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What is index linking?

Posted: 27 June 2024
Nick Hobbs, Chief Distribution Officer, Allianz Insurance

Index linking is the amount applied to insurance policies by insurers, designed to safeguard the sum insured against changes in the economic environment. Reflecting inflationary changes and the cost of living, index linking helps to protect against underinsurance. For any customer finding themselves in this position it can be a surprise, especially when they realise they’re responsible for a percentage of the claims costs due to their asset not being insured for its full value.

Index linking is commonly used in buildings insurance to calculate the difference between the sum insured and a property’s rebuild value, which may be out of line if inflation and other economic factors such as the cost of living, rise.

It’s not, however, just limited to buildings. Changes and developments in the economic environment can affect the value of other assets as well, such as stock, materials, and parts.

Insurers use various indices to calculate index linking, including the Consumer Price Index (CPI) and Retail Price Index (RPI).

For both residential and commercial buildings insurance many insurers refer to information provided by the Building Cost Information Service (BCIS). The BCIS uses several factors in their calculations including the cost of labour, materials, and professional fees.

By applying index linking, the sum insured is automatically updated (usually increased) in line with economic changes when the policy renews, although it's not recommended to rely on index linking alone. This is because the index used represents an average so may not be reflective of increases required on all buildings. This can vary depending on the nature of construction materials and/or specialist labour requirements as well.

Where a customer is underinsured, there can be several consequences. The claims settlement may be reduced, and the ‘average’ clause applied. This means if the insurer identifies that inadequate levels of cover have been purchased , it can reduce the settlement by the same underinsured percentage.
Another potential repercussion of being underinsured is the threat of disruption to business, perhaps whilst rebuilding takes place or due to delays with replacing stock and materials. This in turn could result in loss of customers, loss of income and reputational damage.

Customers should be aware of obtaining the right type of valuation for property insurance purposes. Survey data from Rebuild Cost Assessment revealed that 80% of properties in the UK are underinsured, and that those underinsured are only covered for 68% of their total value 1.

Insurers require a reinstatement cost valuation by a RICS qualified valuer for insurance purposes, which calculates the cost of rebuilding a premises from the ground up should it be destroyed (e.g. by a fire).

This is different from a market valuation which represents the likely amount a building would sell for at the time the valuation is made. Similarly, a mortgage valuation is not an eligible for insurance purposes since this is conducted by the lender to check that the property will be suitable security for the loan amount.

A reinstatement cost valuation should be carried out by a professional, whether in person or as a desktop valuation assessment; the latter is completed using information, which is publicly available, plus any data the surveyor may already have regarding the premises and/or area.

There are things  customers can do to help reduce the likelihood of being underinsured:

  • Regularly reviewing their sums insured.
  • Ensuring declared values are index linked; however, it's not recommended to rely on index linking alone, because the index used represents an average so may not be reflective of increases required on all buildings. This can vary depending on the nature of construction materials and/or specialist labour requirements.
  • Using brokers, who are ideally placed to provide advice and guidance to their customers on the risk of underinsurance.
  • Considering re-evaluations of all their insured property, compiled by a professional member of the Royal Institute of Chartered Surveyors (RICS) or some other suitable valuer as agreed by the insurer, at no more than three-year intervals.
  • Considering whether a desktop valuation may be possible. Some insurers, including Allianz Insurance plc, will now consider desktop valuation surveys.
  • Investigating options for longer indemnity periods, considering all external economic factors and current influences on inflation which could delay the repair, reinstatement or rebuild of their property.
Brokers are instrumental in working with businesses help identify correct sums insured and indemnity periods, so starting these conversations early is key in finding the right insurer to meet their needs.