Average Clause in Fire Insurance — Why Getting Your Sum Insured Wrong Costs You on Every Claim

A commercial building owner insures their property for RM5 million. The building's actual reinstatement value is RM10 million. A fire damages one floor. The repair cost is RM1 million.

The insurer doesn't pay RM1 million. They pay RM500,000.

The owner has just discovered the average clause, also known as the condition of average. It's the single most expensive lesson in fire insurance, and it hits property owners on every claim, not just total losses.

This guide explains how the average clause works under Malaysian fire insurance policy wordings, why commercial properties become underinsured over time, and what you can do before your next renewal to avoid the penalty.

How the Average Clause Actually Works

The fire insurance policy wording states it clearly: "If the property hereby insured shall, at the breaking out of any fire, be collectively of greater value than the sum insured thereon, then the Insured shall be considered as being his own Insurer for the difference, and shall bear a rateable proportion of the loss accordingly."

The formula is straightforward:

Claim payout = (Sum insured / Actual value at time of loss) x Loss amount

Every item in the policy is separately subject to this condition. So if your building sum insured is adequate but your contents sum insured is too low, the average clause applies to the contents claim independently.

A Worked Example

Consider this situation. A property owner insures their commercial building for RM5 million. Construction cost inflation and unrecorded improvements mean the building's actual reinstatement value is now RM8 million. A fire causes RM400,000 in damage to one section.

Component	Amount
Sum insured (building)	RM5,000,000
Actual reinstatement value	RM8,000,000
Degree of underinsurance	37.5% (RM3 million shortfall)
Fire damage (actual repair cost)	RM400,000
Average clause calculation	(RM5M / RM8M) x RM400,000
Insurer pays	RM250,000
Property owner bears	RM150,000

The property owner pays RM150,000 out of pocket for a RM400,000 loss, on top of the premium they've been paying. The average clause applies the same proportional penalty regardless of whether the claim is RM400,000 or RM40,000. Every claim gets reduced.

Why Buildings Become Underinsured

Underinsurance rarely happens deliberately. Most property owners set their sum insured when the policy was first taken out, and it drifts out of alignment over the years. The causes are predictable.

Cause of Underinsurance	How It Happens	How Quickly It Compounds
Construction cost inflation	Building materials, labour costs, and regulatory requirements increase over time. The cost to rebuild today is higher than when the sum insured was first set.	Cumulative. Even moderate inflation of 3-5% annually can create a significant gap over a 5-10 year period.
Renovations and improvements not added	A new mezzanine floor, upgraded M&E systems, expanded office fit-out, or structural additions that increase the building's reinstatement value but are never reported to the insurer.	Immediate. Every unreported improvement is uninsured value from day one.
M&E upgrades	New air conditioning systems, electrical upgrades, lift installations, fire protection systems. These are part of the building's reinstatement cost but often not reflected in the building sum insured.	Immediate. M&E can represent 30-40% of a building's total reinstatement value.
Confusing market value with reinstatement value	The property was insured based on its market purchase price (which includes land value and reflects market conditions) rather than the reinstatement cost (cost to rebuild). In some areas, reinstatement value exceeds market value.	Varies. The gap depends on land values in the area relative to construction costs.
Extension or expansion of the building	Additional floors, annexes, or extensions to the original building that weren't communicated to the insurer.	Immediate. The additional built-up area is effectively uninsured.

The Reinstatement Value Clause: Your Protection Against Average

The standard fire policy settles claims on an indemnity basis, meaning the insurer pays the actual value of the property at the time of loss, after deducting for wear and tear and depreciation. For an older building, this could mean significantly less than the cost to actually repair or rebuild it.

The reinstatement value clause changes this. When the reinstatement value clause applies, the insurer pays the cost to reinstate or replace the property to a condition equal to (but not better than) its condition when new, without deduction for depreciation. This is a memorandum that can be added to the policy, but it comes with conditions.

The reinstatement must be carried out with reasonable dispatch. The property must be reinstated on the same site or another site approved by the insurer. And critically, the average clause still applies, but it's calculated against the reinstatement value rather than the depreciated value.

This means if you opt for the reinstatement value basis, your sum insured needs to reflect the full cost to rebuild as new, not the current depreciated value. Getting this wrong under a reinstatement value policy is actually worse, because you're still subject to average, but the benchmark against which average is calculated is higher.

The Market Value Condition: When It Applies Instead

For property insured other than stock and building items, the standard fire policy includes a market value condition. In the event of a loss, the insurer pays the insured value or the market value, whichever is lower, subject to excess and average.

