Insurers to Curb Agency Compensation in 2010, Consultant Study Finds
January 7, 2010
Total property/casualty insurance agency compensation is expected to decrease slightly in 2010, largely due to contingent commission changes, according to a new compensation study.
Four out of 10 insurance companies plan to modify their agent compensation plans in 2010 by hiking premium volume requirements, increasing stop loss thresholds, adding growth requirements or eliminating contingent commission plans altogether, reports the insurance consulting firm Ward Group in its findings from a study of agency compensation and management practices for property/casualty insurance companies.
The study focused on commission practices, agent incentives and other agency management practices and includes aggregated results from 2008 and 2009 for 99 companies. Independent agency companies represented 80 percent of the participants.
Key findings include:
- 40% of companies plan to modify their contingent plan in 2010;
- 10% of companies plan to increase premium volume requirements compared to 4% that plan to decrease the volume requirement;
- 6% of companies plan to increase the stop loss thresholds compared to only 1% that plan to decrease the amount;
- 12% of companies plan to change their contingent formulas to pay less contingent commission compared to 4% that expect to pay more;
- 6% of companies plan to add growth requirements to their contingent formulas and 5% plan to add retention requirements; and
- 3% of companies are considering eliminating their contingent commission plans completely.
- Are more likely to modify base commission by line of business
- Are more likely to modify base commission by new and renewal business
- Are less likely to have separate plans for personal and commercial lines
- Have 20% fewer agents per manager than average
- Require their top tier agents to demonstrate exceptional characteristics and proven commitment to the company. This benchmark had 50% fewer agents in their top tier and had implemented more challenging criteria for their top agency selection (in terms of higher production and lower loss ratios requirements)
In addition to predicting that agency compensation will drop in 2010 largely due to contingent commission changes, Rieder said he expects agency trips and conferences to be smaller and less costly than in 2009 and prior years.
He also said that agency recruitment appears to be more aggressive as companies appoint more new agents to expand their sales forces. However, he believes most companies have not made effective changes to their contingent plans over the last three to five years to align with current market conditions.
2010년 1월 14일 목요일
Local Governments Increase Homeowners' Loss - Part III
Local Governments Increase Homeowners' Loss - Part III
Christopher J. Boggs, CPCU, ARM, ALCM
October 13, 2008
Our previous article ended with several examples of coverage limit gaps created by the application of local building codes. This post will discuss those examples further and end with a highlighted discussion of the HO 04 77 endorsement.
Loss/Gap and the Reality of Building Codes
In all the prior examples, the greatest ordinance or law expense is the cost associated with the undamaged portion of the house (the cost to tear down and rebuild to current code). However, consideration must be given to the fact that it is not likely a house could be 80 percent damaged and not be declared a total loss or at least a constructive total loss (unless it's a magic fire that just stops and causes no further damage). This massive cost and gap in coverage limit is most likely to be found in a house that suffers 50 to 60 percent damage.
Discounting the costs associated with the undamaged part of the house, the cost to bring the entire house up to current building code could, itself, use up and greatly exceed the ordinance or law coverage offered in the unendorsed homeowners' policy. In the first example, the cost to bring the entire house up to current code is $60,000 (3,000 square feet times $20 per square foot) leaving the homeowner out of pocket $30,000.
The difference between the cost to rebuild the structure as it stood and the cost to bring it to current building code is largely a function of the house's age and the rapidity and breadth of changes in the building codes adopted by the authority having jurisdiction. Agents should have a good handle on the major changes between the time the house was built and the current building code. With that recommendation made, it is impossible to know all applicable building codes, several volumes of manuals are necessary to hold them; but the agent can undertake to know the major changes involving major requirements such as are contained in the national electric code, the applicable flood plain management codes and other MAJOR changes (ADA guidelines and changes in building procedures and materials since the house was constructed).
As stated earlier, the building codes applicable to a specific house, while enforced by the local authority, can emanate from enumerable sources; but the good news is that ordinance or law coverage responds to ALL building codes, regardless of the genesis. The policy specifically states, "You may use up to 10% of the limit of liability that applies to Coverage A for the increased costs you incur due to the enforcement of any ordinance or law which requires or regulates…". "Any" has no limitation.
Homeowners' Endorsements NOT Altering the Ordinance or Law Exclusion/Limitation
Additional Limits of Liability for Coverages A, B, C and D (HO 04 11 or equivalent state-specific form). This form allows the insured to purchase an additional amount of dwelling coverage (Coverage "A") AFTER the loss occurs in the event that the estimated replacement cost purchased was less than the actual replacement cost (the old "guaranteed replacement cost" coverage). Once additional Coverage "A" limits are purchased, all other coverage parts increase in kind (based on the applicable percentages), including the 10 percent additional coverage for ordinance or law.
Endorsement provisions require the insured to: 1) carry 100 percent insurance to value; 2) allow the insurance carrier to adjust the limits based on replacement cost valuations completed; 3) allow the insurer to apply an inflation factor; and 4) notify the insurance carrier if any improvements are made that increase the value of the structure more than 5 percent.
However, this endorsement does NOT alter the ordinance or law exclusion in the loss settlement provisions. ISO's HO-3 form specifically states, "In this Condition C., the terms 'cost to repair or replace' and 'replacement cost' do not include the increased costs incurred to comply with the enforcement of any ordinance or law, except to the extent that coverage for these increased costs is provided in E.11. Ordinance Or Law under Section I - Property Coverages." The E.11. additional coverage is the 10% of Coverage A as discussed previously.
