What is underinsurance and how can I avoid it?

Imagine a fire breaks out and destroys one of your home’s upstairs bedrooms. The quote to fix it is $50,000 but your insurance says ‘sorry, you’re underinsured. we can only give you $25,000’. 

This gap between the damage cost and the insurance payout is a classic case of underinsurance, a situation that, unfortunately, 80% of Australian homeowners find themselves in, according to estimates by the Insurance Council of Australia.

In this guide, we’ll explain what underinsurance is, its dire consequences and tips for preventing it.

Essentially, underinsurance is when your insurance coverage falls short of what's needed to fully cover the cost of damage or loss. It's like having a safety net that's too small; if something goes wrong, it won't catch everything. 

For example, imagine your home is valued at $500,000 to rebuild, yet on your building insurance policy, you’re only insured for $250,000. If disaster leads to total loss, your insurance will only cover half of the rebuild costs and you’ll have to fork out the remaining $250,000.

But it doesn't stop there. Revisiting our bedroom fire scenario, you'd think $250,000 in coverage has you well-prepared for a $50,000 repair job. Here's where underinsurance really shows its teeth: because your insurance covers only half of your home's true rebuild value, payouts for partial damages adjust accordingly. 

So, in this case, you're still facing a half-payout scenario, receiving just $25,000 to repair the bedroom. And if the insurance company suspects you’ve underinsured yourself on purpose, you could even be denied altogether.

The fallout from underinsurance stretches far beyond the initial shock of insufficient funds. Here's a more concise look at how it can further impact you:

• Financial strain. The gap in coverage often leads to additional debts, like loans, dragging down your financial stability over time.
• Emotional stress. Facing a loss without enough support can significantly heighten stress and anxiety, making recovery even harder.
• Recovery delays. A lack of immediate funds means repairs and rebuilding get pushed back, prolonging the time your life is in limbo.
• Increased premiums. Post-claim, you might see your insurance costs climb, especially if you're adjusting coverage to better suit your needs.
• Risk of non-renewal. Experiencing a major loss with inadequate coverage could lead insurers to view you as too risky, potentially leaving you without coverage.

As you can see, underinsurance doesn't just affect your wallet at the moment of loss; its ripples can disturb various aspects of your life, underlining the critical need for adequate insurance coverage.

Underinsurance isn't always about cutting corners to save on premiums. Here are some genuine reasons it can happen:

• Estimation errors. Guesswork in assessing the cost to repair, rebuild, or replace can lead to significant shortfalls in coverage.
• Lifestyle changes. Renovations, new furniture purchases, and other upgrades often aren't accounted for in existing policies.
• Rising costs. The increasing expense of building materials and labour, along with compliance with current building codes, can inflate rebuild costs beyond initial coverage.
• Unforeseen expenses. Costs like demolition, site cleanup, and temporary accommodation during repairs can add up quickly, exceeding basic policy limits.
• Incomplete inventories. Failing to account for the full range of personal possessions, including those stored outside the main living areas or of significant value, can lead to underinsurance.
• Market value vs. rebuild cost confusion. Insuring a property based on its market value rather than the cost to rebuild can either lead to overinsurance or underinsurance, depending on the local real estate and construction markets.
• Regular policy reviews neglected. Life moves fast, and failing to regularly review and update insurance coverage to reflect current needs can leave gaps in protection.

Addressing these common pitfalls by using tools like insurance calculators, conducting thorough home inventories, and engaging in regular policy reviews with your insurer can help ensure your coverage matches your actual needs, safeguarding against the financial and emotional stress of underinsurance.

In 2019 research from MCG Quantity Surveyors found that a large number of Australian homes could be underinsured by as much as 66%! In 2021 the Financial Rights Legal Centre released a report showing that underinsurance was one of the five biggest issues for people making claims post extreme weather events.

As you can see underinsurance poses a big problem for many in Australia. That said, there are ways you can reduce the risk to yourself.

Our tips for avoiding underinsurance are:

Tip 1: Know your insurance policy, inside out

Make sure you know exactly what your home insurance policy covers. This includes knowing how your insurance provider defines terms such as ‘fire’ and ‘water damage.’ It may seem like there should be a standard definition for these, but there aren’t.

To make sure you’re not caught short, we recommend reading the product disclosure statement that comes with your policy from cover to cover. If you aren’t sure of anything detailed in the PDS, don’t be shy about contacting the insurance company for further explanation.

Tip 2: Keep your cover up to date

If you’ve been with the same insurance provider for a few years, make sure your policy is still up to date. The value of your home might have gone up since you signed up to the policy. Or you might have built an extension, revamped the exterior or even simply acquired more expensive contents. For any of these scenarios the insurance you have would most likely need to be increased.

You might review your cover and decide to pay for more optional extras too. For instance, maybe your area wasn’t formerly classified as a flood zone, but now it is. In this case,you may want to add flood cover to your policy. Or you may even decide that the policy you have at the moment isn’t cutting the mustard, in which case you could review what other home and contents insurance plans are available in Australia.

Tip 3: Don’t undervalue your home

It may be easier said than done, but making sure your home isn’t undervalued is crucial. There are a number of online calculators you can use to get an estimate of how much your home is worth. One of these is CoreLogic’s Rebuild Cost Calculator.

Although these calculators will only be able to give an estimate, so it might not be ideal to rely on them completely. Home valuation experts could be another option to get an estimate of how much your home is worth. A quick internet search will bring up home value assessment experts in your state or territory.

Tip 4: Take out underinsurance protection

As underinsurance is an ongoing issue in Australia, a number of insurance companies now offer underinsurance protection. This is usually available as an optional extra with home building insurance.

Often insurance providers will refer to this as a sum insured safeguard or safety net. This safeguard or safety net is usually a specific percentage extra that the insurance provider is willing to pay, if it is discovered that a home has been underinsured.

For example, an insurance company might offer a 25% sum insured safeguard. This means if your home is insured for $300,000 and you find out the rebuild costs are actually $400,000, this safeguard could provide an additional $75,000 (25% of $300,000) towards your rebuilding costs, making the total payout $375,000 and reducing your out-of-pocket expenses.

Want to read more about how home insurance works? Check out Mozo’s home insurance guides for more information on what to look for in a policy. Or, if you’re thinking about switching, take a look at the home insurance deals on offer below.