Market value for this purpose means the value at the time of loss, less due allowance for wear and tear and/or depreciation. The valuation must be determined by a qualified valuer, manufacturer's authorised agent, or Loss Adjuster registered under the Financial Services Act 2013.

The practical point: for machinery, equipment, and contents, market value settlement means you receive less than what it would cost to buy a new replacement. If you want new-for-old replacement, you need the reinstatement value clause to apply to these items as well.

How to Review Your Sum Insured Before Renewal

A sum insured review doesn't have to be complicated. It does have to be honest. Here's a practical approach.

For buildings: Get a professional reinstatement valuation from a registered valuer. This should cover the cost to demolish, clear debris, and rebuild to the same specification, including all M&E installations, at current construction costs. General guidance is to re-value every three to five years, or immediately after any significant renovation or extension.

For contents and fixtures: Walk through the premises with an updated asset register. List every major item: furniture, fittings, tenant improvements, IT equipment, office equipment. Estimate the current replacement cost for each category. Include tenant's improvements separately if they're covered under your policy.

For machinery and plant: Use the current replacement cost, including installation, commissioning, and freight. For specialised equipment that's no longer manufactured, use the cost of the nearest equivalent plus any modification costs.

For stock: Use the maximum stock value likely to be held at any point during the policy period, not just the average. Fire doesn't conveniently happen when your stock is at its lowest.

Sum Insured Review Checklist

Item	Check
Building reinstatement valuation	☐ Dated within last 3-5 years? If not, commission a new one.
Renovations and improvements	☐ All renovations since last valuation have been added to sum insured?
M&E systems	☐ Air conditioning, lifts, electrical systems, fire protection included in building sum insured?
Construction cost inflation	☐ Sum insured adjusted for construction cost increases since last review?
Contents and fixtures	☐ Asset register updated and reconciled against the contents sum insured?
Machinery and plant	☐ Current replacement cost (including installation) used, not book value?
Stock	☐ Maximum stock value during the policy period used, not average?
Basis of settlement	☐ Confirmed whether policy settles on reinstatement or market value basis?

FAQ

What is the average clause in fire insurance?

The average clause (condition of average) is a standard condition in Malaysian fire insurance policies. If your property is worth more than the sum insured at the time of a fire, the insurer reduces any claim payment proportionally. You're treated as your own insurer for the difference between the sum insured and the actual value.

Does the average clause apply to small claims?

Yes. The average clause applies proportionally to every claim, regardless of size. A property insured for 50% of its actual value will only receive 50% of any claim, whether it's RM10,000 or RM1 million. There's no threshold below which it doesn't apply.

How often should I re-value my property for insurance purposes?

General industry guidance is every three to five years for a professional reinstatement valuation, or immediately after any significant renovation, extension, or change in building specification. In periods of rapid construction cost inflation, more frequent reviews are prudent.

Does the average clause apply to IAR policies too?

Yes. The IAR policy also contains an average clause that works the same way. Whether you have fire or IAR, underinsurance will reduce your claim payout. The type of policy doesn't protect you from average; only adequate sum insured does.

What's the difference between reinstatement value and market value for fire insurance?

Reinstatement value is the cost to rebuild the property to its current specification as new, without depreciation. Market value is the current value allowing for wear, tear, and depreciation. Fire policies can settle on either basis depending on the clauses applied. For more detail, see our sum insured guide.

Can I avoid the average clause by choosing a higher excess instead?

No. The excess (deductible) and the average clause are separate mechanisms. The excess is applied after the average clause calculation. Choosing a higher excess reduces your premium but does nothing to prevent underinsurance penalties. The only way to avoid average is to insure for the correct value.

Foundation Conclusion

The average clause is the penalty you pay for not paying attention. It doesn't discriminate by claim size. It doesn't care whether you forgot to update your sum insured or deliberately kept it low to save premium. The calculation is mechanical: underinsured means underpaid, on every single claim.

Reviewing your sum insured before renewal is one of the highest-ROI activities in commercial property management. The cost of a professional valuation is trivial compared to the shortfall on a single claim. Foundation works with property owners across Malaysia to ensure their fire insurance and IAR sum insured figures reflect reality, not history.

Talk to our risk specialists about reviewing your sum insured

Disclaimer: This article provides general guidance on insurance coverage available in the Malaysian market as of March 2026. Policy terms, conditions, and availability vary by insurer. Always review your specific policy wording or consult a qualified insurance professional before making coverage decisions.