Underinsurance remains one of the most pressing risks for commercial property owners in South Africa, particularly for large-scale operations where assets can reach hundreds of millions or even billions of rand. Brokers, as trusted advisors, play a pivotal role in guiding clients through the complexities of commercial insurance, ensuring not only that their property, stock, and assets are properly insured but also that Business Interruption coverage is adequate to protect against financial devastation following a loss.

This blog addresses the importance of ensuring that insurance valuations are current, the impact of the Average Clause, and why proper Business Interruption insurance is critical to the survival of large businesses in the event of a disaster.

Why Underinsurance Happens

Underinsurance occurs when the insured value of a business’s property, assets, or stock is lower than the current replacement cost. This can happen for a number of reasons, including inflation, rising construction costs, changes in stock levels, or operational expansions. Many businesses mistakenly rely on the automatic annual Escalation Clause – which increases the insured value by an average of about 10%, as sufficient protection. However, this clause is potentially not enough to keep pace with the actual costs of rebuilding, replacing assets, or covering business interruptions.

The Role of the Average Clause

The Average Clause is a key concept in commercial assets  insurance, especially when underinsurance is at play. This clause allows insurers to reduce payouts proportional to the level of underinsurance. The greater the underinsurance, the less the insurer will pay.

For example, if a business insures its property for R80 million, but the actual replacement cost is R100 million, and a claim is made for R50 million, the insurer will only pay 80% of the claim, or R40 million. 

The business will be responsible for the R10 million shortfall. When claims involve large assets and substantial sums insured, this reduction in payout can severely hinder a business’s recovery, or even lead to closure.

The Limitations of the Automatic Escalation Clause

While an automatic Escalation Clause that provides an average of 10% annual increase in the sum insured, it often falls short of reflecting the real replacement costs, especially in volatile markets like South Africa’s, where construction materials and labour costs have surged. The clause also fails to account for any operational changes, such as facility upgrades, additional machinery, or increased stock levels. 

If a business has invested in expanding its premises or holds more stock than previously declared, relying solely on this clause could leave them exposed to underinsurance. Accurate, professional valuations are necessary to ensure that the sums insured reflect the real value of the business’s property and assets.

The Importance of Accurate Stock Declarations

One of the most common areas where underinsurance occurs is in stock declarations. Many businesses, particularly those with high stock turnover, may overlook the need to regularly update their stock values in their insurance policies. During times of economic instability, businesses may carry more stock to offset supply chain risks, yet fail to update their cover accordingly.

For instance, a business that routinely holds R200 million in stock but insures only R150 million of it is at serious risk of underinsurance. In the event of a loss, the insurer will apply the average formula based on the declared and actual values, leaving the business to cover a significant portion of the shortfall.

Brokers must play a proactive role in ensuring that their clients regularly declare their stock levels and that the sums insured are updated to accurately reflect current holdings. This is critical in industries where stock levels fluctuate, such as manufacturing, retail, and distribution.

The Potential Impact of Underinsurance on Large Businesses

For PARTNER RISK’s clients, who typically have assets in the hundreds of millions or billions, the consequences of underinsurance are severe. In the event of a total loss, underinsurance could lead to financial insolvency, with the business unable to afford the cost of rebuilding or replacing critical assets. Even partial losses, when underinsurance is involved, can result in substantial out-of-pocket expenses that could disrupt operations for extended periods.

It is imperative that brokers communicate the serious risks associated with underinsurance to their clients. The consequences can be devastating, especially for businesses that rely on their property, stock, and assets to generate revenue.

Business Interruption Insurance: The Often Overlooked Essential

While ensuring accurate property and asset valuations is crucial, Business Interruption cover is equally important in protecting a company’s revenue stream and/or cost base, in the event of a disaster. This coverage provides financial support to help businesses maintain operations and maintain standard operating costs and recover lost income when their property is damaged or unusable due to an insured peril.

Despite its importance, Business Interruption cover is often underinsured, leaving companies vulnerable to prolonged financial losses. According to the Chartered Institute of Loss Adjusters, approximately 43% of business interruption insurance is underinsured by 53%. This significant gap can be catastrophic for businesses trying to recover from a major loss.

The main reason for this underinsurance is that businesses often miscalculate the maximum indemnity period, or the time it will take to return to normal operations. 

The true period of disruption following a fire, flood, or other catastrophe can be far longer than anticipated, particularly when dealing with specialised equipment, seasonal variations, or lengthy repair and construction timelines.

For instance, if a business insures for a 12-month indemnity period but the actual recovery takes 18 months, the business will be left uncovered for the final six months, during which time they are still incurring expenses without generating revenue. This can create a financial gap that severely impacts the business’s ability to stay afloat.

Brokers’ Role in Ensuring Adequate Business Interruption Cover

As a broker, you play a critical role in ensuring that your clients are adequately covered for business interruption, particularly those with high-value assets and complex operations. Here’s how you can help:

• Assess the Maximum Indemnity Period Accurately: Work with clients to accurately calculate how long it would take to restore operations after a worst-case scenario, taking into account the complexity of their operations, seasonal factors, regulatory requirements, and the time required to source specialised machinery or equipment.

• Review Business Interruption Sums Insured: Ensure that your clients’ Business Interruption coverage is based on the correct figures, including gross profit and fixed operating costs. Underinsurance in this area can leave clients exposed to financial ruin, even if their physical assets are adequately insured.

• Tailor Business Interruption Policies to the Business’s Needs: Each business’s operations are unique, and a tailored approach is required when structuring business interruption cover. This includes understanding supply chain dependencies, key client relationships, and the impact of potential delays on revenue generation.

The Broker’s Responsibility: A Comprehensive Approach to Insurance

Ensuring that clients are adequately covered involves more than just setting up a policy. It requires continuous engagement and a comprehensive approach to risk management. Here are some key steps brokers should take to mitigate underinsurance:

• Encourage Regular Property and Asset Valuations: Annual valuations ensure that the sums insured reflect the current replacement cost of property and assets, keeping clients adequately covered.

• Ensure Accurate Stock Declarations: Stock levels can fluctuate, and it is essential that businesses declare the correct values to ensure that they are properly insured.

• Explain the Impact of the Average Clause: Make sure clients understand how the average clause works and how it will reduce payouts in proportion to the level of underinsurance.

• Review Business Interruption Coverage Regularly: Business Interruption insurance must be reviewed to ensure that it reflects current operational realities and that the maximum indemnity period is sufficient to cover the time required for full recovery.

Underinsurance remains a significant risk for commercial property owners, especially when dealing with high-value assets and complex business operations. While accurate property, asset, and stock valuations are essential, brokers must also focus on ensuring that clients have sufficient business interruption coverage to protect their revenue streams during times of crisis.

By taking a proactive approach, encouraging regular valuations, reviewing stock levels, and tailoring Business Interruption policies to meet the client’s specific needs – brokers can ensure their clients are fully protected. Avoiding underinsurance is not just about covering the present; it’s about safeguarding the future.