In our experience, the concept of co-insurance in relation to business interruption is one of the least understood and most feared topics by all parties involved. Many brokers don’t have a good idea of how best to set appropriate policy limits for business interruption, many adjusters don’t fully understand how to determine co-insurance compliance and many insured’s feel unfairly penalized when co-insurance requirements are applied following a claim.
Any business interruption policy which isn’t classified as Actual Loss Sustained (ALS) is subject to some degree of co-insurance requirement, typically ranging from 80% to 100%. The idea behind co-insurance requirements is to force the Insured to purchase an adequate amount of insurance relative to the size of their business. If the Insured purchases less insurance than is required to cover the business in the event of a total loss then they become their own co-insurer and are responsible for a proportionate amount of any loss incurred.
Setting policy limits with co-insurance
When the limits for insurance are set one of the most important factors to consider is what the potential maximum indemnity period for a loss would be. The limits must be set considering the absolute worst case scenario. The typical worst case scenario is illustrated by the following example:
A business interruption policy with a maximum twelve month indemnity period and a one year renewal is put into place on January 1, 2015 with the policy expiring on December 31, 2015. On December 31, 2015 the business suffers a total loss fire and will be unable to resume operations for the maximum twelve month indemnity period. The indemnity period would then stretch to December 30, 2016, two years from the inception of the policy.
The above scenario highlights the need to consider not only the requirements of the business at the time the policy is purchased but the requirement to estimate the performance of the business for the next two years. Failure to consider these changes in a business which is growing could have significant negative impacts in the event of a loss.
Common mistakes when setting policy limits
Some of the most common mistakes we see with regard to the setting of policy limits include the following:
- Failure to consider annual growth or the potential value of new contracts, resulting in underestimating future profits and expenses;
- Failure to consider all the fixed expenses of the business, as opposed to those which cease during a loss period;
- Insuring multiple locations under one policy with insufficient limits to cover all locations on the basis they all are down at the same time.
- Deducting expenses which would be expected to be saved in the event of a loss. Saved expenses are not taken into consideration in determining co-insurance compliance.
- Setting limits based on revenue only. This would result in over insuring the business as the variable expenses would not be insured in the event of a loss.
- Setting limits based on net income only. This would result in significant under-insurance as none of the fixed expenses of the business would be considered.
Obviously all of the above issues can impact the insured…and unfortunately it is often not identified until a loss occurs.
Checking co-insurance compliance
In the event of a loss, co-insurance compliance would be determined by the following two part formula:
Projected Annual Sales for the 12 Months Following the Date of Loss
Multiplied by: Gross Profit/Gross Earnings Rate
Equals: Annual Gross Profit/Gross Earnings
Multiplied by: Co-Insurance Requirement (80%/90%/100%)
Equals: Limit of Insurance Required
Actual Policy Limit
Divided by: Limit of Insurance Required
Equals: Loss Recovery Rate
If the actual policy limit is in excess of the limit of insurance required, then there will be no co-insurance penalty and the recoverable loss will be 100%. However, if the actual limit is less than the limit required, the recovery rate on the loss will be less than 100%. The difference between the recovery rate and 100% will represent the portion of the loss the Insured will be responsible for or the insured is co-insuring.
When all parties involved have just a basic understanding of what co-insurance is and what it’s impact can be in the event of a claim the entire process from policy purchase to the conclusion of a claim can go very smoothly. While it may seem complex a first it is not really that scary to deal with and ADS is always available to help you out.