Average Clause, Reinstatement Basis and GST in a Factory Fire
A factory is insured under a Standard Fire and Special Perils policy on a reinstatement value basis: building Rs 1.20 crore, plant and machinery Rs 90 lakh and stock Rs 40 lakh. Following a fire on 12 January the surveyor assesses that the cost of reinstating the damaged bay is Rs 60 lakh and that the reinstatement value of the entire building on the date of loss is Rs 2.40 crore. Three machines, six years old, are destroyed: the cost of replacing them with new machines of the same capacity is Rs 27 lakh and their depreciated value is Rs 18 lakh, while the reinstatement value of all plant and machinery is Rs 90 lakh. Stock destroyed at cost is Rs 16 lakh. Scrap from the machines realises Rs 1.5 lakh and damaged stock realises Rs 40,000. The building contractor's invoice includes GST at 18 per cent, and the insured is a registered dealer who claims input tax credit. The insured asks for the full Rs 60 lakh for the building.
1. Compute the amount payable under each item, showing every deduction, and state the basis on which the average clause is applied.
Read the worked answer
Building. Sum insured Rs 1.20 crore against a reinstatement value at risk of Rs 2.40 crore - the insured is his own insurer for 50 per cent. Loss on reinstatement basis Rs 60 lakh, therefore admissible = 60 x (120/240) = Rs 30 lakh. GST at 18 per cent is on the contractor's bill, but the insured is a registered dealer entitled to input tax credit, so the GST is not a loss to him; the claim is assessed net of GST. If it had been a property not used for business, or the insured were unregistered, GST would be a genuine additional cost and would form part of the loss.
Plant and machinery. Sum insured Rs 90 lakh equals the reinstatement value Rs 90 lakh, so no shortfall and no average. Replacement cost Rs 27 lakh less scrap Rs 1.5 lakh = Rs 25.5 lakh, but this is payable only on proof of replacement. Until the machines are actually replaced, the claim is settled on indemnity basis: Rs 18 lakh less Rs 1.5 lakh = Rs 16.5 lakh, with the balance of Rs 9 lakh released against the supplier's invoice and proof of payment.
Stock. Rs 16 lakh at cost less Rs 40,000 realised on damaged stock = Rs 15.6 lakh. Sum insured Rs 40 lakh matches the value at risk, so no average.
Total on reinstatement terms: 30 + 25.5 + 15.6 = Rs 71.1 lakh, of which about Rs 62.1 lakh can be released immediately on an indemnity basis, the balance on proof of reinstatement and replacement. The building figure above is on reinstatement value; if the building is not reinstated, the depreciated cost of the damaged bay, similarly averaged, must be computed and will be lower.
2. The insured argues that the average clause should be tested against the depreciated value of the building, which would reduce the shortfall. Is he right?
Read the worked answer
In principle, no. The reinstatement value clause is a concession: it pays new for old. Its consideration is that the sum insured must represent the full cost of reinstatement at the date of loss. If the sum insured were tested only against a depreciated value while the loss is paid at replacement cost, the insured would recover more than his loss, which is exactly what the average condition exists to prevent. Where the policy is declared on reinstatement value basis, the value at risk for average purposes is the reinstatement value.
In arithmetic, the point is interesting. If the building were settled on indemnity basis, with depreciation at 40 per cent, the depreciated value of the whole building would be Rs 1.44 crore against a sum insured of Rs 1.20 crore - a shortfall of about 16.7 per cent - while the depreciated cost of the damaged bay would be Rs 36 lakh. The payable figure would be 36 x (120/144) = Rs 30 lakh, the same answer as on the reinstatement route. The two routes coincide here only because the same depreciation ratio applies both to the whole property and to the damaged bay. If the damaged bay were newer or older than the building as a whole, the answers would diverge, and the basis of settlement would then directly change the amount.
Practical consequence. Present both computations, explain why they coincide in this case, and note that the insurer's failure to obtain a reinstatement valuation at underwriting is an underwriting lapse that does not alter the contractual basis. The election of basis is the insurer's, and the surveyor's role is to make the consequence transparent.
3. How should the salvage and the GST be handled, and what conditions attach to the release of the balance of the claim?
Read the worked answer
Salvage. Once the claim is paid in full, salvage belongs to the insurer. The surveyor must identify it, record it item by item with photographs, value it (scrap rate for ferrous and non-ferrous, resale value for damaged stock), and either arrange disposal with the insurer's written consent or permit the insured to retain it at the assessed value, deducting that value from the claim. Salvage must never be released, sold or removed by the insured before the insurer's written instruction, and the report should state where it is stored and under whose control. Note that replaced parts from a repair settlement are also salvage and belong to the insurer.
GST. For an input-tax-credit-eligible insured, GST on repairs and replacements is not a loss - the tax is recovered through the credit mechanism - so the claim is computed on the net-of-GST cost. Where the insured is unregistered, or the property is not used in the course of business, GST is an irreducible additional cost and is included in the loss. The surveyor should obtain the GST registration and a declaration on ITC before finalising.
Conditions on the balance. Reinstatement must be completed within the period allowed by the policy (normally twelve months from the date of loss); payment of the balance is against the contractor's and supplier's bills, proof of payment and a joint inspection confirming that the work was actually done. Any improvement or upgradation beyond the original specification - higher capacity machines, better finish - is at the insured's own cost and is not payable. If reinstatement is not carried out, the claim is finally settled on indemnity basis with no further release.