Common Pitfalls in Common Pitfalls in Commercial Property InsuranceCommercial Property Insurance

Presented by:Presented by:Craig MathreCraig Mathre, CPCU, CLU, CIC, ASLI, AU, IAC, AAM, ARM, ARE, CPCU, CLU, CIC, ASLI, AU, IAC, AAM, ARM, ARE

Markel ReMarkel Re4521 Highwoods Parkway4521 Highwoods Parkway

Glen Allen, VA 23060Glen Allen, VA 23060

November, 2006November, 2006

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Common Pitfalls in Common Pitfalls in Commercial Property InsuranceCommercial Property Insurance

PitfallPitfall…..”a hidden or not easily recognized danger or difficulty”. This is how …..”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 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”used to describe “a hole in the ground that serves as a trap”

Measurement of Business Income and Extra Expense ExposuresMeasurement of Business Income and Extra Expense Exposures

Functional Building ValuationFunctional Building Valuation

Ordinance or Law ExposuresOrdinance or Law Exposures

Agreed ValueAgreed Value

Replacement Cost CoverageReplacement Cost Coverage

Inflation Guard CoverageInflation Guard Coverage

Blanket InsuranceBlanket Insurance

Leasehold InterestLeasehold Interest

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Business income loss exposures involve two Business income loss exposures involve two important financial consequences: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

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Example #1: (a profitable business)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)Example #2: (an unprofitable business)

Actual After Loss Had No Loss Occurred

Revenues $100,000 $150,000

Expenses $200,000 $175,000

Net Income (Loss) ( $100,000) ( $ 25,000)

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 Example: Reduction in Net Income Resulting From Changes in Both Revenue and ExpensesBoth 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 ValuationFunctional 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 ExposuresOrdinance 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: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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ExamplesExamples

1. policy term: 1/1/06 to 1/1/07insurable value of the property at 1/1/06: $1,000,000limit of insurance: $800,000loss occurs on 7/1/06insurable value of the property at 7/1/06: $1,200,000

loss payable = amount of insurance carried $800,000 $800,000 amount of insurance required 80% of $1,200,000 $960,000

= .83 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 1/1/07limit of insurance: $1,000,000insurable value of the property at 1/1/06: $1,250,000loss 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 CoverageReplacement 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 GuardInflation 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 $1,010,000 180 days into the policy term $1,020,000 270 days into the policy term $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 InsuranceBlanket 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: Building #1 at Location #1 $1,000,000

Building #2 at Location #1 $2,000,000

Example: 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: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

Schedule insurance: per above

Blanket insurance: $180,000 90% $162,000

Loss: a total loss to Building #1 ($100,000)

Schedule insurance will pay: $90,000Blanket 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 Limit

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 $540,000

Loss: 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: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 InsuranceDisadvantages 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 InterestLeasehold 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.