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The dangers of underinsurance

Business owners know that insurance is a necessary part of protecting their livelihood from unexpected loss, but the truth remains that the majority of Australian businesses are woefully underinsured.

Business owners know that Australia is a country where the forces of nature can cause havoc on a frighteningly regular basis. Floods, bushfires and cyclones have a devastating effect on communities and businesses, but so too can other unforeseen events. And any loss can result in a business not being able to work at full capacity.

The importance of valuing your business correctly

When the unexpected happens, businesses rely on insurance cover to make good their losses and allow them to start working again as soon as possible. Thankfully, the majority of businesses have property insurance to cover their buildings, plant, equipment and contents, as well as business interruption cover for loss of earnings, typically held through an Industrial Special Risks policy.

What many businesses don’t understand is that unless their business and assets have been valued correctly, they may be significantly underinsured, without even knowing it.

Even more concerning is that many businesses will have based their insurance cover on the advice of an insurance broker, or relied on the advice of a trusted employee who may have been responsible for their insurance needs for years.

In this case, business owners may well think their business is covered, when the reality is that with the best intentions in the world, their broker or employee may have left the business exposed to significant risk.

So how can you be sure that you have the insurance you need?

Top trap: self-assessment often leads to underinsurance

Insurance is designed to restore a business to the position it was in before the loss and to reinstate the business on a like-for-like basis without financial penalty.

Without a formal valuation, the likelihood is that insured values may be based on incorrect advice and false assumptions which can lead to two major problems:

– Initial valuations are incorrect

– Initially incorrect valuations are then reviewed annually by staff who often fail to account for the real rise in the cost of reinstatement.

These costs can include professional fees, changes to building codes, debris removal, site improvements and currency fluctuations, as well as lead times for DA approval, planning, rebuild period and policy life.

Other common practices that can lead to incorrect valuations

  1. Simply adding 5-10 percent to last year’s figures
  2. Basing increases on real estate conditions
  3. Asking a bank, builder, architect or real estate agent for the valuation
  4. Relying on advice from an in-house accountant or engineer
  5. Referring to building guides
  6. Adopting book value
  7. Using financial valuation reports and deducting land value
  8. Adopting the second-hand purchase of a price of an asset

The risks of getting it wrong

It is an unfortunate truth that most businesses have only 50-75 percent of the correct value insured. And the risks of underinsurance can affect more than just the business. Ultimately it is the Directors of a company who bear responsibility for declaring insured values, and they can be penalised for misrepresentation in the event of a claim.

Problems typically occur when businesses are looking for a speedy claim process after a loss, and it transpires that there is no solid basis for the declared insurance values. In this case, ensuing investigations by the insurer can lead to a protracted claims process and delayed settlements which can take months or even years.

If the property and business has been underinsured, even if unintentionally, the insurer may decide that the underinsurance is deliberate and refuse to pay the claim at all. This is an extreme case, but it can happen.

On the other hand, if the insurer does decide to pay, despite the underinsurance, the pay out will not cover the full loss and the business will need to make up the shortfall.

Neither situation is ideal, particularly when a business is trying to get up and running quickly after a loss.

Case Study:  The reality of underinsurance

Many people think that underinsurance would only impact them in the event of a total loss, where they would not receive the full value of their loss and would need to fund the shortfall.

In fact this is not true, as even if you suffer a partial loss you can be penalised for underinsurance.

Let’s take the case of a building insured for $4 million. Imagine that a fire during the year causes $2 million of damage. You could be forgiven for thinking that you would be fine. The building is insured for $4 million and you only require $2 million to make good, right?

Wrong, unfortunately. The loss adjuster will want to know how you arrived at your insured values and a thorough evaluation of what was in the area of loss. Without a proper valuation, you will be unable to answer these questions to his satisfaction, and he will make his own assessment.

If his assessment shows that you were underinsured by 50%, you may only receive 50% of the cost of the loss due to the fire. That means $1 million to replace losses of $2 million.

You will be left to fund the remaining $1 million, even though you thought you were adequately insured.

The benefits of getting it right

It is not difficult to ensure that you are properly insured. The key is to make sure that your business has been properly assessed by a qualified insurance valuer. A proper valuation process removes the risk to your business and to your Directors of underinsurance, and ensures that there will be no gap in the event of a claim.

Bear in mind that it is also important to have an up-to-date asset register which will allow you to respond to a loss with the minimum impact to your business. In fact, one of the advantages of the valuation process is that it forces many businesses to implement internal processes, such as asset registers, that have long been on the to-do list.

The benefits of having a valuation carried out are significant, both to you and your business, and include:

  • Not paying the consequences of underinsurance in the event of a claim
  • Not paying excessive premiums due to overinsurance
  • More negotiating power when it comes to renewals
  • Fast-tracked claims process without disputes around the insured values
  • Minimised interruption to business operations
  • Established lead times for business interruption calculations
  • Implementation of internal processes, such as asset registers
  • Compliance for risk mitigation

What should you do to ensure your business is correctly insured?

It is absolutely crucial to have your business and its assets valued correctly, and that means using a professionally qualified insurance valuer. Professional qualifications, such as the Aon-sponsored Insurance Valuation Program trains qualified professional valuers in the process of insurance valuations, something that the majority of valuers aren’t qualified to do.

A professional insurance valuation program usually runs for three years, in which the valuer makes an on-site valuation in year one, followed by an on-desk review in each of the following two years.

And best of all, in most cases the cost of the insurance valuation program can be added to the cost of your premium.

Unexpected loss or catastrophic natural disasters are disruptive enough without finding that your level of insurance cover is inadequate or worse.

If your business is your livelihood, it pays to protect it, and that means understanding the value of your business and its assets, and insuring them properly.

Neil Hemmings
As National Sales Manager for Aon Valuation Services, Neil has 25 years’ experience in key areas of insurance risk management providing insurance valuation services to both the private and public sectors in particular, small to medium enterprise businesses.