This is our 41st edition of the Claim Solutions Newsletter. It provides a possible solution to underinsurance which often afflicts Consequential Loss claims. Your feedback is welcome.
The first quarter of 2011 has been a busy time with many sectors of the insurance industry experiencing heavy increases in claims.
A list of possible insured events is contained on page 4. This includes fires, explosions and ongoing storm damage affecting eastern Australia for many months. These events highlight the need for good risk management and insurance.
We wish a speedy recovery to all those who have sustained a loss.
If we can be of assistance please do not hesitate to contact us.
Many insurance claims are reduced due to the application of underinsurance penalties; none more so than Consequential Loss insurance claims. This newsletter presents a possible solution to the application of underinsurance for both Insureds and Insurers. It proposes slight modifications to the way in which a Consequential Loss Risk is placed to ensure the Insurer always collects sufficient premium to reflect the risk and enable the underinsurance clauseassociated with Consequential Loss Policies to be removed.
A few ground rules. The comments in this articlerelate to Section 2 of a Mark IV Industrial Special Risks (ISR) Policy which covers Consequential Loss. They may equally apply to many other policies which respond to Loss of Gross Profit/Gross Revenue and/or Payroll. In practice the terms “Consequential Loss” and “Business Interruption” are largely interchangeable. We will use the term “Consequential Loss” throughout this article as this is how the risk is described in the Mark IV ISR Policy.
The Underinsurance Clause - What is it?
As this article focuses on the underinsurance clause it is included below in full followed by an explanation. Stay with us. The Gross Profit section of the Consequential Loss policy responds
“provided that if the Declared Value of Gross Profit at the commencement of each Period of Insurance be less than the sum produced by applying the Rate of Gross Profit to the Annual Turnover (or its proportionately increased multiple thereof, where the Indemnity Period exceeds 12 months), the amount payable hereunder shall be proportionately reduced.”
Essentially this means that if the Declared Value on Gross Profit is less than the amount which should have been declared, any claim will be reduced in proportion to the extent of underinsurance. For example if the Insured declared $1m but should have declared $2m the Insurer can only pay 50% of any claim for Loss of Gross Profit. The claim is proportionately reduced. There is no margin for error.
Many articles have been written, seminars delivered and worksheets developed on how an Insured should determine the amount to be declared. There are two main elements to getting the Declared Value right and these are (1) the period of time which is insured (i.e. the Indemnity Period) and (2) the level of profit which is being insured (i.e. Insurable Gross Profit).
This is the period from the date of loss to the date the results of the business return to normal. The time it takes for the results of the business to return to normal should be nominated after considering factors such as the period required to rebuild, reinstate contents, relocate to alternative premises, re-employ & train staff, win business back from competitors, etc. It often takes longer for the results of the business to return to normal than originally anticipated. Clearly the indemnity period is subjective.
If an "Indemnity Period" of 12 months is selected it is important to recognise an insured event may occur on the last day of the period of insurance. If so the Indemnity Period commences on this date and the cover may respond over the following 12 months. As a result it is not only necessary to consider the results of the business over the period of insurance but over the following twelve months. If an Indemnity Period in excess of 12 months is required the results of the business need to be considered further into the future. Not an easy task.
Insurable Gross Profit
The insurable Gross Profit may differ from the accounting Gross Profit. The insurable Gross Profit is defined in the policy. The Gross Profit used to determine the Declared Value must be consistent with this definition.
The Mark IV ISR policy defines Gross Profit as the Sales (i.e.turnover) (net of discounts) plus Closing Stock less Opening Stock less Uninsured Working Expenses. An Insured needs to review the most recent annual Profit & Loss Statement prior to renewal of the cover and extract the Sales (net of discounts), Closing Stock & Opening Stock. Uninsured Working Expenses also need to be extracted. These are the expenses that do not need to be insured. They should only include those expenses that vary directly with the level of sales. They differ from one business to the next but may include purchases, freight, energy, etc. They are dependent on how an expense behaves.
