7.3 Average and Underinsurance Calculations

Study Focus

Average reduces a partial loss in proportion to underinsurance. The policy determines the relevant value at risk and any threshold concession.

The Condition of Average, Deductibles, and Policy Terms

In property and commercial general insurance, an insurance contract is strictly an agreement of indemnity. Its governing legal purpose is to place the insured party in the same financial position after a loss as they enjoyed immediately before the occurrence — no more, and no less. Two critical policy mechanisms preserve this principle and safeguard the financial integrity of the common insurance pool: the Condition of Average and Risk Retention Provisions (excesses, deductibles, and franchises).

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The Principle and Condition of Average (Underinsurance Penalty)

In property insurance, policyholders are responsible for declaring a Sum Insured that represents the true, full replacement or market value of the property at risk. However, some policyholders deliberately or inadvertently declare a sum insured far below the actual value to pay a smaller premium.

The Rationale of the Average Clause

Insurance operates by collecting equitable premium contributions from all participants to create a collective claims fund. Premium rates are expressed as a percentage or per-mille rate of the sum insured (e.g., 0.15% of the declared value). If an owner of a building worth RM 1,000,000 insures it for only RM 500,000, they contribute only half of their fair share of premium into the insurance pool.

Because the vast majority of property losses are partial (such as minor kitchen fires or localized roof damage of RM 50,000) rather than total destructions, an underinsured policyholder who receives 100% reimbursement for partial losses would enjoy full protection while paying half the required premium. This would unjustly penalize fully insured participants whose premiums support the fund.

To prevent this inequity, general property policies include the Condition of Average (also known as the Pro-Rata Average Clause). Under this clause, if property at the time of loss is of greater value than the sum insured, the insured is deemed to be their own insurer for the difference, and must bear a ratable proportion of the loss.

The Core Average Formula

$$\text{Claim Payable} = \text{Loss Amount} \times \left( \frac{\text{Sum Insured}}{\text{Actual Value at Risk at Time of Loss}} \right)$$

Where:

• Loss Amount is the assessed, adjusted financial loss resulting from the insured peril.
• Sum Insured is the maximum coverage limit stated in the policy schedule.
• Actual Value at Risk is the true, full insurable value of the property immediately before the loss occurred.
• The maximum payable can never exceed the Sum Insured.

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Worked Numerical Calculation Examples in Malaysian Ringgit (RM)

Understanding how average applies in practice is essential for every general insurance professional. The following scenarios demonstrate the exact mathematical steps used by loss adjusters.

Scenario 1: Partial Loss with Underinsurance

A commercial warehouse owner insures their building for RM 300,000. A localized electrical fire breaks out, inflicting assessed structural damage of RM 60,000. During the claims investigation, an independent loss adjuster determines that the actual replacement value of the building at the time of the fire was RM 500,000.

+--------------------------------------------------------------------------+
|                       AVERAGE CALCULATION: PARTIAL LOSS                  |
|                                                                          |
|  Sum Insured (SI)          : RM 300,000                                  |
|  Actual Value at Risk (VAR): RM 500,000                                  |
|  Assessed Loss             : RM  60,000                                  |
|  Degree of Insurance       : RM 300,000 / RM 500,000 = 60% (0.60)        |
|                                                                          |
|  Claim Payable = RM 60,000 x (RM 300,000 / RM 500,000)                   |
|                = RM 60,000 x 0.60                                        |
|                = RM 36,000                                               |
|                                                                          |
|  Loss Borne by Insured (Underinsurance Penalty):                         |
|                = RM 60,000 - RM 36,000                                   |
|                = RM 24,000 (40% self-insured)                            |
+--------------------------------------------------------------------------+

Even though the gross loss of RM 60,000 was well within the RM 300,000 policy limit, the insurer pays only RM 36,000. Because the owner chose to insure only 60% of the building's value, the insurer indemnifies only 60% of the partial loss. The owner absorbs the remaining RM 24,000 as a self-insured co-insurer.

Scenario 2: Total Loss with Underinsurance

Assume the same warehouse suffering from underinsurance (Sum Insured: RM 300,000; Actual Value at Risk: RM 500,000) is completely destroyed in a massive industrial blaze, resulting in an assessed total loss of RM 500,000.

Applying the average formula:

$$\text{Claim Payable} = \text{RM } 500,000 \times \left( \frac{\text{RM } 300,000}{\text{RM } 500,000} \right) = \text{RM } 500,000 \times 0.60 = \text{RM } 300,000$$

In a total loss, the mathematical result equals the Sum Insured. The insurer pays RM 300,000 (the policy limit), and the policyholder absorbs the uninsurable shortfall of RM 200,000. This illustrates an important exam rule: on a total loss, the Condition of Average does not reduce the payout below the Sum Insured; the insurer pays the full Sum Insured, but the policyholder loses everything beyond that figure.

Scenario 3: Multiple Item Average (Itemized Average)

Commercial property policies frequently specify distinct sums insured across different asset classes on the policy schedule. In Malaysian practice, average applies to each item separately; an insured cannot use surplus coverage on one item to offset a deficiency on another.

Consider an industrial workshop damaged by fire:

Key Principle: Although total insurance (RM 900,000) exceeds total losses (RM 220,000), the owner suffers a combined penalty of RM 70,000 across machinery and stock because items are assessed independently.

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The Special Condition of Average (75% or 85% Rule)

In certain commercial and agricultural property policies, maintaining an exact 100% sum insured throughout the entire policy year is challenging due to seasonal stock fluctuations, currency shifts, or fluctuating construction costs. To provide commercial leeway, a contract may include a Special Condition of Average, with a specified percentage threshold. The worked example below expressly assumes an 85% waiver threshold and use of full value at risk below that threshold; other wordings may use a different denominator.

How the 85% Pro-Rata Rule Operates

Under the hypothetical clause supplied in this example, the underinsurance penalty is completely waived if the declared Sum Insured represents at least 85% of the actual value of the property at the time of loss.

+--------------------------------------------------------------------------+
|                 SPECIAL CONDITION OF AVERAGE (85% RULE)                  |
|                                                                          |
|  THRESHOLD TEST: Is Sum Insured >= 85% of Actual Value at Risk?          |
|                                                                          |
|  [YES] --> AVERAGE WAIVED: Insurer pays 100% of the partial loss         |
|            (Subject to the Sum Insured limit).                           |
|                                                                          |
|  [NO]  --> AVERAGE ENFORCED IN FULL: Penalty calculated against 100%     |
|            of Value at Risk, NOT against the 85% threshold!              |
+--------------------------------------------------------------------------+

Numerical Example of the 85% Rule

A retail building has an actual value at risk of RM 1,000,000 at the time of a fire, causing RM 100,000 in damage:

• Case A (Sum Insured = RM 850,000): The sum insured is exactly 85% of RM 1,000,000. Because the 85% threshold is met, the condition of average does not operate. The insurer pays the full loss of RM 100,000.
• Case B (Sum Insured = RM 800,000): The sum insured represents 80%, which is below the 85% threshold. Because the threshold was breached, average is applied against the full actual value (RM 1,000,000), not against the 85% mark: $\text{Claim Payable} = \text{RM } 100,000 \times \left( \frac{\text{RM } 800,000}{\text{RM } 1,000,000} \right) = \text{RM } 80,000$. The insured receives RM 80,000 and absorbs a penalty of RM 20,000.

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