Average clause, salvage and three-way reinsurance allocation on a fire loss
A chemical manufacturer's fire-cum-special-perils policy covers plant and machinery on a reinstatement-value basis for a sum insured of Rs 40.00 crore. The proposal form and the pre-acceptance survey both recorded the reinstatement value at Rs 50.00 crore, but the underwriter issued the policy at Rs 40.00 crore and no average-clause endorsement was discussed with the insured. A boiler-house explosion causes damage assessed by the surveyor at Rs 12.00 crore, inclusive of Rs 0.80 crore of debris-removal costs, which are covered within the sum insured. Scrap from the damaged machinery realises Rs 1.00 crore. The policy carries an excess of 2% of each claim, subject to a minimum of Rs 15 lakh.
The risk was retained 5% net, 45% was ceded to a nine-line surplus treaty, and the remaining 50% was placed facultatively with a single reinsurer on identical terms. The insured has now threatened to approach the regulator and to litigate the average clause, arguing that the insurer inspected the risk and itself selected the sum insured.
1. Compute the gross claim payable to the insured, showing each deduction in order, and state how the settlement is shared between the insurer's net account, the surplus treaty and the facultative reinsurer.
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Step 1 - Admissible loss. The surveyor's Rs 12.00 crore includes debris removal, which is covered within the sum insured, so the full Rs 12.00 crore stands. Scrap realises Rs 1.00 crore: Rs 12.00 - Rs 1.00 = Rs 11.00 crore.
Step 2 - Underinsurance. The clause operates where sum insured is below value at risk: 40.00 / 50.00 = 0.80. Payable = 11.00 x 0.80 = Rs 8.80 crore. The average clause is applied before the excess and before any reinsurance allocation, because reinsurers follow the terms of the original policy.
Step 3 - Excess. 2% of the claim = Rs 8.80 x 0.02 = Rs 17.60 lakh, which exceeds the Rs 15 lakh minimum, so Rs 17.60 lakh is deducted. Net claim = 8.80 - 0.176 = Rs 8.624 crore (about Rs 8.62 crore).
Step 4 - Reinsurance shares (on the original sum insured: 5% / 45% / 50%):
- Net retention: 5% of 8.624 = Rs 43.12 lakh.
- Surplus treaty: 45% = Rs 3.88 crore.
- Facultative: 50% = Rs 4.31 crore. Each reinsurer takes its proportional share of the reduced claim, not of the unreduced Rs 11.00 crore.
2. Assess the insured's estoppel argument and advise whether the insurer can safely insist on the average clause in full.
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The average clause is a contractual condition, not a penalty, and it is not void merely because the insurer proposed the figure. To succeed in estoppel or waiver the insured must show a representation by the insurer, reliance on it, and detriment.
For the insured. The survey report on the insurer's own file records Rs 50.00 crore. The insurer therefore knew the correct value and still issued at Rs 40.00 crore without an average endorsement or a written intimation that the sum insured was inadequate. A court may read that as a representation that the sum insured was accepted as adequate, and a regulator may read it as mis-selling or deficiency in service.
For the insurer. The duty to declare the correct value rests on the insured; underinsurance lowered his premium; and there is no written waiver of the clause. An estoppel argument is weakest where the insured had independent means of knowing the reinstatement cost.
Judgement. The legal position is defensible but the conduct optics are poor, and litigation will fix the insurer with its own survey report. A negotiated outcome is the better commercial call: pay the claim with average applied, offer a modest ex-gratia contribution, and simultaneously re-rate the sum insured to Rs 50.00 crore prospectively. If the insurer chooses to waive average, take a signed waiver and release, and obtain reinsurer consent before payment (see next task).
3. If the insurer decides to waive average as a commercial settlement, what is the maximum gross exposure, who bears the extra cost, and what must be documented?
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Without the average clause, the starting figure is Rs 11.00 crore. The excess is 2% of the claim: 11.00 x 0.02 = Rs 22.00 lakh, which exceeds the Rs 15 lakh minimum, so the maximum gross payment becomes 11.00 - 0.22 = Rs 10.78 crore.
The waiver therefore costs 10.78 - 8.624 = Rs 2.156 crore of gross claim, of which Rs 1.078 crore (50%) would fall on the facultative reinsurer and Rs 0.970 crore (45%) on the surplus treaty if they consent, leaving Rs 1.078 crore (5%) net if they do not.
Documentation points. (i) A written waiver of the average clause for this loss only, expressly without creating a precedent. (ii) Prior written consent from the surplus and facultative reinsurers, or an express reservation that the insurer bears the differential itself. Do not pay first and negotiate later; a reinsurer is entitled to say that an unauthorised concession on a policy term is not a settlement it must follow. (iii) A full and final discharge from the insured, covering the claim, the valuation dispute and any regulatory complaint. (iv) A re-rating note and an average-clause endorsement for renewal, so the same gap does not recur.