A Wakeup Call on Disaster Insurance

With so many disasters in the news these days—tornadoes in Florida, floods and mud slides in California, ice storms and power outages in Canada—one might expect business owners to keep their property and casualty policies up to speed. In my experience, however, many owners are lax about making sure that they have proper coverage.

I see mistakes made both by agents and business owners that seriously undermine the point of property insurance. Some people just don't believe it's worth their time to review their insurance coverage. Many a business has been undone by the owner's inattention to important details of coverage, and below I describe several examples of closely held family companies that learned this lesson the hard way.

So how can you determine whether your property coverage actually provides the protection you expect? At a minimum, you should look into the following policy endorsements or modifications. You should press your agent to tell you whether you have these coverages, and if not, why not. Proper protection, like the devil, is in the details.

Insuring for replacement

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Insurance valuations of real property (buildings and other structures) bear no relationship to market real estate values. Yet many business owners mistakenly insure their buildings for their market values. A good agent will insist upon insuring the building for its full replacement cost or for actual cash value—which is full replacement cost less depreciation. Remember, the value of land is not insurable; therefore it is not included in the valuation.

Problem: A heavy machinery manufacturer had not revised the replacement-cost values on its complex of buildings in many years. When a fire partially damaged one of its buildings, the company was surprised to learn that although the damage was well beneath the limit of insurance, it was reimbursed for only 60 percent of its loss.

That's because the replacement costs of its buildings at the time of the fire were below its policy's 80 percent coinsurance requirement. In almost all property insurance contracts, there is a coinsurance clause stipulating that if you don't insure your property for at least 80 percent of its value, then in case of a partial loss, you will suffer a penalty in the form of only partial reimbursement..

The amount reimbursed will equal the amount of the partial loss multiplied by a fraction. The numerator of the fraction is the limit of the insurance actually carried on the property, and the denominator is usually 80 percent of the full value of the property as of the date of loss. Thus if a fire causes $200,000 worth of damage and you carry only $600,000 of insurance the insurer would pay only $150,000 ($600,000 divided by $800,000, times $200,000), and the insured would have to pay the remaining $50,000. To avoid the coinsurance penalty for partial losses, you would have to carry $800,000 if the building would cost $1 million to replace.

Solution: The valuation you place on your buildings must be carefully considered in order to avoid being penalized when claims are settled. There are important reasons to hire an engineer to appraise the existing structures so there are no discrepancies when claims are made.

You and your property insurer must agree on the value of your buildings. The agreed-value endorsement allows you to have the policy's coinsurance clause suspended. You simply sign and date a property valuation form. If the insurer finds it reasonable, it will then suspend the coinsurance clause and you will be protected against any hike in the property's replacement cost until the next policy anniversary date.

Updating the value of machinery

Another common error is to fail to update replacement values on your machinery or equipment every few years. If your machines are antiquated and can only be replaced by a more expensive new generation, they may not be adequately covered. Likewise, if you don't keep an up-to-date inventory of equipment and contents, you may find that the cost of replacing it exceeds your coverage.

Problem: A specialty fabric manufacturer had a fire in its print shop, destroying its old, highly customized printing machines. Although the company had replacement-cost coverage, it received only 50 percent of the costs of buying new equipment. The machines were so old they could not actually be replaced with anything similar. They had to be replaced by a whole new generation of computerized equipment. When antiquated machinery is destroyed, however, an insurer will not pay to replace it with modern equipment. This came as a great surprise to the fabric manufacturer.

Solution: You can purchase an item in your policy called the functional replacement-cost endorsement. It provides that if outdated machinery is destroyed in a catastrophe, the insurer will pay to replace it with the new generation.

Insuring for loss of income

Businesses often do not adequately estimate and insure the income that might be lost in a disaster.

Problem: A large plastics manufacturer was growing rapidly but did not properly update the business income projections on its insurance policy. The company also failed to secure the agreed-value endorsement to suspend the coinsurance clause on its business income coverage. After a severe fire, there was no problem in getting the insurer to pay for repair and replacement of its damaged buildings and machinery. But for the month the business was shut down, the insurance settlement was $350,000 less than the company's actual loss of income and continuing expenses.

Solution: Project your income correctly for business-interruption coverage. You need records, kept off site, that accurately show your net income as well as costs that will continue after a business shutdown and those that will cease. Submitting a properly updated business-income worksheet and securing the agreed-value endorsement as part of the business-interruption coverage would have solved this problem. You will also find that the accounting terminology used by the insurance industry is unique. Therefore, both the insured's accountant and its insurance agent should be involved in preparing business income projections.

Costs of business interruptions

Even business owners who do accurately estimate their business income and buy interruption insurance often fail to realize that coverage under the policy ceases soon after the physical damage has been fixed.

