Understanding Underinsurance

The last thing you want to hear when you claim is that your insurance won’t cover your total loss. Or that your insurer is refusing to pay the full value of your claim. But that can be one of the very real and damaging consequences of underinsurance. Being underinsured can mean your insurer decides to pay only a proportion of the sum you're claiming for and they're perfectly within their rights to do so.

What is underinsurance?

Underinsurance is when a policy's level of cover is less than a claim's potential total value. The difference between the two means the person or business claiming is out of pocket from the start. If you insure your office contents for £15,000 but, after a burglary, the replacement cost is £20,000, you're short £5,000.

Law of averages

Insurers also use the ‘average rule’ to calculate claims. It means if you’re underinsured, they can reduce the amount they pay you by the same proportion you're underinsured. In this case, that’s £15,000 worth of equipment cover minus 25% (£5,000) underinsured, so a total payout of only £11,250 which is £8,750 short of the true replacement cost. Here’s some more examples:

Example One:

A contractor buys machinery for £10,000 (second-hand) so they insure it for the same value however if they need to claim on the insurance they aren’t able to get that specific piece of machinery for £10,000, brand new the machinery would be £15,000 then they are underinsured by 1/3rd. The insurer could then apply the average clause and only pay out 2/3rds of the £10,000 claim minus the policy excess amount. This makes the payout significantly less than the £15,000 required to replace the machine.

Example Two:

If you value and insure your property at £300,000, but the true cost to rebuild it is £600,000 then you would be effectively underinsured by 50%. So if you made a claim for damage for £100,000 your insurer would only pay out half of your claim so £50,000 then minus your policy excess potentially leaving you seriously out of pocket. Many clients assume they need to insure their building for the market value which isn’t the case. It is recommended that you review the cost of rebuild of your property every year to ensure the insured value has kept pace with inflation.

If your insurer believes that you underinsured your property on purpose to reduce the cost of your premium then it can refuse to pay out at all and can cancel your policy altogether.

What causes underinsurance?

Underinsurance can happen when you undervalue the cost of all your kit (by only totting up your costliest items, for example). Or when you miss something off the list – like carpets, furniture, fixtures, fittings, or hired equipment. It can also happen when you value your contents at the price you bought them. Remember, your level of cover should be enough to repair or replace all your equipment today.

It could be better to overestimate how much your stuff's worth than risk losing out. If your cover includes stock, you might want wiggle room for seasonal stock increases. Same goes for any new equipment you buy, including non-tangible items like software programmes.

Once you’ve worked out the cost of everything, you can choose the most appropriate level of cover for your business. And you’ll have the best chance of making sure you’re not left underinsured if you ever have to claim.

How else can I be underinsured?

Underinsurance goes beyond office equipment:

Property: you only insure for a building’s market price, not the re-build cost – which can be much more. With recent rises in the cost of building materials and labour, underinsurance is a big problem here. It’s estimated over 40% of UK commercial properties are underinsured, with an average shortfall of 43%.

Professional indemnity: you haven't enough cover for the most expensive mistake you could make. Or for if a client sues you for the total value of a failed project, not just your part in it. You should also account for legal costs which can run into many £thousands if a claim is complicated or drawn out.

Business interruption: your workplace is out of action, but your cover isn’t enough to compensate you for your lost income and additional expenses in the time it takes you to get back on your feet.

What next?

Underinsurance can leave you seriously out of pocket. So it's important to regularly review your insurance and make sure you have enough cover – and not always just before your annual renewal. We'd advise going through each of your policies and taking a realistic view on whether you have enough to allow for a worst-case scenario. Take your time working it out or keep a spreadsheet which you can update. If you keep any expensive artwork in your office, get it revalued every three to five years.

For residential properties you can use the ABI Rebuild Cost Calculator to work out the cost to rebuild your house. If you’re calculating the rebuild cost of a commercial property you own, it’s best to get a surveyor’s quote or speak to your mortgage lender. Also, The Building Cost Information Service (BCIS) has a handy online calculator you can also use.

A risk not worth taking

Working out how much cover you should have is essential for your business. The consequences of underinsurance can be serious in two ways: leaving you unable to claim for your full loss, and making you susceptible to the average rule, reducing your claim further.

How to avoid being underinsured for:

Buildings

It's estimated two in every five commercial properties in the UK are underinsured. With rising inflation and supply chain disruption affecting both the price and availability of building materials and labour, it’s important you review your level of commercial property insurance every year. When calculating rebuild costs, remember the preparation costs. You'll probably have to pay someone to remove any rubbish or debris, as well as making sure the area is safe to use. If you have a listed building as an office, be aware that any rebuild costs are likely to be high. Work is also likely to take longer, as specific building supplies and equipment can be more difficult to source. If in doubt, commission a survey first.

Equipment:

Add everything up. From carpets to coat racks to cups; from mouses to monitors to mobiles. If you needed to replace everything your business owns, you need to make sure your level of cover is enough to do just that. To avoid underinsuring your general office equipment, it's good practice to review your level of cover every year. Especially if you’ve updated your fixtures and fittings recently, or bought a new piece of kit or software. Don’t forget to account for seasonal stock increases and any hired equipment.

Ideally, keep an inventory of what's what and put someone in charge of updating it. If a Director takes this on, they should be aware that they're liable for the shortfall if failure to keep track of assets means the company is underinsured when there's a claim.

Business interruption

If there's some kind of business crippling disaster, business interruption insurance keeps you up and running while your property insurance sorts out a more permanent solution. Your level of insurance must be enough to cover both your income losses and added expenses for the entire time you’re out of action.

When working out how much cover you need, be realistic about how much income you could stand to lose. If you’ve lost specialist machinery, equipment or essential software, or have to temporarily set up elsewhere, it might take you longer to rebuild your business.

What if you lose clients to your competitors? Or have extra costs you have to cover? Bear in mind, too, that if your equipment is particularly niche, it may take a while to find replacements, especially if it has to be sourced from abroad.

Professional indemnity insurance

With professional indemnity insurance, the most important things to consider are the likelihood of a claim, and the potential cost of that claim. You should think about what you do, what clients you work with, and how much your contracts are worth. Bear in mind that if the total cost of a claim exceeds your level of cover, your insurer won't pick up the shortfall.

That's especially important if your policy is “in the aggregate”. It means your policy only gives you a certain amount of money (the level of cover) to pay all claims in one year . If you reach this level of cover in just one claim, there's nothing left to pay anything else. As every business is unique, it’s hard to be prescriptive. Blog on “What level of Pi cover do I need” can help you decide how much professional indemnity insurance you need to not be underinsured.

Making sure you're not underinsured

There's a lot to consider when it comes to making sure your business is well covered.

Obviously, it pays to keep your insurer in the loop when something changes, like if your turnover goes up. They'll know best whether or not you need to increase your level of cover. It's also good practice to use your insurance renewal as an opportunity to check your levels of cover.

Don't forget, you have obligations under the terms of your policy. Insurers may be inclined to treat you less leniently if you've gone past your renewal without making any necessary adjustments.

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