Specified Additional Amount Of Insurance For Coverage A - Dwelling (HO 04 20 or equivalent state-specific form). This is a modified version of the HO 04 11 containing all the same provisions and limitations. The major difference is that only Coverage Part A (Dwelling) can be increased. None of the other limits, including the ordinance or law limit, are increased. A second difference of this endorsement is that the amount of additional coverage available for purchase is limited to either 25 percent or 50 percent of the pre-loss Coverage A (whichever the underwriting carrier will allow).
The HO 04 20 uses the same definition of "replacement cost" as the HO 04 11; meaning that none of the additional costs required by the application of an ordinance or law are covered by the attachment of this endorsement.
Confusion over both forms is generated by a misunderstanding of the meaning of "replacement cost" used in the homeowners' form and the subject endorsements. Replacement cost means to replace with "like kind and quality." Basically this translates "to put back exactly what was there, like it was, using new material; but excluding the cost of any upgrades requested by the insured or mandated by any governmental authority."
The definition of replacement cost does not include the cost to do such things as:
• Raise the house three feet to get it above base flood elevation (BFE) to comply with the current flood plain management code;
• Add more electrical outlets to meet national electric code (NEC) requirements;
• Move the house back 10 feet to meet set-back requirements; or
• Widen doorways and raise counters to meet ADA requirements.
All of these costs result from governmental ordinances or laws and are examples of expenses not included in the definition of "replacement cost." So, even buying more Coverage "A" will not cover these expenses. The cost to meet any or all of these and other jurisdictional requirements will have to be covered under the ordinance or law extension, the endorsement increasing coverage (HO 04 77) or out of the insured's pocket (if there is not enough additional coverage from either of the other options).
In short, neither endorsement rescues the insured from the additional costs necessitated by a local jurisdiction's enforcement of the local building codes requiring a house to be brought, in its entirety, up to current building code.
Ordinance or Law Increased Amount of Coverage (HO 04 77)
Two ordinance or law endorsements exist for use with homeowners' policies: 1) the Ordinance or Law Increased Amount of Coverage (HO 04 77); and 2) the Ordinance or Law Coverage (HO 05 62). The HO 05 62 is attached when there is no automatic ordinance or law coverage provided by the homeowners' form. Coverage provided by this endorsement is the same as has been discussed previously except that the insured chooses the coverage limit desired.
However, since most ISO homeowners' policies include ordinance or law as an additional coverage (10 percent of "A" as reported), this article focuses on the use of the HO 04 77 to increase the amount of ordinance or law coverage.
Coverage breadth is not changed by the HO 04 77, only the amount of coverage. The insured can choose to increase the limits to 25 percent, 50 percent 75 percent or even 100 percent of Coverage "A." The premiums for each level is a percentage of the homeowners' base premium ranging from 13 percent (to increase to 25 percent of "A") up to 67 percent (raising the limit to 100 percent of Coverage "A").
The very first example presented in the first post developed an ordinance or law-induced claim expense of $165,000; that equates to about 55 percent of Coverage "A." Increasing the ordinance or law limit to 50 percent of Coverage "A" would increase the base premium by approximately 35 percent. A $1,000 premium would become a $1,350 premium; but that $350 is preferable to the out-of-packet expense of $135,000 presented in the example.
But, as previously stated, such a loss and extreme application of an ordinance or law claim is probably rare. However, it is still highly recommended and even professionally necessary to offer additional amounts of ordinance or law coverage, at least the 25 percent option. In some states, Florida being one, the agent is required to offer the 25 percent and 50 percent alternatives; and the insured has the option to purchase or reject the offer of coverage (by signature).
Conclusion
Ordinance or law coverage is more commonly discussed and highlighted in commercial property conversations, but rarely is such a discussion carried on with personal lines clients. As was presented in this three-part series, the lack of this coverage has the potential to be very expensive to the insured (and potentially the agency if an errors and omissions suit results).
Without being overly dramatic, ordinance or law is a very real homeowners' exposure often overlooked during the personal lines risk management and insurance planning process. Agents should offer the protection and explain the exposure as clearly and quickly as possible; especially to clients in a home 10 years old and older. A great marketing opportunity may be to write a letter to clients owning older homes to explain their new exposure and present a solution. Regardless, do not ignore this potential out-of-pocket expense faced by your homeowner clients.
The next post will provide agents a sample letter that can be sent to clients to explain this gap in coverage. Hopefully the letter will serve two purposes: 1) as a marketing tool to let your homeowner clients know that you are looking out for their best interest; and 2) as an errors and omissions protection. If one of your clients suffers major damage leading to an ordinance or law problem that is not paid by insurance; being able to prove in court that you notified the insured of this potential gap will go a long way towards helping you win the case.
Christopher J. Boggs, CPCU, ARM, ALCM
October 13, 2008
Our previous article ended with several examples of coverage limit gaps created by the application of local building codes. This post will discuss those examples further and end with a highlighted discussion of the HO 04 77 endorsement.
Loss/Gap and the Reality of Building Codes
In all the prior examples, the greatest ordinance or law expense is the cost associated with the undamaged portion of the house (the cost to tear down and rebuild to current code). However, consideration must be given to the fact that it is not likely a house could be 80 percent damaged and not be declared a total loss or at least a constructive total loss (unless it's a magic fire that just stops and causes no further damage). This massive cost and gap in coverage limit is most likely to be found in a house that suffers 50 to 60 percent damage.
Discounting the costs associated with the undamaged part of the house, the cost to bring the entire house up to current building code could, itself, use up and greatly exceed the ordinance or law coverage offered in the unendorsed homeowners' policy. In the first example, the cost to bring the entire house up to current code is $60,000 (3,000 square feet times $20 per square foot) leaving the homeowner out of pocket $30,000.
