The Underinsured Factory and the Average Clause
A manufacturer insures its factory for £4 million on a reinstatement basis. A fire destroys the main production hall. The loss adjuster values the reinstatement cost of the building at £6 million, but the insured argues that £4 million was the market value and that the policy was sold as 'full value'. The policy contains a condition of average: 'If the sum insured is less than the full reinstatement cost at the time of loss, the amount payable shall be reduced in proportion.' The building's reinstatement cost is £6 million; the damaged hall represents 60% of the total building. The policy also has a £50,000 excess. The insured has cash-flow problems and needs an interim payment.
1. Calculate the likely indemnity for the building damage and explain the effect of the average condition.
Read the worked answer
The sum insured is £4 million against a full reinstatement cost of £6 million, so the insured is underinsured by one-third. The damaged hall is 60% of the building, so its reinstatement cost is 60% × £6 million = £3.6 million. Applying average: (£4 million ÷ £6 million) × £3.6 million = £2.4 million. Deduct the £50,000 excess, giving £2.35 million.
The insured's argument that £4 million was the market value is irrelevant if the policy is on a reinstatement basis; the measure is reinstatement cost, not market value. The 'full value' sales argument may support a claim in misrepresentation or negligence against the broker, but it does not override the policy condition as between insurer and insured. The exam answer must show the arithmetic, identify the correct measure of value, and explain that average is a proportionate reduction, not a penalty. It should also note that the insured may have a separate remedy against the intermediary if the sum insured was set on bad advice.
2. Advise on the interim payment and on how the insurer should handle the insured's cash-flow crisis.
Read the worked answer
The insurer should make an interim payment where liability is clear and the amount can be estimated, but it must reserve its position on the final figure. Here the building damage is clearly covered and the average calculation is arithmetically determinable, so an interim payment of a substantial part of £2.35 million is reasonable, subject to proof of loss and any mortgagee's interest. The insurer should not pay the full amount before verifying the reinstatement cost and the proportion of damage.
Cash-flow pressure does not change the contractual entitlement, but good claims practice and regulatory conduct standards favour prompt, fair settlement and clear communication. The insurer should explain the average calculation in writing, set out what further information it needs, and consider whether business interruption cover also responds. If the insured disputes the valuation, the insurer should obtain an independent valuation and consider the policy's dispute-resolution or arbitration clause. The model answer should combine the contractual calculation with conduct expectations: transparency, prompt interim payment where justified, and reservation of rights.