What is underinsurance?
Underinsurance occurs when a person or business insurance cover is insufficient to cover the full value of potential losses or liabilities. It is also known as average. This inadequacy can result from underestimating the value of insured assets, opting for lower cover limits to reduce premiums, or not fully understanding the scope of necessary coverage.
Average is not a punitive clause, but it is a fair way to ensure that all parties are covered for the premium that is paid. If you only pay a percentage of the premium, it is only fair that you are compensated for the same percentage to ensure the insurance pool is sufficient for all contributors.
Causes of underinsurance
- Misjudgment of value: Many people underestimate the value of their assets, leading to insufficient coverage. This is mostly because you need to consider the new replacement value of the items and not what you paid for it even if it is second hand. Similar to building insurance you might not consider the true replacement cost of their home, including materials and labor and any professional fees when setting the sum insured.
- Cost-cutting: To save money, individuals and businesses might choose lower sum insureds and higher deductibles, reducing premiums but increasing the risk of underinsurance.
- Lack of awareness: Some policyholders may not fully understand their insurance policies, leading to gaps in cover. This can include misunderstanding terms, exclusions, and conditions of the policy. Specifically, what additional percentages need to be added for extensions to ensure the sum insured is sufficient.
- Inflation and economic changes: Over time, inflation and economic changes can increase the cost of replacing or repairing insured assets. Without regular policy reviews and adjustments, cover can become inadequate.
Consequences of underinsurance
The consequences of underinsurance can be severe and far-reaching, affecting both individuals and businesses in various ways:
- Financial hardship: When a loss occurs, underinsured individuals or businesses must cover the gap between their insurance payout and the actual cost of the loss, leading to significant financial strain or even bankruptcy in severe cases.
- Delayed recovery: Insufficient insurance cover can delay recovery and rebuilding efforts. For example, a homeowner with underinsured property might struggle to afford repairs or rebuilding, prolonging the period of disruption and discomfort.
- Average being applied: The average clause is a standard policy condition that applies when the sum insured is less than the actual value of the insured property. It ensures that the insurer only pays a proportion of the claim, reflecting the ratio of the sum insured to the actual value of the property.
How the average clause works
Consider a property valued at R1,000,000 that is insured for only R500,000. If a loss of R200,000 occurs, the insurer will apply the average clause to determine the payout. Thus, the insured is only 50% covered and the payout will only be 50% of the loss.
The insurer will use the following formula to calculate the amount that will be paid out:
In this example, the policyholder would receive only R100,000, significantly less than the actual loss of R200,000, due to underinsurance.
Addressing underinsurance
To mitigate the risks and consequences of underinsurance, individuals and businesses can take several proactive steps:
- Regular policy reviews: Periodically reviewing and updating insurance policies ensures that coverage keeps pace with changes in asset values, inflation, and other relevant factors.
- Accurate valuations: Obtaining professional valuations of assets provides a more accurate basis for setting coverage limits, particularly for high-value items and properties.
- Understanding policies: Policyholders should take the time to thoroughly understand their insurance policies, including terms, conditions, exclusions, and coverage limits. Consulting with insurance professionals can help clarify any uncertainties.
Underinsurance is a significant issue that can have devastating financial and legal consequences. The average clause further complicates the situation by reducing claim payouts in cases of underinsurance. By understanding the causes and consequences of underinsurance and taking proactive steps to address potential coverage gaps, individuals and businesses can better protect themselves against unforeseen risks and ensure a more secure future. Regular policy reviews, accurate valuations, and a clear understanding of insurance terms are essential components of an effective risk management strategy.