When taking out an insurance policy for your physical assets, whether it’s your house, or your business equipment, one of the most important decisions you’ll need to make is how much to insure them for. Unfortunately, it’s also one of the easiest things to get wrong. You may have heard of underinsurance and how serious the consequences can be, but the reality is, underinsurance is common in Australia, and the problem may be much closer to home than you might realise. Let’s take a look at underinsurance in some more detail, how it can impact a claim, and steps you can take to prevent it.

Underinsurance can occur when an asset is insured for a value that is less than what it would costs to replace it with something of similar make, model or capacity. For example, say a home owner insures their house for $300,000, the house is completely destroyed by a natural disaster, and the cost to rebuild the house is $500,000. This means the house was underinsured.

The practical consequence here would be that the insurer would not have to pay the full policy limit, in this case, $300,000. The amount paid to the homeowner for this claim would be reduced in proportion to the extent the house has been underinsured, and the homeowner may need to contribute to the cost to rebuild the house with their own funds. The practical consequence means that an insurer would not have to pay the full policy limit (ie the value the asset was insured for, in this example the $300,000). The insurer would reduce its claim payment amount by having reference to the extent of underinsure meaning the owner would potentially need to contribute to the cost to rebuild the house with their own funds.

Almost two-thirds of small businesses have admitted they may be underinsured, so it’s not an issue to be taken lightly. In the event of a claim or total loss, being underinsured often means having to contribute to the cost of repairs or rebuilds out of your own pocket. One of the key reasons for underinsurance being so common is that many people don’t understand how underinsurance works. There are some who deliberately underinsure thinking they’d be happy to downgrade or purchase less equipment if there was a claim, but do not realise it also affects the maximum amount an insurer is required to pay. It could also mean that when rebuilding after a major event, material cost increases may also result in owners making decisions about the quality of materials or important design features.

There is a misconception that underinsurance will only impact a claim if there is a total loss, such as if your house burns down, or your business premises are destroyed completely. However, underinsurance can impact any claim, even when there is only partial damage, if an asset is not insured for its true replacement value. If you make a claim, and at the time of assessing the claim, it is discovered that your assets were underinsured, then the amount paid to you will be reduced in line with the amount you had underinsured for. To demonstrate using a simple example,

You insure your equipment for $100,000. An insured event occurs such as a fire, damaging $50,000 worth of your equipment. You put in a claim for $50,000 for repairs and replacement of the damaged equipment. An assessor determines that your total equipment is valued at $200,000. As you have declared/insured your equipment for $100,000 but the assessed value is $200,000, you have underinsured yourself by 50%. Your claim will therefore be reduced by 50%, meaning you will only receive $25,000 and not the full $50,000 you have claimed for.

There are several steps a property or business owner can take to prevent underinsurance. , which include some basic due diligence when purchasing or renewing an insurance policy. When nominating your sum insured, take some time to calculate the cost of replacing or rebuilding your assets new for old, rather than the purchase amount. There are also calculators online which can assist, or seeking the assistance of a professional valuation service. Reviewing your sum insured should also be ongoing, so also don’t forget to review this throughout the year, and when you purchase new equipment, upgrade or renovate, as you’re likely to need to adjust your sum insured accordingly.