Blog Question on Under-insurance when it is a total loss

bigstock-Questions-And-Answers-8042036I was asked from Jason:

“Hi Allan

I just wanted to ask you a simple question, as you’re the expert in these matters.

From time to time I hear comments from insurance brokers who seem to think average (business insurance) applies to a full loss situation.  Every time I have this discussion, I begin to question myself despite literature I have read/read that supports my belief – that average doesn’t apply in this situation.

So could you please put the matter straight, does average apply in the matter of a full loss?  (from everything I’ve read, if the client is under-insured then the reality of that will become evident upon a full loss).

If correct, do you have any literature on this topic (apart from what I can ordinarily find myself)?


Jason” [surname and email provided]

This is an important question as under insurance is a major problem, often with life changing effects on business owners in far too many claims.

I replied the following:

“Hi Jason,

Thanks for your note. It is certainly a question that confuses many in the industry. The answer depends on what is meant by a total loss.

Strictly speaking the test for coinsurance applies to all property claims under a most commercial insurance policies where the loss exceeds 10% of the declared value/sum insured.

The way the policies are written, the test for co-insurance applies first, and then the second test is the limit of liability / sum insured.

Mathematically if the value at risk equals the loss, that is, everything is destroyed including the foundations of a building for example then the insured will end up with the sum insured/ limit of liability.

Let me show you by way of example:

Example 1 – Everything is destroyed and Value at Risk = Loss Amount and Policy has a Sum Insured or if Declared Value on ISR = Limit of Liability
Sum Insured/Declared Value = $1,000,000 (Note in case of an ISR Policy assume Limit of Liability is also $1,000,000)
 Value at Risk = $2,000,000
Loss Amount = $2,000,000
 Co-Insurance 80%
 Test 1 – Test for Under Insurance = Sum Insured or  Declared Value / Value at Risk x Loss Amount
 =  $1,000,000 /80% of $2,000,000  x  2,000,000
 = $1,000,000 /1,600,000 x $2,000,000
= 62.50% x $2,000,000
 =  $1,250,000
 But claim payment limit to
Sum Insured / Declared Value = $1,000,000
 (less any policy deductibles)

If in the same situation the limit of liability was greater than the declared value, then the insured could receive a payout higher than the amount they have declared.

Example 2 – Declared Value is greater than the Value at Risk where total asset insured is destroyed 
Declared Value = $1,000,000
Limit of Liability = $1,500,000
Value at Risk = $2,000,000
Loss Amount = $2,000,000
Co-Insurance % 80%
Test 1 – Test for Under Insurance = Sum Insured or Declared Value / 80$ of Value at Risk x Loss Amount
= $1,000,000 / 80% of $2,000,000 x $2,000,000
= $1,000,000 / $1,600,000 x $2,000,000
= 62.50% x $2,000,000
= $1,250,000.00
As claim after average is less than
the Limit of Liability client entitled
to $1,250,000.00
Plus any removal of debris, extra
cost of reinstatement and other
benefits not subject to test for
co-insurance (subject to any sub-
limits) less any policy deductible.

Where it gets more complicated is where the loss exceeds the declared value of sum insured, but not everything has been destroyed. That is, the loss does not equal the value at risk. In such a case, mathematically the insured could be paid less than the sum insured even though the sum insured has been exhausted.

Again let me show you by way of example

Example 3 – Loss Greater than Sum Insured/Declared Value but not everything destroyed, say foundations and slab undamaged.
Declared Value = $1,000,000
Limit of Liability = $1,000,000
Value at Risk = $2,000,000
Loss Amount = $1,500,000
Co-Insurance % 80%
Test 1 – Test for Under Insurance = Sum Insured 0r Declared Value / 80 % of Value at Risk x Loss Amount
= $1,000,000 / 80% of $2,000,000 x $1,500,000
= $1,000,000 / $1,600.000 x $1,500,000
= 62.50% x $1,500,000
= $937,500
Claim is limited to the net amount $937,500
after average assuming no
additional cover for removal
of debris, extra
cost of reinstatement etc
less any policy deductible.

If you have any further questions please don’t hesitate to let me know.

One final point is that a great tool that is free from LMI Group is the Under Insurance under insurance appCalculator. It is available through the iTunes App Store for iPhones and iPads (search on LMI Mobile) or through LMI RiskCoach under calculators on your PC.



2 responses to “Blog Question on Under-insurance when it is a total loss”

  1. Peter Finn says:

    Although Alan’s examples are excellent, as usual, they beg the question as to ” what happens to any BI component of the claim – particularly when the MD claim proceeds are inadequate to finance the reinstatement of the Business in its previous form – or at all?”
    Although this did not form part of Jason’s question, nevertheless I think it would be helpful if Alan included this aspect of the claim situation.

  2. Allan says:

    Peter is 100% correct. Business interruption insurance is vital for the business, any business to keep paying the bills when the business suffers a disruption. There is no use replacing the asset even with full insurance if your staff and customers have left and you have no income in the meantime.
    Insurance is not about cost as so many ads on television and radio would have us believe. It is about protection. Protecting your assets and income stream. That is why having full insurance on both the property and business interruption is so important but in my experience as a claims person is there so rarely when it comes to the crunch.
    If you are in any doubt about the adequacy of your insurance, I recommend you speak with your insurance broker.

Leave a Reply

Your email address will not be published. Required fields are marked *