We wrote previously about coinsurance penalties in the property policy arena. Coinsurance is conceptually identical in the property damage and business income arenas. Did the insured buy a limit and accompanying coinsurance percentage that understates the risk at hand? In the business income arena, describing the process to assess whether a penalty applies is more involved because the description of the Business Income value is more detailed.
The coinsurance wording of a business income policy effectively asks a simple question: Is the limit of insurance for business income less than the required Insurance value? If the answer is “yes,” there is work to do to impose a penalty. If the answer is “no,” the loss will be paid without penalty, subject to deductibles, limits and so on.
Of course, that simple question will not be found verbatim within the policy. Instead, the policy says, (with liberally paraphrased sections in braces and in red):
“We will not pay the full amount of any Business Income loss
if (emphasis added)
the Limit of Insurance for Business Income is less than
[the Required Insurance.]
Instead, we will determine the most we will pay
[by dividing the Limit of Insurance by the Required Insurance,
then multiplying the amount of the loss by that fraction,
after which, we will subtract the deductible from that product.
Then we will pay you the remainder] or the limit of insurance,
whichever is less.”
As with our property coinsurance article, we find ourselves 150-plus words into this post having used “required insurance” three times without defining it. Required insurance in business income policies is:
The sum of net income and operating expenses
for a designated 12-month period
the coinsurance percentage shown for business income in the declarations
Business income policies will define business income early in the policy as net income and continuing normal operating expenses incurred, including payroll. Later in the policy, there is wording to determine operating expenses to be added (back) to net income for the purpose of applying the coinsurance condition.
Step 1: Identify net income for the appropriate 12-month period.
Step 2: List all operating expenses for the appropriate 12-month period.
Step 3: Deduct from that list of expenses the expenses that meet the 12 (as per an ISO form we relied upon) listed categories.
- Items 1 through 5 are of a sales deduction nature
- Prepaid freight outgoing, returns and allowances, discounts, bad debts, collection expenses
- Items 6 through 9 are of a product material cost or purchased services nature.
- Item 10 pertains to utilities, but only if an endorsement is in place to exclude all or a portion of utilities from coverage.
- Item 11 pertains to ordinary payroll, but only if an endorsement is in place to exclude all or a portion of ordinary payroll from coverage.
- Item 12 pertains to special deductions for mining properties.
Items 1 through 9 are expenses that would discontinue with lost sales; 100% variable.
Items 10 and 11 are operating expenses that may continue, in part or in whole, during an interruption, but by endorsement, the insured is choosing not to insure at least a portion of the normal expense.
The “appropriate 12-month period” may be entirely pre-loss and unchanged by the loss event. It may involve post-loss periods that are affected by the loss event. In the latter, it is typical to develop values as if no loss occurred. However, there may be case law that says otherwise. Determine what is appropriate by the policy and by case law in the appropriate jurisdiction.
Business income coinsurance conditions, broken down to these steps, should be easier to assess. Follow the policy.
The investigative accounting group of Meaden & Moore is experienced in such matters and is ready to assist.