Unmasking underinsurance: A vital guide for UK SMEs

Underinsurance is a common but often overlooked issue that can have serious consequences for any business owner. It can occur if your business’ growth outpaces its insurance coverage. This can leave you exposed to financial and operational risks in the event of a major incident.

In this article, we'll explore how you can determine if your business could be underinsured and provide examples of common areas where underinsurance can occur.

What is underinsurance?

Underinsurance is when your business insurance coverage falls short of its actual needs. It occurs when the declared total value of assets (such as commercial property, buildings, and contents) and exposures fall below the real time values.

This is often unintentional and results from not keeping policies up to date. It could also be due to not accurately assessing your business's market value and potential risks.

Consequences of underinsurance

Policy loss limits

If the value of your insured assets increases, you need to increase the sum insured. If you don't raise the maximum amount your insurance will cover, your business might not get full compensation if a big loss exceeds that limit.

Application of underinsurance average clause

In many insurance contracts there’s a Condition of Average. This means that when receiving a claim for a property or business, the insurer could believe the property or business is underinsured. Then they can reduce the claim by the corresponding percentage.

We'll use an example of an outbuilding on your premises which is damaged. You work out it will cost £100,000 to repair and your insured value is £500,000. You would make a claim for the full amount and expect this to be paid in full. But at the time of making your claim, the total replacement cost of your property and possessions is valued at £1million. Then your property would be underinsured by 50%. This means that your insurer could impose a proportionate settlement and you would only receive a 50% pay out. This would leave you to find £50,000 to contribute to the cost of your outbuilding repairs.

If the underinsurance is too large, the insurer could even say that the policy is void. This is because the client failed in their duty of fair presentation under the Insurance Act.

Adequacy of indemnity period

Some business interruption insurance policies include a maximum indemnity period. This is the maximum duration that insurers will pay business interruption losses following an insured event. These are usually set at 12, 18, 24, 30, or 36 months following the loss event.

For example, if you suffer delays because you haven’t reinstated damaged property before the business interruption indemnity period expires, this may lead to uninsured extra costs and loss of revenue or profit.

Declaration-linked mechanisms

Some business interruption policies include a ‘declaration-linked mechanism’ that allows for some growth. For example a 33.33% increase in the estimated gross profit over the indemnity period. While this provides some protection against inflation, it may still be inadequate for rapidly growing and changing businesses during a significant inflationary period.

Common areas of underinsurance

Property and assets

One of the most common areas where underinsurance occurs. Many underestimate the value of their property, equipment, and inventory. A staggering 76% of UK properties are underinsured.¹ In the event of a claim, you'll be responsible for covering the shortfall as well as the percentage difference in lack of insurance cover.

Business interruption

Business interruption insurance helps you cover lost income during disruptions. But underestimating the potential lasting impact of an incident can lead to underinsurance (as explained above). The Chartered Institute of Loss Adjusters estimate as many as 40% of business interruption policies are underinsured with an average shortfall of 45%.²

Liability insurance

Liability insurance protects your business from legal claims. Underinsurance in this area can be particularly risky. If you're sued for a sum that exceeds your policy limits, you may have to cover the additional expenses out of pocket.

Cyber insurance

Many assume that a standard business insurance policy is enough to protect you from a cyberattack. While some overlaps exist (as with all lines of insurance), traditional insurance policies lack the depth and breadth of standalone cyber cover. These policies also won’t come with experienced cyber claims and incident response capabilities.

Plant, machinery and equipment

Just as property values fluctuate - so does the value of machinery. This is especially true if there are supply chain complications, or demand exceeding supply capabilities.

How to determine if you're properly insured

1. Review your buildings insurance, contents insurance and other policies. Make sure you have an up-to-date valuation of your business assets and potential risks. Pay particular attention to the adequacy of your indemnity period. You want to protect your income and your ability to trade, long term while a rebuild is ongoing.
2. Conduct a risk assessment to identify potential risks and liabilities specific to your industry and business operations. This will help you determine if your current coverage is adequate. A full rebuild cost assessment is a great way to highlight the underinsurance gap with properties in particular.
3. Seek professional advice by consulting an insurance broker to help you assess your insurance needs accurately. They can provide valuable insights into industry-specific risks and ensure you have the right coverage in place.
4. Conduct a thorough inventory of your business assets, including equipment, stock, and other valuable items. This will help you determine how much cover you need. You should provide this to your insurer at the inception or renewal of the policy or whenever there is a change that will impact the coverage of your policy.

Don't let underinsurance be the Achilles’ heel of your business

As your business grows and changes, so should your insurance coverage. Underinsurance can pose a significant threat to your business's financial health and growth goals. It's crucial to regularly review your insurance coverage, accurately assess your business's value and potential risks, and seek professional guidance when necessary. By doing so, you can ensure that your business is adequately protected, primed for growth and prepared to weather any storm that comes its way.

Sources:

1. rebuildcostassessment.com/post/annual-infographic-2024

2. zurich.co.uk/news-and-insight/major-loss-events-reveal-the-dangers-of-underinsurance

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