Transcript Lighthouse Eldercare Program Excess Casualty Opportunity

Common Pitfalls in
Commercial Property Insurance
Presented by:
Craig Mathre, CPCU, CLU, CIC, ASLI, AU, IAC, AAM, ARM, ARE
Markel Re
4521 Highwoods Parkway
Glen Allen, VA 23060
November, 2006
Common Pitfalls in
Commercial Property Insurance
Pitfall…..”a hidden or not easily recognized danger or difficulty”. This is how
the dictionary defines these concealed hazards. It also happen to be the word
used to describe “a hole in the ground that serves as a trap”
 Measurement of Business Income and Extra Expense Exposures
 Functional Building Valuation
 Ordinance or Law Exposures
 Agreed Value
 Replacement Cost Coverage
 Inflation Guard Coverage
 Blanket Insurance
 Leasehold Interest
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Business income loss exposures involve two
important financial consequences:
1. Reduction of the organization’s revenues arising out of direct damage
to covered property by a covered cause of loss; and
2. Extra expenses incurred by the organization in order to avoid or
minimize the interruption of business operations and loss of income
following a direct physical loss.
Business income losses are quantified in terms of net income (i.e. the
difference between revenues and expenses). A common misconception is that
a business needs to be operating at a profitable level in order to be exposed to
a business income loss
2
Example #1: (a profitable business)
Actual After Loss
Had No Loss Occurred
Revenues
$100,000
$200,000
Expenses
$ 75,000
$ 50,000
Net Income
$ 25,000
$150,000
Business Income Loss = $125,000
Example #2: (an unprofitable business)
Actual After Loss
Had No Loss Occurred
Revenues
$100,000
$150,000
Expenses
$200,000
$175,000
( $100,000)
( $ 25,000)
Net Income (Loss)
Business Income Loss = $75,000
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
A third, more subtle effect of a business interruption may actually
lessen the reduction in net income, since some normal operating
expenses may either decrease or cease during a shutdown or
slowdown of operations.

One of the most significant challenges in measuring the business
income loss arises out of the fact that such measurement requires
that we fairly accurately estimate what the organization’s revenues
and expenses would have been had there been no physical
damage loss.
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Example: Reduction in Net Income Resulting From Changes in Both
Revenue and Expenses
DEF Corporation owns a video rental store in a one-story masonry building near a large
shopping mall. A strong thunderstorm damages the roof of the building, allowing rain to
enter and cause significant damage to the video rental store’s inventory. Repairing the
damage will take 60 days.
After the Loss
Had No Loss Occurred
Revenues
0
$120,000
Expenses
$10,000
$100,000
Net Income
($10,000)
$20,000
During the 60 day shutdown, DEF had no revenue from rentals. Some operating expenses
continued during this period, albeit at a lesser rate. Other expenses did not continue.
As result of these changes in revenue and expenses, the actual net income during the 60
day period of business interruption was a net loss of $10,000.
The net loss of $10,000 however, is not the total measure of the actual business income
loss. The actual loss of net income attributable to the shutdown is measured by the
difference between what net income would have been earned had no loss occurred
($20,000) and the net income (loss in this case, of $10,000), a difference of $30,000.
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A critical component of business income losses is the extent to which normal operating
expenses continue during a period of business interruption. Accordingly, each dollar of
expense reduces net income by one dollar and each dollar of expense that does not
continue during a business interruption increases net income by that same amount.
Therefore, a critically important part of estimating potential business income losses is
determining which normal operating expenses will continue and which will not, in the event of
a business interruption of a particular length.
It is also important to consider additional expenses, above and beyond normal operating
expenses, that may be incurred to mitigate the impact of a business interruption. Such
expenses are routinely referred to as extra expenses.
