Underinsurance is the situation in which the sum insured under a policy is lower than the actual value of the assets it covers. When it exists, the insurer does not pay the full loss but only a proportional part of it — even though the premium is up to date and the claim falls squarely within the cover taken out. It is the most frequent, and the most expensive, defect in industrial property policies.
An industrial company can have its policy in force, its premium paid and still recover only a fraction of the loss after a fire or a major breakdown. The reason is almost always the same: the figure stated in the policy stopped reflecting the value of the asset base years ago. And it is rarely discovered before the claim, precisely when there is no longer any remedy.
What is underinsurance and why is it so common in industry?
Underinsurance exists when the sum insured is lower than the actual value of the assets covered at the time of the loss. It is not a breach by the policyholder: it is an automatic consequence of how property insurance works, resting on the indemnity principle — insurance repairs the loss, it does not enrich — and on the correspondence between premium and risk. If less value is declared, less premium is paid, and the effective cover shrinks in the same measure.
In industrial assets the mismatch is especially frequent because policies are signed with a figure — often the depreciated book value — and are not updated while the cost of replacing the equipment rises year after year. In the market practice we observe in our valuations, it is not unusual to find plants that believe they are covered 100% and are in fact covered at around 60% of their replacement value.
How does the average clause work?
The average clause (or condition of average) is the mechanism by which the insurer adjusts the settlement when there is underinsurance: it pays the loss in the same proportion that exists between the sum insured and the actual value of the asset. In Spain it is expressly provided for in Article 30 of the Insurance Contract Act (Ley 50/1980), and equivalent mechanisms exist across the main European markets.
The formula:
Settlement = Loss × (Sum insured / Actual value)
The example, step by step
A production line has an actual value today of EUR 1,000,000. The policy, signed years ago and never updated, insures it for EUR 600,000. A fire causes a partial loss of EUR 200,000.
- Degree of cover: EUR 600,000 / EUR 1,000,000 = 0.6. The line is insured at 60% of its value.
- Applying the rule: EUR 200,000 × 0.6 = EUR 120,000 of settlement.
- Cost to the company: the remaining EUR 80,000 — 40% of the loss — is borne by the policyholder, plus any applicable deductible.
The company does not recover less because the claim was poorly covered, but because it was insuring only 60% of the asset — and, consistently, paying premium for only that 60%.
Does it apply even when the loss is partial?
Yes, and that is the usual surprise. Many policyholders assume that, if the loss (EUR 200,000) is below the sum insured (EUR 600,000), the policy responds in full. It does not: the average clause applies to every claim, total or partial, unless the policy has expressly waived it. In a total loss, the settlement is capped, at most, at the sum insured.
Replacement cost new or actual cash value?
Avoiding underinsurance requires insuring on the correct value, which is not the book value. The two technical references are:
- RCN — Replacement Cost New. What it would cost today to acquire, transport and install a new asset equivalent in capacity and performance. It is the basis for “new-for-old” cover, common for industrial machinery in operation.
- ACV — Actual Cash Value. The RCN less depreciation for age, use and condition. It reflects what the asset is worth in its current state and is the basis for “actual value” cover.
Each basis of settlement demands its own value. Insuring at ACV an asset base with new-for-old cover creates structural underinsurance, because the denominator of the average clause will be the RCN. And the reverse: insuring at RCN under actual-value cover means paying premium for a value that will never be recovered. Net book value serves neither basis: it carries depreciation criteria unrelated to the real cost of replacement — an asset fully written off in the books can cost more today than when it was bought.
Why do industrial policies end up underinsured?
Industrial underinsurance almost never stems from a conscious decision to save premium. It stems from the drift between a static figure — the one in the policy — and a living asset base. The usual mechanisms:
- Capital goods inflation. The replacement cost of machinery — materials, components, transport, installation — rises over the years. A sum insured that was correct in its day falls short a few years later even if nothing changes in the plant.
- Uncommunicated extensions and investments. New lines, automation, tooling, facility upgrades. CAPEX enters the plant but not always the policy: no one passes each investment on to the broker or the insurer.
- Sums inherited from book value. The initial figure was taken from net fixed assets and drags along tax depreciation that has nothing to do with the cost of replacing the asset.
- Automatic renewals without technical review. The policy renews each year as it stands, or with a flat uplift that does not distinguish between asset types.
- Outdated valuations. The last valuation for insurance purposes — if there was one — is too many years old to remain representative.
The Spanish insurance industry association, UNESPA, maintains a constant educational effort so that policyholders understand what they buy; even so, in the industrial segment the sum insured is rarely reviewed with technical rigour.
How is it corrected? Valuation for insurance purposes
The correction is a technical valuation exercise, not an administrative formality:
- A complete insurable inventory, asset by asset, with technical identification: make, model, year, capacity and condition.
- Calculation of the RCN and the ACV of each asset on a current market basis, including transport, installation and engineering.
- Adjustment of the sum insured by category — buildings, installations, machinery, stock — to the calculated values and to the basis of settlement taken out.
- Periodic review. The pattern we apply in our practice: annual updating of values — at least through indices by asset type — and a full valuation with inspection every few years, or earlier if there are significant investments.
For the figure to withstand the scrutiny of an insurer — or of a loss adjuster after the claim — the valuation must be prepared under recognised standards: the RICS Red Book and the International Valuation Standards (IVS) define bases of value, methodology and the valuer’s independence requirements. This is a piece of valuation for industrial insurance work that, in addition to eliminating underinsurance, detects the opposite case — overinsurance — where the company pays premium for a value it will never recover.
What should you look at in the policy?
Even before valuing, a technical reading of the policy reveals where the risk lies:
- The sum insured per category. Buildings, machinery and installations, stock and business interruption are insured separately, and the average clause is assessed category by category.
- The basis of settlement. Is the cover new-for-old or actual value? The sum insured must be calculated on that same basis.
- The clauses that mitigate the average clause. The market offers mechanisms worth negotiating: waiver of average up to a certain percentage of deviation, capital compensation between categories, automatic revaluation margins, or agreed value where a prior accepted valuation exists.
- Deductibles and limits. A low per-claim sublimit can cut the settlement even before the average clause comes into play.
A policy with a well-calculated sum and well-negotiated clauses is the difference between resuming operations after a serious loss or funding the gap from the company’s own cash.
The practical conclusion
Underinsurance goes unnoticed until the claim. By then, the average clause has already decided how much is paid out, and no subsequent negotiation changes it. The only way to avoid that surprise is to know the actual value of the asset base beforehand — with a valuation for insurance purposes prepared under standards and kept up to date — and to align the policy with it. That is, precisely, the purpose of a well-prepared insurance valuation.