What is Average Clause in Fire Insurance?

Fire insurance acts as a safety net to shield businesses from any losses or damages caused to the property structure and contents during any unexpected fire emergency. When the business owner buys the fire insurance policy for the property, the coverage needs to align with the actual market value of the property. This can define the maximum coverage limit and accordingly, the premium for the insurance policy is estimated. Several times, the insured sum may not be the same as the exact value of the property at the time of the fire emergency. This difference between the actual value of the property and the insured sum is called ‘underinsurance’ which also subsequently reduces the premium price of the policy. Let’s understand more about ‘underinsurance’ and how it is linked to the average clause in fire insurance.

Average Clause Meaning

The average clause in fire insurance, also known as the “underinsurance clause” plays a significant role in the claims settlement process during a fire emergency. The average clause helps estimate the final coverage amount to cover the losses due to a fire accident. The fundamental objective of the average clause is to avert the insured from underestimating the property to lower the premium price. The average clause implies the policyholders should opt for an adequate sum aligning with the actual property value, so the insured will receive the required coverage limit in case of losses due to a fire accident.

The average clause holds significance when the insured undervalues the actual price of the property while purchasing the policy. During such cases, when the insured property bears losses due to fire, the insurer will not cover the complete coverage for the total losses incurred. The final settlement amount is calculated according to the ratio of the sum insured to the original property value. The average clause ensures the insured covers a proportionate loss as per the underinsured amount.

How does the Average Clause affect your Claim?

The average policy in fire insurance is integral to persuading the insured to refrain from underinsurance. Further, the main objective of the average clause is to ensure the insured and insurer pay fair and proportionate compensation when a partial loss occurs due to a fire emergency. This prevents the policyholder from claiming an additional profit by exaggerating the loss and misappropriating financially to benefit from the claims settlement process.

The average policy in fire insurance also establishes a premium price that aligns with the best interest of the insured, justifying the coverage benefits. It follows a standard fair practice where the premium indicates the actual value of the insured property. When the insured opts for underinsuring the property, the premium price is lower as compared to the actual value, making it unfair for several other policyholders and the insurer. Average clause meaning balance for both insurers and the insured, ensuring the insurer pays a fair compensation aligning with the degree of underinsurance by the insured.

Formula to calculate coverage with insured

Let’s understand the average clause definition more clearly by applying the formula through an example. Suppose, the actual value of the property is ₹ 5 lakhs, but the policyholder bought fire insurance by undervaluing it to ₹ 4 lakhs. This indicates a clear underinsurance of 20 percent. In the event of a fire emergency, the insured property suffered a loss of ₹ 2 lakhs. Now, what will be the coverage amount?

The common answer would be ₹ 2 lakhs. However, when implementing the formula of the average clause, the coverage amount comes up to ₹ 1.6 lakhs. The final compensation of ₹ 1.6 lakhs indicates fairness to the insurer by reducing the coverage by 20%, which was also the percent of underinsurance by the insured in the first place.

The formula of the average clause for coverage:

Claim amount = (Sum Insured / Actual Value of Property) * Loss Amount

Here,

• The Sum Insured implies the insured amount for fire insurance as mentioned in the policy.
• The actual value of the property is the market rate of the property.
• Loss amount is the loss incurred due to a fire accident.

According to the average clause formula, the insured undervalued the property by 20%, so he/she will have to pay ₹ 40,000 from his pocket to ensure fair treatment towards the insurer.

Case Study

Let’s understand the application of the average clause in fire insurance better with the following case study.

Mr. Karan, a 35-year-old, was the owner of a textile manufacturing company based in Gujarat. Mr. Karan exported the goods throughout Gujarat, but also met the client requirements throughout the country. Around 2015, there was a fire emergency, damaging around 50 % of his current stock, which was supposed to be delivered to a client nearby. Fortunately, Mr. Karan had purchased a fire insurance policy, so he immediately informed the insurer about the loss and began the claims process. His property was underinsured, so, the coverage amount provided by the insurer would have applied the average clause.

