Underinsurance mandates proportionate deduction from partial-loss claims under the policy’s average clause.

National Aluminium Company Limited (“NALCO”) obtained a Standard Fire and Special Perils Insurance Policy from HDFC ERGO General Insurance Company Limited (“the insurer”) for its coal/lignite-based Captive Power Plant at Angul, Odisha, with a sum insured of ₹23,473,242,000 for the policy period 1 June 2017 to 31 May 2018.

On 11 July 2017, a fire damaged the Generator Transformer of Unit-08. The transformer was sent to BHEL for assessment and repair, and NALCO submitted a claim which was eventually revised to ₹6,95,35,369.

The surveyor’s final report assessed the loss after applying a 56.53% deduction for underinsurance. The surveyor valued the entire power-generation unit at ₹54,000,000,000, as against the insured value of ₹23,473,242,000.

The insurer consequently offered approximately ₹23.52 lakh in settlement, which NALCO rejected.

Arbitration under Clause 13 of the General Conditions culminated in a majority award dated 17 May 2023, rectified on 16 June 2023. The majority accepted the assessed loss but declined to apply the underinsurance deduction, awarding NALCO ₹4,25,66,183, together with interest in the event of non-payment within four months and ₹10 lakh towards litigation costs.

The minority view held that proportional deduction for underinsurance was justified.

HDFC ERGO challenged the award under Section 34 of the Arbitration and Conciliation Act, 1996.

Whether the insurer was entitled to apply the proportionate deduction for underinsurance under Clause 10 of the insurance policy when the insured value of the power-generation unit was substantially lower than its actual/reinstatement value.

Whether the majority arbitral award, by declining to apply the underinsurance deduction, suffered from patent illegality warranting interference under Section 34 of the Arbitration and Conciliation Act, 1996.

Whether the principle of averaging applies where the claim is for repair of part of an insured property rather than for total replacement or total loss.

The Court applied Section 34 of the Arbitration and Conciliation Act, 1996, under which an arbitral award may be set aside for patent illegality, while recognising that the provision does not confer appellate jurisdiction or permit routine reappreciation of evidence.

Clause 10 of the General Conditions required the insured to bear a rateable proportion of the loss where the insured property was worth more than the sum insured, treating the insured as its own insurer for the difference.

Section 64VB of the Insurance Act, 1938 requires insurance risk to be assumed against receipt or prescribed securing of the requisite premium; therefore, no risk is covered for value in excess of the insured sum without corresponding premium.

In Sikka Papers Limited v. National Insurance Company Ltd., (2009) 7 SCC 777, the Supreme Court upheld pro-rata reduction of a partial loss claim for underinsurance.

In I.C. Sharma v. Oriental Insurance Company Limited, (2018) 2 SCC 76, the Supreme Court held that averaging applies where only part of the insured goods is lost or damaged, although in a case of total loss the insurer’s liability is limited to the sum insured.

The Court found that the parties did not dispute either the surveyor’s valuation of the unit or the loss assessment; the only dispute concerned the application of underinsurance.

Since the unit’s value was ₹54,000,000,000 while the sum insured was only ₹23,473,242,000, NALCO had paid premium only in respect of approximately 43.47% of the unit’s value, leaving an underinsurance component of 56.53%.

Under Clause 10, NALCO was therefore required to bear the corresponding proportion of the loss.

The majority’s reliance on the fact that the claim related to repair rather than replacement, and that the policy covered the entire unit rather than merely the transformer, was held irrelevant to the contractual averaging requirement.

Applying the principles in Sikka Papers and I.C. Sharma, the Court held that a partial loss must be reduced proportionately where the property is underinsured.

The majority award, by accepting the underinsurance finding but refusing to give effect to the resulting deduction, ignored Clause 10 and travelled beyond the statutory framework of Section 64VB, thereby suffering from patent illegality.

The majority arbitral award was contrary to Clause 10 of the policy and the applicable principles governing averaging and was therefore vitiated by patent illegality under Section 34.

The award dated 17 May 2023, as rectified on 16 June 2023, was set aside; the petition was allowed and the pending application was disposed of.