In this article our insurance team discusses a common pitfall encountered by property owners looking to their insurance policies for compensation following catastrophic damage: the Average Clause.
This article is the second in a series of articles published by Mishcon de Reya focused on property damage insurance, designed to help those affected by the recent storm season to ensure that their insurance claims are paid in full.
When buying any insurance policy, as the policyholder you are responsible for advising your insurer as to the correct value of the property you wish to insure. Your insurer will use this value, amongst other considerations, to calculate your insurance premium.
If the value of your property has been calculated incorrectly and is higher than the sum insured, your property will be underinsured. This exposes your insurer to a greater level of risk than it would have otherwise expected based on the level of premium it is receiving.
The law of average
To protect themselves against this eventuality, insurers often include an Average Clause in property policies. These are designed to proportionately reduce the amount that insurers are liable to pay dependent on the level of underinsurance.
Insurers argue that the law of average is justified because they have taken on risk that they did not expect. However, it can be devastating for policyholders who have, in good faith, underestimated the amount of cover they need. This is particularly so when their property has suffered catastrophic damage.
A commercial building and its contents are insured for £500,000. Following a series of hurricanes, the entire building is destroyed. The total cost of repairing, building and/or replacing the building and its contents turns out to be £1m. The building and its contents are therefore underinsured by 50%.
The policyholder makes a claim for the amount he believes he is due under the policy, being £500,000. However, relying on an Average Clause, the insurer can refuse to pay no more than £250,000 in compensation.
The policyholder is therefore dealt a double blow; he originally thought he had bought £500,000 of cover, and paid a premium on that basis, but now his cover is effectively worth £250,000. He is both unable to claim back the premium paid and also treated as uninsured for £750,000 of his total loss. This can be enough to put a commercial property owner out of business.
Before submitting a hurricane claim
The simple lesson for policyholders is this:
If your policy contains an Average Clause, make sure you obtain a reliable preliminary estimate of your claim value before you submit it.
If you think your claim may exceed the amount you are insured for, then you should take expert legal advice to assist with the preparation of your claim. Our insurance team would be happy to help you with this.
Avoiding the Average Clause in future
We have set out some steps policyholders can take to reduce the risk of falling foul of the law of average in future:
1. Be wary of valuation tools – many insurers will direct you to online valuation tools to help you value your property. Although these may act as an initial guide, you should always double check the figures carefully and determine whether the tool is suitable for your particular circumstances.
2. Accurate valuation – the sum insured should be based on the cost of rebuilding or replacing your property, and not necessarily the purchase price. Your broker should be able to assist you in establishing what should and shouldn't be included when calculating the correct level of coverage.
3. On renewal, review and update the sum insured – problems can often occur at renewal of your policy, do not assume that your insurer has correctly taken into account an increase in property value. Insurers will often calculate new premiums based on pre-existing valuation information and increase the value insured by a given percentage each year; if the initial value was incorrectly calculated, or external inflationary factors have increased, this method may be inadequate.
4. Expert valuation – depending on the size and complexity of your property, it may be necessary or beneficial to instruct a professional firm to conduct a detailed valuation. This will provide you with the best estimation of the correct level of cover you require and, provided you agree to such a valuation being carried out on a regular basis, your insurer may agree to disapply the 'Average Clause' in your policy.
If you have any concerns you wish to discuss, a member of the Insurance team will be happy to help. For more information, please contact Richard Leedham or Sonia Campbell.