Question: What is the average clause? How does it operate in an insurance policy?
- C.T. & O.G.
Answer: Thanks for pointing out my two errors in last week's
article. I mistakenly assumed that most readers knew about the average clause. Secondly, I did not explain how it worked. I argued that the regulators The Financial Services Commission had failed in its attempts to get insurers to properly describe the 'nature and effect' of the clause in the rules it laid down last August.
WHAT IS THE AVERAGE CLAUSE?
The twelve insurance providers tried to explain the clause two Sundays ago in a number of newspaper advertisements. Unhappily in my opinion they used almost word for word the same technical and legal jargon used in The Jamaica Gazette. There was very little practical advice in the advertisement for the average consumer.
The typical clause says: "If the sum insured at the time of loss or damage shall be less than the value of the property, the insured will be considered as being his own insurer for the difference between the sum insured and the value of the property insured at the time of such loss or damage and shall bear a rateable share of the loss."
The clause I have cited comes into effect when the sum insured is less than 100 per cent of the value of the property. In some cases it may be as low as 75 per cent.
The clause is found in many types of policies. It applies to assets like buildings and their contents. Almost all insurance covering houses and contents include it. The theory behind it is not rocket science. Premium rates assume that the sums insured choosen by consumers represent full value. In practice, this seldom happens.
As a result, buyers pay less in premium than they would have paid had they insured for the full amount. Under insurance it is unfair to those who insure for the correct [or full] values. It is also unjust to insurers. The clause seeks to promote equity for all three groups.
HOW THE CLAUSE OPERATES
IN PRACTICE:
The clause kicks in when a claim has been made. The value at risk [that is, the correct insured value] is calculated. Reference is made, in the case of a building, to its floor area and the actual construction cost based on material and labour charges at that time. The sum insured is then compared with the value at risk and then applied to the amount claimed to calculate the amount payable using the following
formula:
See formula 1 below
Here are examples of how the clause would operate under three different sets of circumstances:
CASE NO. I:
1. The sum insured is $7 million.
2. The value at risk is $10 million.
3. The loss is $5 million.
Using the formula the amount recoverable from insurers would be $3,500,000 calculated as follows:
See formula 2 below
Since the sum insured represents only 70 per cent of the value at risk the policyholder was under-insured by 30 per cent. He (or or she] is therefore entitled to recover 70 per cent of the loss. The remainder of the loss, $1,500,000, [or 30 per cent] would be assumed by the insured.
CASE NO. II:
Assumptions:
1. Same 1 and 2 in Case No. I
2. The loss is $8,000,000.
The insured would be entitled to recover only $5,600,000 of the loss. The sum insured represents the same 70 per cent of the value at risk as stated in Case No. I. The policyholder would be considered his own insurer for the remaining 30 per cent of the loss or $2,400,000.
CASE NO. III:
Assumptions:
1. Identical to 1 and 2 in Case
Nos. I & II
2. The loss is $10,000,000.
In this example, the insurers would pay $7,000,000, the sum insured, since that amount represents 70 per cent of the value at risk. The policyholder would be responsible for the remaining 30 per cent of the loss or $3,000,000.
In my opinion, there is nothing unfair about the average clause. What bothers me is that neither the insurers nor past or present regulators appear to have devoted sufficient resources and energy in explaining it to consumers in plain language and to reduce its impact as they have done so admirably in the case of motor vehicle values.
I hope that this article and the one I wrote last week will go some way in bridging the information gap.
Cedric E. Stephens provides independent information and advice about the management of risks and insurance. If
you need free information or counsel to help you solve a problem write to The Financial Editor or contact Mr.
Stephens directly at aegis@cwjamaica.com.
