What it means
The cover responds to direct physical damage, so it pays for the burnt roof, the melted machinery and the ruined stock. It does not by itself pay for the profit you lose while the site is rebuilt, which is what separate business interruption cover exists to do.
Firms that buy the first without the second are often surprised by how much of the real loss falls outside the policy. The settlement basis matters as much as the limit.
A reinstatement or replacement cost policy pays what it costs to put in a new equivalent item, while an indemnity or actual cash value policy deducts depreciation for age and wear, which on a ten-year-old production line can be the difference between recovering most of the loss and recovering half of it. Most commercial property policies contain an average clause, sometimes called a coinsurance clause, that requires the insured to carry cover of at least a stated percentage of full replacement value, commonly 80% or 90%.
If the sum insured falls below that level, the insurer reduces every claim in proportion, so underinsurance bites on small and partial losses rather than only on total ones. Pricing is usually expressed as a rate per $100 of cover, and the rate reflects construction materials, what happens inside the building, fire protection such as sprinklers and alarms, and the exposure from neighbouring premises.
A sprinklered steel-framed warehouse storing metal parts attracts a far lower rate than an unsprinklered timber unit storing foam packaging. Conditions and exclusions do quiet but heavy work in this class.
Hot works permits, sprinkler impairment notices, unoccupancy limits and housekeeping standards are common policy conditions, and breaching one during a period of high risk can reduce or void a claim that would otherwise have been paid without argument.
In practice
Real-world examples.
Example
A restaurant group suffers a kitchen fire that destroys the extraction system and closes the site for six weeks. The property policy pays $180,000 to rebuild the kitchen, and the separate business interruption section pays the lost gross profit while the doors are shut.
Example
A furniture manufacturer installs a sprinkler system and upgrades its electrical distribution board, and at renewal its property rate falls from $0.48 to $0.31 per $100 of cover. On a $6,000,000 sum insured that saves $10,200 a year, paying back a large part of the installation cost within a few renewals.
Example
A landlord insures a small industrial unit for the price paid four years ago rather than current rebuilding cost. After a fire, the average clause reduces a $90,000 partial claim by a third, and the landlord funds the balance out of reserves.
Formula
Calculation
Annual premium = (sum insured / 100) x rate per $100 of cover
Claim payment = (sum insured / (average percentage x full replacement value)) x loss, less the deductible
A distribution business owns a warehouse and contents with a full replacement value of $2,000,000. The policy carries an 80% average clause, so the required sum insured is 0.80 x $2,000,000 = $1,600,000, but the owner insures for only $1,200,000. At a rate of $0.35 per $100 of cover, the annual premium is ($1,200,000 / 100) x $0.35 = 12,000 x $0.35 = $4,200.
A fire causes $500,000 of damage. Because the sum insured is only $1,200,000 against a required $1,600,000, the insurer applies the proportion $1,200,000 / $1,600,000 = 0.75. The claim payment before the deductible is 0.75 x $500,000 = $375,000, and after the $25,000 deductible the business receives $350,000. The uninsured shortfall is $500,000 - $350,000 = $150,000, and insuring properly would have cost only ($400,000 / 100) x $0.35 = $1,400 more in premium.Case study
Seen in the real world.
Kestrel Joinery is a fictional cabinet maker used purely as an illustrative example. It insured its workshop and machinery for $1,500,000, a figure set when the business moved in and never revisited, even after it bought two large CNC routers and expanded the finishing bay.
By the time a dust extraction fault started a fire, the true replacement value of the building and contents was $2,400,000. The policy's 80% average clause required cover of $1,920,000, so on a $300,000 loss the insurer paid $1,500,000 / $1,920,000 = 0.78125 of the loss, which came to $234,375 before a $10,000 deductible and $224,375 after it. Kestrel absorbed the remaining $75,625 itself.
The lesson the finance director drew was not that the insurer behaved badly but that the sum insured had become a stale number. Kestrel now revalues buildings and plant every year before renewal, records new capital purchases on the schedule as they are installed, and keeps the hot works permit book in the workshop where the team will actually use it.
Watch out
Common mistakes.
- Insuring for market value instead of rebuilding cost. Market value includes land and reflects what a buyer would pay, whereas the policy needs to fund construction, professional fees and debris removal.
- Assuming the fire policy covers lost trading profit. Damage cover and business interruption cover are different sections, and the second has to be bought and sized separately.
- Leaving the sum insured unchanged after buying new plant. Average clauses cut every claim proportionately, so underinsurance quietly reduces small claims as well as large ones.
Questions
People also ask.
Does fire insurance cover arson by an employee?
Deliberate damage by a member of staff is usually covered, but damage arranged or committed by the policyholder or a director is excluded as a matter of course.
What is the average clause in plain terms?
It is a rule saying that if you insure for less than the stated share of full value, the insurer pays only the same share of each loss.
Should a tenant buy fire insurance if the landlord already has?
Usually yes, because the landlord's policy covers the building, while the tenant's fit-out, stock, equipment and loss of profit remain the tenant's own exposure.
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