Trieschmann, Hoyt & Sommer

Risk Management and Commercial Property—Part I

Chapter 9

©2005, Thomson/South-Western

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Chapter Objectives

• Explain how the Simplified Commercial Lines Portfolio policy meets property loss exposures

• Identify property and perils covered by boiler and machinery insurance

• Describe how insurance contracts can be designed to insure property that fluctuates in value

• List the different types of consequential loss exposures and types of insurance coverage available for such loss exposures

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The Commercial Package Policy (CPP)• In January 1986, a new, simplified approach to

commercial insurance coverage was introduced by the insurance industry

• Under the Commercial Package Policy (CPP) – The insured can obtain almost all types of insurance

coverage

• Broader contract provisions are included in the CPP

• The CPP has seven separate sets of coverage – Commercial property, liability, crime, boiler and

machinery, commercial auto, inland marine, and farm

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The Commercial Package Policy (CPP)• An insured can pick and choose

coverages in the CPP

• The CPP allows many insureds to use one policy to meet most of their insurance needs – Workers’ compensation and ocean marine

insurance must be purchased separately

• The CPP has many options available

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Building and Personal Property Coverage Form • Basic protection for buildings and personal property in the

CPP • Property coverage is divided into three major categories

– Buildings • Includes the buildings described on the declarations page • Any additions, extensions, fixtures, machinery and equipment

constituting a permanent part of the described buildings • Service equipment

– Your business personal property • Includes business personal property owned by the insured and usual

to the occupancy of the insured – Personal property of others

• Improvements and betterments – Alterations made to a leased building by the insured that the insured

cannot legally remove when the lease is terminated • Personal property of others in the insureds control

– Develops in situations where the insured repairs the property of others

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Extensions of Coverage

• BPP has extensions of coverage that expand protection to other categories of property – Newly acquired or constructed property – Your business personal property at newly acquired premises – Personal effects and property of others – Valuable papers and records–cost of research – Property off-premises – Outdoor property

• All of these extensions are an additional amount of insurance – Apply only if the policy has an 80 percent or higher coinsurance

clause

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Specific versus Blanket Coverage

• Under specific coverage, property at one or more locations is listed and specifically insured

• Under blanket coverage, property at several locations may be insured under a single item

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Common Clauses in the BPP

• Common clauses include – Coinsurance– Subrogation– Electrical apparatus

• No loss to electrical items will be covered if caused by artificially generated electrical currents

– Unless fire ensues, and then loss is covered only for the fire damage – Power failure

• Spoilage due to power failure from an insured peril is not covered unless the loss of power is from an on-premises insured peril

– Operation of building laws• No loss will be paid that results from the operation of building codes

– Alterations and repairs • Allows the insured to make this type of modification without its being

considered an increase in hazard – Which would cause the coverage to be suspended

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Common Clauses in the BPP

• Two important exclusions were added to property clauses in 2002 – Mold claims

• Have skyrocketed in a few states in the early 2000s• Prior to 2002, mold was listed in the so-called “wear and

tear” exclusion

– After the terrorist attacks of September 11, insurers begin excluding terrorism from their policies

• The Terrorism Risk Insurance Act (TRIA) was enacted in November 2002

– By the federal government to provide a backup for insurers that could not get reinsurance coverage for terrorism

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Insured Perils

• The basic form of the BPP covers – Fire, lightning, explosions, windstorm and hail, smoke, riot or

civil commotion, vandalism, sprinkler linkage, sinkhole collapse, and volcanic action

• The broad form includes the basic perils plus – Falling objects, the weight of ice, sleet, and snow; and accidental

discharge of water or steam from a system or appliance containing steam or water other than an automatic sprinkler system

• The special cause of loss form covers all direct physical losses except those that are excluded – Examples of excluded perils

• Earth movement, flood, war, enforcement of building ordinance, smog, insect damage, and wear and tear

– The old name for this type of coverage was “all risk” • The new name is “open perils”

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Debris Removal

• The BPP form includes coverage for debris removal – However if the loss is > or equal to the policy

• There is additional debris coverage up to $10,000

• BPP provides coverage for costs of pollution cleanup and removal from land or water at the described premises

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Subrogation

• Practically all contracts of property insurance are subject to the right of subrogation – By the insurer against any liable third party

