The most frequent question producers ask me concerns how to set the amount of insurance for business income coverage. Here’s one from a NYC producer: “We are insuring a condo association of 50 units… If total annual maintenance fees amount to $250,000 for all units combined, would you suggest that we write the [Business Income] policy with a limit of $250,000 (assuming 100% co-ins) for the condo association?”

The Good News: Setting business income insurance amounts is easier for habitational property owners than for most other businesses. Fewer expenses discontinue in the event of a loss and there’s little seasonal variation in income. Furthermore, an increase in income is much easier to predict than for most other businesses. The Bad News: It still requires some work.

One hundred percent coinsurance is the common choice for multi-family dwellings—it’s often what mortgagees require. It’s not a bad choice, but it may not be the best. You should encourage the insured to consider its exposures and look at the alternatives.1 There may be a solution that will avoid problems when the loss occurs.

To start, have the insured estimate how long it would take to restore the building after the worst possible loss. One of our clients recently had serious fire damage in one of its buildings. The fire damaged 31 of the 80 apartments. It took 10 months to complete the repairs and move the tenants back in. He felt that the reconstruction had gone very smoothly; that won’t always happen. And as extensive as the damage was, it was far from a total loss to the building.

Total losses are rare, but they do hap-pen. Other than small residential or commercial properties, I’ve had only two total losses in my career, but I’ve had a good number that were worse than 31 out of 80 apartments.

The classic underestimate of fire dam- age potential was a fire a number of years ago in a high-rise Center City Philadelphia office building that resulted in a total loss to the building. That’s not supposed to happen. Because it was a fire-resistive building, the insurer’s guidelines called for reinsurance based on the cost to restore six floors, not the entire building. The underwriter purchased facultative reinsurance accordingly.2 Big mistake; the loss was many times the amount of reinsurance. (Surprising insurance connection: The fire originated in the offices of a reinsurance firm that was having its floors refinished.)

As hard as it is to estimate the maxi- mum possible damage for property insurance, it’s harder to estimate the time needed to restore facilities for business income insurance.

Encourage clients to ask an architect or contractor for an estimate of how long it would take to rebuild after a catastrophic loss. Don’t overlook potential problems such as planning, zoning, building permits, special-order items, etc. And remember that ordinance or law coverage is just as necessary to business income as for direct damage. Add the time needed to bring the building up to current codes. Coverage tip: If building ordinances require the insured to install a substantial upgrade in order to obtain a building permit for the repairs, the period of restoration will increase, but the policy coverage for the business income restoration period remains the same unless the policy is endorsed. (ISO has an endorsement for that purpose: CP 15 31 10 12 Ordinance or Law – Increased Period of Restoration.)

Once the insured has estimated the maximum period of restoration (MPR), the time needed in the worst case situation, to restore the building and move the tenants back in, then the total possible income loss can be estimated. Since coverage for a loss that occurs during the pol- icy period doesn’t end with policy expiration, if rents are expected to increase, assume that the loss occurs on the last day of the policy period. Calculate the gross loss of income accordingly for the MPR.

From that total, deduct any expenses?that will definitely discontinue during the?period of restoration and add anticipated?extra expense to expedite restoration.3 That should be a workable estimate of the insured’s maximum possible loss; it’s the minimum amount of insurance needed.4?While BOP policies with 12 months of unlimited business income coverage seem?to avoid this problem, the 12-month time?limit can be bad new for some insureds. ?It’s not unusual for restoration of a severely damaged building to drag on for 18 months or more.

The questioner is asking about a policy?that is subject to coinsurance, so there’s another calculation required. The insured?has to select a coinsurance percentage and?an amount of insurance adequate to com-?ply with coinsurance. ISO offers a range?of coinsurance percentages from 50% to?125%. Here’s my suggestion for a way to?select the coinsurance percentage and the?amount of insurance.

Calculate the coinsurance basis. That’s the amount to which the coinsurance percentage will be applied. It’s not the same as the maximum possible loss since not all expenses that may discontinue are excluded from the coinsurance basis and it covers the entire twelve- month period starting with policy inception, not the estimated restoration period.

For condos and rental properties, the total annual rent roll can be used as the coinsurance basis. The items that the policy permits to be deducted in computing the coinsurance basis, including the one that’s the largest for many insureds, cost of goods sold, don’t apply to condos and rental properties.

Divide the maximum anticipated business income exposure by the coinsurance basis.

Select the next higher coinsurance percentage. For example, if the result in step 2 is .37, select 50% coinsurance. If it’s .53, select 60% coinsurance and so forth. If the result is equal to or more than 1.25, select 125% as that’s the highest coinsurance ISO provides.

The amount of insurance should equal the coinsurance percentage times the coin- surance basis or the estimated maximum possible loss, whichever is greater.

If the insured won’t go through the process, point out the possibility of a severe loss and quote the cost for an amount of insurance equal to the annual rent roll using 100 percent coinsurance rate, and 1.25 times the annual rent roll using 125 percent coinsurance rate. Let the insured choose the limit it feels will be adequate.