The difference between the cost to rebuild the structure as it stood and the cost to bring it to current building code is largely a function of the house's age and the rapidity and breadth of changes in the building codes adopted by the authority having jurisdiction. Agents should have a good handle on the major changes between the time the house was built and the current building code. With that recommendation made, it is impossible to know all applicable building codes, several volumes of manuals are necessary to hold them; but the agent can undertake to know the major changes involving major requirements such as are contained in the national electric code, the applicable flood plain management codes and other MAJOR changes (ADA guidelines and changes in building procedures and materials since the house was constructed).
As stated earlier, the building codes applicable to a specific house, while enforced by the local authority, can emanate from enumerable sources; but the good news is that ordinance or law coverage responds to ALL building codes, regardless of the genesis. The policy specifically states, "You may use up to 10% of the limit of liability that applies to Coverage A for the increased costs you incur due to the enforcement of any ordinance or law which requires or regulates…". "Any" has no limitation.
Homeowners' Endorsements NOT Altering the Ordinance or Law Exclusion/Limitation
Additional Limits of Liability for Coverages A, B, C and D (HO 04 11 or equivalent state-specific form). This form allows the insured to purchase an additional amount of dwelling coverage (Coverage "A") AFTER the loss occurs in the event that the estimated replacement cost purchased was less than the actual replacement cost (the old "guaranteed replacement cost" coverage). Once additional Coverage "A" limits are purchased, all other coverage parts increase in kind (based on the applicable percentages), including the 10 percent additional coverage for ordinance or law.
Endorsement provisions require the insured to: 1) carry 100 percent insurance to value; 2) allow the insurance carrier to adjust the limits based on replacement cost valuations completed; 3) allow the insurer to apply an inflation factor; and 4) notify the insurance carrier if any improvements are made that increase the value of the structure more than 5 percent.
However, this endorsement does NOT alter the ordinance or law exclusion in the loss settlement provisions. ISO's HO-3 form specifically states, "In this Condition C., the terms 'cost to repair or replace' and 'replacement cost' do not include the increased costs incurred to comply with the enforcement of any ordinance or law, except to the extent that coverage for these increased costs is provided in E.11. Ordinance Or Law under Section I - Property Coverages." The E.11. additional coverage is the 10% of Coverage A as discussed previously.
Specified Additional Amount Of Insurance For Coverage A - Dwelling (HO 04 20 or equivalent state-specific form). This is a modified version of the HO 04 11 containing all the same provisions and limitations. The major difference is that only Coverage Part A (Dwelling) can be increased. None of the other limits, including the ordinance or law limit, are increased. A second difference of this endorsement is that the amount of additional coverage available for purchase is limited to either 25 percent or 50 percent of the pre-loss Coverage A (whichever the underwriting carrier will allow).
The HO 04 20 uses the same definition of "replacement cost" as the HO 04 11; meaning that none of the additional costs required by the application of an ordinance or law are covered by the attachment of this endorsement.
Confusion over both forms is generated by a misunderstanding of the meaning of "replacement cost" used in the homeowners' form and the subject endorsements. Replacement cost means to replace with "like kind and quality." Basically this translates "to put back exactly what was there, like it was, using new material; but excluding the cost of any upgrades requested by the insured or mandated by any governmental authority."
The definition of replacement cost does not include the cost to do such things as:
• Raise the house three feet to get it above base flood elevation (BFE) to comply with the current flood plain management code;
• Add more electrical outlets to meet national electric code (NEC) requirements;
• Move the house back 10 feet to meet set-back requirements; or
• Widen doorways and raise counters to meet ADA requirements.
All of these costs result from governmental ordinances or laws and are examples of expenses not included in the definition of "replacement cost." So, even buying more Coverage "A" will not cover these expenses. The cost to meet any or all of these and other jurisdictional requirements will have to be covered under the ordinance or law extension, the endorsement increasing coverage (HO 04 77) or out of the insured's pocket (if there is not enough additional coverage from either of the other options).
In short, neither endorsement rescues the insured from the additional costs necessitated by a local jurisdiction's enforcement of the local building codes requiring a house to be brought, in its entirety, up to current building code.
Ordinance or Law Increased Amount of Coverage (HO 04 77)
Two ordinance or law endorsements exist for use with homeowners' policies: 1) the Ordinance or Law Increased Amount of Coverage (HO 04 77); and 2) the Ordinance or Law Coverage (HO 05 62). The HO 05 62 is attached when there is no automatic ordinance or law coverage provided by the homeowners' form. Coverage provided by this endorsement is the same as has been discussed previously except that the insured chooses the coverage limit desired.
However, since most ISO homeowners' policies include ordinance or law as an additional coverage (10 percent of "A" as reported), this article focuses on the use of the HO 04 77 to increase the amount of ordinance or law coverage.
Coverage breadth is not changed by the HO 04 77, only the amount of coverage. The insured can choose to increase the limits to 25 percent, 50 percent 75 percent or even 100 percent of Coverage "A." The premiums for each level is a percentage of the homeowners' base premium ranging from 13 percent (to increase to 25 percent of "A") up to 67 percent (raising the limit to 100 percent of Coverage "A").
The very first example presented in the first post developed an ordinance or law-induced claim expense of $165,000; that equates to about 55 percent of Coverage "A." Increasing the ordinance or law limit to 50 percent of Coverage "A" would increase the base premium by approximately 35 percent. A $1,000 premium would become a $1,350 premium; but that $350 is preferable to the out-of-packet expense of $135,000 presented in the example.
But, as previously stated, such a loss and extreme application of an ordinance or law claim is probably rare. However, it is still highly recommended and even professionally necessary to offer additional amounts of ordinance or law coverage, at least the 25 percent option. In some states, Florida being one, the agent is required to offer the 25 percent and 50 percent alternatives; and the insured has the option to purchase or reject the offer of coverage (by signature).
