BUSINESS INCOME ALTERNATIVES TO COINSURANCE

(June 2019)

INTRODUCTION

The Insurance Services Office (ISO) Business Income Coverage Forms CP 00 30 and CP 00 32 are subject to the coinsurance additional condition. The named insured receives a rate credit in return for insuring to value. However, at the time of loss, it is penalized if the limit selected is not equal to or greater than the limit that would satisfy the coinsurance additional condition.

Example: Poppy’s Pop Sticks had net income and continuing operating expenses of $150,000 last year. Poppy doesn’t anticipate any major changes and estimates that sales will increase to $160,000 this year. As a result, he tells his agent to use a 50% coinsurance limit of $80,000. The summer is unusually hot, and sales far exceed expectations. A tornado destroys the roof of the pop stick manufacturing plant at the beginning of August and Poppy is out of business for three months. Based on the eight months of actual figures available, Poppy’s projected annual net income and continuing operations expenses for the year is $200,000. The loss for the three affected months is $50,000. The coinsurance penalty is calculated as follows:
1. Projected annual sales	$200,000
2. Coinsurance percentage	X .50
3. Required amount of insurance	= $100,000
4. Limit	÷ $80,000
5. Penalty for underinsurance	= .80
6. Actual loss amount	$50,000
7. Penalty factor (Step 3)	X .80
8. Amount paid	= $40,000

In this example, Poppy increased the business income limit in line with projected sales but still incurred a penalty because even the best estimates do not guarantee elimination of the coinsurance penalty. ISO recognized this problem and developed three alternatives to coinsurance in the business income coverage forms. They are Optional Coverages in the business income coverage forms.

MAXIMUM PERIOD OF INDEMNITY

This option eliminates the coinsurance requirement by letting the named insured select a specific limit of insurance. If there is a covered loss, the named insured is paid for up to 120 days of the loss or the limit of insurance, whichever is less.

Example: Poppy’s Pop Sticks selects this option. He selects a limit based on dividing his projected net income and continuing operating expense amount by 365 days and then multiplying that figure by 120 days. That results in a $52,603 limit. On the other hand, another approach might be to select the months with the highest sales and insure for the anticipated net income during those periods. Sales were $20,000 in June, $25,000 in July, $30,000 in August, and $20,000 in September, for a total of $95,000. Poppy could use any approach and select a limit of $95,000 because loss payments end when the limit is used up or after 120 days.

This option has a significant rating surcharge but is an excellent selection in cases where the amount of downtime is limited and fairly certain. This option is triggered when there is an entry in the box next to Maximum Period of Indemnity on the declarations.

MONTHLY LIMIT OF INDEMNITY

This option eliminates the coinsurance requirement by letting the named insured select a specific limit of insurance. It then agrees to receive payments in increments of 1/3, 1/4, or 1/6 of the selected limit each thirty days until the limit is used up or the period of restoration ends, whichever comes first.

Example: To use this option, Poppy needs to know the maximum length of time he would be out of business and the maximum amount he needs for any given 30-day period. He knows he can get back in business and resume operations within 4 months and that the month with the highest revenue in August. If he chooses the 1/4 option (but decides to stay with his core months of June, July, and August), the limit is $75,000. When the August loss occurs, the payment is as follows:
Period	Loss amount	Limit available	Amount paid
First 30 days	$30,000	$75,000 multiplied by 1/4 or .25 (25%) = $18,750	$18,750
Second 30 days	$15,000	$75,000 multiplied by 1/4 or .25 (25%) = $18,750	$15,000
Third 30 days	$10,000	$75,000 multiplied by 1/4 or .25 (25%) = $18,750	$10,000
Fourth 30 days	Resume business		$0
Totals	$55,000		$43,750

Poppy is adequately insured if the loss to the manufacturing plant occurs in any month other than August. However, because of the date when the loss occurred, he does not completely recover his loss because the monthly limitation selected was inadequate to respond to and cover the amount of loss sustained. If Poppy’s loss continues for more than four months, the policy continues to respond until business operations resume or the limit is exhausted, whichever occurs first. The 1/4 recovery limitation does not restrict or limit the coverage to four months.

This option is subject to a rating surcharge but is an excellent selection in cases where the month that presents the largest loss can be identified and a limit and recovery basis selected to cover it. This option is activated when there is an entry in the box next to Monthly Limit of Indemnity on the declarations.

BUSINESS INCOME AGREED VALUE

This option suspends the coinsurance additional condition for 12 months or until the end of the policy period. This is subject to the named insured submitting a Business Income Report/Worksheet at the beginning of the policy period, each time the business income insurance limit changes, and at each 12-month anniversary of coverage. The named insured and the insurance company must agree on the appropriate limit of insurance based on the Business Income Report/Worksheet.

The estimated value developed on the worksheet must be multiplied by the coinsurance percentage. The limit of insurance selected must equal or be greater than that estimated value and must be shown on the declarations, along with the selected coinsurance percentage. The selected coinsurance percentage is triggered if the named insured violates any of this optional coverage’s provisions.

Example: Poppy’s Pop Sticks always completes the Business Income Report/Worksheet on time. Poppy submits the worksheet to the insurance company, both parties agree to the $80,000 limit, and coinsurance is suspended. The $50,000 loss that occurs in August is paid in full.

A penalty similar to a coinsurance penalty is calculated if the limit of insurance selected is less than the agreed amount. The limit is divided by the agreed value and the result multiplied by the actual loss.

This option is subject to a 10% rating surcharge and involves completing the Business Income Report/Worksheet annually. The difficulty in estimating revenues might make this option the best selection for many insureds. This option is triggered when the date of the last Business Income Report/Worksheet is entered on the declarations below the Agreed Value Optional Coverage.

UNDERWRITING

Insurance company profitability depends on writing coverage with adequate insurance to value. This allows the "law of large numbers" and statistics to operate more accurately and efficiently. While the first two options above encourage the named insured to not insure to value, substantial rate surcharges make up for the premium shortfall as a result of inadequate limits and act as stabilizing or leveling devices. The third alternative places more of a burden on the underwriter. The named insured submits a worksheet based on actual figures. It then estimates the corresponding figures for the upcoming year. The underwriter insures based on the figures for the upcoming year and must be aware of general trends in the economy and especially in the specific industry involved. It is also important to review worksheets from previous years to determine if the named insured tends to make accurate estimates. In addition, the requirement to provide a worksheet at least annually or each time the limit changes should never be waived.