What it means
Normally, property insurance includes an average clause (also called a co-insurance condition). If you insure an asset for less than its full value, the insurer reduces every claim in the same proportion.
This encourages people to insure properly, but it can feel harsh when only a small part of the value is ever at risk. A first loss policy works differently.
The insurer agrees to pay the loss up to the first loss limit, with no proportional reduction. The name comes from the idea that the policy covers the first slice of any loss and the owner carries anything above it.
Businesses use this cover where a total loss would be remote. A warehouse spread over many units, a large stock of goods in many locations or a chain of shops are common examples, because a fire or theft is unlikely to destroy everything at once.
Theft and goods in transit are other typical uses. The premium is usually higher in proportion to the sum insured than it would be on a full-value policy, because the insurer cannot reduce claims through averaging.
However, the total premium can be lower, because the sum insured is smaller. The buyer must choose the limit carefully by estimating the largest realistic loss.
The risk is under-insurance. If a disaster causes losses above the first loss limit, the owner pays the excess.
Risk managers therefore study the maximum probable loss before setting the limit and often keep a record of how they reached it.
In practice
Real-world examples.
Example
A jewellery wholesaler stores stock in a secure vault with a total value of $5,000,000. It buys first loss cover for $750,000, because a theft of the whole stock is extremely unlikely.
Example
A courier company moves parcels in many vans every day. It insures goods in transit on a first loss basis with a limit equal to the value of the most valuable van load, not the entire fleet's contents.
Example
A chain of 40 convenience stores insures against fire. Since one fire could not destroy all stores, it chooses a first loss limit sized to the value of the biggest single site.
Formula
Calculation
Under a first loss policy, the payout is the lower of the loss and the first loss limit, less any deductible.
Payout = lower of (Loss, First loss limit), then less any deductible
Under an ordinary policy with an average clause, the payout is scaled down:
Payout with averaging = Loss x (Sum insured divided by Value at risk)
Worked example: a retailer holds stock worth $1,000,000 and buys $200,000 of cover. It suffers a $150,000 theft loss.
First loss policy payout = lower of $150,000 and $200,000 = $150,000
Ordinary policy with averaging = $150,000 x ($200,000 divided by $1,000,000) = $150,000 x 20% = $30,000
If the loss had been $350,000, the first loss policy would pay only its $200,000 limit and the retailer would carry $150,000.Case study
Seen in the real world.
Marlow Textiles is a fictional manufacturer with five warehouses holding $12,000,000 of fabric in total. Its broker pointed out that insuring the full value would be costly, because a single fire would never destroy all five buildings. The largest single warehouse held $3,000,000.
In this illustrative case, Marlow bought first loss cover with a $3,500,000 limit, which left a margin above its biggest site. A fire later damaged one warehouse and caused $1,400,000 of loss. The insurer paid the full amount, less the deductible, without any proportional reduction. The case shows how this cover can save premium when the limit is set with care.
Watch out
Common mistakes.
- Setting the limit too low. If a loss is larger than the first loss limit, the owner carries the rest, so the limit should reflect the largest realistic loss.
- Assuming first loss means the first claim. The phrase refers to the first slice of any single loss, not to the order in which claims are made.
- Believing the premium must always be lower. The rate is often higher per dollar of cover, so the saving only appears when the sum insured is much lower than the full value.
Questions
People also ask.
How is it different from a deductible?
A deductible is the part of a loss that the owner pays first, while a first loss limit is the maximum the insurer pays. Policies can include both.
Who uses first loss policies most?
Businesses with spread-out assets, such as retailers, logistics firms and wholesalers, and also lenders who insure against defaults on a portfolio of loans.
Does the insurer still check the full value of the asset?
Yes, usually. It needs to understand the total exposure to set the rate, even though claims are not reduced by averaging.
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