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Personal Lines Insurance
Monday, May 1, 1989
Day-one is OK

It is then that he is often found to be underinsured, either because he underestimated the cost of rebuilding or replacing the property, or because he failed to increase the sums insured in line with inflation, knows, to their cost, that capital goods are becoming ever more expensive; but it is not so widely known that, these days, most property is insured for replacement cost, or “as new”, regardless of age.
Domestic insurance
If the sum insured is adequate, this arrangement is beneficial to both parties. The policyholder, after an unexpected loss for which he is financially unprepared, does not have to pay the difference between the depreciated value of his property and the cost of replacing it with new. The insurer obtains more premium because the sums insured are higher, being based on the current replacement cost instead of the depreciated or current market value. Unfortunately, the prospective policyholder, when contemplating the premium he is asked to pay, and before a loss occurs, is likely to take a more conservative view of the value of his property than after it has been damaged or destroyed and he is formulating his claim.
In such circumstances, the insurer may be entitled to apply “average” and the policyholder will lose much, if not all, of the benefit he would otherwise have derived from his new for old policy.
Average, in this context, means that the insurer will pay a reduced amount of the agreed loss in proportion to the sum insured compared to the total replacement cost of all the property insured.
The policyholder will have to accept a settlement based on the depreciated value of the property immediately prior to the loss, and pay the difference from his own pocket.
Business insurance
The owner of business premises may face further problems.
Not only must he decide upon the cost of rebuilding at the time of effecting his fire policy, but he must also estimate how long it will take to complete the work of reconstruction, and what the final cost is likely to be at the end of the rebuilding operations.
It is this last figure which will be used by the insurer to negotiate settlement of the claim, and for a decision as to whether average is applicable. In addition, all the incidental costs incurred in the rebuilding must be included in the sum insured such as the removal of debris, site clearance, and professional fees for architects and engineers, fees charged by the local municipality for the scrutiny of plans; and, any extra costs incurred in complying with the requirements of a public authority.
Even if the policyholder were willing and able to do so, he cannot, in all fairness, be expected to pay the full premium, from inception, for a given sum insured (where it has to be projected on inflated costs for a hypothetical situation which might arise as far as two or three years ahead).
This could be the case if the damage should occur at the end of the current year of insurance and if the rebuilding period thereafter were, say, two years - not too long for a large or complex structure, including the preparation of tender documents and the letting of contracts.
It would be unfair to the policyholder because the costs of reconstruction would escalate only gradually during the three- year period, and the insurer, while collecting premium from inception on the full final sum insured, would not be at risk for the total amount until the end of the period.
Day one basis
Relatively recently, a method of overcoming this difficulty as devised in the UK and adapted for use in South Africa. It can be applied to buildings and to plant and machinery, but not to stock or other contents and, so far, it is used only for business risks and not for domestic insurances.
It is known as the ‘‘day-one’’ basis. The owner must decide upon the new replacement cost of the property at the inception date of the insurance — including all the incidental costs mentioned above (say R20m). This figure is known as the ‘‘declared value’’. For a large or complex building, a professional valuation is desirable to ensure that the all-important declared value is accurate.
Provision for inflation must then be made. This will depend on the likely period for reconstruction or replacement and the anticipated rate of inflation for the period. An inflation rate of 30%, 40%, or 50% may be selected for this purpose. Say, it will take three years for total reconstruction and inflation is assumed to amount to 50% for that period.
The chosen percentage is then added to the declared value to arrive at the sum insured (say R30m being R20m plus 50%) to be applied from day one. Average would then he applied only if the declared value was less than the actual cost of reinstatement at inception on day one.
The normal rate of premium applicable to the risk is loaded by a percentage which varies according to the selected increase in the declared value. The resultant premium rate is applied to the declared value — not to the sum insured. This premium loading is usually of the order of 15% for a 30% increase in the declared value; 17,5% for a 40% increase; and 20% for 50%. Thus, in this case, the basic premium is loaded by 20%.
Alternatively, the initial premium may be charged on a provisional, or adjustable basis, when the premium loadings would he approximately half of those indicated above.
But at the end of each period of insurance, an additional premium is payable, equal to 50% of the difference between the original provisional premium and the premium payable on the revised declared value for the next ensuing period of insurance. The day one basis of insuring against inflation is the simplest and most effective and equitable method so far devised for handling what is indeed a very tricky problem.

Copyright © Insurance Times and Investments® Vol:2.5 1st May, 1989
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