People take insurance to cover their loss but their dream shatters when they receive much less in claims than their expectations, Dr Som Majumdar explains
‘It’s a tragedy to lose one’s home in a devastating fire, explosion or a favourite motor vehicle in an accident, and is only made worse if the dream home or car cannot be replaced in the same previous condition because the insurance cover is inadequate’.
People take insurance to cover their loss but their dream shatters when they receive much less in claims than their expectations. Consumers can become underinsured over time as the sum insured under the policy, even where it is increased annually, does not keep pace with rebuilding or replacement costs. Recent research insurance market found that the increase in consumer price index (CPI) per annum does not move faster rate than that in building repair cost.
Reliance on the CPI to determine the amount of the annual increase may therefore cause a significant gap in a relatively short period of time.
What is underinsurance?
More significant is underinsurance than non-insurance. This occurs when the sum insured is below the rebuilding/replacement cost of the property. A report by the Australian Securities & Investments Commission (ASIC) conducted in 2005 in the wake of the 2003 Canberra bushfires estimated that between 27% and 81% of households were underinsured by 10% or more against rebuilding costs.
Underinsurance occurs because:
In most of the case, the onus of fixing the correct sum insured is on the home owner who may not have adequate technical knowledge and therefore takes recourse to on-line estimators provided by the insurance company that are often not reliable.
Policyholders often do not increase the sum insured on their policy intermittently and sometimes neglect to capture increases in building costs and home improvement or renovations including GST (goods and services tax) provision of extra 10%.
The general attitude to reduce cost of premium believing that total loss is remote also induces the policyholder to take a lower value of sum insured causing underinsurance.
Post-event demand surge can also result in significant increases in rebuilding costs, meaning that an appropriate sum insured to replace a property on a standalone basis may not be sufficient at a time when many homes in a given area are being rebuilt. A report of ASIC suggested that building costs increased by 75% after Cyclone Tracy in Darwin in 1974.
Consumers often neglect to pay heed to supplementary cost in form of council regulation, new building code, cost of increased landscaping, architect’s fees, cost of alternate accommodation, etc.
Effects of underinsurance
Effect of underinsuring the property in the event of a claim is characterised by ‘Condition of Average’ (in the US) or ‘Pro-rata condition of average or co-insurance’ (in Commonwealth countries). This means that if at the time of loss, the sum insured is less than the full value of the property; the insured himself shall be his own insurer for the difference and bear a rateable proportion for each and every loss. However, Insurance Contracts Act Sec 44(2) reduces the difference for domestic insurance whereby the insurer cannot apply the average clause if it is less than 80% of full value. To make the application of this clause lot clearer, the following example may be worth noting:
Assuming the value of a home is Rs. 5 lakh which was insured for Rs. 3 lakh and the storm damage was Rs. 80,000. The first thing is to check if average clause applies. 80% of Rs. 5 lakh = Rs. 4 lakh. As this is more than the sum insured (Rs. 3 lakh), the average clause applies and the rateable proportion shall be borne by the insured. In this case underinsurance is 75% of the full value i.e. (Rs. 3 lakh / Rs. 4 lakh x 100). So the insurer will pay 75% of the loss of Rs. 80,000 i.e., Rs. 60,000 and the proportion to be borne by insured is Rs. 20,000. If there is any excess or deductible applied on the policy, the original claim of Rs. 60,000 shall be further reduced by that excess or deductible. This is clearly defined in the provisions of Insurance Act and in the policy.
Usually the settlement option is clearly stated in the policy that says ‘the company (insurer) will pay to the insured the value of the property at the time of happening of its destruction or the amount of such damage or at its option, reinstate or replace such property or any part thereof’. Indemnity (an exact financial compensation for loss) is to return the insured to their pre-loss position as if the loss had not occurred, no better or worse off. Therefore, by under insuring the property I a bid to save premium, the insured could not be better off in any way because the settlement options will be the privilege of the insurer in any of the four ways as they deem fit, such as (a) Repair, (b) Replace, (c) Reinstate, or (d) Cash payment.
