Risk Management

Bye-bye agreed value?

With the margin clause option on the horizon, agents need to begin doing their homework

By Donald S. Malecki, CPCU

It will not be long before property insurance written on a blanket and agreed amount basis will be only a memory of a device by which insurance buyers capitalized on their coverage at a cost savings.

The Insurance Services Office is introducing a “Blanket Insurance—Margin Clause Option” endorsement for implementation in most jurisdictions effective in August 2008. The margin clause currently is being used sparingly by some insurers, but that is going to change—and a lot sooner than ISO’s filing is approved.

It has taken some insurance buyers a long time to learn that purchasing one amount of insurance available for loss to buildings or structures and/or business personal property at any included location is a good thing, particularly when an agreed value clause sets aside the limiting effect of a coinsurance clause.

The way blanket property insurance developed over the years could be said to resemble the so-called “first loss insurance” concept, which also is history. Property insurance was purchased for a limit that realistically represented the maximum probable loss at any one or more locations during any one policy year.

The caveat with this concept was that there had to be some prearranged agreement with the insurer for a reinstatement of the insurance amount. It would also have been beneficial to have an automatic reinstatement of limit so that simultaneous losses, each exhausting the limit, as in a hurricane, flood or earthquake, would all be covered on payment of successive reinstatement fees.

Demise of the blanket concept

For some insurers and reinsurers, the problem with blanket insurance on an agreed amount basis, and probably the first-loss insurance concept too, is that the premium is not commensurate with the risk.

An underwriter, in explaining his company’s rationale for adding a margin clause, stated that after large losses—involving hurricanes and other events and even following the destruction of September 11, 2001—insurers found that many properties were underinsured, but insureds were still able to capitalize on recoveries without being penalized.

Consider this example: A policy is written for a blanket limit of $2 million on two buildings with no coinsurance penalty, and includes a statement of value representing that the replacement cost of each building is $1 million. If one of the buildings is destroyed and it costs $2 million to replace it, the insured can collect the $2 million even though the insured purchased only $1 million of overage on that building.

The company’s fallacious rationale is that the insured actually purchased $2 million of coverage, so why not give the insured the coverage it purchased? Underwriters could avoid this situation by (1) requiring appraisals of real property from certified professionals every five years or so, instead of permitting insurance agents/brokers to calculate estimates based on square footage or other measures; and (2) being more discretionary in issuing the agreed value (formerly known as the agreed amount) provision.

When the agreed value provision is applicable, it in effect suspends the coinsurance clause, which otherwise requires an insured to purchase coverage on its property to a certain specified percentage of its full value ranging from 80% to 100%. (When blanket coverage applies, 90% is mandatory.)

Absent the agreed value provision, if, at the time of loss, it is determined that the amount of insurance is less than the limit required by the coinsurance clause for all locations, the insured is penalized or considered to be coinsured (partners with the insurer). The reason is that the insured will be required to share its proportion of the insurance deficiency.

Avoiding a penalty is one of two incentives for complying with the coinsurance clause. The other incentive is that a rate credit is available when insurance is at or above the required coinsurance percentage of value.

Insurance buyers have come to learn that the agreed value provision is a good thing to have so as to maximize the amount of insurance payable in the event of loss. It also avoids having to understand the mechanics of coinsurance, which remains an enigma to many people.

In fact, nothing could encourage more insurance buyers to take advantage of the agreed value provision than the approach taken by ISO with its Building and Personal Property Coverage Form CP 00 10, where agreed value is a coverage option. All it takes to activate it is a designation in the property declarations.

Another string attached

After going through the entire exercise of obtaining property valuations, completing a statement of values, and assuming that blanket coverage applies without a coinsurance penalty, insurance buyers will likely be surprised to learn that another string is attached to the insurance requirement: the blanket insurance—margin clause option.

This margin clause, although being introduced as an optional endorsement, is likely to be found on most property policies, barring the larger highly protected risk (HPR) where more underwriting and engineering control exists.

The way the proposed ISO endorsement is set up, the loss payment on an individual property under the blanket will be limited to its stated value, plus a percentage of that value (or margin). In other words, the maximum amount payable after loss will be determined by applying the margin clause percentage, as indicated in the endorsement, to the value of the property shown in the latest statement of values on file with the insurer.

This endorsement also provides that if the statement of values does not reflect individually the value of each building and the value of contents of each building or premises, the insurer will determine the individual values as a part of the total values prior to application of the margin clause.

The newly proposed standard endorsement states that actual loss payment will be based on the amount of loss or damage, subject to all applicable policy provisions, including the limits of insurance, coinsurance, deductible and valuation conditions. Although not mentioned, it also includes optional coverage, such as the agreed value provision. The margin can vary by location and type of property, but does not increase the blanket limit.

Here is an example of the mechanics of the margin clause. In this example there are three buildings subject to a blanket limit of $4 million and the combined value of the three buildings at the time of loss is $5 million. The margin is 120%; the blanket is underinsured and subject to a coinsurance penalty.

Given that blanket insurance is subject to a 90% coinsurance clause, the blanket limit is short $500,000, meaning the named insured is a coinsured.

Building #1, with a stated value of $1 million, is destroyed. Following the loss it is determined that the actual value of that building was $1.2 million.

The amount payable is determined as follows:

(1) The blanket limit of $4 million is divided by $4.5 million, the amount required by the 90% coinsurance clause. The result is a coinsurance penalty factor of .889.

(2) The amount of loss—$1.2 million—is multiplied by the above coinsurance penalty factor. The result, $1,066,800, is the adjusted amount of loss.

(3) From the above result of $1,066,800 is deducted $10,000, which is the applicable deductible.

(4) The result is $1,056,800, which is the amount payable. The remainder of $143, 200 represents the coinsurance penalty and deductible to be assumed by the insured.

With the Building and Personal Property Coverage Form offering the agreed value option, it may be advisable to select it in order to offset any coinsurance penalty that might otherwise exist.

Conclusion

It will be interesting to note how many insurers will implement this proposed margin clause. Chances are that it may become quite prevalent in light of reinsurance pressures. In fact, this approach might still be better than covering property on a scheduled basis.

If one were to look at the historic development of blanket property insurance, long before the agreed amount (now agreed value) provision was introduced, one would note that there were various precautionary measures to prevent the practices that now are in vogue to maximize insurance at the lowest possible cost.

Why these old methods were eliminated is anyone’s guess—probably attributable to competition. Whether competition will affect the margin clause remains to be seen. In the meantime, there is no time like the present to begin learning more about this concept, which, by the way, should come at no additional cost to insureds. *

The author
Donald S. Malecki, CPCU, has spent 47 years in the insurance and risk management consulting business. During his career he was a supervising casualty underwriter for a large Eastern insurer, as well as a broker. He currently is a principal of Malecki Deimling Nielander & Associates L.L.C., an insurance, risk and management consulting business headquartered in Erlanger, Kentucky.