THE MISADVENTURES OF ERNIE AND OLIVER: SPECIAL INTERESTS
E&O series continues with review of valuation and insureds
By Christopher W. Cook
It’s looking like trouble in paradise for Ernie and Oliver. Ernie, to say the least, is not very enlightened. One time while taking an oral exam, he forgot to speak. In high school, when taking effortful observational Scantron quizzes with the “Do not write in this space” section, he would enter “OK.” Oliver has earnestly observed numerous errors and omissions (that was a cheap one) on Ernie’s part. The name of a new client, Edward Olson, was misspelled, and his address existed on no map.
Agents should be familiar with the ordinances and laws relating to building codes in the locations where they write business so that they can help their clients who suffer a significant uncovered loss.
Oliver is starting to examine occupational pursuits other than insurance. Ernie and Oliver’s adventure appears to be heading for an ominous ending (they can be reversed, too).
How about some more E&O basics so you can avoid a similar fate?
Let’s start by talking about valuation—the process of determining the value of an item or property. The insurable value depends on the applicable valuation provision in the policy. This shows how the value will be determined and how the value is applied when settling claims. Valuation methods are:
- Replacement cost—the amount needed to repair or replace the property at today’s cost with no deduction for depreciation.
- Actual cash value—generally considered what it takes to replace at today’s cost less depreciation, but because it is not a defined term it can vary due to court interpretations.
- Functional replacement cost— the cost to repair or replace with property that will provide the same function as the damaged property. An example could be replacing an older or ornate building with one that is smaller and more in keeping with the current owner’s needs.
Coverage in an amount greater than the value of the property insured or the amount of loss sustainable by the insured is referred to as overinsurance. It’s less prevalent than underinsurance (we’ll get to that shortly) and may occur when it’s difficult to establish an exact insurable value.
Insurance in an amount that is insufficient to cover a loss—underinsurance—can be intentional or unintentional. In personal lines, many home owners assume that the limit should be consistent with market value due to its fluctuation. Since underinsurance costs less than insurance to value (ITV), home owners can be tempted to skimp in order to save.
When it comes to underinsurance, most losses are partial losses and are covered on a replacement cost basis subject to the ITV clause. If the amount of insurance is less than 80%, penalties are imposed; losses are paid on an actual cash value basis instead of replacement cost.
Here is the ITV clause in the ISO HO 00 03 ISO form:
- Buildings covered under Coverage A or B at replacement cost without deduction for depreciation, subject to the following:
a. If, at the time of loss, the amount of insurance in this policy on the damaged building is 80% or more of the full replacement cost of the building immediately before the loss, we will pay the cost to repair or replace, without deduction for depreciation, but no more than the least of the following amounts:
(1) The limit of liability under this policy that applies to the building;
- The replacement cost of that part of the building damaged with material of like kind and quality and for like use; or
- The necessary amount actually spent to repair or replace the damaged building. If the building is rebuilt at a new premises, the cost described in (2) above is limited to the cost which would have been incurred if the building had been built at the original premises.
- If, at the time of loss, the amount of insurance in this policy on the damaged building is less than 80% of the full replacement cost of the building immediately before the loss, we will pay the greater of the following amounts, but not more than the limit of liability under this policy that applies to the building: (1) The actual cash value of that part of the building damaged; or
- (2) That proportion of the cost to repair or replace, without deduction for depreciation, that part of the building damaged, which the total amount of insurance in this policy on the damaged building bears to 80% of the replacement cost of the building.
- To determine the amount of insurance required to equal 80% of the full replacement cost of the building immediately before the loss, do not include the value of:
- Excavations, footings, foundations, piers, or any other structures or devices that support all or part of the building, which are below the undersurface of the lowest basement floor;
- Those supports described in (1) above which are below the surface of the ground inside the foundation walls, if there is no basement; and
- (3) Underground flues, pipes, wiring and drains.
Commercial property policies contain a coinsurance clause that requires the insured to maintain insurance at least equal to a stipulated percentage of the value in order to collect partial losses in full. The basic rating contemplates 80% coinsurance, which can be increased to 90% or 100%. The insured receives additional rate discounts for higher percentages.
The coinsurance clause in the ISO CP 00 10–Building and Personal Property Coverage Form states:
If a Coinsurance percentage is shown in the Declarations, the following condition applies:
- We will not pay the full amount of any loss if the value of Covered Property at the time of loss times the Coinsurance percentage shown for it in the Declarations is greater than the Limit of Insurance for the property. Instead, we will determine the most we will pay using the following steps:
- Multiply the value of Covered Property at the time of loss by the Coinsurance percentage;
- Divide the Limit of Insurance of the property by the figure determined in Step (1);
- Multiply the total amount of loss, before the application of any deductible, by the figure determined in Step (2); and
- Subtract the deductible from the figure determined in Step (3). We will pay the amount determined in Step (4) or the Limit of Insurance, whichever is less. For the remainder, you will either have to rely on other insurance or absorb the loss yourself.
