10 Top tips to Avoid the Pitfall of Underinsurance

1. Insure buildings for rebuild/reinstatement value, not market value

Policyholders often think that the market value of their building will be an accurate indication of what it would cost to rebuild, in the event that the building was totally destroyed.

  • Costs of rebuilding are often considerably higher than the market value of the property and severe underinsurance issues can arise when the incorrect figure is used.
  • When a policyholder has a valuation of a building carried out, it is essential that the type of valuation is determined and that the correct – rebuild/reinstatement – value is used to set the sum insured.

A number of insurers are now offering policy wordings that exclude the underinsurance average clause for buildings, where a valuation is carried out by one of the insurers approved valuers and is then updated every three years.

2. Take all areas into account, not just the main building and include professional fees including demolition

The assumption is made by policyholders that the building consists only of the main structure, however:

  • For sum insured purposes the value needs to include not only the main structure of the building but also the external car parking and other hard standing areas, roads, fencing, walls and anything else on the site as a whole.
  • The value will also need to include the cost of demolishing the entire structure, including removing the floor slab and foundations, as well as all the professional fees associated with rebuilding such as architects, surveyors, planning experts and so forth.

Professional fees can add up to 15% of the figure excluding these professional fees.

3. Insure plant and machinery for what it would cost you to replace it now with new equipment

  • Most plant and machinery policies are written on a “new for old” basis, meaning that the sum insured needs to be on the basis of what it would cost to replace all of the plant and machinery with brand new equipment, even in circumstances where the equipment that was damaged or destroyed in an incident was initially bought second hand.
  • The sum insured is often based on the original cost of the plant and machinery when it was first purchased. That may have been many years previously and the costs for a new piece of equipment may be very much higher.
  • In some cases is the situation where the sum insured is based on the written down value of the piece of equipment after depreciation has been deducted from the original cost – perhaps over many years. This can lead to a situation where some pieces of equipment are valued at nil in terms of the written down value and if that figure is then used as the basis for the sum insured it is easy to see how major problems may arise. 

If a policyholder has no intention to replace certain items of equipment with brand new replacements then the basis for the insurance cover – at least for those items of plant and machinery – should be on indemnity which would mean that the second hand value would be the sum insured. This would allow the policyholder to purchase a second hand replacement and to have the insurance cover in place to meet that cost.

4. Don’t overlook the cumulative cost of small items

With a bit of luck, all of the major pieces of plant and machinery will be included within the cover, what is often forgotten are all of the small pieces of equipment such as hand tools or racking.

  • Whilst smaller items may have fairly low individual values, they will add up to a significant sum in the event that they are totally destroyed. They all need to be included in the overall sum insured, as they form part of the value at risk.
  • These smaller items often never find their way into the fixed asset schedule, as when they are acquired they are not treated as fixed assets but are expensed within the profit and loss account. However, for insurance purposes, they need to be included in the sum insured because they form part of the plant and machinery.

5. Remember to highlight new purchases

  • A “capital additions” clause is included in most policies which will allow the sum insured to be increased to take account of equipment that may have been acquired since the previous policy renewal.
  • Usually there is an upper limit on capital additions – typically 10% of the overall sum insured. However, if since the last renewal, a major piece of equipment has been acquired and the insurer has not been notified a 10% capital additions clause may be hopelessly inadequate.

It is essential that you let your Broker know of any major pieces of equipment or new depots or locations that are taken on, or acquired after the date of renewal, so that they can be added to the policy .

6. Use the insurance definition of Gross Profit

A leading cause of problems in Business Interruption policies is the definition of Gross Profit.   

  • It is crucial that the policyholder is aware of what the Gross Profit definition for insurance purposes means. Some insurers, notably Aviva, have started to abandon the use of the term “Gross Profit” and now use “Insured Profit”.
  • The accounting definition of Gross Profit is different, completely different, to the insurance definition of Gross Profit.

(The accounting definition will show Gross Profit after the deduction of purchases and typically, production wages. Other costs are also frequently deducted such as repairs, depreciation and so forth.)

  • The insurance policy definition of Gross Profit is sales, less purchases adjusted for opening and closing stock. Occasionally carriage, packaging and freight are also deducted but not always.

A business which has a high production wage cost and which has based the Gross Profit sum insured for insurance purposes on the Gross Profit figure that appears in the accounts is going to have a very unpleasant surprise in the event that there is a significant Business Interruption claim. Underinsurance averaging will seriously reduce the amount that will be paid by insurers.

7. Consider a Declaration Linked Basis

It is essential that the sum insured takes into account the trend of the business.