• It may turn out, for example, that while the insured’s property insurance provides coverage for loss – Someone else has agreed to assume this liability by

contract or is held liable because of its negligence in causing the damages

• If the insurer pays the claim, it has a right to any such claims that the insured may have had against others

• Such recoveries assign responsibility to the party that is responsible for the damages

– Holding that party accountable for its actions

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Endorsements used with the BPP

• An insured can add earthquake and radioactive contamination to the list of insured perils

• The limits of recovery on such property as outdoor signs, trees, shrubs, plants, and radio and television antennas may be increased

• Special market value endorsements are available for distilled spirits and wines

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Endorsements used with the BPP

• Two endorsements that modify the BPP include – Replacement cost

• Like that found in the homeowner’s policy and changes the basis of recovery from actual cash value to replacement cost

– Ordinance and law endorsement • Used when older buildings must be repaired

according to a more stringent building code

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Boiler and Machinery Insurance (Equipment Breakdown Coverage)• Explosions caused by steam boilers, compressors,

engines, electrical equipment, flywheels, air tanks, and furnaces constitute a serious source of loss that the layperson often does not recognize

• Has developed along somewhat different lines from the usual insurance contract – Recognizing that prevention of losses is even more important

than indemnification of loss• Insurers have taken on the service of inspection and servicing of

boiler operations and technical machinery – Failure of the vessel to pass an inspection may mean imminent danger

to continued operations – The insurer reserves the right to suspend coverage immediately if

recommended repairs or replacements are not made

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Insuring Agreements

• Loss to property – Perhaps the chief reason for the purchase of boiler

and machinery insurance is either to • Replace damaged property belonging to the insured in the

event of sudden or accidental loss• Or to prevent the occurrence of such a loss

• Expediting expenses – The reasonable extra cost of expediting repair of the

machinery• Including overtime costs and the extra cost of express or

other rapid means of transportation

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Optional Endorsements

• Business income insurance – One of the important types of loss stemming from the failure of

the steam boiler or other vital machinery • Is the shutdown of an entire plant

– Use and occupancy insurance is commonly added by endorsement to the boiler and machinery contract

• Extra expense – Could arise from the failure of a heating plant boiler

• Forcing a business to install temporary alternative methods of heating at considerable expense

• Consequential damage – Provides protection when an interruption of power is due to

failure of an insured object on the insured’s own premises

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Business Owners Policy

• Designed for certain small- to medium-sized businesses– Small- to medium-sized is defined to mean

• Apartments and office buildings of less than six stories and with a total area of less than 100,000 square feet

• A standalone policy and cannot be added to the CPP

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Business Owners Policy

• Property forms used– Standard and special – Mandatory coverage exists for both direct and indirect loss to

property, liability, and medical payments – Options include outdoor signs, money and securities, employee

dishonesty, and mechanical breakdown • Recovery basis

– Prior to 1996, the business owners program assumed the insured would insure 100 percent to value

– However practical experience has shown the need for an insurance-to-value requirement

• Because many insureds underreport their property values – For full replacement cost coverage to apply

• The amount of Insurance at the time of the loss must be at least 80 percent of the full replacement cost

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Other Commercial Property Forms

• Difference in conditions insurance (DIC)– Written with the insureds basic contract because DIC excludes

the basic cause of loss perils – Generally only large firms purchase this coverage but it is

becoming more popular

• Builders’ risk – Used to insure buildings under construction – Usual approach requires the insured to purchase an amount of

insurance equal to the finished value of the building – However the rate charge is usually 55% of the standard rate – The insured has full coverage during the construction period

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Reporting Forms

• Designed to adjust insurable coverage on contents to changing property values at one location or in different locations

• Have several advantages – The amount of insurance protection is automatically adjusted to

changes in values of property at different locations – New locations are automatically covered – The insured does not have to pay premiums on limits of liability

in the policy • Rather pays premiums according to the actual values at risk

– The possibility of having gaps in coverage or duplication of insurance is virtually eliminated

– Insured avoids being short-rated when coverage is reduced

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Reporting Forms

• Important purpose of reporting forms – To adjust insurance protection for business firms that have many

plants located in different geographical areas – Or wish protection to be adjusted automatically to constantly

changing values at these plants

• The insured purchases an insurance policy with a stated maximum as its limit – This figure is the most the insurer will ever pay – However the insured is only charged for the exposure that exists

