Total Loss Clause - Small Print, Big Impact
In a competitive insurance market, it can be tempting to offer "attractive" terms and conditions. But if "attractive" means including wording that goes against the basic principles of insurance, it can have costly implications for the insurer.
One example we saw in Brazil recently was the use of a total loss clause in a property policy - a clause more usually seen in motor or machinery insurance coverage. The wording was inappropriate for a buildings policy and it led to the insurer paying out significantly more than the damage caused, which goes against Article 781 of the Brazilian Civil Code.
Property coverage is based on the simple principles of indemnity, insurable interest and good faith. The principle of indemnity is especially important here because it states that the insured shall not profit from a covered loss but shall be restored to approximately the same financial position than existed prior to the loss.
In the example that caught our attention, the insured was a manufacturer of toys. The risk was a warehouse covering 14,000 square meters, plus several attached secondary sheds with internal access totalling an area of 18,500 square meters. A fire destroyed the metal structures of the main warehouse.
The wording in the policy’s general conditions defined a total loss as:
a) the insured object is destroyed or so extensively damaged that it loses its characteristics as an insured good, or;
b) the reconstruction, repair and/or replacement cost reaches or is more than 75% of its actual value.
Such wording makes sense in a motor or machinery policy because the cost of these goods is generally low, whereas the liability for a major repair job can be high. In addition, if the car or machine is declared a constructive total loss, the salvage becomes the property of the insurer.
An additional problem with the use of this wording in a property context is that it can be an incentive to the policyholder to reach the 75% target and justify a higher settlement figure. In this case, it meant the insured received a higher indemnity than the damage suffered, i.e. the value of the new building, instead of the amount for the repair of the damaged building. The insured was put in a better financial position after the loss than prior to it. So, not only was there a breach of the aforementioned principle of indemnity, the final claim actually cost the insurer 50% more than it should have done.
In the end, losses exist and we have to learn from them. We recommend a careful analysis of the General Conditions of the insurance product in order to be certain that the terms and conditions are appropriate to the risk in question and in accordance with the regulations.
After all it’s in everyone’s best interest to be aware of the potential impact of clauses before, rather than after, a claim arises.