Estimating the extra expense exposures for an organization can be challenging. Types of
potential expenses to be considered include:
 rental and maintenance of temporary premises and equipment
 expense of moving to and from temporary premises
 cost to set up temporary premises
 advertising expense to notify customers of the temporary location
 utilities, insurance, and maintenance at the temporary premises
 overtime pay to expedite opening at the same or a new location
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Functional Building Valuation
In underwriting property insurance, underwriters may become uncomfortable in situations
in which the replacement cost of a property significantly exceeds the market value of that
property. In these situations, the underwriter may condition his/her acceptance of the risk
upon the requirement that the property be valued on a functional building valuation basis.
Alternatively, it may be the insured who elects to have property valuation be on a
functional basis rather than the more traditional replacement cost or actual cash value.
The Functional Building Valuation Endorsement is available to modify the coverage
provided by the BPP by providing modified replacement cost coverage. For a total loss,
the endorsement will cover the cost to repair or replace the building with a less costly
building that is functionally equivalent to the original building. For a partial loss, the
insurer will pay for the damaged portion of the building’s repair or replacement calculated
on the basis of using less costly materials, if available, in the architectural style that
existed before the loss. This endorsement also deletes the coinsurance clause.
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If, after a loss, the insured fails to contract for repairs within 180 days or otherwise chooses
not to make a claim based on the cost to repair or replacement, the endorsement sets the
maximum the insured can collect at the lowest of the following amounts:
1. the limit of insurance shown in the endorsement
2. the market value of the damaged building, exclusive of land value, at the time of loss
3. the cost to repair or replace the building on the same site with less costly material in
the same architectural style, less an allowance for physical deterioration and
depreciation
Market value is define to mean “the price which the property might be expected to realize if
offered for sale in a fair market”.
The endorsement automatically includes ordinance or law coverage, subject to the regular
limit of insurance on the building (no separate limits apply for demolition cost or increased
cost of construction).
Certain fixtures and personal property used to service the premises are not specifically
excluded under the endorsement, so items such as awnings or floor coverings, appliances
for refrigerating, ventilating, cooking, dishwashing, laundering, or outdoor equipment or
furniture (covered under Building in the BPP) can be valued at functional replacement cost.
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Ordinance or Law Exposures
Many municipalities have an ordinance or law in place with respect to older buildings which
may require the insured to incur certain expenses no covered by the unendorsed BPP. For
example, a typical ordinance or law may require that in the event a building constructed prior to
1960 suffers damage amounting to 50% or more of its value, two things must happen:
1. the remaining structure cannot be repaired or rebuilt, but must instead be demolished
and the site cleared of debris
2. the to-be-constructed replacement structure must be built according to current building
code requirements
Three potentially out-of-pocket expenses not covered in their current property program:
1
the loss of value of the remaining undamaged portion of the building which is required
to be demolished
2
the actual cost of demolishing the undamaged portion of the building as well as
necessary site clean-up
3
the increased cost of construction, including the increased costs to reconstruct or
remodel undamaged portions of the building, required by ordinance or law
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The Ordinance or Law Endorsement to the BPP
Coverage A covers the reduction in value of the undamaged portion of the building which
must be demolished in order to comply with the ordinance or law.
Coverage B covers the cost to demolish the undamaged portion of the structure and to
remove its debris.
Coverage C covers the increased cost to repair or reconstruct damaged property, or to
reconstruct or remodel undamaged portions of the property, as required by the ordinance
or law.
The coinsurance provision does not apply to Coverages B and C. Coverage A shares it’s
the limit applicable to Building coverage and will apply on either an actual cash value
(default) or replacement cost (option) basis. If coverage is on a replacement cost basis
and the building is actually replaced, Coverage A will pay the lowest of the following
amounts:
1. the amount the insured actually spends
2. what it would have cost to restore a building comparable to the original building
3. the limit of insurance
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If Coverage C is chosen, the replacement cost coverage must be activated and the
property must be repaired or replaced as soon as reasonably possible after a loss.
