Definition - What does Sum Insured mean?
Sum insured is the amount of money that an insurance company is obligated to cover in the event of a covered loss. This term is commonly associated with homeowner's or property insurance but can also apply to other types of insurance.
The sum insured correlates directly to the amount of premium you pay, but not always to the property's actual value or asset insured. If the sum insured is less than the replacement value or required amount to rebuild, it is often referred to as underinsurance.
It is common practice in almost all areas of insurance that compensation is based on the new replacement value in the event of a loss. This means the amount of compensation is enough to fully replace or restore the items to the new condition. The cost of these new items would need to be of identical type, quality and condition.
The purpose of this is to allow the policyholder to feel as if no loss has happened. This is often misunderstood as there are many different terms and levels of replacement value and calculation within the insurance industry.
Three of the main types of sum insured calculations are:
The actual cash value refers to the value of the item at the time of loss. This value is calculated by deducting an amount based on the usage, age and condition of the items. This is referred to as depreciation. The value is intended to allow for the replacement of the item with an item in similar condition. Often, insurance companies will have percentages used as a threshold of when it is better to use the new replacement value.
The third term, which is similar, yet different is the fair market value. This is the amount that you would presumably get for the item if you were to sell it. This amount does not use percentages or set amounts but is set by the market conditions or prices. The replacement cost type can directly impact the sum insured and premium amount charged, which can often be decided upon by the policyholder at the time of purchase.
Insuranceopedia explains Sum Insured
When it comes to calculating the sum insured, understanding the different terms is vital to comprehend the varied premium costs. For example, the replacement type for homeowner's insurance is very different from what might be acceptable for auto insurance.
When the sum insured for the home is not equal to the full replacement price, the homeowner could suffer significant losses if their home is destroyed. For example, if a home is worth $300,000, but the sum insured is only $200,00, (say the cost you paid ten years ago) the homeowner could lose $100,000 worth of value if they experience a total loss on the home.
If the home has to be rebuilt, they may not be able to rebuild for $200,000. Also, if they have a mortgage of $100,000, then the bank will take $100,000, leaving only $100,000 cash. In this case, they would need to borrow a significant amount to rebuild or be without a home.
In contrast, if the insured of a used vehicle had a sum insured that used the actual cash value, the impact could be significantly less. In the case of a total loss, the insured should be able to purchase another vehicle in similar conditions using this calculation, as most vehicles would have had a similar depreciation percentage applied to them.
The sum insured value's complexity can be complicated further as some insurance policies use a combination of new replacement value, actual cash value, and fair market value. The type of calculations often depends on the types of items and the reason for the loss.
A homeowners policy can have a new replacement value for the building and an actual cash value for contents. Due to these terms' complexity, many banks and lenders and insurance companies have rules about underinsurance for homeowners. These rules make it less likely you will be underinsured without your knowledge or due to policy premium costs.
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