Definition: A condition by which an insurer determines that the payment for any damage or any loss will be in proportion to the value insured.
In other words, a part of an insurance policy that states that if the insurance value of a property at the time of loss or damage is less than its real value, payment by the insurance company will be reduced according to the difference.
For example, a building worth 100,000β¬ but insured for 50,000β¬ is totally destroyed,
The insurer will only pay 25,000β¬, which represents 50% of the insurance value, but 25% of the full value.
Of course, the insured has insured his or her building for only 50% of its real value. The insured having taken a risk, he or she has not only lost the full value of the property, but will only be compensated for the proportion of the gambit he or she took when he or she was insured for half of it.
According to the average clause in the insurance policy,
The amount of claim that the insured gets is calculated as follows:
Claim amount = (Actual loss Γ Insured amount) / Value of goods or property at the date of loss.
Suppose a property worth 1,500,000β¬ is insured for 1,300,000β¬, and the fire insurance policy comprises the average clause.
If half the property is damaged due to the fire, the loss that the policy holder incurs is about 750,000β¬ based on the current worth of the property (half amount).
However, the amount that will be paid by the insurer is:
= (750,000 Γ 1,300,000) / 1,500,000 = 650,000β¬
Of course 1,300,000 / 1,500,000 = 86.67%
750,000 * 86.67% = 650,000β¬
Therefore, the additional amount of 100,000β¬ (750,000 β 650,000) has to be borne by the insured him or herself.
Unfortunately, underinsuring is quite common in many markets for various reasons.
It can arise willingly to reduce the cost of the premium which should be paid on the sum insured.
It can also occur by negligence, if the original sum insured has not been updated and increased because of increased value due to inflation or property extensions.
Hence, the average clause is used more often.
For the reinsurer, it is sometimes important to remind insurers of the existence of this average clause.
Indeed, if the reinsurer realizes that the insurer has been too complacent by ignoring underinsurance for commercial reasons (i.e., to not lose a big client), and if the insurer has paid such loss without applying the average clause, the reinsurer has every right to deduct the portion from its reinsurance, which does not have to be paid.