What is Business Underinsurance and how to avoid it

In 2022, a Sedgwick survey* estimated that 80% of UK small and medium-sized enterprises (SMEs) were underinsured.  That means over 3.4 million UK SMEs don’t have the insurance protection they need and could face significant financial problems should they need to make a claim.

This Business Underinsurance Guide explains what business underinsurance is, the potential consequences, and how to avoid the underinsurance trap.

What is underinsurance?

Business underinsurance occurs when a business doesn’t have sufficient financial protection to cover its risks.

The Chartered Institute of Loss Adjusters** has said that 40% of claims involve underinsurance.  This typically accounts for between 35-40% of the total claim, a shortfall that has to be made up by the policyholder.

Know your sums insured

Insurers base their quotes on the ‘sums insured’ – the value of the business assets that need covering.  It’s your responsibility to ensure that these valuations are correct.  If they aren’t and you have to make a claim, then your insurer may seek to correct them.  This correction can either mean they ask you for increased premiums to bring them in line with the cover you’d need for the claim, or they may invoke the ‘average clause.’

Average clause explained: Your payout can be reduced to match the level of cover you’ve been paying for.  So, let’s say you need to make a claim for £100,000 following a fire.  The insurer looks at your policy and sees that you have only been paying for £50,000 of protection.  The insurer will be within their rights to pay you £50,000, leaving you to find the rest.

Under the 2015 Insurance Act, you must provide insurers with a ‘fair representation’ of the risk; if you accidentally underestimate these, you could be left facing a hefty shortfall.  Worse, if you’re deemed to have deliberately underestimated the cover you need to get cheaper business insurance, the insurer could void the policy, and you’ll receive nothing.

While your insurance broker will be happy to help you get the business insurance you need, it’s your responsibility to ensure that your insured sums are correct.

What are the causes of business underinsurance?

There are several causes of underinsurance, including:

Sums insured are too low – policies need to cover the value of the business’s assets and have appropriate indemnity limits – the maximum amount an insurer will pay in a given period.  For example, this could include the potential cost of a professional indemnity claim or system recovery following a cyber-attack.  Ideally, you should review your sums insured ahead of renewing your business insurance.

Business interruption periods are too short – while most businesses have business interruption insurance, the indemnity periods are often too short.  The British Insurance Brokers Association estimates that 43% of companies’ business interruption coverage is around half what it should be at a year***.  Supply chain issues, shortages of labour, and the complexity of rebuilding IT systems can mean that it can take up to two years to get a business back up and running.
Asset valuations are outdated – inflation has pushed up prices across the board, and it’s important to make sure your valuations are correct.

Accountancy and insurance definitions of gross profit are different – an accountant’s gross profit calculation will subtract any cost that varies in proportion to production, but for insurance purposes, they must vary in direct proportion.  This is a key distinction and a source of many underinsurance problems
Standard policy limits aren’t right for all businesses – some businesses will require higher indemnity levels on certain policy elements depending on the level of risk they face.  Again, this is something your broker can help you with when arranging business insurance.

How to calculate sums insured correctly

Having incorrect sums insured is one of the ways that businesses fall into the underinsurance trap.  To help you calculate sums insured correctly, here is our guide to getting the right valuation for your property, contents, stock, plant and machinery, business interruption, and liabilities.

Property

Some business owners underestimate the sums insured for their buildings.  When calculating business premises sums insured, you need to:

• Calculate them based on the rebuild costs, not the property’s market value – the market value is often lower than rebuild costs.  Rebuild costs account for things like building materials, demolition and site clearance, architect’s fees, tradesmen’s time, etc.  These are susceptible to inflation and are one of the reasons that Rebuild Cost Assessment estimates that around 80%°° of commercial properties are underinsured.
• Remember to include everything – outbuildings, driveways, boundary walls, and garages.

