For commercial property owners, the average clause in commercial property insurance can have serious financial consequences. Owners often arrange buildings insurance at renewal and then give it little attention until the following year. However, the cost of reinstating the property is one of the most important figures in a buildings insurance policy. It is also one of the easiest to get wrong.
Construction costs can change considerably over time. Alterations, extensions and changes in specification can also affect rebuilding costs. As a result, a figure set several years ago may no longer reflect the true cost of rebuilding.
If the declared value is too low, the property may be underinsured. This can have serious financial consequences following a claim. It can affect the payout even when the damage involves only part of the building.
What is a Reinstatement Cost Assessment?
A Reinstatement Cost Assessment (RCA) estimates the likely cost of reconstructing a building after major damage or total loss.
Importantly, the reinstatement cost differs from the property’s market value. A commercial building worth £1 million on the open market could cost considerably more or less to demolish and rebuild.
RICS guidance states that a day-one declared value should reflect the likely reconstruction cost. It should also include suitable allowances for demolition, professional fees, statutory fees and other costs.
A properly considered RCA therefore looks beyond a simple construction rate per square metre. Depending on the property, it may consider:
- its size and construction;
- demolition and site clearance;
- access limits;
- neighbouring buildings;
- specialist materials;
- building services;
- listed status;
- asbestos;
- professional fees; and
- statutory requirements.
Relying on an old insurance figure, purchase price or market valuation can therefore leave an owner exposed.
What is the ‘Average Clause’?
The average clause in commercial property insurance is particularly important when an owner insures a building below its correct reinstatement value.
Depending on the policy terms, an insurer may reduce a claim in line with the level of underinsurance. The insurer may do this even when the building has not suffered total destruction. RICS guidance explains that inadequate reinstatement values can lead insurers to apply an average clause. They may then reduce the amount payable in proportion to the underinsurance.
For example, imagine that a commercial property has a correct reinstatement value of:
£2,000,000
However, the owner has insured the property for only:
£1,500,000
The insurance therefore covers 75% of the correct reinstatement value.
An insured event then causes £400,000 of damage. Under the average clause, the insurer could apply the same percentage to the claim:
£400,000 × 75% = £300,000
This could leave the property owner responsible for the remaining £100,000. The exact outcome would depend on the policy wording, terms and circumstances.
This example highlights an important misconception about underinsurance. You do not need to suffer a total loss before an inadequate declared value becomes a problem.
Could an Insurer Refuse a Claim Entirely?
The consequences may become more serious if inaccurate information goes beyond an innocent or ordinary underestimate.
The Insurance Act 2015 places commercial policyholders under a duty of fair presentation. If a policyholder breaches that duty, the insurer’s remedies will depend on the circumstances. They will also depend on what the insurer would have done if it had received the correct information.
If the policyholder acts deliberately or recklessly, the insurer may avoid the insurance contract. It may also refuse all claims and keep the premiums paid.
This differs from an owner discovering that a previous reinstatement estimate has fallen behind current construction costs. Nevertheless, owners should approach declared values carefully. They should not deliberately lower them in an attempt to reduce premiums.
Is Your Commercial Property Underinsured?
Several circumstances should prompt an owner to review the existing declared value.
A review may be appropriate if the owner has simply rolled the figure forward for several years. Extensions, alterations and major refurbishments can also affect the value. A change in the building’s use or specification may have a similar effect.
Owners should also consider unusual construction features. Increases in labour and material costs may have moved well beyond the assumptions in the original assessment.
Older, listed and unusual buildings need particular attention. Rebuilding them may require specialist materials, workmanship or detailing. A standard construction rate may not reflect these costs accurately.
Restricted city-centre sites can also create extra costs. Buildings close to neighbouring properties may require complex demolition, access arrangements and temporary works.
RICS guidance recommends that owners consider inflation each year. It also recommends a full reassessment every three years unless major alterations take place sooner.
How Can an RCA Reduce the Risk of Underinsurance??
A professional RCA provides an evidence-based estimate of the likely reinstatement cost. It avoids relying only on old figures or assumptions.
At Vickery Holman, our Building Surveyors consider the building and the factors around it. These factors may affect the cost of reconstruction. They include the building’s construction, specification, demolition requirements, access, statutory requirements and professional fees.
For commercial property owners, reviewing reinstatement costs involves more than an administrative task at insurance renewal. An accurate and regularly reviewed assessment helps ensure that the declared value reflects the property.
It can also reduce the risk of a major shortfall after a loss. Without an accurate value, the average clause in commercial property insurance could reduce the amount an insurer pays.
If you are unsure whether the declared value for your commercial property remains appropriate, Vickery Holman’s Building Surveying team can provide a Reinstatement Cost Assessment to help inform your buildings insurance requirements.
