Understanding the Average Clause in Latent Defect Insurance Policies

Latent Defects Insurance (LDI), sometimes called Inherent Defects Insurance or a Structural Warranty, is a specialised type of insurance covering structural defects that might not become apparent until long after construction. Often purchased by developers or property owners, LDI protects against costs to correct major structural faults that arise from hidden defects in materials, design, or workmanship. However, like many property insurance policies, LDI includes provisions to mitigate insurer risk—one of these is the Average Clause.

What is the Average Clause in a Latent Defects Insurance policy?

The Average Clause is a policy condition that applies in a Latent Defects Insurance policy when the insured value of a property is lower than the actual reinstatement value (RV). The RV is the cost to restore or replace a building to its original condition following a covered loss.

In simple terms, if the RV provided by the policyholder is lower than the actual cost of reinstatement, any claim settlement will be proportionally reduced by the level of underinsurance. This provision encourages policyholders to provide an accurate RV to ensure they are not inadvertently underinsured, thereby avoiding a reduced payout in the event of a claim.

How the Average Clause Works in Practice

To understand the impact of the Average Clause in a Latent Defects Insurance policy, let’s consider an example:

Scenario:

• Declared RV: £25,000,000 (the amount advised by the client and used as the insured value in the policy)
• Actual RV: £50,000,000 (the real cost to reinstate the property, as discovered during a claim evaluation)
• Claim Amount: £10,000,000

Because the declared RV is only half of the actual reinstatement value (£25,000,000 declared vs. £50,000,000 actual), the insured is underinsured by 50%. The Average Clause in the policy wording (e.g., Section 5, point 5) mandates that the claim payout be reduced by the same percentage as the underinsurance. In this case, the settlement would be adjusted by 50%.

Claim Settlement Calculation:

• Amount Claimed: £10,000,000
• Underinsurance Ratio: 50% (since £25,000,000 is 50% of the actual RV of £50,000,000)
• Settlement Payable: £10,000,000 x 50% = £5,000,000

Therefore, the policyholder would only receive £5,000,000 rather than the full claim amount of £10,000,000.

Key Points to Note About the Average Clause in a Latent Defects Insurance policy

1. The Importance of Accurate RV: Policyholders must provide an accurate RV to avoid any shortfall in claim settlements. The RV should reflect the full reinstatement cost of the insured property, covering materials, labor, and any other expenses necessary to restore the building.
2. Consequences of Underinsurance: If the RV is understated, any claim settlement will be reduced by the level of underinsurance, as demonstrated in the example above. Thus, it is critical to ensure the starting point—i.e., the insured value—is correct and updated over time to reflect changing reinstatement costs.
3. Adjusting Insured Value Over Time: Construction costs may fluctuate, so it’s essential for policyholders to periodically review and update the RV. An accurate RV at policy inception may become insufficient after a few years due to inflation or increased material and labor costs.
4. How the Average Clause Impacts Policyholders: The Average Clause can have a significant financial impact. In the event of a loss, the policyholder will need to cover the portion of costs not compensated by the insurer due to underinsurance. This could lead to substantial out-of-pocket expenses that might have been avoidable with an accurate RV declaration.

How to Avoid the Average Clause Penalty

To avoid the Average Clause penalty within a Latent Defects Insurance, policyholders should take proactive steps:

• Engage Professional Valuation Services: Use a professional valuation firm to calculate an accurate RV, considering all potential reinstatement costs.
• Review and Update Regularly: Construction costs can rise significantly over time. Regularly reviewing the RV ensures the insured value keeps pace with current rebuilding costs.
• Communicate with the Insurer: Share any updated valuations with the insurer promptly to adjust the insured value as needed.

Final Thoughts

The Average Clause serves as an important safeguard for insurers, ensuring that premiums are proportionate to the actual risk. However, for policyholders, it underscores the importance of accurate and up-to-date valuations. By carefully establishing and maintaining an accurate RV, policyholders can avoid the pitfalls of underinsurance and ensure full coverage when claims arise.

In summary, while the Average Clause in Latent Defects Insurance policies protects insurers from exposure to disproportionate risk, it places a responsibility on policyholders to ensure the insured value accurately reflects the true reinstatement cost of the property.

Latent Defects Insurance Made Simple with J3 Advisory

Choosing J3 Advisory for your Latent Defects Insurance means partnering with a team that knows the market inside out.

For property professionals, navigating this complex and competitive space can be a challenge. Many stick with their current providers despite rising costs and average service, simply because switching feels like too much hassle.

That’s where J3 Advisory comes in. Over the past three years, we’ve become a trusted name for developers and housebuilders across the UK. Our expertise and straightforward approach help clients find the right cover quickly and cost-effectively, giving them the confidence that they’re in safe hands. Contact us today to find out more.