Conclusion
Ordinance or law coverage is more commonly discussed and highlighted in commercial property conversations, but rarely is such a discussion carried on with personal lines clients. As was presented in this three-part series, the lack of this coverage has the potential to be very expensive to the insured (and potentially the agency if an errors and omissions suit results).
Without being overly dramatic, ordinance or law is a very real homeowners' exposure often overlooked during the personal lines risk management and insurance planning process. Agents should offer the protection and explain the exposure as clearly and quickly as possible; especially to clients in a home 10 years old and older. A great marketing opportunity may be to write a letter to clients owning older homes to explain their new exposure and present a solution. Regardless, do not ignore this potential out-of-pocket expense faced by your homeowner clients.
The next post will provide agents a sample letter that can be sent to clients to explain this gap in coverage. Hopefully the letter will serve two purposes: 1) as a marketing tool to let your homeowner clients know that you are looking out for their best interest; and 2) as an errors and omissions protection. If one of your clients suffers major damage leading to an ordinance or law problem that is not paid by insurance; being able to prove in court that you notified the insured of this potential gap will go a long way towards helping you win the case.
Local Governments Increase Homeowners' Losses - Part II
Local Governments Increase Homeowners' Losses - Part II
Christopher J. Boggs, CPCU, ARM, ALCM
October 10, 2008
Insurance Services Office's (ISO's) unendorsed homeowners' policy provides a limited amount of coverage to pay the costs associated with the enforcement of any ordinance or law following a major loss. The next several paragraphs will highlight the coverage and limit provided by the unendorsed homeowners' policy, list the types of government-induced losses this limited amount is required to cover and provide claims examples.
Coverage Included in the Homeowners' Policy
Unendorsed, ISO's homeowners' policy(ies) provide only 10 percent of Coverage "A" (Dwelling), in addition to the Coverage A limit, to pay the cost of a loss or increase in loss resulting from the enforcement of any ordinance or law to which the house is subject. For example, a policy with a $300,000 Coverage A limit would provide up to $30,000 of additional protection to cover the add-on expenses arising from a building code-induced loss. Such limit would be called upon to cover three "additional costs" as detailed in the policy's "Additional Coverage - Ordinance or Law" provision:
1) The increased cost necessary to bring the damaged part of the house up to current code;
2) The cost to tear down and remove the debris of the undamaged part of the structure; and
3) The cost to rebuild or repair the undamaged part of the structure in compliance with current building code.
That's a lot to expect from such a minimal amount. Remember apart from this extension or any attached ordinance of law endorsement (if any), the homeowners' policy pays only the cost to tear down, remove the debris of and rebuild/repair the damaged part of the house. NO coverage apart from this additional coverage applies to the undamaged part of the house. An example using the same $300,000 house will help spotlight the potential limit gap. Following are some pertinent facts necessary for this example:
• Value of house: $300,000
• Square footage: 3,000
• Ordinance or Law Additional Coverage (included in the policy): $30,000
• Ordinance or Law Rule applied by the jurisdiction: Percentage Rule (60 percent of "value")
• Amount of Damage: $200,000 (66.7 percent)
• Square Footage Damaged: 2,000 square feet
Based on the above information, the jurisdiction will likely require the house to be torn down and rebuilt to meet current building code. The homeowners' coverage part will only pay the $200,000 plus the cost to remove the debris of the damaged property. Any additional cost resulting directly from the application of one or several ordinances or laws is specifically excluded (except for the small amount granted in the additional coverages section). So, how will the coverage break down; what claims costs will the ordinance or law extension be required to cover and how much will the insured have to pay from his own pocket?
The 10 percent ($30,000) ordinance or law coverage will be called upon to pay the additional per square foot cost to bring the damaged part of the structure up to current building code once rebuilt; the cost to tear down the remaining (undamaged) part of the structure and the cost to rebuild the undamaged part of the structure to comply with the current building code. What might all of this cost and is $30,000 enough? Assumptions needed to complete this example are:
• Cost to rebuild to current building code: $120 per square foot
• Cost to rebuild to prior code: $100 per square foot
• Demolition and Debris Removal cost: $5.00per square foot
Using this information and the costs and limits presented above, the homeowners coupled with the ordinance or law additional coverage will respond and pay as follows:
Homeowners' Policy (without the additional coverage)
• Cost to remove the debris of the damaged portion of the house: $10,000 (2,000 sq. ft. x $5 per sq. ft.)
• Cost to rebuild the damaged portion of the house to old code: $200,000 (2,000 sq. ft. x $100 per sq. ft.)
Total amount paid by the homeowners' coverage (without the additional ordinance or law coverage): $210,000
Ordinance or Law Additional Coverage
• Additional cost to bring the damaged portion of the house up to current building code: $40,000 (2,000 sq. ft. x $20 per sq. ft. (the difference between old building code and current building code));
• Cost to tear down and remove undamaged portion of the house: $5,000 (1,000 sq. ft. x $5 per sq. ft.); plus
• Cost to rebuild the undamaged part of the house to current building code: $120,000 (1,000 sq. ft. x $120 per sq. ft.)
Total amount that would be directly related to the enforcement of the ordinance or law: $165,000.
The amount of coverage available in the unendorsed policy is only $30,000 so the insured in this example would be out of pocket $135,000.
Even if the above example were altered to 80 percent of the house being damaged, the cost to comply with local building code as per the above break down would still be around $123,000 ($93,000 out of the insured's pocket).
Going one step further, if the difference between the old building code and the new is only $10 per square foot, and if the house is 80 percent damaged the amount provided by the ordinance or law extension is still short by $63,000 ($93,000 total cost minus the $30,000 available).
