According to the most recent figures I have from the Society of Chartered Surveyors, published in early 1997, a modest detached house in Dublin should be insured for at least £75,000. In the last year that figure would have risen by another 20 per cent. That house should now be insured in early 1998 for about £90,000. But figures I have seen would suggest that up to 20 per cent are insured for significantly less than this amount.
Based on the chartered surveyor figures for 1996 any house with an area of 1,000 sq ft in Dublin should have been insured for at least £62,000 in that year. By 1998 that figure should probably be around £75,000. But on the basis of the data in the table, around 45 per cent of insured houses in Dublin are insured for less than £75,000. Yet it is obvious that the proportion of houses that have 1,000 sq ft floor area or more considerably exceeds 55 per cent of the total market. Assuming that about 70 per cent of houses (roughly equivalent to the owner-occupier sector) have an area of at least 1,000 sq ft then nearly one house in five is seriously under-insured.
Consider the following example. You have valued your house at £100,000 for fire insurance and pay the appropriate insurance premium. Suppose, however, that the "re-instatement" value (the cost of rebuilding it if it is destroyed) is £150,000. A fire occurs. The damage comes to £50,000 and you naturally expect the insurer to pay up. To your intense annoyance, you receive a letter pointing to the "average clause" in the contract, and also to the fact that the insured amount is equivalent to only two-thirds of the cost of reinstatement of the house. In line with the average clause they enclose a cheque for £33,333.33. You are out of pocket by nearly £17,000, and are convinced that you have been a victim of the fine print on an insurance policy.
When things go wrong the immediate reaction is to blame the insurer. Where averaging is concerned, however, the fault lies with the homeowner and not the insurer.
Suppose there are 500,000 houses in Ireland covered by fire insurance, and that on average 1 per cent are destroyed by fire in any year. (For simplicity, we assume that the house is gutted in every case). Suppose that the average cost of putting the damage right comes to £40,000. The annual fire damage bill will come to £200 million (1 per cent of £500,000 x 40,000). The risk is pooled, and the cost is shared among the insured householders if each pays a premium of 1 per cent of the cost of re-instating his house. In a competitive insurance market fire insurance will cost 1 per cent of the re-instatement value, plus a small amount to cover the insurance companies' costs. These premiums will provide funds to cover the damage to the unlucky householders.
Now suppose that each householder "values" his house at 75 per cent of its re-instatement cost, and pays a correspondingly lower insurance premium. Total premium income will come to £150 million, or 75 per cent of the expected damage. This will meet only 75 per cent of the costs of each claim. Unless the, insurers are to be made bankrupt.
If an individual under-insures by 25 per cent he is taking out insurance to cover 75 per cent of any damage that occurs. It's as simple as that. He is contributing to the cost of the pooled risk less than the expected cost of any damage to him.
If damage occurs, unless everyone else is obliged to pay more than the correct amount, he can collect only what he has elected to cover. This is the effect of the average clause which provides that the ratio of the insured value to the re-instatement cost (and, therefore, of the premiums paid to the "correct" premium) determines the proportion of the cost of any damage that will be met by the policy.
The problem is a poor understanding by most people of the economic basis for insurance. Under-insurance occurs when, for example, the amount specified as the value of the house insured is less than the house's replacement cost. In that case, if damage occurs, the average clause comes into effect. In the vast majority of cases people do not under-insure deliberately. The real problem, however, is that many do not realise how much it costs to rebuild a home.
These people also do not understand averaging and unwittingly become affected by it. Where this is most serious as a problem is in relation to house insurance, for reinstatement of the fabric of the house, particularly after serious fire or flood damage. It applies also to contents, but the scale of the problem is not as large. When you under-insure and pay less than your contribution to the cost of the pooled risk you become a co-insurer, that is you take on a proportion of the risk.
It is in the insurance companies' interests to make this clear. If people do not understand the problem and are under-insured, when they make a claim they feel cheated by the insurer.
Most under-insurance is the result of people not realising what has been happening to the cost of reinstatement. If people adjust their house cover in line with inflation, but reinstatement costs rise more rapidly than consumer prices, people unwittingly start to co-insure.
Between 1988 and 1997 the consumer price index rose by 27 per cent. House prices rose by much more. Even allowing for the site value element in house prices, anyone who indexed the insured value of his house by reference to the annual inflation rate was grossly under-insuring.
Between 1988 and 1994 building costs inflation was fully 20 per cent higher than new house prices inflation (ie: if new houses rose in price by 10 per cent, building costs rose by 12 per cent). Since 1994 the margin has widened further: building costs are rising half as fast again as new house prices.
There is a potential insurance time bomb that could have serious implications for households and lenders. It points to the need for insurers to be much more pro-active in making people aware of the financial exposure they face because they have not adjusted their house insurance to take account of economic reality.
Moore McDowell is attached to the Department of Economics, University College Dublin.
