What is Sum Insured, Its basis & Importance of Adequacy of Sum Insured
Insurance provides coverage against unforeseen events such as accidents, illnesses, property damages or business interruptions. However, simply buying an insurance policy is not enough; what really matters is whether the sum insured – the maximum amount the insurer will pay out in the event of a claim – is sufficient to cover the actual loss. The insurance premium amount mainly depends on the sum insured chosen and type of Covers opted for. Some try to save premium by deliberately choosing sum-insured levels on lower side. But inadequate sum insured can directly lead to under-insurance, causing individuals and businesses to face significant financial losses despite having insurance coverage.
Understanding Sum Insured
The sum insured is the pre-determined monetary limit that the insurance company agrees to pay in the event of a covered total loss. It is commonly used in non-life or general insurance policies such as health, motor, fire, property or marine insurance. Unlike the sum insured (which is a fixed benefit in life insurance policies), the sum insured in general insurance policies is based on the value of the property or interest being protected.
Basis of Sum Insured
The general insurance policies like fire, property, machinery, construction & erection all risk policies are indemnity policies, i.e., the insured in the event of loss is indemnified up to sum insured level the basis of which can be – i) present day market (depreciated) value basis considering the envisaged cost of replacement or reconstruction or re-erection of the property to the stage as it was just before the loss, ii) new replacement value envisaging the cost of reconstruction or re-erection or replacement with features not superior than that just before the loss, however, reconstruction or replacement becomes compulsory. It is worth noting that cost of land per se or in the value of property is not insurable.
Insurance cover for stocks is to be on production or procurement cost basis without any element of profit.
Under business interruption or loss of profit insurance policies, estimated gross profit (equivalent to net profit + standing charges OR estimated turnover – uninsured working expenses) is the basis of sum insured. Working expenses like raw material, electricity, packing, freight etc. are not to be considered in sum insured as in the event of interruptions, such variable costs are not incurred.
Under Motor insurance, IDV (insured declared value) – to be declared by the insured and as accepted by the insurer, based on market value of that motor vehicle becomes the basis of sum insured.
Under above policies, the claims are admissible for unforeseeable events covered under the policies up to the sum insured limits without any element of profit, all these policies being Indemnity policies.
Under Marine Cargo Insurance, invoice value + freight + reasonable profit & other incidentals, say up to 10%, as declared by the insured and as agreed to by the insurer are the basis of sum insured. Under Marine Hull policies, replacement cost should ideally be the basis of sum insured.
Under the Liability policies, the sum insured is either driven by statutory requirements or as per liabilities envisaged in the event of loss.
Under Travel Insurance, sum insured depends on the country of travel and estimated medical costs in that country.
Likewise, prevailing medical costs at a place of living should be basis of sum insured under Health policies.
Since the insured cannot draw any undue benefit or profit under the above policies, over-insurance by way of single or multiple policies of total sum insured value more than the required sum insured is also of no use, but a waste of premium, but under-insurance or inadequate sum insured levels may surely lead to financial loss, hence the need of choosing the sum insured judiciously under the said policies.
All Critical Illness or lump-sum cash policies, accident and death (life insurance) policies are benefit policies for lump-sum protection where the insured can take one single or multiple policies as per his requirement without any restriction on the total sum insured available under his policies.
Importance of Adequacy of Sum Insured OR Risks of Underinsurance
Underinsurance occurs when the sum insured is less than the actual value or reconstruction value (as applicable) of the property, medical treatment or liability. This situation can arise due to various reasons:
• Incorrect estimation of the actual or reconstruction value of the property (without considering cost of land)
• Rise and increase in property repair or restoration costs
• Rise in costs in healthcare
• Lack of periodic review and update of the policy
• Deliberately reducing the sum insured to reduce premium costs
In many insurance contracts, especially property insurance, an “average clause” applies. Under this clause, if the sum insured is found to be less than the actual restoration value at the time of loss, the claim is reduced proportionately. To address future escalations in reconstruction costs, the insured may opt for ‘escalation clause’ by paying some additional premium under property, machinery and construction policies. The importance of adequacy becomes even more evident in health insurance. With rising medical costs, a policy with a certain sum insured may have been sufficient a decade ago, but may fall short today, especially in urban areas where hospitalization for critical illnesses or surgery costs are increasing day by day. Policyholders can also consider floater policies (for families), top-up covers and super top-up plans to enhance their overall protection. Periodic assessment based on age, lifestyle, health inflation and needs of dependents is essential to keep coverage relevant.
Commercial and Business Insurance
In commercial insurance, underestimating the value of loss of stock, machinery or profits due to business interruption can seriously impede recovery after an adverse event. Businesses should ensure that the sum insured under policies such as fire insurance, machinery breakdown, electronic equipment insurance reflects true replacement or restoration costs and most accurate anticipated gross profit under business interruption policies.
Conclusion
The purpose of insurance is to restore the insured to their financial position before the loss occurred – not to enrich them, but certainly not to leave them inadequately protected either. The adequacy of the sum insured is the cornerstone of effective risk transfer. Regularly reviewing your insurance portfolio, adjusting the sum insured in line with inflation and changing needs, and consulting qualified experts can ensure that you are truly protected when it matters the most. Professional assistance from insurance brokers or consultants, using updated market rates and valuation reports, can help to properly evaluate and revise the sum insured.
Inadequate coverage is almost as risky as having no insurance at all. By ensuring that the sum insured is adequate, you not only get a policy – but also peace of mind.