(*Contents coverage and loss of use is not considered in the above example.)
Total Loss
Essentially, the application of an ordinance or law requiring the house to be torn down and rebuilt to current code creates a TOTAL LOSS for the insured even if the house was not totally destroyed by the covered cause of loss. And the additional cost created by the enforcement of the building code is SPECIFICALLY excluded by the policy and coverage is limited to the amount given back in the Additional Coverage - Ordinance or Law (unless increased by endorsement).
Following
The next post will discuss some of the "real-world" fallacies with the above examples; but it will also briefly explore the some of the "real-world" pitfalls of not addressing this exposure. Plus, endorsements that some feel correct this problem will be discussed and a brief discussion of the endorsement that increases the limit of ordinance or law coverage available to the insured.
Christopher J. Boggs, CPCU, ARM, ALCM
October 10, 2008
Insurance Services Office's (ISO's) unendorsed homeowners' policy provides a limited amount of coverage to pay the costs associated with the enforcement of any ordinance or law following a major loss. The next several paragraphs will highlight the coverage and limit provided by the unendorsed homeowners' policy, list the types of government-induced losses this limited amount is required to cover and provide claims examples.
Coverage Included in the Homeowners' Policy
Unendorsed, ISO's homeowners' policy(ies) provide only 10 percent of Coverage "A" (Dwelling), in addition to the Coverage A limit, to pay the cost of a loss or increase in loss resulting from the enforcement of any ordinance or law to which the house is subject. For example, a policy with a $300,000 Coverage A limit would provide up to $30,000 of additional protection to cover the add-on expenses arising from a building code-induced loss. Such limit would be called upon to cover three "additional costs" as detailed in the policy's "Additional Coverage - Ordinance or Law" provision:
1) The increased cost necessary to bring the damaged part of the house up to current code;
2) The cost to tear down and remove the debris of the undamaged part of the structure; and
3) The cost to rebuild or repair the undamaged part of the structure in compliance with current building code.
That's a lot to expect from such a minimal amount. Remember apart from this extension or any attached ordinance of law endorsement (if any), the homeowners' policy pays only the cost to tear down, remove the debris of and rebuild/repair the damaged part of the house. NO coverage apart from this additional coverage applies to the undamaged part of the house. An example using the same $300,000 house will help spotlight the potential limit gap. Following are some pertinent facts necessary for this example:
• Value of house: $300,000
• Square footage: 3,000
• Ordinance or Law Additional Coverage (included in the policy): $30,000
• Ordinance or Law Rule applied by the jurisdiction: Percentage Rule (60 percent of "value")
• Amount of Damage: $200,000 (66.7 percent)
• Square Footage Damaged: 2,000 square feet
Based on the above information, the jurisdiction will likely require the house to be torn down and rebuilt to meet current building code. The homeowners' coverage part will only pay the $200,000 plus the cost to remove the debris of the damaged property. Any additional cost resulting directly from the application of one or several ordinances or laws is specifically excluded (except for the small amount granted in the additional coverages section). So, how will the coverage break down; what claims costs will the ordinance or law extension be required to cover and how much will the insured have to pay from his own pocket?
The 10 percent ($30,000) ordinance or law coverage will be called upon to pay the additional per square foot cost to bring the damaged part of the structure up to current building code once rebuilt; the cost to tear down the remaining (undamaged) part of the structure and the cost to rebuild the undamaged part of the structure to comply with the current building code. What might all of this cost and is $30,000 enough? Assumptions needed to complete this example are:
• Cost to rebuild to current building code: $120 per square foot
• Cost to rebuild to prior code: $100 per square foot
• Demolition and Debris Removal cost: $5.00per square foot
Using this information and the costs and limits presented above, the homeowners coupled with the ordinance or law additional coverage will respond and pay as follows:
Homeowners' Policy (without the additional coverage)
• Cost to remove the debris of the damaged portion of the house: $10,000 (2,000 sq. ft. x $5 per sq. ft.)
• Cost to rebuild the damaged portion of the house to old code: $200,000 (2,000 sq. ft. x $100 per sq. ft.)
Total amount paid by the homeowners' coverage (without the additional ordinance or law coverage): $210,000
Ordinance or Law Additional Coverage
• Additional cost to bring the damaged portion of the house up to current building code: $40,000 (2,000 sq. ft. x $20 per sq. ft. (the difference between old building code and current building code));
• Cost to tear down and remove undamaged portion of the house: $5,000 (1,000 sq. ft. x $5 per sq. ft.); plus
• Cost to rebuild the undamaged part of the house to current building code: $120,000 (1,000 sq. ft. x $120 per sq. ft.)
Total amount that would be directly related to the enforcement of the ordinance or law: $165,000.
The amount of coverage available in the unendorsed policy is only $30,000 so the insured in this example would be out of pocket $135,000.
Even if the above example were altered to 80 percent of the house being damaged, the cost to comply with local building code as per the above break down would still be around $123,000 ($93,000 out of the insured's pocket).
Going one step further, if the difference between the old building code and the new is only $10 per square foot, and if the house is 80 percent damaged the amount provided by the ordinance or law extension is still short by $63,000 ($93,000 total cost minus the $30,000 available).
(*Contents coverage and loss of use is not considered in the above example.)
Total Loss
Essentially, the application of an ordinance or law requiring the house to be torn down and rebuilt to current code creates a TOTAL LOSS for the insured even if the house was not totally destroyed by the covered cause of loss. And the additional cost created by the enforcement of the building code is SPECIFICALLY excluded by the policy and coverage is limited to the amount given back in the Additional Coverage - Ordinance or Law (unless increased by endorsement).
