The Complete Lawyer

Property insurance can be pretty straightforward, but few professionals have mastered the fine points of insuring against the loss of business income (and/or the addition of extra expenses) that occurs after direct damage to property. Many insurance practitioners—agents/brokers, risk managers/commercial insurance buyers, claims adjusters— misunderstand how these programs are designed and how losses are calculated and paid. Whether rendering business advice or litigating a claims settlement, attorneys can provide their clients valuable service if they know their way around this terrain.

Tangible business property (whether real or personal) has two dimensions of value: value as an object and value in producing revenue. The object-value of property can be insured against the aleatory risk of loss from various perils (“direct” property insurance). The revenue-producing value of property can be insured as well: providing indemnification for the loss of money that would have been earned during the time (hence, “time element” insurance) it takes to repair or replace the directly-damaged property.

Time Element Insurance Kicks In After Loss

Time element insurance coverage is only triggered if there is first an insured direct-damage loss to the subject property. As with direct property insurance forms, time element insuring agreements make reference to “covered causes of loss.” Care must be taken here: various “Commercial Package” insurance policies may include by endorsement additional direct-damage perils such as Earthquake, Flood and Mechanical Breakdown. The inclusion of coverage for direct damage from such perils does not automatically provide coverage from time element losses arising from them. Obviously though, earnings losses or extra expenditures following an earthquake are just as damaging as such losses following a fire. Agents and brokers should offer their commercial insurance customers the option of adding time element insurance against all perils that concern the buyer. Only then can an informed business decision be made.

Typically, time element insurance is purchased on real property (“buildings”) and on business personal property (“contents”). Fleet operators and contractors should also be concerned that their motor vehicles, various vessels and mobile equipment might be a significant (or the only) source of business revenue. What would happen to the business’ earnings if a tornado or serious fire hit the main terminal, docks or the contractor’s equipment yard, destroying trucks, boats or equipment? While time element insurance can often be obtained on these classes of property, we will not discuss these specialty areas any further here; however, attorneys need to keep in mind a client’s potential exposures to such losses.

As mentioned, businesses can be exposed to Extra Expense and/or to Business Income time element losses. Business Income can include (or may exclusively involve) rental income. A time element loss can arise from damage to a business’ own property, or could come from damage to someone else’s property. This latter type of loss is called “contingent business income” or “contingent extra expense” and can involve contributing properties (the plant of a supplier of key parts or raw materials), recipient properties (the warehouse of a manufacturer’s major customer), or leader properties (the big mall next door to a restaurant). These losses arising from “dependent properties” are insurable through the use of separate endorsements.

To identify and then quantify time element exposures, the person trying to manage this risk must ask, “What would we do if…?” The continuity of operation of some businesses might be so critical that they couldn’t afford to be shut down at all. A newspaper might fall into this category—it must publish every day no matter the cost, and would have huge exposures to the extra expenses involved in re-locating editing and printing activities, but might suffer no loss of subscribers’ or advertisers’ income at all. In contrast, if the ore crusher of a copper refiner burnt down, there might be no opportunities of any type to stay in business by applying extra expenses—their exposure here would be 100% to loss of business income. Under a variety of conceivable loss scenarios, though, most operations will have exposures to both business income and extra expense losses.

Upon careful analysis, many firms will find that their exposure to time element losses is as large as, or even greater than, their possible loss from any direct damage to property.

Smaller businesses eligible for coverage by BOP (Businessowners Policy) forms often find their policies automatically include Extra Expense Coverage and Business Income coverage for up to a year of their “actual loss sustained.” In many situations, this will suffice as protection. Larger or more complex businesses may also find that some time element insurance is included in the basic Property insurance forms or in broadening “extension endorsements” in their Commercial Package Policy (see “Can You Analyze a Property-Casualty Insurance Policy?” for tips on policy navigation).

Time Element Loss Exposure v. Coinsurance

Typically, though, most sizable business firms have their time element loss exposures covered through the attachment to the Property section of their policy of the “Business Income and Extra Expense Coverage Form” from ISO (form CP 00 30).[1] This coverage form includes coinsurance provisions. In property insurance, coinsurance operates like a quantity discount, encouraging insureds to buy limits high enough to cover most conceivable losses. The downside of a coinsured Property form is that if an insured has purchased limits that, at the time of loss, are below those required by the form, then the insured is penalized and receives less than 100% indemnity. The formula used by an adjuster to determine this penalty is:

_____(Limit of insurance purchased)_____ X (Amount of loss)
(Limit required by coinsurance % selected)

To estimate the “limit required” the insured would fill out a Business Income Worksheet (ISO form CP 15 15), providing actual numbers from a recently-ended 12 month period as well as estimated numbers for the upcoming 12-month policy period. To simplify, this worksheet subtracts (cost of goods sold) from (total gross sales) to get “100% of Business Income exposure for 12 months.”

If an insured thought it would take 12 months to rebuild following a major loss, he or she should be encouraged to select 100% coinsurance and buy a limit equal to the “100% of Business Income exposure for 12 months” shown in the worksheet. If the insured thinks that, even in a worst-case scenario, it would take only six months to rebuild, then a 50% coinsurance clause would be more appropriate, which would allow the purchase of a smaller limit (half as much) of insurance. If it is anticipated that likely losses would involve both loss of income and extra expense, then the limit selected should be increased (without increasing the coinsurance %) to provide for extra expenses arising from a serious claim.

For specialized or intricate operations (like a hospital or a complex manufacturing facility with custom machinery), it might take two, three or more years to rebuild—and 200%, 300% or higher coinsurance clauses (and respectively higher limits of insurance) would be selected. The higher the coinsurance % applied, the lower the rate per $100 of limits purchased will be—this is the “quantity discount” at work. On the same property, a $1,000,000 limit with 100% coinsurance might only cost 25% more than a $500,000 limit with 50% coinsurance.