What is index linking and how does it relate to underinsurance?

Geoff Hall, Chairman, Berkeley Alexander looks at the challenges of underinsurance and how index linking aims to prevent this.

Related topics:  Finance,  Property,  Insurance
Geoff Hall | Berkeley Alexander
14th September 2023
Property insurance 714

Underinsurance is a big issue for the insurance industry right now. Inflation has been at its highest level for three decades, leaving many residential and commercial properties woefully underinsured.

According to a study by Marsh, 80% of UK properties are underinsured, representing some £340 billion worth of homes and businesses.

Buildings and contents need to be insured for the correct amount to avoid a shortfall in the event of a claim. A building, or its contents, correctly valued when a policy was taken out - and for buildings, by “value” I mean the current property rebuild costs, not its market value - may have tipped into underinsurance because of a steep rise in building materials and labour costs.

This may seem like scaremongering, but it’s not. At Berkeley Alexander, we recently helped a client with a small fire claim where the buildings sum insured was set at £1.5million. However, the loss adjuster’s valuation was £2.5million.

Fortunately, the insurer had surveyed the property at inception and agreed the adequacy of the client's initial sum insured, and had index linked in the years since, so the claim was processed (albeit with an additional premium to pay for raising the sum insured from that point onwards), but had that not been the case the result would’ve been very different.

This underinsurance gap will continue to widen if advisers don’t act. Index linking has never been more relevant.

But what is it, how does it differ from sums insured, and how does it relate to underinsurance?

What is index linking?

Index linking is a method of adjusting the sums insured at each insurance renewal to account for changes in inflation, deflation, and the cost of living, and aims to prevent underinsurance or over-insurance. It’s applied by insurers to ensure that the building (and on some policies the contents) values are adjusted in line with current economic conditions.

Index linking differs from sums insured in that the latter are amounts declared by the policyholder to the insurer as the value of the building or contents to be insured (but often only at the inception and then never reviewed again - highlighting the need for brokers to be proactive with the client). Index linking is then added at each subsequent renewal to keep the overall sum insured in line with the market conditions.

Insurers use various indices to calculate index linking, including for contents the Consumer Price Index (CPI) and Retail Price Index (RPI). For buildings insurance, many insurers refer to the Building Cost Information Service (BCIS), which operates under the Royal Institute of Chartered Surveyors (RICS).

How does index linking relate to underinsurance?

The indices use several factors in their calculations including the cost of labour, materials and professional fees to calculate the increases needed to try to keep the property adequately insured.

However, index linking only works when clients consider the factors that can impact the sums insured. Many businesses and homeowners have not reviewed the amount covered by their building or contents insurance, either to save money or because they’re simply unaware of the severity of the risk to their financial security.

What are the consequences?

It’s a misconception that it only matters if there’s a total loss. If the insurer identifies underinsurance at the point of claim, they’re likely to apply what’s called “average”; for example, if they establish that the property is only insured for 75% of its true value, the value of the claim will only be paid out at 75%, thereby leaving the client out of pocket.

So a £40k claim would only result in a £30k payment leaving the client £10k out of pocket. But worse can happen if it’s believed the underinsurance was either deliberate or reckless as insurers can null and void the policy.

Your role in tackling underinsurance

Underinsurance is a huge challenge. As advisors, you have an essential role.

Many policies are now on a “notional sum insured” basis, so provide cover “up to” the stated value. These policies don’t need to index link. However, we’re seeing more enquiries where the property value, and the contents’ value, are getting close to or over the notional sum insured, and this needs attention.

It’s crucial to review the sums insured across your book, paying particular attention to the accuracy of rebuild and replacement costs.

Review your clients’ coverage regularly to ensure that:

· Sums insured are sufficient.

· Indemnity periods and benefit levels are adequate on alternative accommodation costs for homeowners, loss of rent for landlords and Business Interruption cover for commercial clients, considering all external economic factors and current influences on inflation and the supply of labour and materials, to give them valuable protection in the event of a claim.

For buildings, there are some free-to-use tools online that can be used to provide a guide. However, there’s no replacement for a professional survey, particularly for larger properties or non-standard buildings. A 3–5-year revaluation is money well spent.

To sum up…

Underinsurance must be tackled proactively if we’re to identify customers most at risk, help them make informed decisions, and deliver better protection outcomes.

By acting proactively, advisors can ensure they’re always on the front foot when it comes to securing the right level of protection at the right price. Becoming a trusted advisor adds value and increases loyalty and retention.

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