Once the historical, insurable Gross Profit is determined this should be expressed as a ratio to sales to determine the insurable Rate of Gross Profit. If a similar rate is expected in the future it may be used to determine the Declared Value. If not, it needs to be adjusted to reflect the anticipated rate.
The Declared Value on Gross Profit is determined by applying the adjusted Rate of Gross Profit to the maximum annual sales over the renewal period and beyond, depending on the selected indemnity period.
There is huge scope for error when determining the Declared Value. It is often difficult to predict: -
• The time frame which may elapse before the results of the business return to normal.
• The future growth of the business.
• How expenses will behave.
• Whether the historical rate of gross profit will apply to future periods.
It seems the insurance policy expects an Insured to be a fortune teller yet penalises them with no leeway for error if their forecast is wrong.
The Underinsurance Clause - Why Does it Exist?
The Insurer must collect sufficient premium to inter alia pay claims, administration costs, make a profit and issue a dividend to its shareholders. In its simplest form an insurance premium for Consequential Loss is based on a percentage of the risk it insures. The percentage is based on the value of past Consequential Loss claims. The premiums contribute to the pool of funds from which claims are paid. If an Insured under declares it has not contributed sufficient funds to the pool and the Insurer cannot and should not pay the full claim. If all Insureds under declared the Insurer would quickly exhaust the pool and insufficient funds would remain to pay further claims. The Insurer is not only entitled to a full premium it is essential if the Insurer is to survive.
Consequential Loss Policies expects the Insured to provide a great deal of subjective information and if the future proves this information to be incorrect they are penalised. There is no allowance for error. This seems unreasonable.
On the other hand it seems more than reasonable, in fact essential, for an Insurer to collect a sufficient premium to reflect the risk otherwise it may not be viable.
We have a dilemma and it is one that has existed for decades.
Make every Consequential Loss Policy adjustable! The concept already exists in relation to insurances like Workers Compensation and Marine Cargo why not apply it to Consequential Loss? At the beginning of the period of insurance the Insured continues to forecast its Declared Value on Gross Profit based on the selected time required and the level of insurable Gross Profit with all the inherent subjectivity described earlier. An indemnity period, the uninsured working expenses and the dollar value of the cover must all be specified. The premium is calculated on the value declared. This should be no different to the approach currently used to place the cover.
At the end of the period of insurance the Insured must submit a further declaration using its actual financial information for the previous 12 months. There is no subjectivity in this information. It is fact. It is based on the results achieved over the past 12 months.
It may prove that the value declared 12 months prior was too low in which case an additional premium should be paid on the difference. It may prove that the value declared 12 months ago was too high and that the Insured is entitled to a refund of premium. It could prove the amount initially declared was correct and a premium adjustment is not required.
Under any option the Insured pays the correct premium to reflect the risk, the Insurer collects sufficient funds to remain viable and pay all claims and there is no need for any underinsurance clause. It can be removed.
It may come as no surprise to some of our readers that the ISR policy already contains a Premium Adjustment Clause. It has featured in previous newsletters. In reality the premium adjustment clause is rarely used. There may be two reasons. Perhaps it is not understood. Perhaps an Insured is reluctant to apply it because an additional premium may become payable.
Our solution is not to introduce a premium adjustment clause. It already exists.
Our solution is to make it compulsory for all Consequential Loss placements. Insurance is about valuing the risk, paying the premium and, if necessary, making a claim. It is not about underinsurance penalties and yet in many Consequential Loss claims that is what it has become.
About Claim Solutions
Claim Solutions provides a specialist insurance claims service. Our firm is recognised as one of the leading practices in this field with both national and international companies featuring amongst our clients. Our aim is to provide an efficient, professional and complete claims service which responds to your needs in times of crisis. We are available to assist in relation to any of the above incidents or similar losses.
The Articles which appear in this Newsletter are not intended to be a substitute for specific technical advice.