What is the Average Clause in Fire Insurance?

The average clause in insurance is a provision that applies when your property is undervalued or underinsured at the time of policy purchase. It affects the claim settlement in case of a partial loss due to fire. A partial loss is when your property is not destroyed by fire but only partially damaged.

Under the average clause, the insurer applies a reduction factor to your claim amount based on the degree of underinsurance.

The concept applies to most fire insurance policies unless otherwise specified. It is also known as the pro rata condition of average or the underinsurance clause.

To understand how the average clause affects your claim settlement, let us take an example and use a formula. Suppose your property is worth ₹50 lakhs, but you have insured it for only ₹40 lakhs. That means you are underinsured by 20% (10/50 x 100). Suppose a fire breaks out and causes a loss of ₹20 lakhs to your property. How much will you get from your insurance company?

The answer is not ₹20 lakhs, but ₹16 lakhs. That is because the average clause will apply and reduce your claim amount by 20%. Here is the average clause formula to calculate the claim amount:

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

Claim Amount = (40 / 50) × 20

Claim Amount = 0.8 × 20,00,000

Claim Amount = ₹16,00,000

The average clause in fire insurance implies that you must bear a part of the loss, reflecting the extent of your underinsurance. In this example, you must pay ₹4 lakhs from your pocket in addition to the premium you have already paid.

The average clause in fire and burglary insurance is necessary because of the following reasons:

It discourages underinsurance and encourages adequate coverage.

The average clause ensures that the insurance company does not pay more than the proportionate value of the property in case of a partial loss.

It prevents the insured from profiting from the insurance claim, which would otherwise create a moral hazard. A moral hazard is a situation where the insured has an incentive to cause or exaggerate a loss because they can benefit from the insurance claim.

The average clause also ensures that the insured pays a fair premium for the coverage they receive. The premium amount is based on the sum insured, which should reflect the property's actual value.

If the property is underinsured, the insured pays a lower premium than they should, which is unfair to the insurance company and other policyholders. The average clause corrects this imbalance by reducing the claim amount in proportion to the degree of underinsurance.

The best way to avoid the average clause in fire insurance is to insure your property for its total value. However, assessing the property value properly can be challenging, as the property value may change over time due to depreciation, appreciation, inflation, renovation, or market fluctuations.

Here are some tips and recommended actions to prevent common issues in fire insurance policies:

Consult an expert: You can consult a valuer, an architect, or an engineer to help you determine the accurate value of your property. The expert can also advise you on the type of policy and the coverage that suits your property and needs.

Use online tools: You can use calculators, estimators, or comparators to help you estimate the value of your property. These tools can provide you with a range or a benchmark of the property value based on various parameters, such as location, size, age, condition, and property features. However, they may not be updated or accurate and may not reflect your property's specific characteristics.

Update the valuation regularly: You must update the valuation of your property regularly, at least once a year, or whenever there is a significant change in your property, such as renovation, extension, or improvement. This will help you adjust the sum insured and the premium amount accordingly and avoid underinsurance or over-insurance.

Review the policy terms: You must thoroughly review the terms and conditions before purchasing or renewing a fire insurance policy. Check the policy for exclusions, limitations, or endorsements that may affect the claim settlement.

An average clause differs from the reinstatement value clause and the agreed value clause, except that they all influence the claim amount.

The reinstatement value clause states that the claim amount will be based on the cost of reinstating or rebuilding the property rather than its market value. That means the property's depreciation or wear and tear will not be deducted from the claim amount. However, this clause may also include the average clause, reducing the claim amount if the property is underinsured.

The agreed value clause states that the sum will be based on the property's predetermined or agreed value rather than its actual value. That means the claim amount will not be affected by the property's market value fluctuations. Nevertheless, this condition may result in a higher premium as the insurance company takes on more risk.

Fire insurance policy protects property owners in India from the financial impact of fire accidents. However, the average clause makes claim payments tricky, as it requires accurate property valuation. If the property is undervalued, you, as an SME business insurance policyholder, will get less money and have to pay more from your own pocket.

The clause is fair, as it discourages underinsurance, prevents overclaims, and keeps premiums stable. To avoid problems, you should get expert advice, use online resources, and update your property value regularly. You should also learn the differences between other clauses, such as reinstatement value and agreed value, to better understand your coverage.

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What is the difference between partial insurance and underinsurance in Fire Insurance?

Partial insurance is when the policyholder insures only a part of the property or a specific item, while underinsurance is when the policyholder insures the property for a lower value than its actual value. The Average Clause applies only to underinsurance, not to partial insurance.

How is the claim amount calculated under the Average Clause in Fire Insurance?

The claim amount is calculated using the formula: Claim Amount = (Sum Insured/Property's Actual Value) × Loss Amount. This formula ensures that the policyholder shares a part of the loss according to the ratio of the insured amount to the actual property value.

What are some advantages of the Average Clause in Fire Insurance?

Some advantages of the Average Clause in Fire Insurance are:

It encourages policyholders to insure their property for its actual value and pay fair premiums.

It prevents policyholders from profiting from overinsurance or suffering from underinsurance.

It ensures that the insurance company does not incur losses due to underinsurance or overpayment of claims.

What are some disadvantages of the Average Clause in Fire Insurance?

Some disadvantages of the Average Clause in Fire Insurance are:

It may reduce the claim amount significantly if a large margin undervalues the property.

It may complicate the claim settlement process as the actual value of the property and the loss amount must be determined accurately.

It may not cover the full cost of restoring the property to its original condition, especially if it is old or depreciated.

What is the difference between the Average Clause and the Reinstatement Value Clause in Fire Insurance?

The Average Clause applies to policies based on the property's market value, which are subject to depreciation. The Reinstatement Value Clause applies to policies based on the replacement or repair cost of the property, which is not affected by depreciation.