Midway through the claims process, the insurer reviewed the documentation submitted by Mr. Karan and appointed an investigator to review the losses incurred in his textile factory. After thoroughly reviewing the incidents at the factory, the investigator filed a report which elicited that the fire was caused due to circuit failure in the production unit, thereby damaging around 50% of the stocks.

Here are the details of the textile stock as filed by the investigator:

• The actual value of the stock: ₹ 30 lakhs
• Sum insured: ₹ 20 lakhs
• Loss incurred: ₹ 15 lakhs (as 50 % of the textile stock was recovered)

The insurance company implemented the average clause and paid a proportionate claim amount to the extent of underinsurance by Mr. Karan. This can be calculated with the following formula:

Coverage amount = (Sum Insured / Actual Value of Property) * Loss Amount = (20,00,000 / 30,00,000 ) * 15,00,000 = 10,00,000

Therefore, for a loss incurred of ₹15 lakhs by Mr. Karan, the insurer paid a coverage amount of ₹ 10 lakhs following the calculations after implementing the average clause.

How to Avoid Average Clause in Fire Insurance

The most fundamental method to avoid the average clause in fire insurance is to pay fire insurance worth the actual value of the property. However, getting the most accurate value of the property is an important task considering the fluctuating market rates due to property depreciation, inflation, renovations, and increases in prices.

Here are some suggestions to avoid any complications with fire insurance policies:

Expert consultation

The exact value of the property can be determined by consultation with a reputed realtor, architect, or engineer and further recommend more details on the type of insurance policies required and the required coverage amount.

Frequently update the valuation

The insured owning the property should frequently update the exact valuation of the property based on the prevalent market trends and any other significant activities such as renovation and /or extension. This is a great practice to ensure the property is never underinsured or overinsured.

Review the TnCs

The insured should thoroughly review the policy details with inclusions and exclusions as well as the standard terms and conditions. The same needs to be evaluated during the onset of the policy as well as while renewing it further.

Leverage online tools

The insured can use online calculators to estimate the actual value of the property. The tools can act as a guideline and offer a comprehensive range based on several factors such as the size of the property, location of the property, nature of the business, condition of property along with maintenance, as well as unique features of the property.

How to Choose the best Fire Insurance Policy?

Fire insurance covers losses incurred due to a fire emergency destroying the property structure and contents. It also has several add-on covers which can be bought with an additional premium aligning with the unique requirements of each business. When considering to buy the best fire insurance policy, here are some of the key factors to consider:

Evaluate coverage needs

To get the best coverage, it is imperative to understand the requirements of the business, and further compare the required coverage amount with the risk potential of a fire emergency and the value of the property and stocks.

Insurer's reputation

Review the claims settlement ratio (CSR) of different insurers. The higher the CSR, the better the chances of claims being settled in case of emergency. Further, review the clients’ feedback for better clarity on the customer service and the time taken in processing the claims.

Review the coverage and exclusions

Review the policy thoroughly and check all the coverage terms and conditions. It is important to understand the policy exclusions as well as the tenure and renewing conditions as well.

Review the add-ons

Opt for add-ons with an additional premium based on the regional as well other unique requirements or specifications of the business and property. Some of the common add-on covers in fire insurance are Storms, Tempests, Floods and Inundation (STFI) and Riots, Strike, and Malicious Damage (RSMD).

Premium cost

The cost of premium for fire insurance can vary according to the exact value of the property, as well as any add-ons and the required coverage limit. It is important to compare the premium prices for different insurers along with the coverage provided.

Conclusion

During any unexpected fire emergency, fire insurance helps secure businesses by providing coverage for the damage caused to the property structure or contents. The average clause ensures the insured pays a specific premium amount for coverage worth the exact value of the property. In the case of underinsurance, the insured would have paid a lesser premium, and the insurer will use the average clause and provide a coverage amount proportionate to the degree of underinsurance by the insured. This assures fairness for both the insured and the insurer.