Pro Rata Condition of Average
The term "pro rata" is used to describe a proportionate distribution, often involving a partial or incomplete status of payment due. For instance, pro rata can be used in bankruptcy claims, where an insolvent debtor's assets are divided proportionately among creditors based on the size of claims.
In the insurance industry, pro rata means that claims are only paid out in proportion to the insurance interest in the asset; this is also known as the first condition of average.
The pro rata condition of average can also be thought of this way: The insurer is only liable for the proportion of the loss that the amount of insurance under the policy bears to the actual cash value of the asset; the insured assumes all liability beyond that point.
How Pro Rata Works
Typically pro rata typically means that each person or in some cases party is given their fair share of something in relation to the whole.
In terms of annual interest, giving out the correct portion of an annual interest rate can be calculated using a time frame via pro rata.
Calculations for pro rata can be used to determine dividend payments, premiums on insurance, or similar situations where an amount is owed or due.
- Pro rata condition of average relates to the proportion of an asset that an insurance policy covers.
- A claim will only be paid out on an asset based on the insurable interest that the policy covers, so a 50% covered asset will only be paid up to 50% of its value as per the insurance policy.
- Most policies with pro rata conditionality are accompanied by a second, special condition of average.
- Pro rata condition of average is commonly used by property insurance companies whose policies cover damages.
Example of Pro Rata Condition of Average
Suppose that a homeowner takes out $200,000 worth of fire insurance on his home. The home is actually valued at $300,000. A fire subsequently breaks out in the home, causing $60,000 worth of damage to the interiors and exteriors of the property.
If the fire insurance policy uses the pro rata condition of average, the insurance company is only liable in proportion to the level of insurance relative to the value of the property. Since the insurance only covers two-thirds the value of the property ($200,000 / $300,000), the insured can only recover two-thirds the cost of damage—$40,000, in this case ($40,000 / $60,000). This can be unfortunate if the owner cannot afford to support the remaining cost of damages.
Most insurance literature identifies only two separate conditions of average. The first is pro rata, as described above. The second is known as a special condition of average, whereby under-insurance is not penalized unless the sum represents less than 75% of the at-risk value. Most policies with pro rata conditionality are buttressed with a special condition.