Why your bank insists on insurance cover for 120% value of inventories?

The working capital limit (generally known as cash credit limit) is sanctioned by banks and financial institutions to industrial and trading establishments for their investment in various types of current assets typically including raw materials, work in progress, finished goods, and office supplies, used in the operating cycle. This facility offers the borrowers flexibility and comfort to withdraw funds from the bank as per their financial requirements from time to time. The inventory insurance (stock insurance)  policy covers damage while goods are in custody or control at designated units/godowns approved by the insurance company. Stock insurance offers comforts to the borrower as well as the lender in the event of a fire, water damage, vandalism, theft, etc. assured by the insurance company. Each policy will have its own scope of coverage and terms and conditions.

 It is important to remember that whenever the value of the insurance cover is less than the actual stocks of inventory or the value of the plant and machinery, the full claim will not be settled by the insurance company. This is because the insurance company settles insurance claims proportionately to the damage of the assets for ‘underinsured’ assets.

For example, a factory unit purchases a fire insurance policy covering inventory worth Rs.10 lakh against a CC limit of Rs.10 lakh sanctioned by the bank. If at the time of the fire accident, the unit was holding inventories more than the insured amount say worth Rs.15 lakh in its godown. In the insurance company parlance, the unit is holding only 2/3rd of the inventory held in the godown. In this case, insurance available is only 2/3rd of Rs.10 lakh or actual damage whichever is less as the stock is underinsured. Take another example the partial damage of inventory to the extent of only Rs.6 lakh in the above said fire accident. The factory owner naturally claims damage of Rs.6 lakhs from the insurance company, as he holds insurance for Rs.10 lakh.  In this case, the insurance company settles the claim only up to Rs.4 lakhs because only 2/3rd of the stock was insured (the owner has insured inventories only for Rs.10 lakh, which is actually two third of 15 lakhs inventories held in the godown). The insurance company, therefore, settles the claim proportionate to damage to insured stock.

Some borrowers usually hold inventories more than the insurance policy covers which complicates the settlement of claims. To avoid such complications banks insist on insurance coverage of 120% of inventory created out of bank finance.  Bank’s hypothecation clauses will be incorporated in the insurance policies where ever the stocks are hypothecated to the banks. Claims if any will be directly settled to the banks.

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