Problem: A retailer of high-fashion clothing had a devastating fire that destroyed its building along with everything inside. Under the company's standard policy, business-interruption coverage ceased 30 days after the insurer fixed all of the damaged property. Since this was a highly seasonal business, it took a year for the company to regain its lost customers, during which time it was not reimbursed for the lost income.

Solution: Consider adding an extended period of indemnity of up to 365 days to your business-income coverage, to replace lost income during the time between when the physical damage is fixed and when your sales return to normal levels. Standard business-interruption policies continue to cover loss of income for only an additional 30 days after the damaged property is repaired or replaced.

Power disruptions

What happens when your business is rocked by disruptions in vital off-premises services?

Problem: At a metals heat-treating company, an interruption of electrical power to the main oven disturbed the process of hardening very delicate, customized metal parts. The power interruption, caused by storm damage to an off-premises transformer, ruined the parts. Since the insured did not have off-premises direct-damage coverage, it was solely responsible for the $800,000 of ruined property in the oven, which belonged to a high technology customer. Nor was it reimbursed for its lost income during the time the power was out.

Solution: Interruption of off-premises services such as electricity, water, and telecommunications links can be insured for both property damage and loss of income. Some insurers will provide off-premises direct-damage and time-element coverage for no additional premium if the insured or its agent simply asks for it.

Machine disasters

What happens if your boiler or other machinery blows up or malfunctions, closing your business?

Problem: A hotel's boiler, fired by natural gas, ignited and exploded, blowing out the main building's roof and walls and damaging everything inside. Luckily, it was off-season and no one was in the building at the time. However, the owner's property insurance didn't cover the loss.

Solution: A boiler malfunction or explosion that damages your premises doesn't fall under either your property or liability coverage, but requires a boiler and machinery policy. Most business owners have no idea this is the case. Take out a boiler and machinery policy with coverage to your full property limits.

Damage to product

Manufacturers who want to be properly reimbursed for damage to their products should purchase the manufacturer's selling price endorsement.

Problem: A fire in a shoe manufacturing plant totally destroyed its inventory of boat shoes. For shoes that were not actually sold as of the date of the fire, the company was reimbursed only for the cost of manufacture, rather than for the full selling price. Since most of the inventory was not sold, the company was forced to absorb its 30 percent markup, and thus lost its potential profit on the shoes.

Solution: Be sure to include the manufacturer's selling price endorsement in your policy. It reimburses you for the full selling price on all finished goods that are destroyed, even if they have not been sold.

Complying with building codes

If your buildings are not new, coverage that pays the extra costs of replacing them because of today's more stringent safety codes is essential.

Problem: A leather manufacturer's turn-of-the-century building was partially damaged in a hurricane, but it had to be demolished and rebuilt according to current local building codes. The insurer reimbursed the manufacturer for only what it would have cost to repair the damaged section with construction of a like kind and quality. That meant the manufacturer had to pay for razing the undamaged portion of the building, and for replacing both the damaged and undamaged portions in accord with new building codes. The insured company was thus reimbursed for only 20 percent of its costs.

Solution: If your buildings are more than just a few years old, make sure you have the ordinance or law endorsement. It will cover the costs of restoring them in a form that complies with local safety ordinances.

Computer losses

In today's high-tech era, electronic data processing equipment needs special coverage to be protected.

Problem: Lightning damaged the computer system of a hospital billing service. This caused a major disruption of its computerized services that took three months to fully correct. Unfortunately, the basic business-interruption policy paid for loss of business income due to a disruption for only 30 days. Since it took three months for the company to return to normal operations, two months of income were lost.

Solution: Electronic data processing coverage reimburses you for losses unique to electronic apparatus, such as from artificially generated currents, sabotage, or breakdown. It provides the full cost of replacing lost hardware and software as well as losses of business income from disruptions in service.

Supplier and customer losses

Be prepared for a loss of business income due to a disaster suffered by a supplier or customer.

Problem: A fabric manufacturer that obtained 90 percent of its raw material from one supplier was forced to close its production line after that supplier had a major fire. Although the fabric company had business-interruption coverage for its own facility, it did not have contingent business-interruption insurance for stoppages in the flow of raw materials from suppliers. It thus had to absorb the loss of business until the supplier was able to resume normal deliveries. A manufacturer can be hit with similar losses if a disaster prevents a customer from buying its finished product.

Solution: Consider contingent business-interruption coverage so you are protected from the business interruptions of others.

Debris removal

You may need to have significant debris removed. It's one thing to insure your building for the costs of rebuilding it. But demolition debris removal may add heavily to those costs.

Problem: A food processor's building was destroyed by a fire. Due to its location and construction, the costs of removing debris and rubble far exceeded the policy's limit on the costs of debris removal. Because of its remote location and the difficulty associated with the type of rubble, the insured was forced to pay $600,000 out of pocket for removing it.

