The Hindu Business Line : Insurance lingo made easy

An insurance policy remains couched in jargon, making it difficult for a common man to comprehend. An attempt to demystify some terms used in a fire insurance policy.

V. Ramakrishna

In a world where one believes in ‘small is beautiful’, be it a mobile phone or a laptop , an insurance policy remains the only exception. It still remains couched in jargon, making it difficult for a common man to comprehend. An attempt to demystify some terms used in a fire insurance policy.

One big question consumers always have regarding fire/homeowner’s insurance is: What is the right limit or value of insurance I should take? Most consumers assume they will always get enough to rebuild. This is incorrect. It is quite common for people to underestimate the actual (present) value of their property. When disaster strikes and the entire property has to be rebuilt, they realise that they are falling short. Why does this happen?

Well, there are different methods to determine the value of a claim.

Market value: Is the value at which property of a similar age and condition can be bought or sold. It represents the second-hand value, which includes depreciation due to age (and appreciation due to inflation).

Consider this. Ram bought a house for Rs 14 lakhs in Jan 2005 (Rs 4 lakh towards land value and Rs 10 lakh towards construction cost) and takes fire cover for Rs 10 lakh (as land value need not be insured) on market value basis. In October 2005, Ram’s house got damaged beyond repair due to fire and had to be pulled down. Ram’s claim is settled by the insurer for Rs 9.5 lakh (Rs 10 lakh less depreciation @ 5 per cent per year). Claims for properties insured on market value basis are always settled after taking depreciation into account.

Reinstatement/reconstruction value: Is the cost it will take to rebuild the house/office (at today’s costs), including incidentals such as professional fees (architects and surveyors) and removal of wreckage (of the old building). If the building is insured on reinstatement value basis, a claim will be settled for the value of new property without taking any depreciation into account. Going back to the previous example, if Ram had insured his house on reinstatement value basis, the claim would have been settled for Rs 10 lakh.

(When the purpose of insurance is to cover a loss that you cannot afford to pay, it makes sense to cover the building on a reinstatement value basis rather than market value basis).

However, a word of caution. Having a “re-instatement” clause in the insurance policy is not enough. To get the full benefit of such a cover, the policy value has to keep pace every year with the increase in market value.

Now, considering the same example, let us assume that Ram had taken the policy on reinstatement value basis but kept the limit/ value constant (at Rs 10 lakh) at each renewal. The fire occurs in October 2007 (instead of October 2005).

In October 2007, the cost of constructing a similar building had gone up to Rs 15 lakh but Ram’s policy still showed a limit of 10 lakh. In such a situation where the cost of reconstruction has outpaced the insurance coverage, the insurer will settle the claim for only Rs 10 lakh, and for the remaining Rs 5 lakh, Ram will have to dig into his pocket. You could be in a similar situation.

It is always advisable to revise the insurance limit at every renewal (by at least 5 per cent) because in the next year, the costs for constructing a similar building may go up.

Principle of underinsurance

Now let us consider a small variation of the above revised example to understand the concept of underinsurance. Everything remains the same except that the damages due to fire accident (October 2007) were minor and the repair cost worked out to Rs 3 lakh. To his disappointment, Ram’s claim is restricted to only Rs 2 lakh, as he had not insured the building for the correct value (building was insured for only 67 per cent of the latest full value of Rs 15 lakhs; hence, the claim will also be settled for 67 per cent of the actual loss of 3 lakh). This is known as the principle of underinsurance.

This may seem unfair but the spirit of underinsurance is to keep things fair for all. After all, claims can only be paid out of premium paid on full values.

Most consumers and business owners know that the odds of them ever having their entire property destroyed are extremely low.

So, many people only want to buy enough coverage for what they perceive is their probable maximum loss. Underinsurance is an elegant way of forcing policy holders to insure their stuff for its full value.

Remember, reading and understanding your policy can help you avoid problems and disagreements with your insurance company in the event of a loss.

(The author is Chairman, India Insure Risk Management & Insurance Broking Services. Any feedback, comments, suggestions, queries may be sent to askindiainsure@indiainsure.com)

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