The risks of being underinsured – and how to avoid it

The risks of being underinsured – and how to avoid it

Insurance provides a much-needed safety net against unforeseen events and disasters, and it remains one of the most effective ways of preventing the potentially devastating financial impact of a sudden and unexpected loss. While most recognise the importance of having insurance against the above, a less apparent but equally significant risk is being underinsured.

Underinsurance is common – but not for the reasons you may think

In many cases, being underinsured is less of an intentional decision and more of a miscalculation or a misunderstanding. Some policyholders, for example, become underinsured when they conduct property upgrades, for example, when doing alterations and renovations that make a material difference to their asset’s market value. Others become underinsured when they fail to account for the rate of inflation and to update their cover accordingly as time progresses, an exercise that should be conducted annually.

Some may face affordability issues and will try to cut costs by lowering the sums for which they are insured. While this may provide temporary financial relief, it is a short-sighted approach, given that the cost of needing to cover the shortfall out of pocket is likely to lead to unmanageable financial hardship.

According to insurance valuation experts, Quantam, recent statistics on the local market showed that almost 80% of South Africans are underinsured by over 50% of the value of their valuable possessions, compared to only 20.6% who are over-insured by just under 28%. These findings highlight a pressing need for consumer education on the implications of underinsurance and how to avoid it.

Consider a scenario in which someone takes out insurance on their home, but not enough cover to rebuild it entirely. Consider also that the basic principle of insurance is to return the owner of the asset to the same financial position that they were in prior to the damage or destruction of that asset.

If the house in this scenario were to burn down in a fire resulting in a total loss, the insured would not be able to recover the full replacement value of the property via an insurance claim. Instead, the insurer will apply the average condition, which indemnifies the client only for the portion of the loss that has been covered in the policy document. In this case, if the house were worth R2 million but the value covered by the insurance policy was set at R1 million and the client tried to claim for a total loss, they would only be paid out the R1 million, leaving the client personally liable for the balance. The reason for this is that the client was underinsured by 50%.

Should the client only need to claim for a partial loss, the payout will be calculated on the same basis. Consider a scenario where the client, who insured their house for R1 million but the real value was R2 million, tries to claim for a partial loss of R400 000. In this situation, the client’s insured value would be divided by the real value, and multiplied by the partial claim amount, resulting in a payout of only R200 000. This would again leave the client to foot the bill for the remaining 50%. Depending by how much a client is underinsured, these calculations will be worked out differently.

Instances like these can have serious, long-term financial consequences for both individuals and businesses. A similar principle would apply when it comes to insuring your home contents, so care should be taken to ensure you are not underinsured for household contents.

The good news is that it can be avoided

To avoid being underinsured, it is crucial to have a clear understanding of how to determine the sum insured and to work through the policy conditions thoroughly, with the help and guidance of an insurance adviser.

In the case of property, using a qualified surveyor to conduct a property valuation will ensure that the sum insured accurately reflects the value of the building as it appreciates over time. Additionally, it should be standard practice to take regular inventory of your house contents to ensure that every asset, from crockery and cutlery to garage items and clothing, is accounted for in the coverage amount.

When making significant new purchases or undertaking alterations that increase the property’s value, these upgrades should be communicated to your insurer or broker who will provide insight into how the sum insured should be adjusted.

Furthermore, all valuations on assets such as jewellery, homes and antique furniture should be kept up to date to reflect the most current replacement rates. To simplify this process, some insurers provide checklists as helpful guidelines to prevent overlooking specific items in your coverage.

Regular policy reviews are a highly effective way of avoiding underinsurance and the pitfalls involved. Reviews offer clients the valuable opportunity to assess any changes that may have occurred in their lives, such as lifestyle changes or significant events.

Several factors need to be considered in these reviews, which should be conducted in partnership with an adviser, who will be able to explain instances where policy wording has changed, or conditions updated. In general, being proactive is the key to making informed decisions that can accommodate your insurance needs as they evolve and will help ensure that you have sufficient coverage in place.