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Risk of underinsurance grows as inflation bites
Out-of-date valuations can drastically reduce amount insurers pay out
Neil Thomas 4 May 2022

No one can be unaware that the cost of daily living is rising and at a faster rate than in many decades.

Driven by several factors including the displacement of the supply chain during Covid-19, as well as the Russian-Ukraine conflict, each of these events puts a strain on the markets and is reflected in the prices we pay.

The effect of geopolitical events and changes is felt across the globe and manifests itself in higher costs for many basic and commercial products and services. What most of us probably feel acutely is the increase in costs for energy, goods and foods. Prices are also rising significantly across a broad sector of industries, from the price hike of metals and cement in the construction industry to higher costs for lithium batteries and microchips in the high-tech industries, and even within the energy sector, a surge in hydrocarbon costs. In fact, there is very little that is unaffected by the global increase in inflation.

Price volatility for some materials and services have been unprecedented and this has led to some projects being delayed, cancelled or re-tendered, while companies have seen profits disappear. However, why is this important to businesses and in particular their insurance policies?

With rising inflation and a volatile market, businesses with insurance coverage for their assets face the growing risk of underinsurance.

As buyers of insurance, companies need to pay close attention to the replacement values they declare to Insurers. Most insurance policies will pay for the replacement cost of goods and property lost or destroyed at current asset value but only where the replacement cost has been declared to insurers and premium paid on those values.

Many companies buy insurance based on their own internal valuations and use accounting methodology to estimate values, rather than replacement values. Net book values are typically discounted calculations from the original costs and are not a true reflection of the cost to reinstate lost or damaged property at the time of the loss. Replacement valuations can also take into account other factors, such as ESG considerations or more efficient technology, when calculating replacement costs.

Accurate assessments of replacement valuations are particularly important in a volatile market with rising inflation. Out-of-date valuations can result in both underinsurance and more rarely over insurance. On the flip side, regular and accurate replacement value assessments will help risk managers make informed purchasing decisions and better understand insurers’ pricing.

Exchange rate volatility will also feed into replacement values. Assessing cost increases in countries of origin before factoring in exchange rates will be fundamental to ensure accurate valuations.    

As inflationary pressures are expected to stay high during the next 12 months, we will see replacement values continue to rise to varying degrees. The tight labour market and Covid-19 restrictions that are still in place in parts of Asia, as well as the ongoing conflict between Russia and Ukraine, add to the problem and will have varying effects in different countries.

What this means is that companies should get timely and accurate replacement valuations on a regular basis to help combat this threat.

Rising prices and inaccurate valuations mean that policyholders may unwittingly be underinsured or become underinsured during the period of their current policy. During these unprecedented times, it is prudent for companies to have regular check-ins on an annual basis or even more frequently with their insurer to ensure that they have updated their values and cost assessments to reflect the current replacement value of the asset or property.

Why does this matter? It matters because it is important to keep insurance policy values up-to-date, especially when the policy is designed to protect and respond to business needs and interruption or when the business suffers a physical damage event to its property or assets.

Valuations are usually derived at the time the insurance policy is taken out and based on either professional valuations or the company’s best estimate at that time. The value declared should reflect the cost to replace the property in the event that it is totally lost and also to reflect the loss of fixed costs and net profit for the business interruption cover.

It is essential to review insurance policy limits regularly and while an annual valuation is usually sufficient, at a time when prices are rising quickly, it may be prudent to undertake a more frequent assessment. Have a careful look at the values your business has declared and if they are no longer adequate, call your risk adviser and get them corrected. This is usually a fairly simple process and once the values are declared to the insurers, the insurance company will assess the premium due based on the revised replacement values declared to them.

Being underinsured can drastically reduce the amount that insurers will pay out in the event of a claim and may leave the policyholder with insufficient funds to rebuild their asset or replace their stock.

We now enter a radically new age of significantly higher inflation. To ignore changes in replacement values or hesitation to adopt a regular review of valuations could have catastrophic consequences in the event of a loss, putting companies in a vulnerable position.

A more transparent understanding of how insured values are calculated will benefit all market participants, both for the insurance buyers and the insurers.

Neil Thomas is head of claims for Asia at WTW.

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