policy or all liability under it, or else use the right to avoid negotiating a claim settlement at a lower level than the actual loss.
The risks of relying on an inappropriate or inadequate valuation
Without an up-to-date professional valuation, it is potentially very easy for businesses to understate declared property values and end up in a situation of underinsurance. Businesses often approach valuation in ways which can be inappropriate and produce inaccurate or inadequate valuations. For example:
- Basing the valuation on real estate market conditions
- Relying on a valuation from a bank, builder, architect, or real estate agent
- Relying on advice from an in-house accountant or engineer
- Referring to building guides
- Adopting book value
- Using financial valuation reports and deducting land value
- Adopting the second-hand purchase price of an asset
To avoid being caught out by the potential consequences of underinsurance, organisations should take ownership of the valuation process, and ensure valuations and cost assessments reflect the current replacement value of the asset or property. A professional valuation can also help to fast-track the claims process by avoiding disputes around the true value at risk. In contrast, if there is no reliable basis for the declared values, the investigations that follow may lead to protracted claims processes and delayed settlements.
Maintaining the accuracy of valuations is key to effective risk management
An independent professional valuation limits the potential risk of underinsurance and protects the insured against the risk of average applying in the event of a claim.
At Aon, we recommend organising a professional annual valuation based on the full reinstatement value – the cost to rebuild or replace the property insured rather than the market value or written-down asset values. An annual valuation should also accurately account for fluctuations in the value of the property insured in the previous twelve months, such as new buildings, capital expenditure, and disposal or acquisition of assets. Maintaining an up-to-date asset register can help businesses to respond to a loss with minimum impact to operations.
While it’s not always practical or cost-effective for a business to conduct a professional valuation, the current inflationary environment can exacerbate underinsurance risks. For organisations that have not carried out regular valuations or believe their existing property values may be inadequate, out of caution, we recommend a minimum 20% uplift for insured values, in the absence (or in advance of) a professional reinstatement valuation.
Potential impacts for business interruption cover
Supply chain disruption has been one of several factors driving the inflation trend currently seen across the region and globally. As a result, businesses may also need to review the maximum indemnity period for their Business Interruption (BI) insurance and the BI sum insured. When choosing a maximum indemnity period – the time during which the policy provides cover for loss of profit or revenue following an insurable event – a business should keep in mind how long it might actually take to restore buildings and other assets required for resuming operations.
Getting the BI indemnity period wrong is another form of underinsurance. According to the Chartered Institute of Loss Adjusters (CILA) 43% of business interruption insurance is underinsured by 53% on average1. In the current environment, delays in resuming operations are likely to be longer due to increased supply chain lead times as well as labour and materials shortages. For large complex property risks, we recommend businesses carry out ‘worst case’ BI scenario planning, supported by independent insurance professionals, such as loss adjusters or forensic accountants with relevant BI and business continuity experience.
Considering the current challenging market conditions, it is a good practice for organisations to discuss coverage renewals well in advance. This helps insurers understand the latest inflation trends and potential policy changes, specifically around pricing, prior to renewal.
Risk managers using processes to properly manage valuations and coverage limits are better placed for risk resilience during these turbulent times.