8.3 The Condition of Average and Excess

Underinsurance and the Condition of Average

Underinsurance arises when the sum insured is less than the full value of the property at risk at the time of loss. It is one of the most common and most heavily tested issues in property claims. The insured has not paid enough premium for the full value at risk, so it would be unfair to the insurer — and contrary to indemnity — for the insurer to pay the full amount of a partial loss.

The contractual mechanism that deals with underinsurance is the condition of average (also called pro rata average). Where average applies, the insured is deemed to be their own insurer for the difference between the sum insured and the full value, and the insurer pays only a proportion of the loss.

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The Average Formula

The formula for the insurer's payment under a condition of average is:

Payment = (Sum Insured ÷ Full Value) × Loss

Equivalently: the insurer pays the same proportion of the loss as the sum insured bears to the full value of the property at risk.

Worked Example

A commercial property is insured for £40,000. At the time of a fire the property is worth £50,000 (its full rebuilding cost). A partial loss of £10,000 is suffered. Applying average:

• Payment = (£40,000 ÷ £50,000) × £10,000
• Payment = 0.8 × £10,000
• Payment = £8,000

The insured bears the remaining £2,000 themselves — they are their own insurer for the difference between the sum insured and the full value. Note that if the loss had been a total loss (£50,000), the insurer would pay the sum insured of £40,000 (the policy cap), and average would not produce a lower figure because the cap already limits the payment.

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Why Average Is Applied

Average serves two purposes:

1. It preserves indemnity. The insured has only paid premium on £40,000 of value, so it would breach the principle of indemnity for the insurer to indemnify the full £50,000 of value at risk. Paying a pro rata proportion keeps the settlement aligned with the premium paid.

2. It encourages accurate sum insured declaration. If average did not apply, insureds would have a financial incentive to underinsure deliberately (paying less premium while still recovering most partial losses in full). Average removes that incentive.

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Where Average Applies

Average is a contractual clause, not a rule of law — it applies only if the policy includes a condition of average. In practice:

• Commercial property and contents: Average is standard in most commercial policies. It is often described as applying separately to each item of the policy schedule, so each underinsured item is averaged independently.
• Household (domestic) policies: Many household policies on a sum-insured basis now include an average condition, particularly for contents. Some household buildings policies use an 85% condition of average, under which average is not applied unless the sum insured is less than 85% of the full value — a degree of tolerance for minor underinsurance.
• Liability insurance: Average does not apply to liability insurance. The court in Ramco (UK) Ltd v International Insurance Company of Hannover Ltd [2003] confirmed that the condition of average has no application to liability covers, because liability is not a fixed property value.
• Total loss: Where the loss is total, the sum insured is typically paid in full, since the policy cap already limits the payment and average would not reduce it further.

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Reinstatement Basis vs Indemnity (Actual Cash Value) Basis

The basis of valuation determines what counts as the "full value" for average purposes and how the loss itself is measured:

A common trap is to underinsure on a reinstatement basis by insuring for the market (depreciated) value rather than the full rebuilding cost. Because the rebuild cost is almost always higher than the market value for residential property (and is the figure used for average on a reinstatement policy), this can produce severe average reductions even where the insured believed they were fully covered.

Day-One Reinstatement Policies

Many commercial policies are written on a day-one basis: the insured declares the reinstatement cost at the start of the policy period, and the sum insured is that declared value plus an uplift (commonly 15%, sometimes up to 30%) to cover inflation during the year. Average is then assessed against the declared value (not the uplifted sum insured). If the declared value is adequate, the uplift absorbs cost inflation and the claim is paid in full; if the declared value is too low, average applies against the declared value and the settlement is reduced.

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Excess (Deductible)

An excess is the first amount of each claim that the insured bears. If a claim is £3,000 and the excess is £250, the insurer pays £2,750. Excesses are a feature of most general insurance policies.

Compulsory vs Voluntary Excess

• Compulsory excess is imposed by the insurer. It reflects the insurer's view of the risk — for example, a young driver may face a £400 compulsory excess on motor cover, or a property in a flood-risk area may carry a higher compulsory excess for subsidence or flood claims.
• Voluntary excess is chosen by the insured. By agreeing to bear a larger first slice of each claim, the insured accepts more of the small-claim risk and is rewarded with a lower premium. The total excess applied to a claim is usually the sum of the compulsory and voluntary excesses.

Why Excesses Are Used

Excesses serve several purposes for the insurer and the insured:

• Reduce the frequency of small claims. Without an excess, the insurer would handle every minor claim — a scratched bumper, a lost earring — and the administrative cost would exceed the payment. The excess removes the insurer's involvement in those small claims, keeping premiums affordable.
• Deter moral hazard. Because the insured bears the first slice of every claim, they have a financial incentive to take care and avoid losses.
• Lower the premium. A higher voluntary excess reduces the insurer's expected claims cost and is reflected in a lower premium, giving the insured a way to trade first-loss risk for ongoing savings.

Exam nuance: An excess is not the same as the condition of average. An excess applies to every claim (whether or not the sum insured is adequate); average applies only where there is underinsurance. A claim can suffer both an excess and an average reduction.

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Worked Example Combining Average and Excess

A commercial property is insured for £40,000 on a reinstatement basis with a £500 excess. The full reinstatement value is £50,000. A fire causes £10,000 of damage. The settlement is calculated as follows:

1. Apply average: (£40,000 ÷ £50,000) × £10,000 = £8,000.
2. Apply the excess: £8,000 − £500 = £7,500.

The insured receives £7,500, bears the £500 excess, and is their own insurer for the £2,000 of average reduction — a total of £2,500 borne by the insured on a £10,000 loss.

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Key Takeaways

• Underinsurance means the sum insured is less than the full value at risk, and the condition of average reduces the claim pro rata using the formula (sum insured ÷ full value) × loss.
• Average is standard in commercial property policies, increasingly present in household policies on a sum-insured basis, and does not apply to liability insurance.
• An excess is the first amount of each claim borne by the insured; it may be compulsory (imposed by the insurer) or voluntary (chosen by the insured to lower premium).
• Excesses reduce small claims, deter moral hazard, and lower premium; they apply to every claim, unlike average which applies only on underinsurance.
• Reinstatement (as new) basis pays the rebuild cost without deduction for depreciation, subject to an adequate sum insured and the reinstatement condition; the full value for average on a reinstatement policy is the rebuild cost, not the market value.