Following
The next post will discuss some of the "real-world" fallacies with the above examples; but it will also briefly explore the some of the "real-world" pitfalls of not addressing this exposure. Plus, endorsements that some feel correct this problem will be discussed and a brief discussion of the endorsement that increases the limit of ordinance or law coverage available to the insured.
Local Governments Increase Homeowners' Loss - Personal Lines Ordinance or Law
Local Governments Increase Homeowners' Loss - Personal Lines Ordinance or Law
Christopher J. Boggs, CPCU, ARM, ALCM
October 8, 2008
Exponential technological advances, improvements in building materials and methods, changes in external and environmental conditions and the rewriting and re-codification of building codes all occur during the life of a house. The results, within 10 years of completion (maybe even as little as five years past) the house may violate some part of the most current jurisdictional building codes.
Any house not in compliance with current building codes subjects the owners to a coverage limit gap following a "major" loss (as defined below) because: 1) specific jurisdictional requirements stipulate the point at which a particular house has suffered "major" damage and must be brought into building code compliance; and 2) Insurance Services Office's (ISO's) unendorsed homeowners' policy provides only a minimal amount of coverage to pay for the increased expenses resulting from the enforcement of current building codes. Combined, the limitations on coverage and the building code's specifications can lead to a potentially large out-of-pocket expense for the insured.
Major loss or damage is uniquely defined by individual jurisdictions with each applying its own connotative twist. However, two broad categories of major damage have evolved into which most state and local building codes fall:
• The Jurisdictional Authority Rule: States applying this as the measure of major damage allow the authority having jurisdiction (the local government) to judge when a damaged building must be brought in its entirety into compliance with the current building code; and
• The Percentage Rule: Simply, when a building is damaged beyond a certain percentage of its "value," the entire structure must be brought into compliance with local building code. There is no subjective interpretation involved.
Each rule presents its own set of problems regarding ordinance or law coverage and the minimal limits automatically provided in most homeowners' policies. For example:
• The jurisdictional authority rule is subjective in its application. Each jurisdiction develops and applies its own standard to define major damage and determine a structure's fitness for continued use. Decisions can be based on the amount of damage, the age of the building coupled with pre-loss compliance shortfalls or simple safety concerns. There is no one criteria upon which homeowners and their agents can depend, making risk management and insurance planning very difficult in states applying this rule. The jurisdictional authority rule has been likened to being "at the mercy of the man with the clipboard."
• The percentage rule's definition of "value" differs among the states applying this as their codified statute. "Value" in these states could mean anything from actual cash value to appraised value or even market value*. Such breadth of interpretation can create problems for agents that operate in more than one state. (*Market value is negotiated between and agreed to by a willing buyer and a willing seller. It can fluctuate up and down based on the economy, condition, use or need and has little relation to the true cost to rebuild a particular structure.)
Ordinance or Law Sources
Building ordinances and laws enforced by local jurisdictions are promulgated by a wide assortment of contributors. States use these model codes to create a statutory infrastructure but endow to local jurisdictions the authority to adopt and customize building codes to meet local preferences and needs as necessary. Building codes and ordinances are developed and published by:
The Federal Government. Three major advisory codes flow from the Federal government, flood plain management requirements, building requirements contained in the Americans with Disabilities Act (ADA) and the National Earthquake Hazards Reduction Program (NEHRP) model code. All of these are model codes, most specifically the flood plain management requirements (communities desiring to be part of the NFIP must develop their own code utilizing the model code from FEMA). Each state and even the local jurisdiction mold these codes to fit their particular need and exposure. These are not the only codes developed by the Federal government, but they are the best known.
Advisory Organizations. Most codes and standards are developed, monitored and updated by independent advisory organizations. A 1996 National Institute of Standards and Technology (NIST) study revealed that 700 distinct advisory organizations account for more than 93,000 separate standards and codes (not all are building codes, these includes codes for materials, boilers, fire protection systems, etc.).
State and Local Codes. Each state and local jurisdiction has the authority, subject to certain minimum requirements, to massage codes and ordinances as necessary to meet that jurisdiction's needs.
Historical Societies. Although these societies are not branches of local, state or national governments, they are granted pseudo-governmental authority regarding the rebuilding of particular structures. Historical societies' desire to save the historical integrity of a structure for future generations; such efforts, while admirable, can significantly increase the cost of rebuilding a house under the society's control. Any house in an historical district merits special attention and potentially special endorsements outside the intended scope of this article.
Agents planning their homeowner client's insurance and risk management program with these authorities and exposures in mind:
• Need to have a basic understanding of the building codes applicable to and affecting their homeowners' clients;
• Must know which rule of "major damage" is applied; and
• Are required to be versed in how the individual jurisdiction applies the specified rule.
Coming Up!
This is the first of a four-part series on ordinance or law coverage for homeowner clients. The problem and the sources of codes were introduced above. Following posts will highlight the coverage provided by the unendorsed homeowners' policy, claims examples spotlighting the effects of the gap, endorsements that many think correct the problem and the endorsements that do, in fact, mitigate the gap. The last post will be a sample letter agents can copy and paste to their letterhead and send to their clients.
Christopher J. Boggs, CPCU, ARM, ALCM
October 8, 2008
Exponential technological advances, improvements in building materials and methods, changes in external and environmental conditions and the rewriting and re-codification of building codes all occur during the life of a house. The results, within 10 years of completion (maybe even as little as five years past) the house may violate some part of the most current jurisdictional building codes.
