The hidden risks of blanket application of VAT clauses

  • If an organisation cannot claim back VAT on the cost of reinstatement following a loss, then it should include VAT when setting its sum insured. If it can claim back the VAT then there is no need to include that recoverable VAT when setting the sum insured.
  • This simple point is often ignored in favour of simply adding a VAT clause.
  • We explain the purpose of VAT clauses and why customers should be aware of important differences in the way these clauses are worded in policies

When insuring buildings or equipment, an important decision organisations must make is whether or not to include VAT in their sum insured.

Sometimes, this decision can be reasonably straightforward. For example, if an organisation is registered to recover VAT, as most commercial businesses are, it can safely exclude VAT when setting a sum insured. Equally, if an organisation is not VAT-registered, the decision to include VAT is a fairly simple one.

However, there are occasions where the picture is less clear – for example if an organisation is VAT exempt, or partially registered. The biggest danger such organisations could face is finding themselves significantly underinsured in the event of a loss, if they have excluded VAT from their sum insured when they should have included it.

VAT clauses explained

Colin Prince, Underwriting Manager, Property, Zurich, says: “Occasionally, there are circumstances where, following a loss, a policyholder unexpectedly finds themselves unable to recover VAT. This could be due to no particular fault of their own, for example it could be the result of a change in VAT rules of which they were not aware.”

To address this problem, insurers and brokers sometimes include a VAT clause in their policy wordings, so that if a policyholder discovers they are unable to recover VAT following a loss, their insurer will pay that amount, in addition to the normal claim settlement.

Insurers will often add a proviso – as Zurich does – that specifies that if a policyholder is aware they would not be able to recover VAT, they must include the appropriate allowance in their sum insured.

Some insurers and brokers, however, include no such proviso when inserting a VAT clause in a policy. In effect, this means they are agreeing that in the event of a loss, they will pay back VAT regardless of whether or not the policyholder was aware they should have included it in their sum insured in the first place.

Why blanket VAT clauses are not what they seem

Blanket VAT clauses such as this are sometimes portrayed as a no-risk way for customers to reduce their costs, because they can lower their sum insured – safe in the knowledge that VAT is taken care of – and theoretically get a cheaper premium.

However, Colin explains this is often not the case.

“If the consequence of having a blanket VAT clause is that a customer excludes VAT when they know they should have included it, they are effectively lowering their sum insured artificially,” he says.

“However, this won’t make any difference to the costs an insurer would actually incur in settling any resulting claim, so the final cost passed on to their customers as a group is unlikely to be any cheaper.”

As an example, imagine a customer wants to insure £100,000 worth of buildings and equipment, and is quoted £100 for their premium. If that customer knows they cannot recover VAT, then the sensible course of action would be to include VAT in their sum insured, increasing this figure to £120,000.

In turn, their premium should theoretically rise to £120, to reflect the extra cost to the broker or insurer of settling any resultant claim.

On the other hand, if the broker or insurer had included a blanket VAT clause, and the customer had consequently chosen to exclude VAT, they would probably set their sum insured at £100,000. The risk that they would represent to the insurer, however, would be identical in both cases. As a consequence, the insurer’s costs and expenses will be exactly the same and therefore the insurer will still require a premium of £120.

As a consequence, where an insurer is using a blanket VAT clause and not reflecting the individual insureds status in their individual price, they would charge both sets of customers –those who would be able to recover VAT and those who would not – the same premium. This means that the first group of customers are being charged indirectly for a clause which they do not need, and effectively subsidising the second group of customers.

Set correct sum insured to get true value

Either way, the only way for customers to ensure they get the cover they need at the right price, is to set the correct sum insured in the first place, says Neil Collington, Risk and Insurance Consultant, Zurich Municipal.

“What we would say to customers is ‘make sure you understand whether or not you need to include VAT and then source appropriate cover’.

“If somebody is offering to include a blanket VAT clause in your policy, then challenge them on why you need it, because regardless of how they are selling it to you, it might not be beneficial to your organisation.”