Underinsurance Risk for Australian Residential Builders

What it is

Underinsurance is the gap between what a builder policy says it will pay and what the builder is actually exposed to. It is not a missing policy. The cover exists, the premium is paid, the certificate of currency is on file. The number on the schedule is simply too low.

It is the most common insurance failure in Australian residential construction because it does not announce itself. Everything looks compliant right up to the day of the claim. The mechanism that does the damage is the average clause, and most builders have never read it.

Setting the contract works sum insured

Contract works insurance covers the work in progress, the materials and the temporary works against fire, storm, theft, malicious damage and impact. The sum insured is not the contract value. It builds up from:

• The full contract value, including GST and every approved variation.
• Escalation. A 12 to 18 month build in a rising market can move 5 to 10 per cent.
• Removal of debris and demolition of damaged work.
• Professional fees to redesign and re-document after a loss.
• Materials on site, in transit and in storage off site.
• Existing structures on a renovation, usually excluded from contract works.

The average clause and the maths that hurts

Almost every first party policy contains an average or co-insurance clause. If the sum insured is less than the true value at risk, the insurer pays only the proportion that was insured, on every claim, not just a total loss. That is the part people miss.

The formula is: payout equals sum insured divided by true value, multiplied by the loss. Work one. A builder insures a 1.2 million dollar build for a sum insured of 1 million dollars. By the time a fire hits, variations and escalation have pushed the true value at risk to 1.4 million dollars. The fire causes 300,000 dollars of damage.

The builder expects 300,000 dollars less the excess. Instead the insurer applies average. One million divided by 1.4 million is about 71 per cent, so the insurer pays 71 per cent of the loss. That is roughly 214,000 dollars. The builder wears about 86,000 dollars plus the excess, on a claim nowhere near the sum insured.

Section 44 of the Insurance Contracts Act 1984 (Cth) helps, but not builders. It stops an insurer relying on an average provision unless the insurer clearly informed the insured in writing, before the contract was entered into, of the nature and effect of the provision. It also disapplies averaging where the sum insured is at least 80 per cent of value, but only for a building used primarily as a residence for the insured or for its contents. A commercial contract works policy is not that, so the 80 per cent safe harbour does not reach it.

Public liability, professional indemnity and the design trap

Public liability responds to third party injury and property damage. Ten million dollars used to be standard. Twenty million is now the common contractual requirement from developers and principals.

Professional indemnity is where the real hole sits. A builder who does any design, engages the designer, value-engineers a detail or works under a design and construct contract has taken on professional liability. Public liability policies exclude liability arising from professional services or design, so a defect caused by a design decision falls between two policies unless PI is in force.

The exclusion catches builders who thought they were pure construct. Substituting a product, redetailing a junction, signing off a shop drawing: each is a design act. In NSW, registered design practitioners and professional engineers must hold professional indemnity insurance under the Design and Building Practitioners Act 2020.

Tools, plant and the run-off gap

Tools and portable plant are usually scheduled with a per-item limit, so a new laser level is uninsured until the schedule is updated. Subcontractor tools are not covered at all.

Run-off is the gap after handover. Contract works cover ends at or shortly after practical completion and liability policies run for a policy period. A statutory warranty claim can land six years later. If the builder let the policy lapse or restructured the entity, there may be nothing left to respond.

What to do about it

Reset the contract works sum insured at every material variation, not at renewal, with escalation built in.

Ask the broker in writing for the average clause wording and the basis of settlement. Keep the answer on file.

Buy professional indemnity if you touch design at all, and check the run-off period as well as the limit.