None of the three coverages will pay for:
1. any loss due to an ordinance or law that the insured failed to comply with if the
compliance was required before the loss
2. costs associated with any ordinance or law that requires the insured in any way
to respond to or assess the effects of pollutants
Coverages B and C require their own separate limits of insurance, although Coverages
B and C may be blanketed if desired. Choosing appropriate limits of insurance for
Coverages B and C requires the insured to reasonably estimate the cost of demolition
and debris removal and have sufficient knowledge of the local ordinance or law to
determine a reasonable estimate of the increased costs of construction.
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Example:
$1,400,000 Replacement Cost Value of Building
Direct damage by fire: 50%
Potential uncovered losses without Ordinance or Law Endorsement:
 value of the undamaged portion of the building
$700,000
 cost to demolish the undamaged portion of the building
$160,000
 increased cost of construction (to comply with code)
$400,000
These loss exposures can be covered with the Ordinance or Law Endorsement,
as follows:
 Coverage A
$1,400,000 (subject to coinsurance and on a
replacement cost basis)
 Coverage B
$160,000
 Coverage C
$400,000
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Agreed Value is one of three optional coverages which are built into the Building and
Personal Property Coverage Form. (The other two are Replacement Cost and Inflation
Guard). Each of the optional coverages can be triggered by checking a box on the
Declarations (no endorsements are necessary).
When the optional Agreed Value is selected, it removes the coinsurance requirement
from the covered property for which it is designated and substitutes an agreement to
cover any loss in the same proportion that the limit of insurance bears to the agreed
value.
Three very important points should be kept in mind relative to the coinsurance
requirement of the BPP:
1. While the limit of insurance is chosen by the insured at the time the policy is first
issued, the measurement point for determining compliance with the coinsurance
requirement is at the time of loss.
2. Even if the coinsurance requirement is met, the most the insurer will pay in the
event of a total loss is the limit of insurance.
3. Again, even with the coinsurance requirement met, the insurer will not pay an
amount which exceed the amount of the loss.
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Examples
1.
policy term: 1/1/06 to 1/1/07
insurable value of the property at 1/1/06: $1,000,000
limit of insurance: $800,000
loss occurs on 7/1/06
insurable value of the property at 7/1/06: $1,200,000
loss payable = amount of insurance carried
amount of insurance required
= .83
$800,000
80% of $1,200,000
$800,000
$960,000
Only 83% of the covered loss will be paid despite the fact
that the insurance to value requirement had been met at the
time of policy inception.
2. policy term: 1/1/06 to 1/1/07
limit of insurance: $1,000,000
insurable value of the property at 1/1/06: $1,250,000
loss occurs on 7/1/06 and is valued at: $1,100,000
Though the coinsurance requirement has been met ($1,000,000 is 80% of $1,250,000)
the $100,000 of the loss which exceeds the limit of insurance is not covered.
A common misconception surrounding the optional coverage for Agreed Value is that is somehow
“Waives” the coinsurance provision. In reality, it does not. A failure to maintain the limit of
insurance at the agreed value results in the coinsurance provision coming back into play.
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Replacement Cost Coverage
What is commonly overlooked with regard to this important optional coverage is the
following:
1. Even with optional replacement cost coverage selected, the following types of
property will still be valued on an actual cash value basis:
 Property of Others
 Contents of a residence
 Works of art, antiques or rare articles, etc.
 Stock, unless the “including stock” option is selected
2. Tenant’s improvements and betterments are not considered to be Property of
Others, and therefore replacement cost coverage will apply to them.
3. A requirement for replacement cost coverage to apply is that the property actually
be repaired or replaced.
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Inflation Guard
The limit to which it applies in increased automatically throughout the policy term in a
straight-line/prorate fashion. Thus, a building with a $1,000,000 limit of insurance and
4% inflation guard would have the following amounts of coverage at various points in
time:
 90 days into the policy term
 180 days into the policy term
 270 days into the policy term
$1,010,000
$1,020,000
$1,030,000
Seems simple enough……..but there are some things to consider here:
1. The straight-line/prorate approach to increasing the limit of insurance assumes
that inflation also operates in a straight-line manner.