Contents, stock, plant, and machinery

A typical business insurance policy can cover contents, stock, plant equipment and machinery, but there are some things that you’ll want to look out for:

• Replacement values should be ‘as new’ – not as stated on the company’s balance sheet.
• Make sure your equipment and stock inventory are up to date –that it is comprehensive – a lot of small things can add up to a lot of money – and also make sure it covers any goods belonging to customers, such as completed orders that are still with you.
• Stock should be valued based on your maximum holding – so if disaster strikes during your busiest period when you have more materials and stock in, you’ll be covered.
• Get an estimate of the lead times on replacements for specialist equipment – you may find they are no longer made, and you’ll need to up your sums insured for replacements.  It may take weeks or even months for the new equipment to come through, which can impact your business interruption cover.

Business interruption

Another significant cause of underinsurance is business interruption periods are too short.  Business interruption insurance can provide you with an income should you be unable to trade owing to damage to your premises, flooding, or another loss.   Having the right indemnity period is important.  To make sure yours is long enough, consider:

• How long it would realistically take to get your business back to previous trading levels – consider the time it would take to get new equipment, to rebuild or renovate premises, and the time it would take to get new customers if you lost some while you couldn’t operate.
• Consider how much control you have over these things – if you’re a tenant, then you will be in your landlord’s hands.  If the problem was caused by a third party, you may need to wait for civil or criminal action to be settled.  If your premises are destroyed, you may need to wait for planning permission before you can start the rebuilding process.
• What if you’re underinsured?  – this could result in a reduced payout or even no payout at all.  If that happens, you may need extra time to get the finances together to complete the restoration of your business.
• Check your policy’s ‘gross profit’ definition – for insurance purposes, the general definition of gross profit is calculated as turnover minus purchases and variable costs during the indemnity period.  Definitions do vary from insurer to insurer, though, and it’s important to know what they are based on.  One option is to buy cover that’s based on the declarations you make about your anticipated annual gross profit.  It’s standard for such policies to provide an automatic uplift of 33% in your sum insured providing it’s correctly calculated at the policy’s inception.

Liabilities

Liability cover, whether it’s public liability insurance, employers’ liability insurance or something more specialist, such as directors’ and officers’ insurance, comes with indemnity limits.  To work out what limits you need, think about:

• The size of clients you are working with and if they have any specified limits, e.g. a public liability of £10m.
• The size and frequency of any previous claims.
• The chances of multiple employees bringing the same claim.
• The likely cost of defending a claim.
• Whether your contracts with clients impose any additional liabilities, ‘liability assumed under contract’ that you need to factor in.
• If a claim could have multiple public claimants following, for example, a product failure.

Top ten tips for avoiding business underinsurance

Business underinsurance is a serious problem, but there are some simple things that you can do to limit your chances of falling into the underinsurance trap:

1. Consult an independent insurance broker – they’ll be able to give you the help you need to ensure your business is adequately protected.
2. Review your requirements ahead of your renewal – keep a record of your assets and liabilities and check them annually.
3. Value property based on the rebuild valuation – not the market value.  This needs to be done by a qualified professional such as a building surveyor.
4. Don’t underestimate the value of your business’s assets to try and get cheaper cover – in the event of a claim, this could cost you far more than you’ve saved.
5. Be realistic about business interruption indemnity periods – while 12 months is the standard period, 24 months is seen by many as more realistic.  Also, look into buying a declaration-linked policy.  This provides a 33% uplift, providing the sum insured and period of indemnity are both correct and that the declarations are made when requested by insurers.
6. Check your liability limits and contractual obligations – you may find that you are contractually obliged to have higher limits in place.
7. Be aware of new risks – for example, with cyber-attacks on the rise, looking to cyber-insurance protection could be a good idea.
8. Have a disaster recovery plan in place – this will help speed up your business’s recovery and help you avoid exceeding indemnity limits.
9. Factor in inflation when setting limits – rising prices could leave you out of pocket in the event of a claim.  When looking at policy limits, look at what the inflation rate over the past year has been.
10. Include costs such as potential fees for solicitors, IT professionals and accountants – these may require additional cover.

*Sedgwick survey 2022
** The Chartered Institute of Loss Adjusters 2022
*** Biba Manifesto 2023
°° Rebuild Cost Assessment Survey 2021