The insurer’s nasty surprise

  • Author : John Harper
  • Date : April 2011
ABOUT THE AUTHOR: John Harper is a regular tutor for the STEP Offshore Diploma face-to-face courses

Ifirst came to understand the meaning of ‘averaging’ in an insurance context when, as a young chartered accountant in Jersey, one of our client’s hotels was completely destroyed by fire. We became involved as part of the insurance cover was for consequential loss. As the hotel’s auditors we had to make a report about the trading profits that would not now materialise for the two years or so while the hotel remained effectively out of business during reconstruction. We had to certify the results of previous years’ trading and extrapolate them into the future. As an aside, I also learned the value of engaging a loss adjuster in such cases. His fee was covered by the insurance policy and he carefully led us through the complex presentation we were making on behalf of our client to the insurers. I learned from that time that accountancy is an art form and not a science!

Anyway, our hotelier’s problem was that, in terms of the level of cover, he was grossly under-insured. Whether it is a trust-owned piece of real estate or simply your own modest house, you know that you must insure the property, but for how much? Perhaps the most common and certainly the simplest way of picking the amount of cover required is just to look at what was paid. The trouble is, that may mean that you are over-insuring and consequently paying too much in premiums as the value of the land may be a substantial part of what you paid and it is unlikely to disappear, in the absence of a rather nasty earthquake. It is equally likely that in fact, because of market conditions generally or perhaps your excellent negotiating skills, you may have actually paid a price that is far less than it would cost to rebuild the property in exactly the same materials and to the same standard, at today’s prices.

Rebuilding costs vary enormously from one place to another and certainly if the property in question has features that may not be so easily replaced by today’s craftsmen. Difficulties with ease of access may add substantially to the cost, as would, for example, the fact that the property was located on a small island. I recall witnessing the rebuilding of a top hotel on a small Caribbean island that was virtually destroyed by a hurricane. In addition to all the usual costs associated with rebuilding, the hotel had to first build its own dock adjacent to the property so that every bag of cement, every cup and saucer, and every replacement coconut palm could be brought ashore from the ships specially chartered for the purpose (as the local harbour wasn’t big enough).

The cost of employing a firm of chartered surveyors once every three of four years will be well worth the fees. They have all the local data that will be needed to estimate the full replacement cost, taking all local and other factors into account. You will then have their valuation to wave at the insurers if the need ever arises.

Still not convinced? Well now I come to the rub, as they say. Suppose your trust real estate (it could well be a hotel) is insured for a complete write-off at say USD24 million. If the hotel is destroyed and actually costs perhaps USD32 million to replace, you might say to yourself, ‘Well, with the USD24 million I will get I can at least build a slightly more modest replacement’. Wrong! Insurance (very) small print will say something like this: ‘If at the time of any loss or damage the sum insured is lower than the value of the insured property, the insured shall bear a rateable proportion of the loss accordingly’.

Translating this into ‘non-insurance speak’ it means that, in the case of our example, if the replacement cost turns out to be USD32 million and your cover is USD24 million, the insured (you) will bear a rateable portion of the loss. The insurers will not pay out USD24 million. Your rateable proportion is (8/32) = 25 per cent. So, the insurers will pay out (100 per cent – 25 per cent) = 75 per cent of USD24 million, which comes to the princely sum of just USD18 million, little over half of what you actually need.

The idea of employing a good chartered surveyor now seems much more attractive…


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