Beware the pitfalls of underinsurance

With many smaller businesses struggling to recover from the recession, keeping insurance cover to a minimum has been a way of cutting costs which could, however, prove disastrous

When catastrophes strike, small businesses are frequently caught in the crossfire. For example, two thirds of small and medium-sized enterprises (SMEs) have been badly affected by severe weather in the UK over the past three years, according to the Federation for Small Businesses, with damage from the 2013-14 winter floods costing an average of £1,531. Others were temporarily unable to open their retail outlets as a result of riots in 2011.

SMEs are the backbone of the UK economy. Yet research by Towergate shows 43 per cent lack adequate storm cover. Underinsurance is a chronic condition, with up to 80 per cent of properties underinsured and 40 per cent of businesses lacking adequate business interruption cover, according to the Building Cost Information Service and Chartered Institute of Loss Adjusters. Small firms are particularly vulnerable as they do not have the risk management and insurance buying resources of their larger contemporaries.

“Underinsurance is unfortunately a very real feature of the current UK insurance market; a significant issue for material damage and business interruption exposures in particular,” says Jason Eatock, head of SME at Zurich Insurance. “The fundamental issue is one of unexpected negative outcomes for customers when they have a claim, especially where an insurance policy becomes void because underinsurance is found to be deliberate and severe.”

In tough economic times, when many firms are fighting for survival, there is pressure to keep insurance premiums at a minimum. Just under a third of insurance intermediaries saw a reduction in non-essential insurance cover in 2009. By 2010 this had grown to 57 per cent, the British Insurance Brokers’ Association (BIBA) says. During hard times, the cost of insurance rather than extent of coverage is the main criterion for many firms.

Uk winter flood damage
Damage from the 2013-14 winter floods in the UK cost SMEs an average of £1,531

It is often only in the event of a claim that underinsurance gaps are discovered. “If there is a disagreement over the settlement offered, it could be due to the customer not disclosing the right sums insured in the first instance,” says BIBA executive director Graeme Trudgill. “Many customers will look to keep their insurance spend to a minimum, so they may not want to increase their sum insured every year.”

The financial crisis was a big test for small businesses. In an environment of restricted lending and unreliable cash flow, many diversified their business models in order to survive. Plumbers turned their hand to solar panel installation, local grocery stores installed lottery machines and bookshops created in-store cafés.

While their entrepreneurial spirit helped such businesses weather the downturn, this introduced them to new risks. “Shops selling online may well start to export to North America not knowing that standard policies would usually exclude that territory,” says Mr Eatock.

Keeping brokers and insurers abreast of changes to their business is not always at the forefront of a small business owner’s mind. “Our experience tells us that clients do not think to contact us generally,” says Chris Wilde, head of commercial at insurance broker Higos. “It’s only when the insurance broker ties them down to review the cover that they remember they’ve purchased some extra machinery.”

When Leicester-based Eurokey Recycling’s plastics recycling site was destroyed by a fire in May 2010, the plant’s combined commercial insurers threatened to avoid the policy as a result of gross underinsurance.

The rapidly growing recycling firm had seen its turnover grow from £3.2 million in 2005 to an anticipated £25 million in 2010. But the business interruption sum insured of £2.5 million with a Lloyds syndicate had been based on a projected turnover of £11million. The value of stock and machinery was also significantly understated and, as a result, the insurer made a once-only offer of £1.5 million to settle the claim.

Few small businesses knowingly underinsure. Reasons often stem from ignorance surrounding industry terms. “There is a general misconception in that your building sum insured represents what you paid for it, the market value,” says Mr Wilde. “From an insurance perspective it isn’t, it’s the rebuild value that’s important.

70 per cent of businesses involved in a major fire either do not reopen or fail within three years

“Quite often the problem with underinsurance, particularly of a building, is a partial loss rather than a total loss. If you lose 25 per cent of your building, say the roof, you’ve got to find the money to put that back on because, if you’re underinsured, your insurers aren’t going to give you the full rebuild costs.”

Underinsured SMEs frequently go out of business. According to the Arson Prevention Bureau, 70 per cent of businesses involved in a major fire either do not reopen or fail within three years. “Underinsurance puts you under an extreme financial burden,” says Mr Wilde. “If you have the resource to ride that pressure you will get through. If you haven’t got the resource, it’s likely to end up in the business closing.”

Infrequent valuations and insufficient indemnity periods, in the case of business interruption, are other causes. The typical indemnification period for business interruption is one year, but this could prove too short a time-frame. Onerous building regulations and environmental factors, asbestos for example, could leave a small business out of action for a much longer period. “In a market town it could be a 200-year-old building with six-foot walls,” says Mr Wilde. “That will cost a fortune to rebuild and, if it’s listed, that brings in additional complications.”

Disintermediation, as growing numbers of SMEs, particularly micro businesses, bypass the broker to buy insurance online is another concern. SMEs need access to expert advice, says Mr Wilde. “Whatever size your business is, commercial insurance is a complex animal and my view, after 36 years in the trade, is you need to be talking to people who understand your business so they can build the proper protection.”

KNOW THE JARGON

Condition of average

This clause is applied when a claim occurs and the sum insured under the policy is below the actual value of the item. Insurers then apply an “average” to the settlement of the claim, effectively reducing the payment made by the percentage of underinsurance. For instance, if a property is underinsured by 50 per cent and it experiences a £20,000 loss, the insurer will typically offer £10,000, half the amount needed to rebuild.

Gross profit

A flexible term, this is often interpreted differently by accountants and insurers. Overheads, especially wages and utility costs, are routinely deducted from turnover to calculated gross profit in accounts, but should be included for the purposes of calculating business insurance.

Sum insured

This is the maximum amount the insurance company will pay out, if everything you own is totally destroyed.

Valuations

Best practice is to carry out a professional valuation each year or at least at intervals of no more than three years. This allows the surveyor to factor in issues affecting rebuilding costs, including inflation, alterations to the building and legislative changes.

Reinstatement

This cover will replace old machinery for new, but indemnity cover will only provide for the market value of the equipment that has been damaged or lost.