A fire insurance policy has an average clause mentioned in it which takes care of the cases of the under-insurance. In the fire insurance policy, if the assets are insured for less than their full value, the insured is required to bear a proportion of the loss according to the average clause mentioned in the policy document.

Since the fire insurance policy is a contract of indemnity, the insured cannot claim more than the actual amount of loss caused by the fire.

According to the average clause in the fire insurance policy,

  • If the actual cost of the goods/property is higher than the sum insured for such goods/property, then the insured has to bear the difference.
  • The insured must bear the cost arising due to the difference between the actual value of goods/property and the amount for which it is insured.
  • The insurers or the insurance company will only pay for the rateable proportion of the loss.
  • The average clause applies only when the sum insured is less than the actual value of the goods or the property.

Due to the presence of the average clause in the fire insurance policy, the liability of the insurance company is reduced as per the application of the proportionate approach. The insurers do not pay the full amount of loss incurred to the insured. The insured is then responsible for the payment of the unpaid claim amount.

Read more: What is the Scope of Fire Insurance Policy?

Thus, the amount of claim that the insured gets is calculated as:

Claim amount= (Actual loss × Insured amount) /Value of goods or property at the date of fire

Suppose a property worth Rs. 15,00,000 is insured for Rs. 13,00,000 and the fire insurance policy has the average clause in it. If half the property is damaged due to the fire, the loss that the policy holder incurs is about 7,50,000 based on the current worth of the property (half amount). However, the amount that he will be paid by the insurer is:

= (7,50,000 × 13,00,000)/ 15,00,000

=6,50,000

So, the additional amount of Rs. 1,00,000 (7,50,000 – 6,50,000) has to be borne by the insured himself.

Case Study:

Hemant, a 42-year-old individual was the owner of a factory, manufacturing woolen clothes. His factory was located in Amritsar and catered to the client requirements all over Punjab. He exported the finished products as well as the raw materials as per the needs of the clients.

In May 2006, a fire broke out in his factory and damaged half of the stock which was to be shipped to a nearby cloth dealer. The workers could recover the other half of the stock safely before it was engulfed by the fire.

Hemant had a fire insurance policy taken for protecting his stock. As half of the stock was gutted by fire, Hemant contacted his insurance company to cover for the losses incurred.

Read more: What are the physical hazards in fire insurance?

His fire insurance policy had the average clause in it. Upon investigation, the surveyor found that the fire was caused due to the short-circuit in the production area and hence half of the stock was totally burnt and damaged.

Following were the details of the stock:

  • Actual value of the stock: Rs 3,00,000
  • Sum insured for the stock: Rs. 2,00,000
  • Loss incurred: Rs. 1,50,000 (As half the stock was destroyed)

Hence, the insurance company settled the following claim amount for Hemant as per the average clause mentioned in his fire insurance policy:

Claim amount= (Actual loss × Sum insured) /Value of stock at the date of fire

= (1,50,000 × 2,00,000) / 3,00,000

=1,00,000

Thus, the claim amount of 1 lakh was paid to Hemant by his insurers, although the actual loss amount was rupees 1.5 lakhs. Hemant had to himself bear the additional loss of fifty thousand rupees from his own pocket.