Flood Claim, Average Clause, and Risk-Mitigation Spending
A warehousing partnership in Dibrugarh stores tea for small growers. Its main godown and contents are valued at ₹80 lakh at current replacement cost. The firm has a fire-and-flood policy with a sum insured of ₹60 lakh, a deductible of ₹1 lakh per claim, and a pro-rata (average) clause. In the current flood, damage is assessed at ₹24 lakh. Salvage recovered from damaged stock is ₹2 lakh. The policy excludes business interruption, and the firm estimates it will lose ₹3 lakh of contribution margin while the godown is repaired. The insurer's surveyor has accepted the damage estimate. The firm pays a premium rate of 0.50% on the sum insured. Its broker says a sum insured of ₹80 lakh would carry the same 0.50% rate. Separately, a contractor has offered to build a flood barrier for ₹4 lakh, which engineers say would reduce the expected annual flood loss by about ₹2.5 lakh. The partners want to know how much the insurer will pay, and whether to raise the sum insured, buy the barrier, or both.
1. Compute the claim payable, showing the average clause and the deductible. What is the firm's total retained loss?
Read the worked answer
Loss = damage ₹24 lakh − salvage ₹2 lakh = ₹22 lakh.
Average clause: claim before deductible = ₹22 lakh × (sum insured/actual value) = ₹22 × (60/80) = ₹16.5 lakh.
Less deductible ₹1 lakh = ₹15.5 lakh payable.
Business-interruption loss of ₹3 lakh is excluded, so the firm bears ₹22 lakh − ₹15.5 lakh = ₹6.5 lakh of property loss plus ₹3 lakh of lost contribution, a total retained loss of ₹9.5 lakh. The average clause, not the deductible, is the main reason the claim is so far below the loss.
2. Compare raising the sum insured to ₹80 lakh with building the flood barrier. Use the premium, expected loss reduction, and a break-even calculation.
Read the worked answer
Raising sum insured to ₹80 lakh: extra premium = 0.50% × ₹20 lakh = ₹10,000 a year. In a ₹22 lakh loss, the claim becomes ₹22 lakh − ₹1 lakh = ₹21 lakh, i.e. ₹5.5 lakh more than under the current policy. The break-even probability of a loss of this size is ₹10,000/₹5,50,000 ≈ 1.8% a year; given the firm's flood exposure, full insurance is cheap.
Flood barrier: cost ₹4 lakh; expected annual loss reduction ₹2.5 lakh; simple payback = 4/2.5 = 1.6 years, an expected return of about 62.5% a year before maintenance. The barrier also reduces business-interruption losses and may earn a premium discount. On expected values, the barrier is attractive even if the insurer does not reduce the premium.
3. Advise the partners on insurance, retention, and business-interruption cover.
Read the worked answer
Both: raise the sum insured to ₹80 lakh and build the barrier, but sequence them. The barrier is the higher-return risk-reduction measure; it attacks frequency and severity, whereas insurance only transfers the financial consequence. Full-value insurance removes the average-clause penalty and costs only ₹10,000 extra.
The firm should also buy business-interruption cover for at least ₹3 lakh of contribution margin, because the current policy leaves that loss entirely retained. Retain a deductible of ₹1 lakh or even ₹2 lakh if the barrier is built, since the firm can budget that amount; do not retain the co-insurance gap. Check that the policy's flood sub-limit is adequate and that the sum insured is reviewed annually for replacement-cost inflation.