Explaining why commercial insurance policies have penalties for under insurance.

Explaining why commercial insurance policies have penalties for under insurance.

I received this question overnight.

Hi Allan,

I was explaining underinsurance to my husband today on commercial risks and he asked me the question on why do insurance companies apply this, as if he is paying premium on half the risk why should he then get penalised and not paid out the insured amount.

I actually couldn’t tell him why insurance companies do this. Do you know what the insurance companies reasoning is for this?


Regards Kerry [surname and email provided]

Below is my explanation.

Hi Kerry

1. There are a couple of reasons for this.It is too hard to price the cost of risk transfer from the Insured to the insurer when Insured’s elect to only insure partially.

To keep the cost of insurance manageable, I am not sure we are succeeding in this current market, insurers pricing has been based on the full value at risk and then based on its location, occupation, construction etc, Insurers can estimate the maximum probable risk. You will probably see this term used in risk surveys as well.

2. There is also the question that far too many Insured’s under estimate the amount that they will lose in the event of a claim. I have a desk full of claims where the Insured has done this. 2/3rds of the issues I have been contacted on by my colleagues today has been on under insurance issues. In Christchurch, after the earthquake we had a lot of losses that exceeded the sum insured. This is partly due to the removal of co-insurance and partly due to the fire service levy/taxes on insurance.

To better protect Insureds and get the pricing right insurers say that, for value of the property that the Insured is not insuring, then the Insured themselves are the insurer of that component. As you cannot split up which part is insured and which part is self-insured, it is said that the Insured is a co-insurer.

The policy typically gives the Insured 20% tolerance to be under insured and even then the coinsurance clause tests the true value at risk at the start of the policy period (not the date of the loss) [Again I am speaking in general terms as some policies do test on the date of the loss which I am not in favour of].

After a life time in claims I would not like to see the co-insurance clause removed. I think insurance premiums would go up even more and we would see even more cases of people being grossly under insured when it is a major event like a fire, flood, earthquake, or even major storm.

A good case in point was the difference in under insurance following Cyclone Yasi v Cyclone Debbie. The Insured’s learned from the penalties imposed due to under insurance in Yasi and so were much better insured as a generalisation when Debbie hit.

I hope this helps.


I am happy to receive comments from our insurance community on this subject.

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