By Jerome Trupin, CPCU and Arthur L. Flitner, CPCU, ARM, AIC

Sandy propelled insurance issues front and center. One issue was increased wind deductibles. In coastal areas exposed to hurricane-force winds, insurers have pushed for higher deductibles, ranging up to 5 percent for homeowners wind claims. In a storm like Sandy, a 5 percent deductible on all policies might reduce insurers’ paid losses by a billion dollars or more.

Hurricane Deductibles

Eighteen states and the District of Columbia have regulations dealing with hurricane deductibles.1 The governors of many of the affected states were quick to issue statements saying that the higher deductibles didn’t apply to . The insurance industry’s instinctive reaction was to groan, “There they go again,” but the regulators were on firm ground; they weren’t just jawboning.2 The three states that sustained the most damage from Sandy (New Jersey, New York, and Connecticut) are among those that regulate hurricane deductibles. Here’s a brief outline of the hurricane deductible regulations that apply in those three states:

• New Jersey: Applies to losses from a storm designated a hurricane by the National Weather Service but only if sustained winds speeds of 74 mph have been measured somewhere in the state.3

• New York: Applies to a category 1 hurricane (sustained winds of at least 74 miles per hour) or higher making landfall anywhere in New York as determined by the National Weather Service, or a hurricane making landfall outside the state but which is determined by the National Weather Service to have reached Category 1 or higher winds in the area within New York State in which the losses occur.4

• Connecticut: Applies when the National Weather Service declares a hurricane with winds of 74 miles per hour or more anywhere in Connecticut.5

Sandy, which is now ranked as the second most expensive storm to strike the , showed how tricky applying a deductible can be. In all three states, despite the devastation wrought by the storm, it wasn’t a category 1 storm when it made landfall or as it made its way through the state. Applying hurricane deductibles is not the only deductible issue. While other deductible issues won’t generate front page headlines, they can be challenging for property loss adjusters, and their effect on loss payments can be significant for policyholders.

Does Deductible Apply to the Loss or to the Limit?

The fictitious case that follows illustrates an issue that can arise when the amount of loss to covered property exceeds the limit of insurance: Does the deductible apply before, or after, application of the limit? If the deductible is subtracted after application of the limit, the deductible, in effect, reduces the limit.

Mechanical Engineers, Inc. (MEI) provides design/build services out of a building in suburban New Jersey in which it leases space. A fire originating in the restaurant on the floor below MEI’s office spread to MEI’s premises and caused a total loss of MEI’s property. MEI has a commercial property policy providing $1,000,000 business personal property coverage with a $10,000 deductible. The policy applies on a replacement cost basis with agreed value (suspension of coinsurance). The replacement cost of MEI’s damaged and destroyed property is $1,250,000.

In no event will the insurer pay more than the $1,000,000 policy limit for MEI’s contents. However, MEI’s loss settlement could be either $990,000 or $1,000,000, depending on how the deductible is applied. The deductible provision in the commercial property forms developed by Insurance Services Office, Inc. (ISO) anticipates this problem and clearly addresses it: “If the adjusted amount of loss is less than or equal to the Deductible, we will not pay for that loss. If the adjusted amount of loss exceeds the Deductible, we will then subtract the Deductible from the adjusted amount of loss, and will pay the resulting amount or the Limit of Insurance, whichever is less.”6 ISO businessowner forms contain a Deductible provision that is differently worded but has the same effect.

If MEI’s policy includes the ISO Deductible provision, the insurer will pay $1,000,000. (The amount of the loss in excess of the deductible exceeds the limit.) Other policies state that the insurer will pay the amount of the loss that exceeds the deductible, without clarifying that that amount will be paid up to the applicable limit. When that guidance is omitted, an insurer might reason that the “loss” is $1,000,000—the policy limit—and subtract the deductible after applying the limit, in which case the insurer would pay $990,000 for MEI’s loss. In effect, the insurer will have subtracted the deductible from the limit, not from the loss. Subtracting the deductible after applying the limit guarantees that the insured would never be able to collect the full limit, even when the loss exceeds the limit by more than the deductible.

