Underinsurance, a Temporary Kitchen and an Inflated Claim
Spice Lane is a 60-seat restaurant insured under a commercial fire policy. The schedule shows: contents and equipment sum insured $180,000; gross profit (business interruption) sum insured $200,000 over a 12-month indemnity period; a $1,000 deductible applying once per event; and an 80% average (coinsurance) condition on the property section. The sums were set in 2019 from the owner's purchase invoices. A kitchen fire on 3 March put the restaurant out of action for 11 weeks. Reinstatement of equipment and fittings at current cost is $60,000. Annual turnover is $520,000 at a 35% gross profit rate. Turnover lost during the closure was $95,000. The owner rented a temporary kitchen for $12,000 and kept takeaway sales running; he also saved $8,000 in wages because casual staff were laid off. He has claimed $60,000 for property, $95,000 for business interruption and $12,000 for the temporary kitchen. The current replacement value of the property insured is $240,000.
1. Calculate what the insurer should pay on the property damage and explain the averaging reasoning to the owner.
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The average calculation. The condition requires the sum insured to be at least 80% of the full current replacement value: 80% x $240,000 = $192,000. The actual sum insured is $180,000, so the policy is underinsured against that threshold. The settlement fraction is 180,000 / 192,000 = 0.9375. The loss of $60,000 is therefore paid as $60,000 x 0.9375 = $56,250.
Why it works this way. Average is a coinsurance device: above the 80% threshold the insured carries the first slice of small losses, and below it the insured is treated as its own insurer for the shortfall. The 80% allows a margin for normal fluctuation in values, which is why the reduction is 6.25% rather than the 25% shortfall against the $240,000 value. If the condition had been a 100% condition, the reduction would have been 180,000 / 240,000 = 0.75, or $45,000 - the difference is worth explaining to the client.
What this is not. It is not a penalty or a claims-handling decision; it is a contractual formula applied mechanically. Nor is it a way for the insurer to profit: the insured gets the same proportion of every loss, large or small, up to the sum insured.
Explain to the owner. The sums were built from 2019 invoices and never indexed. At today's prices the correct sum insured on an 80% basis is $192,000, so he was roughly $12,000 light and has lost $3,750 on this one claim. Recommend reinstatement plus indexation or an agreed-value/valuation basis at renewal.
2. Calculate the business interruption settlement, explaining each element and what is wrong with the owner's claim.
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Start from gross profit, not turnover. The owner's $95,000 claim is the turnover he lost; the policy insures the gross profit lost on that turnover.
Correct calculation.
- Lost turnover: $95,000 x 35% gross profit rate = $33,250.
- Increased cost of working: the temporary kitchen cost $12,000. It is recoverable because it reduced the loss by allowing takeaway trading to continue, and it does not exceed the loss it avoided. Keep the invoices and evidence of the sales it generated.
- Savings: $8,000 of wages were not paid. If wages are insured standing charges, the saving must be deducted, because the insured must not be better off than if the fire had not happened. If wages were excluded from the gross profit definition, no deduction is made - the wording decides.
- Sub-total: 33,250 + 12,000 - 8,000 = $37,250.
Check the sum insured. The gross profit exposure over 12 months is $520,000 x 35% = $182,000, which is below the $200,000 insured, so no average applies to the business interruption section.
Total settlement. Property $56,250 plus business interruption $37,250 = $93,500, less one deductible of $1,000 applied to the event = $92,500.
What was wrong with the claim. Claiming turnover instead of gross profit overstates the loss by $61,750. Claiming the rent without linking it to preserved sales invites a query. And filing a single lump sum rather than an itemised claim with evidence slows everything down. Advise the client to claim the right figure with supporting accounts rather than a headline number.
3. What advice would you give this client at renewal so that the same outcome is not repeated?
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Fix the values first, then the wording. The property sum insured should be reset to today's reinstatement cost of $240,000, or at least to the $192,000 needed to satisfy the 80% condition, and then indexed at each renewal. For a restaurant, fit-out and equipment costs move quickly; a 2019 invoice base is almost guaranteed to be wrong. A professional valuation or an agreed-value basis removes the argument, and a declaration or adjustable basis suits a business whose stock or equipment fluctuates.
Check the business interruption limits. The $200,000 limit is adequate now against a $182,000 gross profit exposure, but it will not be if turnover grows or the indemnity period is extended. Check the indemnity period against realistic reinstatement time - 11 weeks of closure against a 12-month indemnity period was generous, but a supplier failure or a planning delay could have stretched it. Confirm that the definition of gross profit matches the client's accounts and that standing charges such as key staff wages are treated deliberately, not by accident.
Explain the economics. Underinsurance saves a small premium and costs a large proportion of every claim, and it applies to total losses as well as partial ones. Show the client the premium difference between $180,000 and $240,000 - it is usually modest - and record the advice in writing, including the client's decision if he declines to increase the sum insured.
Finally. Remind the client to notify mid-term changes (new equipment, a change of use, a subtenant) and to keep invoices and stock records, so that the next claim is settled on evidence rather than negotiation.