Let’s talk about the advantages of insurance to value. For insurers, these include more accurate premiums, more funds to pay losses, reduced loss ratios, and maintenance of adequate limits to support losses.
At the same time, the insured can benefit from peace of mind and full recovery from losses. Most insurers encourage the use of ITV and may provide tools to help agents estimate replacement cost values; these values should be monitored and updated regularly.
Several factors can affect the insurable value of a structure. Some factors are covered by insurance and some are not. Construction type, square footage along with local material and labor costs are examples of insurable factors. The market value and changing building codes and ordinances are examples of factors that are not considered in determining valuation unless the policy is endorsed to do so.
Building code changes can pose a significant problem to a commercial client. Some codes require that when significant damage occurs to a building that it be upgraded to current building codes. The codes may even require that the undamaged portion of a building be torn down and rebuilt to those current codes. Some building codes may actually prevent an existing occupancy from rebuilding at its current location. None of these building code cost increases are covered under the standard property form but the good news is that endorsements are available to provide the coverage when needed. Agents should be familiar with the ordinances and laws relating to building codes in the locations where they write business so that they can help their clients who suffer a significant uncovered loss.
We briefly touched on insureds in a previous installment, and we’re going to end this one with some additional information about named insureds and additional insureds as used in a commercial policy.
A named insured is the individual or business shown in the policy declarations as the insured. Throughout the policy, the words “you” and “your” are used when referring to the named insured. When more than one named insured appears, the one listed first on the declarations page is commonly referred to as the first named insured. Makes sense, doesn’t it?
The first named insured, the last named insured, and all the insureds in between have identical coverage. However, the first named insured has specifically assigned duties and obligations related to policy management. The first named insured is responsible for premium payment including providing needed information in audit situations. They also have the right to request policy cancellation and are the only one notified when the insurer cancels the policy. All return premiums are sent only to the first named insured. Double check your clients’ policies to make sure the named insureds are listed in the correct order and also make sure that all named insureds realize that only one of them is in control of the policy.
Other individuals or organizations can have insured status based on their relationship with the named insured. Examples in the commercial liability policy include:
- Partners of a named insured
- Members of a named insured’s joint venture
- Officers, directors or stockholders of a named insured
- Employees or volunteers of a named insured’s corporation; exceptions may apply
- Organizations formed or acquired by a named insured for a limited time
- Legal representative of a named insured in the event of death
- Real estate managers of a named insured
- Any entity added to the policy as an insured by endorsement
It is always important to review the parts of the policy and endorsements that explain exactly who is an insured because while some coverage is provided, there are many limitations. The most important item to remember is that coverage for such an insured is generally not freestanding and requires that any loss be related to the named insured’s business activities.
Another type of insured is called an additional insured and is added by endorsement. Contractual obligations are the primary reason for these endorsements, often found in leases, rental contracts, franchise relationships, and construction projects to name a few. The contracts may even spell out the exact wording required in the additional insured endorsement. This can result in conflicts because the required wording may no longer be available under standard forms.
Here are some reasons an individual or business may want to become an additional insured:
Enforce coverage obligations in a contract. An indemnitee, an individual or party who is being released from liability or who is being protected by the indemnitor, the party agreeing to be responsible for the other party’s liability, wants protection that is guaranteed in the contract. The additional insured endorsement provides that protection even if the other parts of the hold harmless agreements in the contract are unenforceable. Some courts have upheld an individual’s right to directly recover as an additional insured when certain elements of a loss were not allowed under the contract.
Direct right to a defense. Many contracts require that the indemnitor must provide for the defense of the indemnitee. As an additional insured, the indemnitee is entitled to a defense and, under specified circumstances, those defense costs may be covered outside the limits of insurance.
Personal injury coverage. Additional insured status is generally not restricted to only bodily injury or property damage losses. Obligations for personal and advertising injury losses are therefore also covered.
A final note: Under a homeowners policy, the named insured and the named insured’s spouse are considered “you” but only when the spouse resides in the same household as the named insured. This little provision can result in a considerable problem if a couple separates and the insurance agent is not notified. A good suggestion is to always name both spouses as insureds.
Ideally, this E&O information is coming in handy, or at least is providing a good review. Things are currently looking grim for Ernie and Oliver’s agency. Tune in next time for the exciting omega.