An informal and unscientific survey of a number of adjusters indicates that applying the deductible to the loss, rather than to the limit, is the method used by most adjusters unless the policy specifically provides otherwise.

Can Losses to Separate Items Be Combined?

In another fictitious case, Charter High School’s campus is hit by a windstorm that damages three of its buildings. The repair costs are as shown:

Building 1: $3,500

Building 2: $4,000

Building 3: $4,500

The repair costs for all buildings total $12,000, and the school’s commercial property policy has a $5,000 per occurrence deductible. Assuming that each building is insured (on a replacement cost basis) for a separate limit that is sufficient to avoid a coinsurance penalty, how much will the insurer pay for this loss? Can the building losses be combined before applying the deductible? If so, the insurer would pay $7,000 ($12,000 minus the $5,000 deductible).

ISO commercial property forms state that when a loss involves damage to two or more specifically insured items (such as three buildings), the losses cannot be combined before applying the deductible.

Instead, the amount of loss to any one item must equal or exceed the deductible in order for the insured to collect for loss to any of the buildings. However, the deductible applies only once for each occurrence.

If its policy contained that provision, the school would not be able to collect anything because none of the individual building losses equaled or exceeded the deductible.7 If, instead, Building 3 had sustained a $5,500 loss, the insured could have collected $500 on Building 3 plus the $7,500 combined losses to Buildings 1 and 2.

Some policies do not contain such a provision, but simply state that the insurer will pay the part of the loss that exceeds the deductible amount. In this case, the adjuster can combine the losses to two or more specifically insured items and then pay the amount of loss that exceeds the deductible.

Finally, when multiple property items are insured on a blanket basis (one limit applying to all covered property), the current ISO form’s prohibition against combining losses to multiple items does not apply.

Does It Matter Which Item the Deductible is Subtracted From?

Does it matter whether the deductible is subtracted from one covered item instead of another? It might. For example consider this hypothetical case:

A commercial property policy covers two buildings. Both buildings are damaged in a single explosion.

Limit of Insurance – Building 1: $60,000

Limit of Insurance – Building 2: $80,000

Loss to Building 1: $60,100

Loss to Building 2: $90,000

Deductible: $250

If the deductible is applied to Building 1, the insured will collect $59,850 for the Building 1 loss and $80,000 for the Building 2 loss—total $139,850. If, instead, the deductible is applied to the Building 2 loss, the insured will collect $60,000 for the Building 1 loss and $80,000 for the Building 2 loss—total $140,000. In this case the insured is paid the full amount of insurance on Building 1 because the deductible is applied to the Building 2 loss. The full amount of insurance is also paid on Building 2 because the amount of the loss that exceeds the deductible is larger than the amount of insurance.8

The ISO Building and Personal Property Coverage Form (CP 00 10 06 07) uses this same example, applies the deductible to the Building 1 loss, and calculates the total amount of loss payable as $139,850. However, the coverage form contains no provision that would require the deductible to be applied to the Building 1 loss or prevent the adjuster from applying the deductible to the Building 2 loss. Therefore, the authors believe that the deductible can be applied to the Building 2 loss, in the manner described in the deductible provision, allowing the insured to recover $140,000 for the loss.

The same type of claim situation could occur under a homeowners policy when both the dwelling and personal property have been damaged in one occurrence. There too, the insured will benefit from applying the deductible to whichever item (building or personal property) exceeds the applicable limit of insurance, thereby allowing some or all of the deductible to be absorbed by the amount of loss in excess of the limit. In the case of a percentage windstorm deductible, the amount of the deductible could be significant. For example, a 5 percent deductible with a $300,000 Coverage A limit of insurance is $15,000.

Does Deductible Apply Before, or After, Coinsurance? At one time, commercial property forms didn’t say whether to subtract the deductible before or after you applied the coinsurance provision. Now, most forms contain a provision that makes this clear, although there’s a dramatic difference between the method specified in ISO forms and the one that AAIS (American Association of Insurance Services) forms call for.

The deductible provision in the ISO Building and Personal Property coverage form says, “…we will first reduce the amount of loss required by the Coinsurance Condition or the Agreed Value Optional Coverage.”

