Risk management processes and controls are crucial for safeguarding from unexpected events that can lead to financial losses; for both individuals and businesses alike, operating without these measures can result in dire consequences. Insurance is an integral component of risk management; however, underinsurance—instances in which coverage obtained falls short of the actual risk exposure—can also degrade an organization’s overall risk.
In this article, we’ll delve into the concept of underinsurance, exploring its causes, effects, and implications, as well as how proper risk management can reduce its effects.
What is Underinsurance?
Underinsurance refers to a scenario where an individual or organization holds inadequate insurance coverage relative to their actual risk exposure (i.e., the value of the insured asset/liability exceeds the policy limit). These discrepancies can arise due to various factors, such as underestimating the value of the asset, miscalculating potential risks, or consciously choosing to reduce the cost of insured coverage.
Underinsurance Factors and Effects
According to research conducted by Lloyds of London, a significant gap exists between required insurance levels and the actual costs of rebuilding/recovering after a major catastrophe. Crucially, this means that, per the legal status quo, most organizations should expect to front some costs in the event of a disaster. On the home insurance front, individual policyholders are also woefully exposed—recent statistics from Nationwide Insurance revealed that two out of three U.S. homes are underinsured, with an average underinsurance amount hovering around 22%, with some homes underinsured by 60% or more. This translates to millions of American homeowners at risk of a severe financial crisis in the event of a property loss-inducing event.
Several factors contribute to the prevalence of underinsurance. At the most basic level, an individual or organization may underestimate the potential risks they face, leading to the selection of coverage options and features that are either inadequate or misaligned. Firms without an Insurance Policy Administration solution in place lack an integrated view of their organization’s risk position, and the resulting inaccurate risk assessments or a lack of awareness regarding potential losses more often results in a failure to acquire comprehensive insurance policies.
And since cost considerations are leading drivers in insurance policy selection/configuration, economic factors play a significant role in underinsurance. In today’s challenging financial climate, individuals and firms alike may prioritize cost-cutting measures, including the reduction of insurance premiums—this results in greater long-term exposure to risk and vulnerabilities. Additionally, insurance policy complexity and lack of understanding on the part of the policyholder can contribute to underinsurance. Policies often contain intricate terms, conditions, and exclusions, and without the proper communication/guidance, policyholders may inadvertently acquire inadequate coverage.
The Hidden Effects of Inflation
With global inflation rates experiencing their highest annual increases since 1996, policyholders and insurance carriers alike face a less-obvious, more complicated driver of underinsurance: undervaluation. With the cost of land, construction materials, and labor on the rise, infrastructure costs and asset values should also correspondingly increase across all industries and sectors. However, property valuers and insurers in major markets estimate that most businesses have not applied adequate corrections in property valuation, and could possibly be exposed to significant underinsurance risk. If the amount insured is less than the property’s true current value, the policyholder is underinsured—and in a total loss scenario, they will be responsible for the uninsured balance of the loss, since the insurer’s liability is relegated to amounts under the policy’s limits.
Effects of Underinsurance
In the event of a substantial loss or claim, policyholders with insufficient coverage will clearly face more significant financial impacts. This predicament is especially challenging after a catastrophic event, as underinsurance can hinder economic recovery—for example, when businesses lack adequate insurance coverage, they may struggle to rebuild and resume operations, delaying the overall recovery process. In extreme cases, if the out-of-pocket expenses required to cover the shortfall between the policy limit and the actual loss is substantial enough, the individual or organization may look to insolvency and/or bankruptcy as a final option.
Mitigating Underinsurance with Risk Management
To mitigate the risks associated with underinsurance, firms must adopt a proactive, comprehensive risk management approach, one that includes both continuously assessing known risks, as well as surfacing new, unknown risks that emerge over time. This involves evaluating the value of assets, potential liabilities, and estimating the financial impact of various scenarios. By understanding the magnitude of risks, organizations can more accurately determine the appropriate coverage needed and adequately protect their interests. Insurance Policy Administration software can help significantly in this regard by automatically streamlining data access and delivering timely insights to all stakeholders in the insurance value chain (e.g., executives, risk professionals/managers, underwriters, and agents).
Whether it’s due to overreaching cost-cutting measures or inaccurate property valuations, underinsurance can have a potentially devastating impact on an organization. To mitigate the risk of underinsurance, firms should perform regular risk assessments and implement proactive risk management practices for ensuring that adequate coverage is in place. Specialized tooling can help to streamline and automate these efforts.
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