What it means
Many business owners make the mistake of setting their insurance coverage based on historical costs, original purchase prices, or arbitrary guesses to keep monthly premiums low. However, insurers calculate payouts based on the true cost of rebuilding or replacing items at current market rates.
When a claim is made, insurers look at the relationship between what the asset was actually worth and what it was insured for. If you insured an asset for half its true value, the insurer will typically only pay half of your claim.
This practice is known as the average clause. It means you are essentially acting as your own insurer for the uncovered portion, putting your cash flow and financial stability at serious risk.
In practice, underinsurance often creeps in silently over time due to inflation, business growth, or new equipment purchases that were never added to the policy. Business leaders frequently overlook intangible assets, stock fluctuations, and specialised labour costs needed for rebuilding.
Regular asset valuations and transparent conversations with brokers help prevent this nasty surprise. Understanding this concept ensures that when you need your safety net the most, it actually catches you without unexpected financial ruin.
Imagine trying to cover a double bed with a single duvet. When you pull it to protect one cold shoulder, your feet are left completely exposed to the chilly air.
In practice
Real-world examples
Example 1
A tech startup insures its office computers and servers for $50,000, but the true replacement cost is $100,000. After a flood causes $20,000 of damage, the insurer applies the average clause and pays only $10,000. The founders must find the other $10,000 from their own cash while also replacing equipment urgently.
Example 2
A retail business insures its warehouse stock for $200,000 year after year without checking. After a seasonal expansion, stock reaches $400,000 when a fire destroys part of the warehouse and causes $80,000 of loss. Because the stock was only half insured, the insurer pays $40,000 and the retailer absorbs the rest.
Example 3
A boutique hotel insures its historic building for $1,500,000, ignoring rising construction wages and material costs. A kitchen fire causes $300,000 of damage, but a proper valuation shows the true rebuild value is $3,000,000. The insurer pays only 50% of the claim, or $150,000, leaving the owners to fund the other $150,000.
Think of it
Imagine trying to cover a double bed with a single duvet. When you pull it to protect one cold shoulder, your feet are left completely exposed to the chilly air.
Formula
Calculation
Payout = (Insured Value / True Value) x Loss Amount, capped at the policy limit
Example 1:
True Value = $500,000
Insured Value = $300,000
Loss Amount = $100,000
Payout = (300,000 / 500,000) x 100,000 = 0.6 x 100,000 = $60,000
Shortfall = 100,000 - 60,000 = $40,000, paid by you.
Example 2 (fully insured for comparison):
True Value = $500,000
Insured Value = $500,000
Loss Amount = $100,000
Payout = (500,000 / 500,000) x 100,000 = 1.0 x 100,000 = $100,000
Shortfall = $0.
The extra premium for the higher cover is small compared with the $40,000 shortfall in the first example.Case study
Seen in the real world
Oakwood Manufacturing, a fictional mid-sized furniture maker, faced a severe reality check after a workshop fire caused $200,000 of structural and machinery damage. Ten years earlier, the company set its property insurance limit at $500,000 and simply renewed the policy automatically every year without adjustments. Following the incident, loss adjusters determined that inflation, machinery upgrades and higher construction costs meant the building and equipment were actually worth $1,000,000. Because Oakwood was insured for only half of its true replacement value, the insurer applied the average clause. Instead of receiving the $200,000 needed to repair the damage, Oakwood received just $100,000.
The directors had to drain their working capital reserves and secure an emergency bank loan for the remaining $100,000 to resume operations. The saving on premiums over the years was only a few hundred dollars annually, far less than the lost production time and loan interest that followed. After recovering, the illustrative finance team introduced a simple annual routine. Each January they updated an asset register with current replacement costs, asked their broker to review the sum insured, and added a note to the board pack confirming the cover matched the valuation. The extra premium came to about $1,200 a year, a small price for removing a risk that had nearly cost the business its working capital.
Watch out
Common mistakes
- Assuming that original purchase price equals current replacement value.
- Forgetting to update insurance policies when buying new equipment or expanding inventory.
- Skipping professional asset valuations to save money on fees.
Questions
People also ask
How often should I review my insurance coverage?
You should review your asset values and policies at least once a year, or immediately after any major purchase or business expansion.
What is the average clause?
It is a rule insurers use to reduce claim payouts proportionally if they find your property was insured for less than its true value.
Does underinsurance only apply to buildings?
No, it applies to business interruption, stock, machinery, and any other insured asset category.