By Gabrielle Toscan, Managing Director, Breakwater Insurance Brokers
We were recently asked to take a look at a commercial property insurance claim on a policy that we didn’t arrange, and where we’re not the broker. The business owner felt they might be getting short-changed by their insurer and wanted a second opinion from someone who could read the policy and explain what was going on.
Their concern came down to a big gap between two settlement figures: one if they rebuilt the commercial building they’d lost in a fire (the reinstatement value), and a much lower one if they decided to walk away (the indemnity value).
There are some good lessons in this claim that we think every business owner and commercial property owner should understand, because the same rules sit inside many commercial property policies, and most people don’t find out about them until they’re in the middle of a claim.
The short answer on reinstatement vs indemnity value: Under most commercial property policies, reinstatement cover pays to rebuild your building as new, but generally only if you actually rebuild. If you choose not to rebuild, the insurer pays the building’s indemnity value: what it was worth just before the loss, allowing for age and wear and tear. That can be a lot less. And insuring for the lower ‘walk away’ value isn’t the fix it seems, because of the co-insurance clause.
What happened: a fire destroyed a commercial building
We’ll keep this light on detail (and we’ve rounded the figures), but the long and short of it is: a fire completely destroyed a commercial building that the owner ran their business from. It’s not a business that can operate from an alternative premises, so the business hasn’t been able to trade since.
Two settlement options: reinstatement or indemnity
The claim had reached the point where the insurer was advising the owner that they had two options for the building:
- Option 1: a ‘reinstatement cash settlement’
- Option 2: an ‘indemnity settlement’
The dollar difference between these two options was the cause of the concern.
Option 1: reinstatement cash settlement
Under Option 1, the assessor (acting for the insurer) had obtained a scope of works and a quote to rebuild the building. That quote came in at close to $4 million.
To take this option, the owner has to actually rebuild. The insurer pays the money progressively as invoices come in during the rebuild, not as one lump sum. Because it’s a cash settlement, the owner manages the rebuild and pays the builders themselves, rather than the insurer managing the works.
The building was insured for $4m, based on a valuation done for insurance purposes the year before.
Option 2: indemnity settlement
Option 2 is what’s available if the owner doesn’t want to rebuild. The assessor indicated that the indemnity amount was likely to fall somewhere around 65% of the rebuild cost. For the purposes of this post, let’s call it around $2.6m.
Understandably, this left the owner feeling that if they took Option 2, they’d be missing out on $1.4m. That didn’t feel fair to them when they’d been paying premium on a $4m sum insured.
Where we came in: a second opinion on the claim
Insurance is confusing at the best of times. Add the stress of losing your business premises in a fire, and it’s no surprise that people start to wonder whether they’re being treated fairly. Our role here was simply to read the policy wording, check whether the insurer’s position matched it, and explain it in plain English.
It’s a good reminder of why it matters to have an insurance broker who will sit with you, communicate clearly and make sure you understand how your insurance works and what’s happening with your claim. Part of a broker’s job is to make sure your policy is being applied as the wording says and, just as importantly, to make sure you feel that someone is in your corner when it’s you and a big institution deciding the financial outcome of a very distressing event.
Why does rebuilding pay more than walking away?
This was pretty much the question on the owner’s mind: they insured the building for $4m, so why shouldn’t they get $4m when they’ve lost the entire building in an insured event?
To answer this, you need to understand how this kind of policy works.
Reinstatement vs indemnity value: how it works
This policy says the insurer will ‘indemnify the Insured in accordance with the applicable Basis of Settlement’ if the building suffers loss, destruction or damage that the policy covers.
The starting point for buildings is the cost of rebuilding, replacing or repairing them. But the policy also lets the owner choose to claim the ‘indemnity value’ instead. Indemnity value is what the building was worth just before the fire, allowing for its age and wear and tear. The idea is to put the owner back, as close as possible, to where they were before the loss: no better, and no worse.
Think of it this way. The building that burned down wasn’t new. The $4m figure is the cost of a brand-new building. If you rebuild, the policy pays for that new building, and that’s the real value of reinstatement cover. But if you don’t rebuild, paying out the full cost of a new building would leave you better off than before the fire, holding cash for a new building you never had. The indemnity value is the policy’s way of paying you for the building you actually lost.
It’s important that this choice exists, because you don’t want to be forced to go through a full rebuild if you don’t actually want to keep running the business.
You're not choosing between $4m and $2.6m
As we explained to the owner, it sounds like they’re choosing between $4m and $2.6m. But what they’re actually choosing between is:
- Having the insurer fund a $4m rebuild, where that money goes to the builders rather than into their pocket (and any cost overruns beyond the sum insured will come out of their own pocket), so they can get the business going again; OR
- Walking away with a payment for the value of the building as it stood the day before the fire.
