Determining the Sum Insured for Property Insurance

It is vital to understand the operation of an insurance contract in order to look into the aspect of determining the sum insured under the policy.

A contract of insurance is defined as “a contract whereby one party, called the Insurer, in consideration of premium paid by another party, called the Insured, agrees to indemnify the latter in the event of loss of or damage to the subject matter of insurance due to any of the insured perils as per the terms and conditions of the policy”.

Since the purpose of the insurance is to place the insured in the same financial position in which he was at the time of loss, it has to be carefully ascertained that the sum insured considered under the policy is adequate.

The Fire Insurance policy provides for an “average clause” whereby the assessed claims are reduced in proportion to the under-insurance.

Adequacy of the sum insured is important from the point of view of all concerned—the insured, the insurer, the surveyor, and the bank or financial institution that may have an interest in the subject matter of insurance.

The important determinants of the sum insured can be enlisted as below:

• The sum insured is always fixed by the proposer.
  
  
• It is the limit of an Insurer’s liability under a policy.
  
  
• It is the amount on which the rate is applied to determine the premium payable for the insurance.
  
  
• The sum insured should represent the actual value of the property to be insured. Insuring for a higher value than the actual value gives no advantage to the insured as to payment of a claim, if any, is subject to the principle of indemnity.
  
  
• Insuring for value lesser than the actual value makes the insured self-insurer for the difference and claim, if any, is subjected to an ‘average’ clause whereby he is penalized for under-insurance.
  
  
• In case of joint ownership of any property, the insured can get the claim only in respect of his share.
  
  He could, however, ensure full value of the property on behalf of other co-owners as well in which case the claim, if any, is paid to each co-owner to the extent of their insurable interest.

For insurance of buildings, one has to take into account various factors and ensure that the value of the land is excluded since the land cannot be damaged by fire or allied perils.

The plinth and foundations normally do not get damaged but in the event of a serious fire, they can be so affected as to require re-doing. The present-day value of plinth and foundations is substantial and therefore if the intention is to ensure its value, it is suggested that this must be separately declared.

The value of the building should comprise the cost of floors, walls, roofs/ false roofs/ceilings, and the value of all those such items such as pipes and cables that are embedded underground or in the walls/ roofs and become an integral part of the building.

The various methodologies for determining the value of as asset is as under:

1) Original cost

2) Book value or Depreciated Value

3) Market value

4) Reinstatement value

Original cost

Every new asset has original cost at which it has been acquired and is at least relevant during the first year of its insurance.

For older assets, the original cost has no relevance to its value for insurance purposes since it is subject to depreciation due to its age and also appreciation in value due to inflation.

Book value or Depreciated value

Book value or the Depreciated value of a property has no relation to insurable value except in the case of new assets in its first year of insurance.

In the subsequent years, the book value continues to be brought down by depreciation, and such it does not represent the market value or the value of a similar new property.

Market value

This is determined by the amount at which an asset of the same age and condition can be bought or sold. This value takes into account both depreciation due to age and appreciation due to inflation.

For determining the sum insured for buildings, apart from excluding the value of land and plinth, the present cost of construction of a similar building should be taken and then the depreciation for age and usage deducted.

Reinstatement value

This means the value of similar new property/assets.

In fire insurance, the principle of indemnity can be modified in the case of a building, machinery and other fixed assets whereby, subject to the sum insured representing the value of a similar new property, it can be insured under the ‘Reinstatement Value’ clause.

In the case of reinstatement value policy, the basis of loss settlement is the value of the new property without taking any depreciation into account.

This type of insurance enables the owner to replace his property without any financial strain on his own resources and is quite commonly taken by industrialists and building owners.

Replacement value

Replacement value is the actual cost to replace an item or structure at its pre-loss condition. This may not be the market value of the item and is typically distinguished from the actual cash value payment which includes a deduction for depreciation.

For insurance policies for property insurance, a contractual stipulation that the lost asset must be actually repaired or replaced before the replacement cost can be paid is common.

The electrical and electronic equipment is to be ideally insured on Replacement value so as to avoid any monetary disadvantage in purchasing similar equipment after a loss incident.

However, in case of obsolete items, where it is not possible to ascertain replacement cost at all, the last available price of such equipment or of equivalent model & capacity, or of an improved model, discounted for improvement should be taken and escalated by applicable indices such as RBI (Reserve Bank of India) Index.

All this is necessary for arriving at the present cost. This together with Custom Duty and other charges as applicable at the time of effecting the insurance should be taken as Sum Insured.

It is thus imperative for every customer to carefully ascertain the sum insured value for the property/ asset that is being insured. The purpose of taking insurance is to get indemnified and choosing the correct sum insured would surely help in getting the correct benefit of the insurance coverage.