Average Clause Notice
An Important Notice to Our Valued Policyholders
What is an Average Clause?
Property insurance policies are generally subject to the Pro Rata Condition of Average (known as the Average Clause). Many policyholders will remember this clause following Hurricane Gilbert in 1988, when national awareness was raised to its existence.
How it Works
Average Clause is applied when the Sum Insured of a property is less than the Replacement Cost of the property.
When this occurs, the property is said to be under-insured. This is because you will have paid a lower premium than you should have, and you therefore have not contributed an adequate amount to the insurance pool. As a result, you will only be entitle to recover the proportion of the loss that is equal to the proportion of your property’s Sum Insured relative to the current Replacement Value (what the property should have been insured for).
For example, should you have a property which has a replacement value of $10,000,000 and you decide to insure it for $7,000,000 and you suffer a loss from an insured peril, there are three possible alternatives depending on the size of the loss. The formula that is applied in each case is set out below:
Sum Insured x Amount of the Loss = Amount Recoverable – Deductible
Assume the loss is $5,000,000:
$7,000,000 x $5,000,000 = $3,500,000 – Deductible
Assume the loss is $8,000,000:
$7,000,000 x $8,000,000 = $5,600,000 – Deductible
Should you have a total loss i.e. $10,000,000 (replacement cost) then you will only receive the amount you insured the property for, i.e., $7,000,000 less any deductible stated in the policy.
Replacement Cost vs. Market Value
Replacement Cost and Market Value are not the same thing.
The Replacement Cost of a property is the estimated cost of rebuilding the structures on the property from scratch, and it does not take into account the value of the land on which the property is built. Replacement Costs typically increase over time as inflation increases the cost of building inputs and contractor services.
The Market Value of a property is the estimated value of a property, and reflects the amount of money you are likely to earn by selling your property. It includes a lot of factors, including the cost of the structures on your property, the estimated remaining life-time of those structures, any damage to the structures, and the value of the land which is owned – among other factors.
Real Life Application
You valued your house 10 years ago when you first moved in. The Replacement Value was determined to be $10 million – and so you insured your house for exactly that.
Since then, over those 10 years, inflation has increased the cost of building materials (concrete blocks, cement, steel reinforcement bars, tiles etc.) as well as the cost of professional building services and contractors. If a valuation were to be performed today, the current Replacement Value for you house would be $14 million.
Unfortunately, you neglect to adjust the Sum Insured for your policy. Your insurance representative reminds you each year at renewal, but you feel comfortable with the Sum Insured of $10 million, and furthermore you are worried about the premium increase resulting from an increased Sum Insured.
A hurricane hits, and portions of your roof are blown off. The cost of fixing the roof is estimated at $1 million.
When the damage is surveyed it’s determined that your house’s replacement value is $14 million. The Sum Insured of $10 million, and therefore the Average Clause applies to your $1 million claim. You have a Catastrophe deductible of 2% of your Sum Insured, therefore the claim payment you will receive can be calculated as follows:
Claim Paid = [(Sum Insured / Current Replacement Cost) x Claimed Loss] – Deductible
Claim Paid = [($10,000,000 / $14,000,000) x $1,000,000] – (2% * $10,000,000)
Claim Paid = $714,285.70 – $200,000.00
Claim Paid = $514,285.70
What would you have received if your home was not under-insured?
Claim Paid = Claimed Loss – Deductible
Claim Paid = $1,000,000 – (2% * $10,000,000)
Claim Paid = $1,000,000 – $200,000
Claim Paid = $800,000.00
You may be tempted to think “My house is insured for $10 million so this loss will be covered 100%” – but that is not the case. Your entire property is insured for $10 million – and not just the roof. So if your entire property is under-insured, it stands to reason that each aspect of the property is under-insured – unless an object’s value is separated out in a schedule, and correctly valued.
The premium charged, reflects the risk of damage to all aspects of the property. Obviously concrete walls and pavements are far less likely to be damaged in a storm. They are certainly exposed to damage in an earthquake, but strong earthquakes occur far less frequent than powerful storms and hurricanes.
Therefore the rate charged to insure your entire property (for example 0.75%) represents the combination of high risk portions of the property (the roof, antennae, windows, etc.) and low risk portions (walls, pavements, doors, etc.).
If you wanted to only insure your roof, the resulting premium would be very close to the premium to insure your entire property. That is because the risk of damage to a building’s roof, and the cost of repair, is much higher than most other risks, and therefore makes up the majority of the premium charged to insure the entire property against all risks.
Continuing with the example used above, assume your $10 million house was rated by your insurer at 0.75% – for a premium of $75,000. You decide you’re not worried about the risk of damage to your walls and pavement, and you only wish to insure the roof, valued at $1 million. If an insurer agrees, they are likely to charge a rate of 6.5% for a premium of $65,000. The premium is not that much lower, but you are insured for far less risks.
When you insure your property, you are insuring all of it, and therefore you need to provide a value that encompasses all of the property. When the Sum Insured of the entire property is less than the Replacement Value for the entire property, you are paying a premium that is less than your true exposure – i.e. you are under-insuring. In response your clai payments are adjusted to reflect this.