Once we explained it this way, they understood. They weren’t choosing between $4m and $2.6m. They were choosing between having their insurance pay for a new building and a fresh start for the business, or walking away with the value of the building they actually lost.
Should you insure your building for its indemnity value instead?
The next sticking point was: “We would never have rebuilt, so it would have been good to have this explained to us. We could have just paid premium on the indemnity value instead of the rebuild value.”
That’s a logical and understandable reaction. The catch is that most of these policies contain a co-insurance (or ‘under-insurance’) clause. If your sum insured is too far below the full cost of rebuilding, the insurer reduces your claim in proportion. This applies on partial losses, which are far more common than total losses.
We have this conversation with clients a lot. We’ll talk about a building and ask whether it’s been valued. The client will tell us the rebuild cost… and then say, “But we’d never rebuild it to that extent, so we don’t need to insure it for that much.” However, you need to understand that this is not how the policy actually works and you will pay for this reduction in cover in the event of a partial loss.
Worked example: how the co-insurance clause hits a partial loss
Let’s use this case to show what would have happened if the fire had damaged only part of the building. In this policy, the co-insurance clause applies if the building is insured for less than 85% of its full rebuild cost.
- Building insured for $4m, with a full rebuild cost of $4m. No under-insurance here.
- A fire damages part of the building and the repairs cost $2m. The insurer pays the full $2m (less your excess).
- Building insured for $2.6m (roughly its indemnity value), with a full rebuild cost of $4m. This means the building is insured for only 65% of its rebuild cost, which is below the 85% the policy requires.
- The same $2m repair. The insurer applies the co-insurance clause and pays only the proportion that $2.6m bears to 85% of the rebuild cost ($3.4m), which is about 76.5%. So the claim pays out around $1.53m, and the owner has to find the remaining $470,000 or so to finish the repairs.
In other words, the premium saved by insuring for the ‘walk away’ value can be wiped out many times over by a single partial claim.
What this means for business owners and commercial property owners
- Reinstatement cover pays for a new building, but generally only if you rebuild. If you don’t rebuild, expect to receive the value of the old building, which can be a lot less.
- That gap isn’t the insurer short-changing you. It’s the difference between an old building and a new one.
- Don’t cut your sum insured to the ‘walk away’ value. The co-insurance clause can cost you far more on a partial loss than you’ll ever save in premium.
- Have your building valued for insurance purposes. Building costs move quickly, and you don’t want to accidentally expose yourself to the under-insurance penalty. If you’re not sure when your building was last valued, talk to us.
- If you already know you wouldn’t rebuild after a major loss (because you’d sell, retire or relocate), talk to your broker before a claim, not after. There may be a better way to structure your cover or, if not, you will at least understand your cover before you need it.
And if you’re ever unsure whether your claim is being handled fairly, ask. A good broker should be able to show you exactly where in your policy the answer sits.
Frequently asked questions
What is the difference between reinstatement value and indemnity value?
Reinstatement value is the cost of rebuilding or repairing your building as new, at today’s prices. Indemnity value is what the building was actually worth just before the loss, allowing for its age and wear and tear. For an older building, the indemnity value can be well below the reinstatement value.
Do I have to rebuild to receive the full sum insured?
Under most reinstatement policies, the full rebuild cost is only paid if you actually rebuild, and it’s usually paid progressively as the work is invoiced. If you decide not to rebuild, you’ll generally receive the indemnity value instead. Your policy wording sets out the exact conditions, so check it or ask your broker.
What is a co-insurance (under-insurance) clause?
A co-insurance clause reduces your claim if your building is insured for less than a set percentage of its full rebuild cost (85% in the policy above). The insurer pays only the proportion of the loss that your sum insured bears to that required amount, so you carry the shortfall yourself, even on a partial loss.
Can I insure my building for its indemnity value to save on premium?
You can, but it’s rarely a good idea on a reinstatement policy. If your sum insured falls below the co-insurance threshold, any partial claim is reduced in proportion, and a single claim can cost you far more than the premium you saved. Talk to your broker about how your cover is structured instead.
How often should I have my commercial building valued for insurance?
Building and labour costs can change quickly, so your sum insured should be reviewed at every renewal. There’s no hard and fast rule with valuations, but we suggest a professional insurance valuation every few years, after any major renovation or extension or if there have been significant changes in the market.
Want a second opinion on your commercial property insurance?
Whether you’re in the middle of a claim and want someone to explain reinstatement vs indemnity value under your policy, or you’d like to check your building’s sum insured before you ever need to claim, our team at Breakwater Insurance Brokers is here to help business owners and commercial property owners across Warrnambool and South West Victoria, and beyond. Get in touch for a no-obligation chat.
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