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’.

That gap is a classic case of underinsurance, and if your home insurance cover isn’t up to date, it could leave you tens or even hundreds of thousands out of pocket.

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

Underinsurance means the amount you’re insured for doesn’t reflect the actual cost to rebuild your home from scratch if it was totally destroyed. 

It tends to happen when people go with a rough estimate, or forget to regularly review their policy to take into account inflation, renovations and other factors that influence building costs. 

Underinsurance rarely happens because someone’s trying to cut corners. More often, it’s the result of rough guesses, outdated figures or simple oversight. Here are some of the main reasons it happens:

• Outdated estimates. Like almost everything else, building costs have risen sharply in recent years. If your cover is based on figures from even a few years ago, it may no longer cover today’s rebuild expenses.
• Renovations and upgrades. Any improvement such as a new kitchen, an extra bathroom or higher end fixtures increases your home’s value. But unless you update your policy, those additions won’t be insured.
• Rough estimates. Online calculators and simple per‑square‑metre estimates are a useful starting point, but they don’t always tell the full story and can omit costs like demolition, debris removal or meeting current building codes. For more accurate estimates, use the elemental estimating method.
• Market value vs rebuild cost. Your home’s sale price isn’t the same as what it would cost to rebuild from scratch. Depending on where you live, this could leave you either underinsured or overinsured.
• Forgetting to review. Insurance doesn’t refresh itself. If you haven’t checked your cover in a year or two (especially after renovations or big purchases) it probably needs updating.

A quick policy check once a year (or after any major home change) takes less than 10 minutes and can spare you a financial headache later.

If your cover falls short of the real rebuild cost, here’s how it could play out in practice.

Say your home would cost $500,000 to rebuild from scratch. Meanwhile, you haven’t updated your policy in a while, so you’re only insured for $250,000. If your place burns down, $250,000 is all you’d get.

Similarly, even smaller claims can be affected. If, instead of a total loss, the fire only damaged one room and caused $50,000 worth of repairs, the payout could still be reduced. Because your cover only reflects half the home’s actual value, your payout for the smaller claim could likewise be halved.

And if the insurer thinks you’ve intentionally lowballed them to save on premiums, they could deny your claim altogether.

Underinsurance continues to be a widespread issue in Australia, and it’s been highlighted by the Insurance Council of Australia as one of the biggest challenges people face when making claims, especially after major events.

So what can you do to prevent underinsurance? Here are some tips:

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.

Most home insurance policies work on a sum insured basis, meaning you choose the amount your home is covered for, and that becomes the maximum payout.

However, insurers understand that rebuild costs can fluctuate and estimates aren’t always accurate. That’s why many of them offer underinsurance protection - usually in the form of an optional extra. If you purchase underinsurance protection, you can get up to an extra 25% to 30% beyond the sum insured if the rebuild cost ends up being higher than expected.

So if your home is insured for $500,000 and it turns out to cost $600,000 to rebuild, that 25% safeguard could give you up to $625,000 and cover the gap.

In rarer cases, some policies may offer complete replacement cover, where there’s no set limit. Instead, the insurer agrees to pay whatever it costs to rebuild your home to the same standard. Of course, these will usually cost more.

Either way, these protections are meant to cover reasonable miscalculations, not deliberate lowballing. So, you’ll still need to provide accurate information and keep your policy up to date.

In the literal sense, yes, you can be insured for less than your belongings are worth. But it usually doesn’t carry the same level of risk as being underinsured for the building itself.

With building insurance, underinsurance can leave you hundreds of thousands of dollars short if your rebuild cost has increased and your policy hasn’t been updated. Contents insurance, on the other hand, tends to involve smaller numbers, except in rare cases. 

And it’s less about rising replacement costs and more about underestimating the total value of your belongings, forgetting to update your cover after buying new things, or not listing high-value items separately.

Unlike building insurance, contents insurance policies typically don’t have an underinsurance buffer - even as an optional extra. So if your sum insured isn’t enough to replace everything, the difference will come out of your own pocket.

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.