"Underinsurance" remains a hot topic as we carry out our advisory work for policyholders. This issue is anticipated to be of special concern following the Yagi storm insurance event (September 2024), as many companies have had practical experiences regarding its influence on proposal of claim adjustment table.

If policyholders clearly understand the compensation basis of the property insurance and maintain sufficient Sum Insured, the significance of financial protection for their business in the event of losses will be fully realized. However, in practice, not many businesses truly place enough importance on this matter, leading to common pitfalls such as:

- Policyholders are not fully aware of the compensation basis in the contracts, resulting in inappropriate calculations of the Sum Insured.

- Policyholders, even if they grasp the principles of insurance, do not base their decisions on this compensation principle, but rather use values like original cost or depreciated value when participating in insurance.

As a result, "underinsurance" may be present in numerous contracts. It is only when a loss occurs that the policyholder becomes acutely aware of its significance and impact.

1. What is Underinsurance?

According to Article 48 of the Underinsurance Property Insurance Law No. 08/2022/QH15:

• An underinsurance contract is the contract where the sum insured is less than the market value of the insured property at the time of conclusion of the contract.
• When entering into a property underinsurance contract, the insurer or the foreign non-life insurer’s branch shall pay losses in proportion to the sum insured and the market value of the insured property at the time of conclusion or as agreed upon in the insurance contract.

According to common understanding in insurance (subject to specific regulations for each insurance policy):

• Underinsurance can occur when an asset is insured for less than the cost of replacing it with a similar asset (for policies based on replacement costs) or lower than its market value at the time of loss.
• In such cases, the policyholder is considered to be self-insuring for the difference and shall bear for the rate-able proportion of the loss accordingly

2. Applying Underinsurance in Compensation Calculations

Example: Factory A is insured for the value at USD 10,000,000 on a replacement cost basis. The factory experiences a fire incident leading to USD 3,000,000 in repairs, while the reconstruction value of the factory is equivalent to USD 12,000,000. The maximum amount (before deductibles) that Factory A could receive from Insurer is:
 

USD 3,000,000 x (USD 10,000,000 / USD 12,000,000) = USD 2,500,000
 

Factory A would need to bear 17% (USD 10,000,000 / USD 12,000,000) of the loss value due to purchasing "underinsured insurance," which amounts to USD 500,000.

3. Causes and Impact of Underinsurance

Common causes leading to participation in underinsured policies include:

• Subjective Causes:
  • Policyholders may insure based on book value without updating for current values (inflation, exchange rate fluctuations, increased labor and material costs, etc.).
  • Policyholders may tend to reduce the insured amount to save on insurance costs without fully considering the impact of this reduction.
• Other Causes:
  • Failure to find appropriate methods to calculate the insurance amount.
  • Inability to arrange budgets for asset reassessment.
  • Inflation factors may be included in the insurance amount but lag behind price increases during the insurance period.

4. Impacts of Underinsurance:

• As illustrated in the example above, the most direct impact is financial loss to the business. You may have to cover significant costs out of pocket to self-insure when, had the insured amount been accurately calculated, you could have transferred all risks to the insurance company.
• Risks of business interruption may occur due to insufficient funding to promptly repair the property.
• Reinsurers may apply an additional charge if you have not reassessed the value of the insured assets for a long time.
• Risks related to the company's responsibilities to shareholders.
• Risks concerning the responsibility of those calculating the insurance amount before the company.

5. Our Recommendations

Before each renewal and periodically throughout the insurance year, policyholders should:

• Regularly discuss with your insurance advisor/insurance company about the values at risk/value to be insured/sum insured and balance the cost of insurance with the risks of underinsurance.
• Frequently update on significant market fluctuations that could affect you (e.g., exchange rates, shipping costs, consultant fees, inflation, current prices of backup equipment, etc.).
• Update the Sum Insured as soon as you recognize that your company may be participating in “underinsurance.”

In property insurance contracts, there are clauses designed to mitigate some of the impacts of “underinsurance.” You can contact consulting firms/insurance companies to learn more or reach out to us for specific answers.