In contrast, the Building and Personal Property Coverage Part of the American Association of Insurance Services (AAIS) says, “The deductible applies to the loss before application of any coinsurance or reporting provision.”

To see why it matters, consider this hypothetical case: The insured suffers a $500,000 fire loss to its building. The building limit in the insured’s policy is $600,000.

The policy calls for replacement cost coverage, 80 percent coinsurance and a $10,000 deductible. The replacement cost value of all covered property immediately before the loss occurred was $1,500,000. Because the limit is less than 80 percent of the property’s value, the coinsurance provision must be applied. The resulting reduction of the collectible loss amount is often referred to as a coinsurance penalty. In the ISO form, the deductible is subtracted from the loss after the coinsurance penalty is applied, as shown:

– Step 1: $1,500,000 × 80% = $1,200,000;

– Step 2: $900,000 ÷ $1,200,000 = 0.75;

– Step 3: $500,000 × 0.75 = $375,000;

– Step 4: $375,000 – $10,000 = $365,000 payable by insurer;

Using the method described in the AAIS form, the coinsurance factor of 0.75 is calculated as in steps 1 and 2. However, the deductible is subtracted from the loss (step 3) before applying the coinsurance penalty to the amount of loss (step 4) as shown:

– Step 3: $500,000 – $10,000 = $490,000

– Step 4: $490,000 × 0.75 = $367,500 payable by insurer

Subtracting the deductible before applying the coinsurance penalty always results in a larger recovery for the insured, in this case an additional $2,500. The example shows the importance of checking the deductible provision to ascertain when the deductible is subtracted.

The resulting difference between the two approaches becomes more dramatic as either the amount of the deductible or the coinsurance penalty increase. For example, had the deductible been $25,000, the difference between the two methods would have been $6,250. If the amount of insurance had been $600,000 (which would make the coinsurance percentage in step 2 above .50 instead of .75) the difference would have been $5,000.

In summary, the most important advice to help you overcome the challenges of applying deductibles is to pay close attention to the wording of the deductible and coinsurance provisions in the particular policy.

1 The states are: Alabama, Connecticut, Delaware, Florida, Georgia, Hawaii, Louisiana, Maine, Maryland,

Massachusetts, Mississippi, New Jersey, New York, North Carolina, Rhode Island, South Carolina, Texas,

Virginia, and Washington, DC. Source: “Hurricane and Windstorm Deductibles,” Evans, Ewan & Brady

Insurance Agency, Inc., an excellent state-by-state analysis based on Virginia Bureau of Insurance and

Virginia Property Insurance Association information.

http://www.eebins.com/blog/hurricane_and_windstorm_deductibles.aspx

2 “Jawboning” is politely defined as “moral suasion,” but arm-twisting may be a more accurate description.

Prior to hurricane Irene, ’s hurricane-deductible regulations allowed insurers much more flexibility.

When Irene devastated his state, the governor asked insurance companies to voluntarily waive the

higher hurricane deductible. All the leading companies, except one, complied. “Homeowners Spared

Costly Hurricane Deductible.” MSN Money http://money.msn.com/saving-moneytips/

post.aspx?post=41b5e2ac-3a6c-45b3-9f17-392fcb0bae16

3 “Applicability of N.J.A.C. 11:2-42.7 to the Use of Hurricane Deductibles In Connection With Hurricane

Irene,” http://www.state.nj.us/dobi/bulletins/blt11_16.pdf

4 J. Wylie Donald, “A Tale of Two Deductibles: Post-Tropical Cyclone Sandy Is Not a Hurricane,” Climate

Lawyers Blog, http://climatelawyers.com/category/Legislation.aspx

5 “Hurricane Deductibles,” Connecticut Insurance Department Legislative Summary 2012, p. 31,

http://www.ct.gov/cid/lib/cid/2012_Year_End_Final_Report.pdf

7 It might be argued that the deductible is being applied three times, once to each building, and that the insured should therefore be able to collect $7,000.

8 It would be more dramatic with a larger deductible. A $5,000 deductible would produce a difference of $4,900 between the two methods.

The Challenges of Applying Deductibles

Jerry Trupin