The misconception of underinsurance

[Photo credit: David Goehring]

Most consumers believe that if they are underinsured, that the insurer will pay up to the sum insured. Right? No, this is a common misconception. Let's see how rolling the dice on underinsuring your business property can leave you out of pocket.

Take this building example:

• Building Sum Insured: $1,000,000
• Full Replacement Cost to rebuild: $2,000,000
• Building partially damaged by storm: $250,000 (repair cost)

In this example many clients believe that the insurer would pay $250k towards the rebuilding cost as they are insured for $1 Million. This is not the case as most policies contain what is called average, coinsurance or underinsurance clauses.

Most claims or losses in the insurance industry are partial loss claims. In fact, total loss claims where a building or contents are fully destroyed is far less common.

If there was no an underinsurance clause in insurance policies, many insured’s would not insure for full replacement value and thereby an insurer would be unable to collect a full premium commensurate with the total risk. Accordingly, there are underinsurance penalties in most insurance contracts which range from 80% to 100%.

So how does it work?

Building example (with an 80% underinsurance clause)

• Building Sum Insured: $1,000,000
• Replacement Cost to rebuild: $2,000,000
• Building partially damaged by storm: $250,000

Underinsurance calculation

Building Sum Insured ($1M) plus 20% buffer = $1,250,000

The building is therefore insured for only 62.6% of the full Replacement Cost of $2,000,000

Claim payment

Partial Loss Claim Amount (storm damage): $250,000

The insurer pays 62.5% claim ($250k x 62.5%) = $156,250

The amount uninsured ($250k x 37.5%) = $93,750

Hence the importance of using an insurance risk advisor who can point out this to clients and discuss the impact of underinsurance.