26) Arriving at the ‘sum insured’

Everybody who owns property or runs a business has, at some point, felt the need to know how to arrive at the correct ‘sum insured’ for a property. This is an oft repeated question at most seminars and meetings.

If you insure property for less than its actual value, the dreaded ‘under-insurance’ factor comes into play and the Average Clause (that reimburses you for only a part of the claim) may be applied when a claim is made.

Here is a simple version of this calculation for those who buy insurance.
What is part of sum insured?

It is essential to note that the cost of land is not a part of sum insured in a fire policy.
Nor, generally, is the plinth and foundation. Therefore, the sum insured would essentially be the built-up value of the super-structure. Plinth and foundation, can, however, be part of sum insured for a policy that covers earthquake risk.

The value of the building should ideally include the following:
Floors and walls,

False roofs and ceiling,.

Value of embedded items in walls/roofs, that is, Pipes, electric and telephone wiring and similar fixtures.

The following inputs can be used to arrive at the value of building:

Original cost: It is relevant only for the first year of insurance and obviously not for subsequent years.

Book value: The book value has no relevance to insurable value except, of course, in the first year of insurance.

Market Value: The guiding principle is determining the amount at which a building of the same age and condition can be bought or sold.

The steps to be taken for arriving at market value are:

Determine the present cost of a similar building.

Deduct, of course, cost of land, plinth and foundation.

Adjust for depreciation due to age and usage.

Reinstatement Value: It is, in effect, the value of similar new property without taking into account the depreciation. This reinstatement value clause enables building owners to avoid financial strain on their own resources in the even t of a loss.

For arriving at the cost of construction of buildings, CPWD rates are the best guides. The National Buildings Organisation publishes escalation indices every year, which should be used for arriving at insurable value. The final step would be to adjust for depreciation from the estimated current replacement cost (see table).

We now make a comparison of the four methods discussed above:
Assuming it is a 30-year-old building, its original cost in 1975, the year of construction, is Rs 10,00,000, The following parameters have been taken into account for arriving at the above figure:

The Book Value has been calculated at 10 per cent depreciation per year on diminishing value basis.

The Reinstatement Value has been calculated after applying average 10 per cent escalation per year.

The Market Value is calculated by applying 2 per cent depreciation on straight line basis on Reinstatement Value.

By following this methodology, it would become clear that the market value or the reinstatement value, as the case may be, can be correctly fixed and under-insurance avoided.
While insuring property for less than the actual value would invite a proportionate reduction in claim amount due to the condition of Average in Fire Policies, insuring for more than the actual value doesn’t give any advantage to the insured.

In the event of a claim, the principle of indemnity will result in only actual losses being covered. It also results in wastage in extra premium paid on higher sum insured.