The perils of underinsurance

The perils of underinsurance

Published 9 January 2024

The substantial damages awarded in the recent judgment, Infinity Reliance Limited (trading as My 1st Years) v Heath Crawford Limited, remind insurance brokers, once again, of the perils of underinsurance, with business interruption (BI) cover being a particular pitfall.

Background

Infinity Reliance Limited (Infinity) is an online retailer of personalised gifts. Heath Crawford Ltd (Heath), as its insurance broker, had advised Infinity to take out a Commercial Combined policy, which included BI cover (the Policy).

Following a fire in 2021, Infinity had to find and fit out alternative warehouse premises. When Infinity claimed under the Policy, it became apparent it was underinsured for its BI losses, because its cover was based on a forecast gross profit of £24.9m, when it should have been c. £33 million.

The insurers applied average and Infinity only recovered 74% of its adjusted loss; £9.25m instead of £12.17m.

The proceedings

Infinity alleged that Heath was negligent:

• in providing a misleading explanation of how to calculate the BI sum insured;
• for not recommending declaration linked cover (as an alternative to the traditional "sum insured" BI cover), under which the insurer would accept an additional premium, rather than apply average, if actual performance was higher than forecast at the end of the policy period; and
• for failing to recommend "additional increased costs of working" (AICOW) insurance which would have covered more fully the fit out costs at the new warehouse.

Heath accepted that the explanation of how to calculate the BI sum insured, contained in its generic guide, was misleading. Infinity's Finance Director had used this to forecast a flat 10% increase in gross profit, rather than the appropriate, higher, forecast for the future performance of the business, leaving Infinity exposed to the dangers of underinsurance. The Finance Director did not understand how average would work; he assumed the BI sum insured was a limit of liability. Although the guide mentioned declaration linked cover, it did not explain how it worked.

The decision

Following the well-established caselaw on brokers' duties, the judge held that Heath had acted in breach of duty by providing a misleading and incorrect explanation for how to calculate gross profit and also in failing to recommend declaration linked cover.

Key to this decision was the failure to ensure that Infinity understood the implications of underinsurance, so that it could make an informed decision as to the level of its BI cover, and whether to take out declaration linked cover.

Those breaches of duty resulted in Infinity being underinsured and average being applied to its BI claim. Heath was held liable for damages of £2.9m, equating to the uninsured BI losses. However, the damages were reduced by 20% to reflect contributory negligence on Infinity's part in carelessly failing to apply even the flawed guidance on BI, correctly.

Heath was also negligent in failing to explore what additional coverage Infinity might need to meet its costs if its warehouse became unusable. This, the judge decided, would have identified a need for additional (AICOW) cover for fitting out new premises. However, Heath's failure to consider the need for AICOW cover had not caused any additional losses beyond those already caused by the other breaches, for which Infinity was already being compensated.

Key lessons

Although the case turned on its facts and did not make new law, the decision once again underlines the particular skill and care required of a broker to explain in clear terms how a client should calculate gross profit for BI purposes.

Generic explanation documents may not suffice, as these may not apply in all respects to the specific policy involved or be suitable for the client's particular business. Bespoke advice is required.

A broker should also consider whether an alternative type of BI cover to traditional sum insured cover is appropriate, in this case declaration linked cover. This might be suitable where, for example, a client's future sales are especially difficult to predict, so that forecasting its future gross profits figures for BI purposes becomes difficult.

More generally a broker must ensure that the client understands the risks of underinsurance and the possible application of average. Otherwise the client will not be making an informed decision about its BI cover.

The broker must also consider possible additional coverage required to meet a client's business needs in the event of a significant event, such as a fire; in this case taking out AICOW. This requires the broker to have a detailed understanding of the client's business and (although no additional damages were awarded in this case) the judgment underlines just how onerous this duty can be.

This article was first published in Insurance Age.

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