• May receive a refund at the end of the policy period

– Each period the insured is required to report to the company what the actual values were at each location on a specific date

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Consequential Loss Coverage

• Suppose a small manufacturer suffers a serious fire that shuts down its plants for two months while repairs are being made

• The manufacturer is fully insured against direct loss by fire – But carries no consequential loss coverage

• The fire policy pays for the cost of lost raw materials, goods-in-process, and finished goods – As well as repairs to machinery and buildings

• However, the manufacturer finds it is necessary to keep certain key employees on the payroll to help with the reorganization and to render service to customers

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Consequential Loss Coverage

• Additionally, expenses are incurred – Such as taxes, insurance premiums, interest, heat, light, power,

and depreciation • Regardless of the volume of operation

• The manufacturer has been unable to earn any profit on the unsold finished goods – Or on the volume of goods that normally would have been

produced during this period

• The sum of these losses may be so severe that the manufacturer is unable to continue in business

• Consequential damage contracts are devised to indemnify for this type of loss

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Time-Element Contracts

• Businesses face indirect losses of a much greater magnitude than individuals because – Businesses handle larger amounts of money – Restoration can take longer

• It may take one to two years to rebuild a factory – Whereas most houses can be rebuilt within three to six months

• Time-element contracts measure the indirect loss in terms of x dollars per unit of time that passes until the subject matter can be restored

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Business Income Insurance

• Undertakes to reimburse the insured for profits and fixed expenses lost as a result of damage to property from an insured peril

• The property will indemnify the insured subject given the following conditions – Physical damage to property by fire or other insured peril must

be present – A reduction in business must occur

• Must result from the physical damage caused by the named peril – During the period of restoration, it must be established that the

business would have continued to operate – The loss must occur during the policy term at the described

location – If the insured’s loss had not occurred, the business would have

earned a profit or a portion of fixed costs

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Business Income Insurance

• If the business has only been breaking even at the time of the occurrence of the insured loss – A question would be raised as to whether any profits

would have been earned • If it were found that no profits would have been

made even if the business had not been shut down – No real loss from the source would have occurred – No indemnity for lost profits would be paid

• If the business has been earning enough money to cover its fixed expenses – These costs would be reimbursed

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Business Income Loss

• The central idea is to examine the income statement of the firm

• Derive from this statement the various items of income and expense that are to be insured

• Process of isolating the insurable value – Deduct from total gross value the expenses and costs

that are variable • Those that may be discontinued if a fire or other peril were to

cause a shutdown of the business

– The amount obtained is the insurable value and forms the basis of the loss settlement

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Coinsurance

• Most business income forms contain a coinsurance clause

• Requirements vary from 50% upward – Depending on the amount of coverage desired

• If the business concern elects to take the 50% form – It is required to carry at least 50% of its profits plus

operating expenses – Failing to carry this amount, it becomes a coinsurer

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How Much Insurance to Carry?

• The answer depends on what the firm believes the maximum loss might be

• Coinsurance forms are available that allow the insured to carry as little as ½ of its annual insurable value

• However, if the firm has reason to believe it might take as much as a year to restore the business to regular operations – It should carry insurance equal to its full insurable value

• Some firms operate on a seasonal basis – A few months operations might account for an entire year’s

profits

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How Much Insurance to Carry?

• The loss may be only partial – If the business is only partially shut down

• Indemnity can be collected for the partial loss

• Extended-period-of-indemnity endorsement – Under the terms of this endorsement that period of

loss is defined to mean that period necessary to return to normal business operations

• Not just that period necessary to reopen the business physically

– A firm make need several months to obtain new customers and to achieve the same level of operation it enjoyed prior to closure

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Insurance-to-Value Requirements

• By endorsement an insured can choose one of three alternatives to coinsurance – Including a maximum of indemnity – A monthly amount of indemnity – An agreed amount

• Under the standard approach, the insurance-to-value requirement is based on the estimated business income that is expected during the twelve months following the date of purchase of the insurance policy – This approach reduces some of the uncertainty associated with

estimating the required amount of insurance • As the insured knows exactly which twelve months will be used in making

the calculation • Usually a 50 percent minimum coinsurance clause is present in the

business income form– However this implicitly assumes a six-month restoration period

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Insurance-to-Value Requirements

• Those firms with a maximum restoration period of less than six months may have to purchase more insurance than they can collect

