REG-28

Building Assets – Under Insurance Risk and the ‘Co-Insurance’ Clause

AUST  Hendry advises that generally buildings are covered by a ‘replacement with new’ insurance policy, which is the very best basis of settlement as it protects you with ‘new for old’ coverage. To maximise the benefit of this coverage, it does mean you need to ensure that the declared building value or sum insured is adequate to fully replace the asset(s) in accordance with the current building codes and with today’s ever increasing building costs.

Are you familiar with the co-insurance clause? (The penalty for being under insured) A lot of people think if they insure for $4,000,000 for example, they have no risk of having to contribute towards a loss until such time as the loss exceeds that $4,000,000. This is simply not correct.

Here’s a simple example
Steven owns a six level office building and has insured it for $4,000,000. The property is damaged by fire with a damage bill of $3,000,000. The insurers determine that the actual replacement value of the building is $8,000,000. Steven is therefore under insured by 50%. Although Steven may think that the $4,000,000 cover he has is sufficient to cover the damage bill of $3,000,000 the application of the ‘co-insurance’ clause means that Steven is in fact an insurer himself for part of the risk. In other words he shares in the risk associated with under- insuring his building.

Let’s examine how an insurer would assess payments for such a claim. Insurers typically allow some tolerance for being under insured. This is often set as 20% – hence the calculation is based on 80% of the true value of the building at the start date of the policy.

So the basis for the calculation is:

Adjusted Loss = 
Sum insured of declared value   x   The amount of the loss 
80% of the value of risk (replacement value)

The calculation for Steven’s loss is:

Sum insured (declared value) =
$4,000,000  x   $3,000,000 (the amount of the loss)
$6,4000,000 (80% of the value risk (replacement value $8,000,000))
= $1,875,000

The insurer pays $1,875,000 less any policy deductible/excess
Steven wears $1,125,000 plus any policy deductible/excess

It is clear that although there was a buffer of $1,000,000 between the damage bill and the declared value. The insured is still out of pocket due to the application of the ‘co-insurance’ clause because they failed to insure the building for its true replacement value. It may appear to be cheaper to under-insure to save a little in the annual insurance premium; however it is simply not worth it in the event of a claim.

We strongly recommend that a building insurance valuation is carried out every three years to reduce the substantial financial risk associated with under insurance by a qualified valuer with experience in building reinstatement valuations.

Ensure Group Property Valuers contributed extensively in the preparation of this article. Ensure Group specialise in building valuations for insurance replacement purposes. Get in touch via their website www.ensuregroup.com.au or email valuations@ensuregroup.com.au

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