Under-Insurance and the Average Clause: How Claims Get Cut

What the average clause is

Property insurance is priced on the sum insured. The premium you pay for a warehouse is the rate multiplied by the value you declared. If you declare a value lower than the real one, you have paid for a smaller risk than the insurer is actually carrying — and the average clause is the insurer’s remedy.

The clause, sometimes called the pro-rata condition of average or simply “average”, says that if at the time of loss the sum insured is less than the value of the property, the insured is treated as their own insurer for the difference and bears a proportionate share of every loss. It applies to partial losses, which is why it matters so much. Nobody expects a full payout on a total loss when they insured half the value. Most people do expect a full payout on a small fire, and that is where the surprise comes.

The formula is straightforward:

Claim paid = Loss × (Sum insured ÷ Value at risk)

Note the words “value at risk”. The comparison is against the actual value of the property on the day of the loss, on the basis the policy uses (reinstatement or market), not against the figure in last year’s balance sheet and not against what you paid for it.

A worked example

Say a manufacturing plant has a genuine reinstatement value of ₹10 crore for buildings and machinery. When the policy was first taken out the figure was right. Five years on, after two capacity expansions and steady inflation in construction and equipment costs, the sum insured still reads ₹6 crore because nobody updated it.

A fire in one bay causes ₹2 crore of damage. The plant is very much repairable and the insured expects a claim of ₹2 crore less the deductible.

The insurer’s surveyor establishes the value at risk at ₹10 crore. The average clause applies:

• Sum insured ÷ value at risk = 6 ÷ 10 = 60%
• Claim before deductible = ₹2 crore × 60% = ₹1.2 crore
• Less the policy deductible, say ₹5 lakh, the cheque is ₹1.15 crore

The insured absorbs ₹85 lakh on a ₹2 crore loss, having believed the plant was fully insured. The premium saved over five years by leaving the sum at ₹6 crore rather than ₹10 crore would have been a small fraction of that.

Some wordings include a tolerance: if the shortfall is within a stated margin, average is not applied. Check whether your policy has one and what the margin is. It is a cushion against small errors, not a licence to under-declare.

Why sums insured drift

Under-insurance is almost never deliberate. It happens because the sum insured is set once and then left, while the world moves.

Inflation. Construction costs, steel, copper, imported components and labour all rise. A sum insured that was correct five years ago is wrong today even if nothing on site changed.

Capex. New lines, extensions, upgrades and automation add value to a site continuously. Finance capitalises them; nobody tells the insurance manager, or tells them after the policy has renewed.

Currency. Imported machinery is replaced at today’s exchange rate, not the one that applied when it was bought. A weakening local currency raises the reinstatement value of every imported asset on the register without a single physical change.

Copy-forward renewals. The renewal schedule is generated from last year’s schedule. The path of least resistance is to sign it. Ten renewals later the figures bear no relation to the site.

Reinstatement value versus market value

The basis of the sum insured decides what “value at risk” means when average is calculated, so it is worth being clear about the two common ones.

Market value (sometimes called indemnity basis) is the value of the asset as it stands, allowing for age, wear and depreciation. A ten-year-old machine is worth what a ten-year-old machine would fetch. If it is destroyed, the insurer pays that amount — not the cost of a new one.

Reinstatement value is the cost of replacing the asset with a new one of similar type and capacity, including dismantling, transport, installation and commissioning. It is what you actually need to get the plant running again.

Most operating businesses want reinstatement cover, because a pile of depreciated cash does not rebuild a factory. But reinstatement cover only works if the sum insured is set at reinstatement value. Insure on reinstatement basis with a market-value sum and you have built under-insurance into the policy from day one: the value at risk is the new-for-old cost, the sum insured is the depreciated figure, and average applies to every claim. The valuation methods are covered in how to value assets for sum insured.

Detecting under-insurance across a register

For a single site, under-insurance is found by comparing the sum insured to a fresh valuation. Across forty sites and several thousand asset lines, you need a method. The insurance register is the place to run it, and a structured gap analysis is the exercise. Signals to look for:

• Sums insured unchanged for three or more renewals while the fixed asset register has grown.
• Gross block in the fixed asset register higher than the sum insured for the same location, before any adjustment for reinstatement uplift.
• Capex approved or capitalised at a location in the last year with no matching endorsement.
• Sums insured in local currency on assets that would be replaced with imports.
• Locations where the basis of cover is recorded as “market” or is blank.
• A single round-number sum insured covering a location with hundreds of asset lines — a sign it was estimated, not built up.
• Ratios of sum insured to floor area or installed capacity that are far below comparable sites in the group.

None of these proves under-insurance on its own; each tells you where to send a valuer first. A platform that links the asset register to the policy schedule, such as SAIBA Corporate, can flag most of them automatically.

What to do at renewal

Renewal is the one time each year when the sum insured can be reset without an endorsement, so use it. A sensible sequence:

Pull the capex list. Ask finance for every capitalised addition and disposal since the last renewal, by location. Reconcile it to the asset register before the renewal schedule is drafted.

Apply an uplift. For locations without a fresh valuation, apply a documented uplift for construction and equipment cost inflation and, for imported assets, for currency movement. Record the assumption so next year’s reviewer can see it.

Revalue on a cycle. Have a professional valuation of the largest locations on a rolling basis, so every material site is revalued every few years and the smaller ones are indexed in between.

Confirm the basis. Make sure every location is on the same basis and that the basis on the schedule matches the one the sums were built on.

Consider an escalation clause. Many property wordings offer automatic escalation of the sum insured through the year for a small additional premium. It does not fix a sum that is already wrong, but it stops a correct one drifting between renewals.

Write it down. Keep the valuation, the uplift assumptions and the reconciliation in the register. If a surveyor challenges the value, the basis of your figure is the first thing they will ask for. The wider process is in managing corporate insurance renewals.