Coinsurance Part II: Business Income & Other Tools

Earlier this year, we unpacked an article written by William Austin, principal, Austin & Stanovich Risk Managers, LLC, about the importance of arriving at a fairly accurate property valuation in order to avoid a coinsurance penalty. We’re resuming our conversation to examine coinsurance as it relates to business income commercial insurance and a couple of other specialty areas including coinsurance tools.

The process to establish the coinsurance minimum limit for business income is more complicated than that used for building and contents direct damage. The reason is that the insured must determine net income and operating expense expected for the policy year and then deduct operating expenses that would not be expected to continue during the period of interruption (prepaid freight for outgoing shipments, cost of materials that would otherwise be consumed during the manufacturing process, power that is not consumed, ordinary payroll if it is not to be continued, etc.).

Extra expense coverage is not subject to a coinsurance clause. The insured can ask the insurer to quote any limit that is deemed appropriate. Extra expense coverage, when offered as coverage separate from business income, may contain certain percentages such as 40/80/100. These percentages are not coinsurance, but a means to limit the payout of the coverage: up to 40 percent for the first month of recovery; up to 80 percent for the next month of recovery; and no more than 100 percent for the final month of recovery. It is important for the risk management professional to review any percentage used in extra expense coverage to ensure that the coverage provided meets the extra expense needs of the insured.

Example: Business Income

A manufacturer completed a business income worksheet for the recent policy period based on operating 240 days per year (after plant summer shutdown and usual employee paid holidays). The annual business income value is $8 million with an 80 percent coinsurance clause. The insured limit is $6.4 million, excludes ordinary payroll, and is subject to a one daily average value (ADV) deductible.

Scenario 1

A fire occurs and damages key equipment, and the plant must shut down for three months. A business income claim of $2.7 million is filed with the property insurer. What is the net insurance recovery after the deductible?

Scenario 2

Three months after renewal, the company lands three large contracts, and net income surges to an additional $3 million in five months. A fire occurs and damages key equipment, and the plant must shut down for 3 months. A business income claim of $2.7 million is filed with the property insurer. What is the net insurance recovery after the deductible?

Coinsurance issues can occur quickly if an organization experiences net profit growth that had not been expected at the time the business income worksheet was completed. This is what happened in Scenario 2. The risk management professional should compare actual net income to that forecast for the policy year on a regular basis.

Commercial Insurance Coinsurance Tools

A property insurer may waive the coinsurance requirements of the policy if requested by the insured and if the insurer believes the limit to be purchased is sufficient. This is often done by use of an agreed amount endorsement where the insurer will waive coinsurance for the policy coverage period. Sometimes insurers will provide an inflation guard endorsement to the policy in which the building and/or contents limit is increased a certain percentage at each renewal. Educating an insured on how coinsurance works may result in better selection of insured limits and lessen the potential for errors and omissions claim against the agent or broker.

Homeowners Insurance (HO 2 and HO 3)

Some insureds may be surprised to learn that a homeowners policy, especially if based on ISO policy forms, has a coinsurance clause that can impact coverage. In ISO forms, if the damaged home is 80 percent or more of the full replacement cost, then replacement cost valuation will be used subject to the lesser of policy limit or repair or replacement cost. If the insured home fails the 80 percent coinsurance requirement, then loss is settled on actual cash value.

National Flood Insurance Program (NFIP)

The NFIP Dwelling Form (ed. 5/08) provides replacement cost valuation if the dwelling is the insured’s principal residence and either the amount of insurance is at least 80 percent of the actual replacement cost value prior to loss, or the coverage limit is the maximum amount available from the NFIP.

The risk management professional needs to understand and point out to insureds that even an HO form and NFIP dwelling form have coinsurance requirements that can affect coverage.