    • Is the business growing?
    • Have new branches been opened?
    • Has a competitor recently closed down?
  • Right at the end of the policy year a loss may occur, so the forecast for how the business is likely to perform actually needs to stretch out well beyond the policy period and through to the end of the year after the policy period (assuming a 12 month maximum indemnity period).
  • A Declaration Linked Basis requires an estimate of the likely Gross Profit to be given at the renewal and this is then confirmed subsequently once the actual figures are known.
  •  If an estimate is too high then there is a pro rata return of premium and if the estimate is too low an additional premium is payable.
  • There is no underinsurance clause within the policy wording and thus underinsurance averaging cannot be applied.
  • There is an automatic uplift of up to 33.33% that can be added to the sum insured in the event that the estimated figure was too low.

This is not a way of deliberately underinsuring by under estimating the sum insured. Insurers, in the event that the estimated figure is significantly different to what the actual insurable amount should have been, are likely to claim that there has been a Material Misrepresentation. A material misrepresentation would entitle insurers to repudiate not just the Business Interruption element of a claim, but the entire claim including all of the material damage claim as well.

8. Factor-in your purchasing commitments

With the businesses increasingly importing products, in particular from China, consideration needs to be given as to whether it would be more appropriate to insure turnover rather than Gross Profit.

  • Importing from China (and many other countries particularly in the Far East) involves a commitment that cannot be turned off.
  • If there is a catastrophic loss at a production facility, such that no products can be produced until the facility is reinstated, it will not be possible to tell the suppliers factory to suspend the supply as the production facility is not operating. The suppliers will supply what has been ordered and will expect to be paid for those goods. Indeed, it is likely that they will have already been paid under a trade finance agreement.
  • In the above circumstance, it would not be appropriate to assume that purchases will vary in direct proportion to sales and that a significant loss of sales would result in a reduction in purchases. It would be much more sensible in this situation to insure the whole turnover.

Example: A similar situation arose for a potato crisp manufacturer, who suffered a catastrophic fire at one of their factories. That company forward purchases potatoes by agreeing with individual farmers that they will take the entire crop of potatoes that the farmer is able to produce. It was not possible for the crisp manufacturer to subsequently go back to the farmer and say that they did not need the potatoes now as the factory had burned down. The farmer had a contract to supply the potatoes and, accordingly, the crisp manufacturer was obliged to take delivery of the potatoes and pay for them. Fortunately, they were able to dispose of the potatoes in the market although, as a forced seller, they incurred a significant loss. They were insured for loss of Gross Profit and were thus unable to recover the loss incurred in disposing of the potatoes that they could no longer use.

9. Allow sufficient time for recovery

  • When a building that is totally destroyed it is a common misconception that it can be rebuilt exactly as it was previously without the need to apply for planning consent. When a significant part of any building has to be rebuilt planning consent is always required.
  • Even when the Planning Officers are supportive, the normal planning period is approximately four months.
  • One-third of the available cover is likely to be used up simply going through the planning procedure with a 12 month maximum indemnity period.
  • On any significant loss insurers will appoint Forensic Scientists and probably Forensic Accountants as well to investigate the cause of the loss and to look into the financial health of the policyholder. They will also want to ensure that all of the warranties and conditions have been complied with and that no previous statements made by the insured when the policy was put in place were inaccurate. This process can take several weeks and until liability has been accepted by insurers there will be no financial assistance from the insurers by way of interim payments and so forth.
  • There will be no funds from insurers to pay deposits, so orders for replacement machinery cannot be placed.
  • Sophisticated machinery is generally not available “off the shelf” and has to be ordered and manufactured. This is a process that can take many months.
  • Stock often has a lengthy lead time – particularly if it is coming from China or elsewhere in the Far East.
  • Seasonal stock it is generally not possible to order “out of season”. The knock on effect of being unable to supply for one season will usually carry on to the following season and quite possibly the season after that as well. Accordingly it is highly likely that cover of just 12 months will be utterly inadequate to provide a full indemnity for losses.
  • Manufacturers who supply multiple grocers will find that if they are unable to supply for any reason their products are likely to be de-listed by the retailer. To re-gain those listings may take several years. A maximum indemnity period of just 12 months will be insufficient to provide cover, whilst efforts are made to relist the products.

10. Extend cover to include suppliers premises

  • It is not just an incident at a policyholders own premises that can cause a problem. If a key supplier suffers a serious incident, such that they are unable to supply what has been ordered the knock-on impact for the policyholder may be just as serious.
  • Without the benefit of a suppliers’ extension the losses suffered by a policyholder are totally uninsured. 
  • Some suppliers will not be classed as critical as the product that they supply will be readily available from other suppliers. However there will be some products that are totally dependent on that particular supplier and that will take a very long time to source from a different supplier.

What to do next?

If you would like to talk to an expert for more information about minimising the risk of underinsurance on your insurance programme, or to discuss any other risk and insurance need, please give us a call:

Call 01789 761660

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