Any house not in compliance with current building codes subjects the owners to a coverage limit gap following a "major" loss (as defined below) because: 1) specific jurisdictional requirements stipulate the point at which a particular house has suffered "major" damage and must be brought into building code compliance; and 2) Insurance Services Office's (ISO's) unendorsed homeowners' policy provides only a minimal amount of coverage to pay for the increased expenses resulting from the enforcement of current building codes. Combined, the limitations on coverage and the building code's specifications can lead to a potentially large out-of-pocket expense for the insured.
Major loss or damage is uniquely defined by individual jurisdictions with each applying its own connotative twist. However, two broad categories of major damage have evolved into which most state and local building codes fall:
• The Jurisdictional Authority Rule: States applying this as the measure of major damage allow the authority having jurisdiction (the local government) to judge when a damaged building must be brought in its entirety into compliance with the current building code; and
• The Percentage Rule: Simply, when a building is damaged beyond a certain percentage of its "value," the entire structure must be brought into compliance with local building code. There is no subjective interpretation involved.
Each rule presents its own set of problems regarding ordinance or law coverage and the minimal limits automatically provided in most homeowners' policies. For example:
• The jurisdictional authority rule is subjective in its application. Each jurisdiction develops and applies its own standard to define major damage and determine a structure's fitness for continued use. Decisions can be based on the amount of damage, the age of the building coupled with pre-loss compliance shortfalls or simple safety concerns. There is no one criteria upon which homeowners and their agents can depend, making risk management and insurance planning very difficult in states applying this rule. The jurisdictional authority rule has been likened to being "at the mercy of the man with the clipboard."
• The percentage rule's definition of "value" differs among the states applying this as their codified statute. "Value" in these states could mean anything from actual cash value to appraised value or even market value*. Such breadth of interpretation can create problems for agents that operate in more than one state. (*Market value is negotiated between and agreed to by a willing buyer and a willing seller. It can fluctuate up and down based on the economy, condition, use or need and has little relation to the true cost to rebuild a particular structure.)
Ordinance or Law Sources
Building ordinances and laws enforced by local jurisdictions are promulgated by a wide assortment of contributors. States use these model codes to create a statutory infrastructure but endow to local jurisdictions the authority to adopt and customize building codes to meet local preferences and needs as necessary. Building codes and ordinances are developed and published by:
The Federal Government. Three major advisory codes flow from the Federal government, flood plain management requirements, building requirements contained in the Americans with Disabilities Act (ADA) and the National Earthquake Hazards Reduction Program (NEHRP) model code. All of these are model codes, most specifically the flood plain management requirements (communities desiring to be part of the NFIP must develop their own code utilizing the model code from FEMA). Each state and even the local jurisdiction mold these codes to fit their particular need and exposure. These are not the only codes developed by the Federal government, but they are the best known.
Advisory Organizations. Most codes and standards are developed, monitored and updated by independent advisory organizations. A 1996 National Institute of Standards and Technology (NIST) study revealed that 700 distinct advisory organizations account for more than 93,000 separate standards and codes (not all are building codes, these includes codes for materials, boilers, fire protection systems, etc.).
State and Local Codes. Each state and local jurisdiction has the authority, subject to certain minimum requirements, to massage codes and ordinances as necessary to meet that jurisdiction's needs.
Historical Societies. Although these societies are not branches of local, state or national governments, they are granted pseudo-governmental authority regarding the rebuilding of particular structures. Historical societies' desire to save the historical integrity of a structure for future generations; such efforts, while admirable, can significantly increase the cost of rebuilding a house under the society's control. Any house in an historical district merits special attention and potentially special endorsements outside the intended scope of this article.
Agents planning their homeowner client's insurance and risk management program with these authorities and exposures in mind:
• Need to have a basic understanding of the building codes applicable to and affecting their homeowners' clients;
• Must know which rule of "major damage" is applied; and
• Are required to be versed in how the individual jurisdiction applies the specified rule.
Coming Up!
This is the first of a four-part series on ordinance or law coverage for homeowner clients. The problem and the sources of codes were introduced above. Following posts will highlight the coverage provided by the unendorsed homeowners' policy, claims examples spotlighting the effects of the gap, endorsements that many think correct the problem and the endorsements that do, in fact, mitigate the gap. The last post will be a sample letter agents can copy and paste to their letterhead and send to their clients.
A Letter to Your Homeowner Clients - Ordinance or Law Exposure
A Letter to Your Homeowner Clients - Ordinance or Law Exposure
Christopher J. Boggs, CPCU, ARM, ALCM
October 15, 2008
Following this introduction is a sample letter agents can send their homeowner clients to warn or, if you prefer, notify the insured about the potential coverage limit gap caused by the enforcement of any ordinances or laws. Agents should feel free to copy and paste this letter to their letterhead; making any necessary modifications.
Several parts of the letter are in parenthesis, underlined and italicized; these areas are to be filled in with specific information about the client; such as the Coverage "A" limit or the amount extended for Ordinance or Law coverage (usually 10 percent of Coverage "A"). This information will personalize the letter to the specific insured.
This letter is to convey several points and accomplish specific goals: 1) notifying the insured that there is a potential gap in available coverage; 2) notify the insured what, externally, creates this gap; 3) notify the insured that there is a fix; 4) get you in front of the insured giving you the opportunity to cement the relationship and protect the insured; and 5) give an errors and omissions defense.
Following is the letter.
******************************************
Dear (Homeowner),
Building codes are constantly changed and updated. Houses in total compliance just a few years ago may no longer meet our community's current building code requirements. In fact, homes built more than 10 years ago (maybe even as new as five or six years) may not comply with today's laws and ordinances.
Any lack of compliance, although unintentional, could be personally costly following a major loss to your home. Standard, unendorsed homeowners' policies provide only a limited amount of coverage to pay for any additional cost caused by the building inspector's insistence that your entire home be brought into full compliance with local building codes following a loss.