Solution: The company could have saved the $600,000 with an endorsement to cover debris removal for a customized amount based on a worst-case scenario. Insurance companies try to limit their maximum liability for particularly costly claims such as debris removal. Most property policies cover debris removal only for a lower sublimit of the full policy limit. That may prove inadequate for your needs. Insist on a higher customized amount.

Earthquakes and floods

Specific policy endorsements for insuring your business against earthquakes and floods are relatively inexpensive, considering the possible costs from such catastrophes. Many business owners in New England, for example, are shocked to learn that they are in earthquake zones. You can locate your business flood zone by visiting your city hall and examining a local flood map.

Problem: A futon manufacturer's inventory of cotton batting was destroyed when overflowing waters from a nearby river flooded its basement. The company had no flood insurance; thus it had to dispose of the ruined inventory and buy new stock at its own expense. The lost income and property damage amounted to more than $200,000.

Solution: Flood coverage could have been added to the existing policy for about $1,000 more per year.

Emerging whole

Now let's look at the case of a family owned business that saw its plant destroyed in a major fire but was able to emerge whole from the disaster because it had proper coverage. Fortunately, the owner had updated his property insurance just six months earlier to cover the entire loss.

The company is a textile manufacturer in Massachusetts that is one of the largest employers in its town, with 250 workers and annual sales of $200 million. The current owner purchased the company in 1988 when it was spun off from its former corporate owner. It has experienced explosive growth in the 10 years since then, with major customers such as Cannon, DuPont, and 3M.

The plant was in a 180,000 square-foot masonry building constructed in the late 1950s. On a Sunday night in the winter of 1996, a smoky, choking four-alarm fire roared through the plant, causing extensive damage to the building, machinery, and inventory. The next day, the owner and his insurance consultant surveyed the damage. The total loss was estimated at $5.5 million.

The company was able to survive the disaster because of the endorsements that were added to improve the old policy. Under the original policy, the building had been undervalued and did not have the agreed-value endorsement. By updating the building valuation and adding the agreed-value endorsement, the insured escaped having to suffer an extensive coinsurance penalty.

The new policy had also been endorsed to provide functional replacement cost on machinery and equipment, enabling the firm to buy the proper modern replacement machinery. At the insurance agent's request, the company had hired an engineer to estimate the cost of replacing each machine with one using current technology; those amounts were added to the coverage.

Although the company had been growing rapidly, the business-income worksheets upon which the business-interruption coverage was based had not been filled out correctly and lacked the agreed-value endorsement. The new agent had carefully crafted the business-interruption coverage to account for the ever-increasing growth, thereby securing the agreed-value endorsement. Thus, the company was not hurt by having insufficient business-interruption coverage. The agent had also added a 180-day extended-period indemnity, so that the company continued to be reimbursed for its loss of business income for six months after its building and contents had been replaced.

Before the policy review, the company would have received only its cost of manufacture for unsold finished goods. But the new policy had the manufacturer's selling price endorsement, which meant that it received the full markup on destroyed finished goods that were not sold at the time of the fire.

The company had also obtained an endorsement for ordinance or law coverage, and was thus reimbursed for the cost of rebuilding under today's more stringent codes. The codes required wiring, plumbing, and construction upgrades at costs significantly higher than for simply replacing the original construction.

Unrelated to the fire, but coincidentally within a few months of it, a major raw material supplier also had a fire that interrupted delivery of necessary materials to the textile manufacturer. The textile company's old policy did not have contingent business-interruption coverage for suppliers, but the new policy did. The company thus received its business income for the month in which supplies were interrupted.

Within two weeks of the textile company fire, the plant was producing at 80 percent of capacity, thanks to the extraordinary efforts of the insurer and the contingency plans worked out between the agent and management. Temporary offices were set up in the offices of the town's mayor. Business was back to normal, with only minor inconveniences due to completion of construction. The business-interruption coverage paid employees for the two weeks they were out of work. During the claim settlement process, all money was advanced, so there was never a shortage of funds to pay for the construction and reinstallation of machinery.

The entire $5.5 million loss was covered by the new policy, minus a $25,000 deductible. Had the policy not been updated and amended, the company would have been reimbursed for only $3.5 million. Because the owner had updated his coverage, the company was able to quickly recover from a catastrophe and continue enjoying phenomenal growth. Obviously, when it comes to property insurance, it pays to update your policy and pay attention to the details.

Michael A. Lusardi is an independent insurance consultant and broker in Sutton, MA. He is also editor and a principal of The Burnham System, a Massachusetts-based publisher of insurance educational material. He is one of only 20 people in the United States to have earned nine prestigious insurance designations.

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