The contents of home may be insured either separately or frequently with the dwelling home as ‘home & contents insurance’. Regardless of type of policy, separate or joint, the insurance claim on either part cannot be transferred to the other, for example, underinsurance of the contents cannot be offset by the claim made on the building insurance. By default, under contents insurance, ‘the-new-for-old’ dictum applies and that increases the likelihood of underinsurance. A TV or a video may have a low resale value but contains a high ‘new-for-old’ value because in the event of a claim there will be a replacement by a new TV of same type. In such a scenario, if the insurance is not properly effected for the TV, the admissible claim on that item may be heavily prejudiced. This is because when the underinsurance takes place, the insurers do not get the compensatory premium in terms of actuarial value of cost of claim thereby the insured appears to get profit out of insurance by paying a premium lower than necessary and this vitiates the very principle of indemnity.
Motor vehicle insurance
The vehicle insurance is acted upon the information provided in the proposal form. It is the duty of the insured to define what should be the actual price he or she would be required to spend to replace the car in the same condition as it was just prior to the loss.
By default, the insurer will determine the price of the vehicle at every renewal considering the wear and tear towards the usage of the vehicle. However, if the insured wants to be specific about the cost of replacement he or she could be in his or her own right to declare the value of desired sum insured which is known as ‘agreed value’ policy and the premium would be worked out accordingly. But, the insured is to determine what should be the reasonably correct estimate otherwise he may pay high premium at a gross over insurance of his car whereas at the time of loss, the insurer will determine the cost of replacement of similar model at pre-loss position to decide the quantum of loss which may be much less than the vale he or she has insured for.
The other alternative is to insure the car at ‘market value’. If the car is destroyed beyond repair, the market value of the car will be the settlement value regardless of the cost of replacement. In such a case, the reliance is made on the insurer to determine what would be the market value. If however, the insured declares his or her own value which may be very high, the insurer will not pay that value as the claim even though the insured pays the premium at a higher amount.
This is because the principles of indemnity would apply that prohibit the insured to get financially better placed than that of the case just prior to the loss. In conclusion, it is the duty of the insured to assess every year what would be the replacement cost of the vehicle of that particular model considering the length of usage of the car.
After a consumer has taken out the home building cover, it is necessary to periodically update the value of sum insured by keeping cognisance to any improvements to the property together with the future increase in cost of material and labour following the CPI Index. This would help to give effect to future cost due to changes in local council regulation, building code or any possible increase in supplementary cost, etc to avoid becoming underinsured over time.
A 2000 survey of 1,000 randomly selected homeowners conducted by Australian insurance industry discovered that typically 87% of homes were insured for less than their replacement value and the average level of underinsurance was around 35%. Likewise, the life insurance is also another aspect where the underinsurance is a common phenomenon. In its latest publication in Sigma, Swiss Re reveals by quoting instance of American people’s tendency to take a life cover that ‘American lives are either uninsured or underinsured by staggering dimensions. The study also reveals by assessing the need of protection cost of the dependents in case the primary bread earner dies, the insurance gap which is otherwise known as ‘under insurance’ has been worked out to be US$20 trillion (Source: Sigma, 5 Sept 2012).’
In the same token, the Indian population also follows the same tendency and per capital sum insured relative to GDP (gross domestic product) is way below any standard. One such measure to combat underinsurance is for the consumers to compare prices of different insurers whereby they can determine the desired level of their policy cover relative to their earning power or increase sum insured without having to pay a higher premium. Web based tools or acceptance of insurers’ renewal offer on increased value of sum insured may be other helpful hints.
The author is a Ph.D, FII, ANZIIF (Fellow) CIP. He is the former underwriter of GIO Re Sydney Australia and is now the Director of International Business, Kaden Boriss, an international law firm with offices in Sydney Canberra Singapore and New Delhi.