24.07.23

Interest rates and underinsurance

Interest Rates Climb to Highest Level in 15 Years

During a Monetary Policy Committee (MPC) meeting on 21st June, the Bank of England (BoE) raised interest rates for a 13th consecutive time in an effort to tackle persistent inflation. The MPC voted to increase the Bank Rate by 0.5 percentage points to 5%, the highest level seen in 15 years. The move comes after inflation remained at 8.7% in the year to May, despite economists originally anticipating a fall. Cox Mahon, the specialist insurance broker, are advising clients that despite the tough environment, insurance cover and costs is one area that should not be subject to a cost-cutting exercise as the consequences could be disastrous. Also, there is a direct link between interest rates and underinsurance.

Economic Outlook for Interest Rates

The latest Bank Rate rise has led to speculation that the UK could tip into a recession later this year or early next. However, this is just conjecture; the BoE will release its revised economic forecasts next month.

Increased Financial Pressure

With yet another Bank Rate rise, UK households will continue to experience financial pressures. Specifically, households with mortgages not currently within fixed rates will see their monthly payments increase immediately, approximately £47 per month more for those with a typical tracker mortgage.

Consequently, the cost-of-living crisis may continue to bite for many. In fact, more than 1.4 million mortgage holders could see their disposable incomes fall by more than 20%, according to the Institute for Fiscal Studies. Worse still, renters may also be affected should landlords need to pass borrowing costs on.

Next Steps

With disposable incomes hit by the latest interest rates rise, individuals and businesses need to look at ways to cut costs while staying abreast of the economic outlook.

Regardless, some costs, such as insurance premiums, remain a worthy investment during tough economic times where business risks are still a major concern. It’s also critical that clients are as truthful as possible when providing information about commodities to be insured. Clients are reminded of the consequences of underinsurance and the average clause.

So what is the Average Clause?

When a business is underinsured, the insurer can apply the ‘average clause’. This is a clause in the insurance policy stating that “the policyholder must bear a proportion of any loss if assets were insured for less than their full replacement value”. If the insurer finds the business has taken out inadequate insurance, it can reduce the settlement by the same percentage the asset is underinsured – so you may not get the pay-out you expect.

In short, taking out insufficient insurance cover will mean any claim will be insufficiently covered.

Average Clause example

John’s property has a reinstatement value of £1.8 million on an insurance policy. He needs to claim £240,000 for repairs due to flood damage. On this basis it would be assumed that John’s cover was adequate. However, if the insurer can establish the total cost to rebuild John’s property is £2 million, they can claim that John had inadequate cover in place. In this case cover amounts to 90%, so there is a 10% shortfall or ‘underinsurance gap’. Under the Average Clause the insurer can then reduce the claim amount by the same proportion as the amount of underinsurance (10%). Which means that a claim for £240,000 would be reduced to £216,000, leaving John financially liable for the £24,000 difference – even though he had a total of £1.8 million of insurance in place.

The average clause in an insurance policy is there to encourage policyholders to declare honest values when insuring their assets. Insurers do understand, however, that valuations can vary during a policy period – particularly when the claim involves property. Some insurers will counteract this by applying a ‘Special Condition of Average’ which states that the average clause will only be applied if the sum insured falls below a certain percentage. For instance, if the percentage was stated as 75% in the average clause example we have used here, John should receive his full pay-out.

It is important that you should ensure to the best of your knowledge that you are declaring the total reinstatement value of your assets. Also, if you are concerned about an average clause that may affect your policy talk to us for further clarification. Similarly, please talk to us if you have concerns about meeting your insurance payments as it is important that you maintain your cover.