• The BPP has two optional coverages from which to choose – Maximum period of indemnity

• Replaces the insurance-to-value requirement with the maximum restoration period of 120 days

– Monthly limit of indemnity • Designed for small businesses and does not have a coinsurance

clause

• To assure full recovery for any loss – The insured must carry sufficient limits so that the selected limit

will cover the total earnings for any one month

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Insurance-to-Value Requirements

• Agreed amount clause – Substitutes an agreed amount of coverage for the coinsurance clause – The insured must complete and sign a business income worksheet

when the endorsement is purchased – If that statement underestimates income

• A penalty will be applied if a loss occurs • Contingent business income

– Sometimes a firm is forced to shut down because an insured peril forced the shutdown of a plant belonging to a supplier or to an important customer on whom the firm depends

– Contingent business income insurance has been devised to deal with these situations

– The regular business income policy will not cover such losses • Because the insured peril did not cause any damage at the firm’s own

property – The coverage form is called the business income from dependent

properties

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Extra Expense Income

• Certain types of business firms do not find it possible or expedient to close down following the destruction of their physical plants – Firms such as laundries, newspapers, dairies,

public utilities, banks, and oil dealers will often continue their businesses using alternative facilities

• Closing of these firms would deprive the public of a vital service or would involve a complete loss of goodwill or of business to competitors

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Extra Expense Income

• Because these firms will continue to operate if loss occurs – Business income insurance is not attractive

• These firms need extra expense insurance that covers expenses beyond the normal cost of conducting business – Examples of extra expenses

• Rental of quarters, purchase of extra transportation facilities, leasing of substitute equipment, overtime payments to employees, the cost of moving to temporary facilities, and the cost of additional advertising to inform the public the firm is still operational

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Leasehold Interest Insurance

• Leasehold – An interest in real property that is created by an

agreement (a lease) that gives the lessee (the tenant) the right of enjoyment and use of the property for a period of time

– May become very valuable to the lessee because changing business conditions, improvements in the property, and good management may increase the rental value of real estate considerably above the rental under the lease

• This increase in value creates what is known as leasehold interest, or leasehold value

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Contracts Without a Time Element

• Use to insure losses that result from fire – But where the loss cannot be measured either

by direct damage by fire or in terms of elapsed time

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Manufacturers Selling Price

• BPP covers goods and finished stock that are sold but not delivered at selling price

• This endorsement applies this approach to finished stock regardless of whether it has been delivered

• It differs from business income insurance – The latter covers profits that would have been earned

in the future had the fire or other insured peril not damaged the firm’s plant

• Endorsement covers the loss of the profit element in goods already manufactured but destroyed before they could be sold

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Accounts Receivable Insurance • Attempts to indemnify an insured for the loss brought about because

of the inability to collect from open account debtors after a fire destroys accounts receivable records

• If a catastrophe makes it impossible to prove the existence of a debt because there are no records of the transaction – Some debtors may refuse to honor their obligations

• Written on a special-form basis – With various exclusions including bookkeeping, accounting, or billing

errors and admissions • The coverage applies only while the accounts receivable records

are on the premises – For an additional premium the records may be covered while at another

temporary location • It may be required that the records be stored in a vault or a safe

when the business is closed

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Rain or Event Insurance• Rain, as such, seldom causes any direct damage to property• The accumulation of water due to extended rainfall does cause

much loss to property– In the form of flood or rising water

• Such coverage is generally not available from private insurers• However, rain itself may result in indirect loss

– Its occurrence may greatly reduce the expected profits of promoters of an outdoor or public event

• Rain insurance covers the loss of profits and fixed expenses or extra expenses due to rain, hail, snow or sleet

• The advisability of purchasing rain insurance depends on the promoter’s estimate of the actual effect of rainfall on anticipated attendance and the resulting profit– In some areas rain is so common that it does not discourage attendance

substantially• Whereas in other locations even a light rainfall will ruin attendance

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Hospital Disaster Risk Management• Many business such as utilities and hospitals

may have liability suits arise from their alleged negligence in preparing for a major storm

• For instance, if a storm knocks out power to a hospital and the hospital’s secondary power source fails to work– The hospital may suffer lawsuits from patients who

were harmed or died during the interval• For instance, those in ICU and on life support

– It does not take much of a power interruption to cause serious injury or death