For businesses that rely on key equipment, underinsurance can have unexpected and severe consequences. Simply using the purchase cost for valuing assets is a mistake made by many, resulting in inaccurate sums insured and inadequate claim settlements.
Valuing assets for insurance purposes requires a particular methodology, and brokers can play a key role in helping customers approach the issue.
The basis of settlement determines how an insurer will calculate a claim settlement. When setting the sum insured, different approaches must be taken, depending on which basis of settlement is specified.
Insurance policies can specify different bases of settlement. It is therefore essential that the applicable basis is known before valuing assets.
In the UK, either an indemnity or, more commonly, reinstatement basis is generally used for items of plant and machinery. Other bases of settlement do exist, such as an agreed value basis, but are less common for most customers’ purposes.
An indemnity basis reflects the traditional principle of insurance: to return the insured to their position prior to the loss – no more, no less.
An indemnity basis will cover either:
• Cost of repair, less an allowance for wear, tear, depreciation and all relevant forms of obsolescence
• Cost of a replacement with a similar machine, giving regard to its age and condition and all relevant forms of obsolescence
A settlement on this basis is therefore unlikely to fund the full cost of a new replacement asset, so customers should be particularly conscious of overstating sums insured.
The purchase cost should be avoided, as the value of plant and machinery can rapidly depreciate once in operation. A reasonable starting point is the current market value of the asset, taking into account age and condition.
Difficulty arises where a current market value is not easily determinable, particularly if the asset is no longer being produced or actively bought and sold.
Valuations for an indemnity basis can therefore be a difficult task for customers to undertake alone, and both under- and overinsurance are distinct risks.
Reinstatement is now the most common basis of settlement used in the UK insurance market. This basis departs from traditional principles, as a claim settlement will result in an improvement to the insured’s position.
Reinstatement will cover either:
• Cost of repair, with no deductions made for wear, tear, depreciation or other forms of obsolescence
• Cost of replacing the asset with a new item of similar type, capacity and utility (i.e. ‘new for old’)
The sum insured on a reinstatement basis should include the full cost of completely replacing an item of plant or machinery with a new item of similar type, capacity and utility. In addition to the purchase cost, this sum should include factors such as freight and installation costs.
If the item is readily available for purchase, then determining an appropriate sum insured should be relatively simple. However, difficulty arises if machinery is old or no longer in production. In those circumstances, the cost of an alternative piece of equipment of a similar nature and capacity must be identified.
Informing customers of the correct basis of settlement is very important if they are to provide suitable sums insured.
The approach taken to valuations will produce quite different results, with reinstatement sums insured being notably higher than those on an indemnity basis. Approaching a valuation from the wrong starting point is likely to result in either over- or underinsurance.
Plant and machinery are also particularly susceptible to fluctuations in value, making it difficult for customers to establish an accurate sum insured.
Although brokers do play a key role in guiding customers in their approach to valuations, it should be stressed that there is no substitute for advising that regular professional valuations should be undertaken for insurance purposes.
Originally published on Insider Zurich.