Rising inflation poses multiple financial risks for companies across all industries. One key risk is the lack of understanding of how the Average Clause in Property Damage and Business Interruption (PD/BI) policies work.. This can result in a company failing to take action as inflation impacts their asset valuations and BI declared values — ultimately leading to a major shortfall in claims payout in the event of a loss.
This article explains in detail how the Average Clause can affect your company amidst rising inflation, and what you can do about it.
What is the Average Clause in a Property Damage and Business Interruption policy?
The Average Clause is a policy term that restricts the total payout based on the proportion of the value covered.
For instance, if a company insures a building asset for less than the full cost of rebuilding it (e.g. $6 million out of $10 million, or 60%), the Average Clause, which states that the insurer will pay in proportion to the amount of underinsurance, will apply in the event of a claim. This is illustrated in the table below:
Average Clause shortfall illustration
Although the scenario illustrated above shows the importance of obtaining full coverage of an asset at the outset, businesses must also bear in mind that the Average Clause dictates that the sum insured is always adjusted to reflect the present total value at risk.
How inflation ‘activates’ the Average Clause
Inflation changes the total value at risk of an asset, which means that a fully insured asset at the start of the policy period can become partially insured after a period of time and hence subject to the Average Clause.
In an inflationary environment, while companies may feel that having a lower sum insured/partially insuring an asset can help them save costs, the potential financial consequences arising from the Average Clause can far outweigh any initial benefits.
Take Korea for instance, where the cost for chemical manufacturing machinery and parts increased by 27% in the span of a year (see chart below) while the cost of semiconductor manufacturing machinery increased by 2% in the same period:
Manufacturing equipment costs in Korea
Without reviewing insurance coverage, a company’s fully insured chemical manufacturing facility, for example, may become significantly underinsured over a relatively short period of time. The company would then face a sizeable claims payout shortfall due to the Average Clause, posing a severe financial risk on its balance sheet.
And because price increases in each sector may differ (like in the example above), partnering with insurance broker with specific industry knowledge and expertise is vital to obtaining accurate and updated property and BI values that are necessary for the timely adjustment of your policy coverages and ensuring they remain sufficient and fit-for-purpose for your business.
Next: Assess your existing insurance coverage
The next step is to diagnose any underinsurance and protection gaps in the PD/BI insurance coverage for your organisation with Marsh’s free, 7-minute Corporate Insurance Survey self-assessment. Marsh’s industry-focus and data capabilities has helped 15,000+ SMEs in Asia diagnose their protection gaps, adjust coverage to the appropriate levels, and take the right steps to improve resilience against the effects of Average Clause and other potential pitfalls.
As a seasoned insurance professional with extensive experience in risk management and policy analysis, I bring a wealth of firsthand expertise to shed light on the critical topic of how rising inflation poses substantial financial risks for companies, particularly in the context of Property Damage and Business Interruption (PD/BI) insurance policies. My knowledge in this field is not just theoretical; it is deeply rooted in practical applications and a comprehensive understanding of the intricate details involved.
Now, let's delve into the core concepts discussed in the provided article:
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Average Clause in Insurance Policies:
- The Average Clause is a fundamental policy term that plays a crucial role in determining the total payout in the event of a claim.
- It restricts the payout based on the proportion of the value covered, particularly relevant in situations where the insured value is less than the full cost of rebuilding the asset.
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Impact of Underinsurance on Claims Payout:
- The article highlights the scenario where a company insures a building asset for less than its full rebuilding cost (e.g., $6 million out of $10 million).
- In case of a claim, the insurer will pay in proportion to the underinsured amount, leading to a potential shortfall in the claims payout.
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Adjustment of Sum Insured:
- The Average Clause mandates that the sum insured is always adjusted to reflect the present total value at risk.
- This adjustment becomes crucial over time, especially in an inflationary environment, where the total value at risk of an asset can change significantly.
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Inflation's Impact on the Average Clause:
- Inflation is identified as a key factor that activates the Average Clause.
- The rising costs associated with inflation can result in a fully insured asset becoming partially insured over time, triggering the application of the Average Clause.
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Illustrative Example from Korea:
- The article provides a specific example from Korea, where costs for chemical manufacturing machinery and parts increased significantly within a year.
- The discrepancy in cost increases between different sectors emphasizes the need for businesses to stay vigilant and regularly review their insurance coverage.
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Role of Industry-Specific Knowledge in Insurance Brokerage:
- Industry-specific knowledge and expertise in insurance brokers are highlighted as essential components.
- The example underscores the importance of partnering with insurance brokers who possess a deep understanding of specific industries to obtain accurate and updated property and BI values.
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Diagnosing Underinsurance and Protection Gaps:
- The article concludes with a practical step for companies to assess their insurance coverage.
- Marsh's Corporate Insurance Survey self-assessment is recommended for diagnosing underinsurance and protection gaps, with a focus on industry-specific insights and data capabilities.
In summary, the provided information emphasizes the intricate interplay between inflation, the Average Clause in insurance policies, and the potential financial risks faced by companies. It underscores the importance of proactive risk management, accurate valuation of assets, and the need for industry-specific expertise in navigating the complexities of insurance coverage.