2. Insurance coverage is focused on the cost of repairing or replacing real and
personal property and the adequacy of limits of insurance is a function of the cost
of two very specialized things:
• the cost of building materials and supplies
• the cost of construction labor
The cost levels of these two things may or may not parallel general price level
changes in the economy.
3. Inflation guard does not guarantee insurance-to-value or compliance with
coinsurance requirements.
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Blanket Insurance
Specific Coverage - Covers one category of property (i.e. Building, Your Business Personal
Property, or Personal Property of Others) at a single location. A specific and separate limit of
insurance applies to each item of covered property.
Example: Building #1 at Location #1
$1,000,000
Schedule Coverage – Covers 2 or more items or 2 or more categories of property, with a
separate limit of insurance applicable to each item.
Example:
Example:
Building #1 at Location #1
$1,000,000
Building #2 at Location #1
$2,000,000
YBPP at Location #1 / Building #1
$1,000,000
YBPP at Location #2 / Building #1
$2,000,000
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Blanket Coverage – covers under a single limit of insurance either:
1. more than one category of covered property at a single location; or
2. one or more categories of covered property at more than one location
Coinsurance of at least 90% is required for blanket coverage. An exception to this is
made when:
1. Personal Property of Others is blanketed with Your Business Personal
Property; or
2. Tenants Improvements and Betterments are covered in the same item with
your Business Personal Property
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Examples of Comparing Schedule Coverage and Blanket Coverage:
#1:
Two or more buildings
Value
Coinsurance
Limit
Building #1
$100,000
90%
$90,000
Building #2
$ 80,000
90%
$72,000
90%
$162,000
Schedule insurance: per above
Blanket insurance:
Loss:
$180,000
a total loss to Building #1 ($100,000)
Schedule insurance will pay: $90,000
Blanket insurance will pay: $100,000
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#2:
Two ore more categories of property at the same location (in this case, Building,
Your Business Personal Property, and Personal Property of Others)
Value
Coinsurance
Building
$300,000
90%
$270,000
Your Business Personal Property
$200,000
90%
$180,000
Personal Property of Others
$100,000
90%
$ 90,000
Total
$600,000
Loss:
Limit
$540,000
a total loss to personal property ($300,000) and a $100,000 loss to Building
Schedule insurance will pay: $270,000 for personal property + $100,000 for
Building, for a total of $370000
Blanket insurance will pay: the full $400,000 loss
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Advantages of Blanket Insurance:
 The insured can apply the insurance where it is needed to cover the loss
when more than one category of property is covered on a blanket basis
 Values can shift across locations and still be covered in full as long as the
blanket limit reflects the total value of the property
 When the policy covers personal property at several locations the insured
does not have to worry about fluctuating values between locations
 Makes reporting forms easier to handle
 Coinsurance applies to the blanket limit (not to any one category of property
or any one location)
 The insured has 100% insurance-to-value at each location but only has to
carry 90% insurance-to-value overall
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Disadvantages of Blanket Insurance:
 Requires 90% or 100% coinsurance
 Underwriter may not be willing to provide coverage on a blanket basis
 Requires a Statement of Values from the Insured
 Blanket average rates apply for only one year
 Requires that coverage and causes of loss be consistent for all items
included within the blanket
 Can be difficult for the insured to understand
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Leasehold Interest
Landlord terminate the lease in either of the following circumstances:
1. The building or premises are damaged by fire or other perils to a specified
percentage of the value of the building or premises; or
2. The amount of time required to repair or replace the damaged property exceeds
a specified period.
Cancellation of a lease can cause the tenant to suffer a financial loss in any of the
following circumstances:
1
The lessee (tenant) has a lease at a rental rate much lower than the prevailing
rental value of comparable premises.
2
The lessee has sublet the premises to someone else, at a profit.
3
The lessee paid a bonus to acquire the lease (and perhaps the favorable terms
of the lease).
4
The lessee has paid advance rent that is not recoverable under the terms of the
lease in the event of termination of the lease.
5
The lessee has installed improvements and betterments.
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