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Corporate risks

Underinsurance - a hidden risk?

24 May 2024

Underinsurance has always been a critical yet often overlooked issue impacting businesses and insurers. The persistent high level of inflation, on the back of Brexit, the pandemic and Russia’s invasion of Ukraine, has exacerbated the risk, emphasising the need for regular policy reviews and professional valuations.

Corporate risks

Understanding Underinsurance

Underinsurance occurs when an insurance policy’s limits are not sufficient to cover the cost of a claim. This discrepancy often emerges following inflationary periods, when the cost to replace, repair, or rebuild assets outstrips the sums originally specified in insurance policies. The cumulative effects of inflation in the UK since 2020 have, for many businesses, led to a widening of this gap. According to modelling by Aviva [1], an estimated 50% of businesses in the UK are now underinsured​​.

The Consequences of Underinsurance

The real-world impacts of underinsurance are far-reaching. If you have not insured for the full value of your property, then insurers have not been collecting enough premium to cover the real value at risk. In most commercial property insurance policies, the ‘Average’ clause is the mechanism that insurers use to reflect this position. In simple terms, the amount you receive once the figures are agreed is reduced in proportion to the degree you are under-insured. If the property is a total loss, the most you can receive is the sum insured.

Whilst your business may be able to sustain a reduced payout for a small claim, in the event of a major loss, having appropriate sums insured aligned to the values at risk could be the difference between a business surviving or going under.

And it is not just tangible assets that are susceptible to the perils of underinsurance – according to the Chartered Institute of Loss Adjusters, as many as 40% of business interruption policies are underinsured, with the average shortfall running to 45% [2].

Common Indicators That You Could Be Underinsured

  • Your building has not had a professional valuation within the last three years and/or hasn’t had the appropriate index linking applied.
  • You haven’t factored in costs, such as professional fees or site clearance.
  • Your organisation would not be able to make a full recovery of VAT, but this hasn’t been factored into the valuations.
  • The property is finished to a significantly higher standard than normal.
  • The building is listed, made of quarried stone or certain non-standard construction methods.
  • Replacement machinery and plant would be sourced from overseas, but you haven’t considered how exchange rate fluctuations would impact valuations.
  • You do not understand nor have factored the difference between the ‘Insured Gross Profit’ (as defined in your policy) and an ‘Accounting Gross Profit’ calculation when arriving at your business interruption sum insured.
  • Your business interruption indemnity period has been set without consideration to factors such as the time required for planning permission to be obtained, site clearance and recovering customers and trading levels back to pre-loss levels.

Getting the Right Cover: Steps to Avoid Underinsurance

Professional Valuations – Regular professional valuations are crucial to ensuring accurate insurance cover. These valuations must account for all potential expenses, including architect’s fees, public authority or planning costs, and VAT where applicable.

Accurate Sums Insured – Maintaining an up-to-date inventory of all business contents, including customer goods and peak stock levels, is essential for setting the right sum insured. This is particularly important during key trading periods or in circumstances such as stockpiling due to supply concerns.

Review Business Interruption (BI) Definitions and Cover – The definitions of annual gross profit used for accountancy purposes can differ from those used in insurance policies. Businesses must ensure their BI insurance sums align with the insurance policy definitions and accurately reflect expected costs and profits. This may include adjustments for growth or recovery from previous downturns, like those experienced during the COVID-19 pandemic.

Appropriate Indemnity Periods – Choosing the right indemnity period is critical. Many businesses underestimate the time required to recover to pre-loss trading levels, particularly when dealing with historic or unusual buildings or specialist equipment that may take longer to replace.

Adjustable or Non-Adjustable – speak with your insurance broker to assess whether an adjustable or non-adjustable (sometimes referred to as Declaration Linked) business interruption cover is appropriate for your business and your requirements. Weigh up the advantages and disadvantages of both options, including the benefit of the 33% uplift (providing that the sum insured and period of indemnity are both correct initially) provided for under an adjustable policy. 

Leveraging Data – Insurers, brokers and chartered surveyors can help prevent underinsurance by using data analytics to compare a business’s insurance cover with that of similar entities.

Although inflation has cooled considerably in recent months, the importance of aligning insurance coverage with the real-time value of assets and the risks of underinsurance remains paramount. Ultimately, ongoing collaboration between businesses and insurance experts is essential to ensure that your policies will respond appropriately at the time of loss.

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[1] Based on Aviva’s SME modelled data, excluding Fleet, August 2022

[2] BIBA – How to Avoid Underinsurance – Page 4 (publitas.com)