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The Real Story on Non-Coinsurance Business Income Options

In another article, I discussed some of the pitfalls of covering Business Income exposures on an “actual loss sustained” basis without an actual limit specified. Many agents see the approach as a method to avoid application of a coinsurance penalty if the managed to screw up on estimating the insured’s business income exposure.

I won’t be rehashing them is this article, but based on my observation, it appears to be the preferred method used by insurance agents and brokers to avoid the potential application of a coinsurance penalty. However, there are a host of other methods available to avoid any potential coinsurance penalties. Some are better than others. Some options are easier or simpler than others. I wish I could say usage is geared to the better options rather than easy or simple options, but I would be lying.

Before I start digging into the options, I want to point out these options are listed within the ISO Business income Forms CP 00 30 and CP 00 32. The forms are identical except for CP 00 30 combines both Business Income and Extra Expense into one combined limit, while CP 00 32 only covers Business Income. For the uninformed layperson, Business Income replaces loss profits while Extra Expense covers expense to maintain operations or shorten the disruption. Selecting non-coinsurance options is done by selecting and specifying the selection on the policy declaration pages. For the sake of reference, they can be found on pages 7 and 8 on CP 00 30 and CP 00 32. I recommend any of my insurance brethren to read them.

The first and most often selected option I agents and brokers select is a “monthly limitation” option. ISO offers options for 1/6th, 1/4th, or 1/3rd monthly limit. Selecting one of these limits will restrict the potential of the established business income limit to the fraction selected. For example, if the insured has a $1,000,000 limit and selects 1/4th monthly limitation, they can collect at most $250,000 for any consecutive 30-day period. Any lost profits are greater than $250,000 are not covered.

This method is not bad from a coverage perspective but requires seasonal variations of the insured’s profit picture to be considered. This condition may require the need to purchase higher limits to appropriately cover the seasonal exposures. Let me demonstrate.

Most non-grocery retail risks have significant seasonal exposures. Toy and game retailers (both physical and online retailers) have a large portion of their sales sandwiched in between Thanksgiving and Christmas. It isn’t uncommon to see 50% of their sales in between the holidays. Furthermore, since Business Income Coverage covers lost profits, an even higher percentage profits may be sandwiched between them.

In the example mentioned above, the amount of lost profit covered in an unadjusted amount is limited to $250,000 in lost profits. However, assuming that period may represent upwards of $500,000 of lost profit, they would need an annual limit adjusted to $2,000,000 to fully cover the short period. Hence a need to purchase twice the amount of limit or 50% more that needed on an annual basis.

It may be adding insult to injury, but because there is no coinsurance clause, ISO surcharges the option upwards of 26%. Not only is there an increased premium cost resulting from higher limit requirements, there is a rate boost as well over a well-constructed plan with coinsurance. Therefore, while the simplicity may make the option attractive to sell, it is generally not a good option for the insured.

A second non-coinsurance option available is establishing a maximum period of indemnity. Rather than limit payments to a specific amount per 30-day period, this option limits the length of time after the waiting period the insured can be reimbursed for lost profits to 120 days. Unlike the monthly limitation option, any or al of the selected limit can be spent in any fashion. However, once the 120 days passes, no future lost profits or continuing expenses are covered.

As with the monthly limitation option, businesses with seasonal operations will need to select a limit that corresponds to the insured’s busy season of making profits. Just as important, consideration need to be given to the length of time it will take the insured to get back in business at the present or another location.

As with the monthly limitation option, the maximum period of indemnity also carries a rate modifier, in effect surcharging the business income premium and producing a higher rate than a business income programs with coinsurance clauses. The reason behind surcharging both of these programs is the underwriter not having a clear look at the insured’s financial data to properly evaluate the level of exposure at risk. Nor do they have an opportunity to assure the insured is carrying a limit that assures rate adequacy. Rate adequacy is a critical component of the underwriting process. Option which does not permit an appropriate evaluation require extra premium to compensate.

While both the Monthly Limitation and Maximum Period of Indemnity options are simple to explain and comprehend, they both carry with them potential coverage pitfalls. In addition, both programs carry a rating structure significantly higher than options with coinsurance clauses.

There is a third option to suspend or negate the coinsurance clauses in CP 00 30 and CP 00 32, Agreed Value. Unlike both options previously describe, Agreed Value does not include any premium surcharges. Furthermore, it can be structured and customized for every insured’s unique loss exposure.

The premise of agreed value is underwriters have had the opportunity to access and review the insured’s financial performance over the last 12 months and projections for the next 12 months. Upon reviewing the data, the underwriter has developed a confidence level the valued reflects an accurate value. Hence, follow on rating factors can be selected with a high degree of confidence the rating is developing an adequate premium. Therefore, the underwriter agrees to waive the application of a coinsurance requirement. Since, they have confirmed rating formulas are based upon a true value, they are willing to waive the requirement for no additional premium charge.

There is an important condition, the insured MUST provide a complete business income worksheet for the prior 12 months with a projection for the next 12 months. The agreed value must be at least equal to the amount estimated for the next 12 months times the selected coinsurance level. In doing so the coinsurance clause is suspended. Should the insured fail to provide a completed business income worksheet, the coinsurance condition is automatically reinstated.

I recently published another article detailing the shortfalls of relying on insuring risks without a specified business income limit. Two major flaws with using an unspecified business income limit are the extra cost to cover the exposure and the likelihood to make coverage modifications to structure coverage to match the insured’s exposures. Using the Agreed Value option offers “the best of both worlds.” Underwriters and agents can structure the coverage to be cost effective in the limit selection by enabling them to utilize the appropriate coinsurance level and adjusting the extended period of indemnity to match the insured’s need. On the other hand, it also offers the relative safety of avoiding application of potential coinsurance penalties, thereby enabling the insured to take advantage of rate credits offered by adopting a higher coinsurance stance.

All 3 of the options are already built into the Business Income Coverage Forms (CP 00 30 & CP 00 32). Depending upon the insured’s circumstances, one may work best to provide the needed coverage at the lowest expense to the insured. Which one works best will be determined by each insured’s needs on a case-by-case basis, but our goal as insurance professionals is to match the coverage effectively to protect the insured from risk.

In closing, there is only one way to structure a client’s business income coverage so that it maximizes protection while keeping premiums at their lowest. You need to dig into how the operate. That means you need to be able to evaluate various aspects of the client’s financial position. If you are not, you are not doing a credible job addressing their exposures. I’ll leave it at that.

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