Avoiding the financial ramifications of not having sufficient cover for a claim

Clayton Ellary, from Aon South Africa’s Commercial Risk Solutions, explains that as pressures mount, more and more cases of underinsurance are being recorded.

“Underinsurance is when insurance cover in terms of sum insured is not sufficient to cover the full cost of a potential claim. It can apply to a property, plant and machinery, business interruption and even exposures like cyber liability and Directors and Officers cover. In fact, any area of insurance can be impacted by underinsurance with potentially severe consequences for the balance sheet and the ability of the business to recover from an uninsured or underinsured loss,” explains Clayton.

Using a property claim as an example, Clayton explains how underinsurance occurs:

Following a loss, your insurer will calculate the replacement value for which you should have insured your buildings or contents. If your sum insured is less than the actual replacement value, your insurer will pay a proportion of your claim.

Example:

Claim = R200 000  

Sum Insured = R1 000 000

Replacement value = R2 000 000

The under-insurance calculation is calculated as follows:

Sum Insured / Correct Replacement Value X Value of Claim

R1 000 000 / R2 000 000 X R 200 000

Claim settlement = R100 000

“As illustrated, the implications of under-insuring your assets can be severe as you run the risk of being inadequately indemnified in the event of a loss due to the application of what is termed the ‘Average formula’,” Clayton warns.

Aon highlights 5 factors driving the business underinsurance trend, including:

• The steep rise in costs of labour and materials, exacerbated by exchange rate and commodity volatility is making repairs and replacement of machinery, equipment and property far more expensive. Property values are also on the rise, adding extra pressure in this space.
• Business interruption indemnity periods are often not sufficient for the true scale of an insured event. Claims costs are also on the rise, notably in areas such as Directors & Officers Insurance (D&O) and cyber liability - all leading to insurance limits that need to be increased.
• If an insured elects an indemnity period of longer than 12 months, then the Gross Profit sum insured should reflect that period. In addition, if the indemnity period is 24 months, the trended Gross Profit should reflect that period.
• If an insured selects an indemnity period of less than 12 months, the Gross Profit sum insured should reflect 12 months – this is in accordance with standard policy terms and conditions.
• Increased insurance pricing, reduced reinsurance capacity and restrictions in the scope of cover have created significant challenges. It’s one reason why we have seen a hike in insurance pricing – by as much as 50% or more in some instances and lines – as well as restrictions in cover and even markets withdrawing from certain industry sectors as reinsurer appetites wane.
• Often, insureds don’t keep pace with the impact of volatility and changes in their operating environment which means that their valuations are inaccurate and out of date. Some businesses will erroneously insure for the market value of their premises rather than considering what it will cost to rebuild at today’s prices. It may also be that a business has changed its operating model and as such its exposures have changed, but it is still using previous, outdated valuations that are irrelevant to the changed business circumstances – for example holding more stock on premises to counter supply chain vulnerabilities, or the very nature of the business has changed, as we saw happen during the pandemic. Consider for example office premises that now have retail or manufacturing tenants and what this means for the declared risks on site.

Preventing Underinsurance

Underinsurance is a potential financial pitfall that can be avoided by setting the correct sum insured on all policy sections of your cover, conducting proper valuations and engaging with a professional risk advisor or broker to get the balance right. 

“For your Buildings, Machinery, and Plant we recommend that you undertake regular replacement valuations, considering the impact of new replacement cost, VAT, inflation and exchange rate fluctuations. These valuations should include the actual cost of rebuilding or replacing any of these items at today’s costs including demolition, clearing costs, professional fees and any other improvements to the property insured. An expert broker in the field would be able to arrange a professional reinstatement valuation that will allow you to be better informed of the true replacement value of these items,” Clayton explains.

On average, 43% of business interruption insurance is underinsured by 53%, according to the Chartered Institute of Loss Adjusters (CILA). “One of the reasons for this is that the selected maximum indemnity period turns out to be far shorter than the actual period of disruption caused by accidental property damage. It is worth considering an increase in your maximum indemnity period to reflect the true extent of disruption, including allowing for an increased time for reinstatement,” says Clayton.

“It is also becoming more relevant but more challenging to insure loss of profit or revenue during an interruption that results from a customer or supplier incident, as supply chains become more fragile. It is well worth the effort to engage with a risk advisor who specialises in the field to understand and map out the true extent of supply chain risks your business could potentially face to mitigate and transfer the risks,” he adds.

Don’t let underinsurance scupper your business’ ability to recover from a major event.  The interconnectivity of traditional and emerging risks demands a more holistic approach. “Fact-based will be well worth the effort to engage with an expert broker to comprehensively identify, evaluate, quantify and mitigate risk with a solutions-based management approach that takes a long-term view and collaborates with all role-players throughout your business value chain. Better decisions start when you are better informed of the risks you are faced with, and their interconnectivity with other factors,” Clayton concludes.