In all cases, you want the agreed amount option (coinsurance waiver) to be part of the policy. It’s easier to obtain for business income insurance for condos and other rental property since the insurance company will probably just want to know the annual rent roll to determine if the amount is adequate. Much more information is needed for other businesses.

Selecting a Business Income Amount of Insurance is Much More Difficult for Other Businesses

As complex as setting an amount of insurance for a condo may sound, it really isn’t that hard after you’ve done it once or twice. It’s more difficult for other businesses, particularly those that have seasonal variation or costs of goods sold calculations.

For firms with seasonal variations in operations, such as retailers who frequently do as much as 70% of their business in the final quarter of the year, monthly calculations are vital. If there’s any meaningful variation month-to-month, here’s my recommendation:

Have the insured estimate operating revenues for the MPR on a month- by-month basis. As pointed out for condos, if revenues are expected to grow, increase the estimate accordingly.

Have the insured estimate expenses that won’t continue in the event of an interruption (again adjusting for any expected changes if the MPR starts at the end of the policy period).

Because well-run midsize or larger businesses do monthly projections for at least one year into the future—most do it for a longer period—steps 1 and 2 should not be an onerous task for the CFO or controller. But even if the insured just uses the current year’s figures and projects them into the future on a simple percentage basis to account for expected changes, the result will be more accurate simply using the current figures.

Subtract expenses that would not continue during a suspension of operations from estimated operating revenues on a month-by-month basis. This will give estimated business income exposure by the month.

Because many businesses have seasonal variations, select the period containing the number of months equal to the MPR that produces the highest total business income expo- sure no matter when it starts during the policy term.

Add the insured’s estimate of extra expenses that would be incurred during the selected period.

Add the insured’s estimate of anticipated business income loss during the period needed to rebuild business after the property is restored. (ISO business income forms include 30 days of this extended coverage. This can be extended to two years in ISO forms. Some independent forms provide longer coverage or even no time limit on this extension.)

The total of lines5, 6 and 7 is the amount of insurance the insured should carry.

There are many uncertainties involved in calculating business income exposure— how long will it take to restore operations, what will continuing expenses amount to, how much extra expense will be incurred, etc. The insured might want to carry a higher amount of insurance to provide a margin of safety.

Because the business income coinsurance excludable items rarely, if ever, factor into business income calculations for con- dos and rental properties, I disregarded them in answering the question about a condo. Other businesses are not so lucky. Here are the items that can be deducted in determining the coinsurance basis that they’ll need to calculate:

For retail and wholesale operations, Cost of Goods Sold,
Cost of services purchased from out- siders (not the insured’s employees) to resell that do not continue under contract

,?• Outgoing Prepaid Freight,

Returns & Allowances,
Discounts,
Bad Debts, and
Collection Expenses.

Endorsements are available to eliminate or modify coverage for ordinary payroll and power, heat and refrigeration expenses. For some insureds, incorporating these endorsements can lower their coinsurance basis and premium without sacrificing meaningful coverage.

Many expenses that may discontinue are not excluded in calculating the coinsurance basis. That’s why some firms’ maxi- mum possible loss is far less than their coinsurance basis. (That’s seldom true for condos and rental properties.) For more details, see the ISO form CP 15 15 10 12 Business Income Report/Worksheet.

Don’t attempt to do the cost of goods sold calculations called for by the work- sheet. The insured’s CFO or accountant should complete the worksheet. You should point out a possible snag for a firm with manufacturing operations. ISO uses the term “cost of goods sold” differently than accountants in one respect. In accounting practice cost of goods sold includes factory labor. ISO excludes factory labor costs in its calculation of cost of goods sold. You’ll want to alert the CFO or accountant to that trap. It’s a way to help your insured even though you’re not an accountant.

Telephone Toll Fraud

A client calls saying that she’s received a $500,000 bill from the phone company for unauthorized charges and the phone company refuses to waive the charges. She wants to know what coverage her firm has.

That’s apparently what happened to the producer for a school district. The producer submitted the claim to the district’s property, crime, and cyber liability insurers. Coverage for the loss was declined by all three.5 What can a producer do?

Is there any coverage available for such a loss? Yes. ISO has an endorsement for its crime form to provide some coverage for losses of this type, CR 04 16 08 13 Telephone Toll Fraud. It will pay for loss from long distance telephone toll call charges incurred by the insured resulting directly from fraudulent use of an account code or system password to gain access to the insured’s voice computer system. The insured’s system must have:

A call disconnect feature to terminate a caller’s access after three unsuccessful attempts to enter an account code, and
System passwords that the insured changes regularly as required by the insurer.

You should tell your clients about this exposure and the available coverage—the losses can be substantial.

The requirements in the ISO form worry me. If you offer ISO-type coverage, be sure the insured understands the requirements. There are insurers that do not limit the coverage in that way. What’s more, two of our clients have been offered the better coverage at no additional premium. You always look good when you can get some- thing for free for your clients.

Business Income—Purchase Adequate Limits Whether or not Coinsurance Applies; Telephone Toll Fraud

Jerry Trupin