Under Insurance in Fire - With Example

Sum Insured Is The Maximum Amount Insurance Company Will Pay Out For A Covered Event Or Claim Under A Policy. But Policyholders Might Get Dismayed When They Find Out They're Underinsured. !.

Under-Insurance refers to a situation where the sum insured (the amount covered by an insurance policy) is less than the actual value of the insured property or asset at the time of loss. This results in the policyholder receiving a reduced claim payout due to the application of the Average clause in insurance policies. Under-insurance is a common issue in both fire insurance and motor insurance, leading to significant financial consequences for the policyholder. 

Under-insurance in the context of fire with example to illustrate its impact.

Under-Insurance in Fire Insurance:

Definition*: In fire insurance, under-insurance occurs when the sum insured for a property (e.g., building, machinery, stock, or contents) is lower than its actual replacement value or market value at the time of loss. Fire insurance policies typically cover losses caused by fire, lightning, explosion, and other perils specified in the policy.

How Under-Insurance Works:

- Fire insurance policies often include an Average Clause, which stipulates that if the property is under-insured, the claim payout will be reduced in proportion to the degree of under-insurance.

- The formula for calculating the claim payout under the average clause is:

  

Claim Payout = (Sum Insured/Actual Value of Property) *Loss Amount

- This means the policyholder bears a portion of the loss proportional to the under-insured amount.

Consequences of Under-Insurance:

• The policyholder receives less compensation than the actual loss, leading to out-of-pocket expenses.
• It undermines the purpose of insurance, leaving the policyholder financially vulnerable.
• It may lead to disputes with the insurer during claim settlement.

Example:

- Scenario: A factory owner insures their machinery worth $100,000 for a sum insured of $ 60,000 under a fire insurance policy. A fire causes damage worth $ 50,000 to the machinery.

- Calculation:

Degree of under-insurance = Sum Insured/Actual Value 

                                           = 60,000/100,000 = 60%

Claim payout                     = 60% 50,000       = 30,000

- Outcome: The policyholder receives only $30,000 instead of the full $ 50,000 loss, forcing them to cover the remaining $ 20,000 from their own funds.

Causes of Under-Insurance in Fire Insurance:

• Underestimating the replacement cost of assets due to inflation or market changes.
• Deliberately choosing a lower sum insured to reduce premium costs.
• Failure to update the sum insured periodically to reflect current values.
• Misunderstanding policy terms or lack of professional valuation.

Prevention:

• Conduct regular valuations of property and assets to ensure the sum insured reflects current replacement costs.
• Account for inflation and depreciation when setting the sum insured.
• Consult with insurance advisors or surveyors to determine accurate values.
• Review and update the policy annually or when significant changes occur (e.g., renovations or additions to property).

Hence, its better to pay Peanut today to save the mounds for tomorrow.