Your homeowners' policy provides (replace with the amount of coverage) coverage on your home; an additional (actual amount) is available to cover the add-on expense necessary to comply with local building code. That (Ordinance or Law amount) is all that is available to pay:
• The cost to tear down the undamaged portion of the house (so the entire house can be rebuilt to code); and
• The cost to rebuild the entire house to current building code (the damaged AND undamaged parts).
By itself, (Ordinance or Law amount) may not give you enough coverage to accomplish these requirements. Any amount above (Ord & Law amount) will have to be paid by YOU.
You do have the option to increase your protection and save yourself from this out-of-pocket expense. The Ordinance or Law Increased Amount of Coverage endorsement (HO 04 77 (or whatever state specific endorsement is used)) can be attached to fill this gaping hole. Several levels of protection are available to meet your needs.
We feel you need to be aware of your policy's current limits and coverage limitations. You also need to know that there is a way to fill the gap and protect yourself from a potentially devastating out-of-pocket expense. Please call us to explore your options.
Sincerely,
Agent's Name
*******************************************
This letter is solely intended to assist the agent in introducing this exposure to clients and in no way guarantees that the agent will be protected from any charges related to the conduct of his/her business or operation as an agent or agency. The duty to identify and manage a client's, prospect's or any other party's risk lies fully with the agent. Neither Insurance Journal, MyNewMarkets.com or Wells Publishing assume any liability associated with the use or non-use of this letter.
Christopher J. Boggs, CPCU, ARM, ALCM
October 15, 2008
Following this introduction is a sample letter agents can send their homeowner clients to warn or, if you prefer, notify the insured about the potential coverage limit gap caused by the enforcement of any ordinances or laws. Agents should feel free to copy and paste this letter to their letterhead; making any necessary modifications.
Several parts of the letter are in parenthesis, underlined and italicized; these areas are to be filled in with specific information about the client; such as the Coverage "A" limit or the amount extended for Ordinance or Law coverage (usually 10 percent of Coverage "A"). This information will personalize the letter to the specific insured.
This letter is to convey several points and accomplish specific goals: 1) notifying the insured that there is a potential gap in available coverage; 2) notify the insured what, externally, creates this gap; 3) notify the insured that there is a fix; 4) get you in front of the insured giving you the opportunity to cement the relationship and protect the insured; and 5) give an errors and omissions defense.
Following is the letter.
******************************************
Dear (Homeowner),
Building codes are constantly changed and updated. Houses in total compliance just a few years ago may no longer meet our community's current building code requirements. In fact, homes built more than 10 years ago (maybe even as new as five or six years) may not comply with today's laws and ordinances.
Any lack of compliance, although unintentional, could be personally costly following a major loss to your home. Standard, unendorsed homeowners' policies provide only a limited amount of coverage to pay for any additional cost caused by the building inspector's insistence that your entire home be brought into full compliance with local building codes following a loss.
Your homeowners' policy provides (replace with the amount of coverage) coverage on your home; an additional (actual amount) is available to cover the add-on expense necessary to comply with local building code. That (Ordinance or Law amount) is all that is available to pay:
• The cost to tear down the undamaged portion of the house (so the entire house can be rebuilt to code); and
• The cost to rebuild the entire house to current building code (the damaged AND undamaged parts).
By itself, (Ordinance or Law amount) may not give you enough coverage to accomplish these requirements. Any amount above (Ord & Law amount) will have to be paid by YOU.
You do have the option to increase your protection and save yourself from this out-of-pocket expense. The Ordinance or Law Increased Amount of Coverage endorsement (HO 04 77 (or whatever state specific endorsement is used)) can be attached to fill this gaping hole. Several levels of protection are available to meet your needs.
We feel you need to be aware of your policy's current limits and coverage limitations. You also need to know that there is a way to fill the gap and protect yourself from a potentially devastating out-of-pocket expense. Please call us to explore your options.
Sincerely,
Agent's Name
*******************************************
This letter is solely intended to assist the agent in introducing this exposure to clients and in no way guarantees that the agent will be protected from any charges related to the conduct of his/her business or operation as an agent or agency. The duty to identify and manage a client's, prospect's or any other party's risk lies fully with the agent. Neither Insurance Journal, MyNewMarkets.com or Wells Publishing assume any liability associated with the use or non-use of this letter.
Property Value Options
Property Value Options
Christopher J. Boggs, CPCU, ARM, ALCM
June 11, 2008
Property insurance valuation options are not limited to replacement cost, actual cash value or even market value (although market value is not a customary insurance value). Insureds can choose among several specialized options to meet specific needs: functional replacement cost, agreed amount and stated value. Each valuation method has a specific use and meets a unique need as highlighted in the next several paragraphs.
Functional Replacement Cost
Building codes may not allow or the realistic needs of the insured may not require that a building be rebuilt to the same square footage or utilizing the same materials existing prior to a major loss. Likewise, the insured may not need furniture, fixtures or equipment with a myriad of additional features. ISO offers two endorsements which allow insureds to value real and personal property at less than replacement cost, but in amounts adequate to rebuild or replace with property that is operationally equivalent:
• CP 04 38 - Functional Building Valuation; and
• CP 04 39 - Functional Personal Property Valuation - Other Than Stock.
Functional replacement cost endorsements value property at the cost necessary to replace damaged or destroyed property with new property of unlike kind and quality which perform the same general function allowing the insured to accomplish their business objectives. Property replaced using functionally equivalent materials and products are less expensive and often require a shorter replacement schedule. Buildings may be smaller or built using less expensive building materials; and business personal property will perform the essential functions, but may not have the amenities of the furniture or equipment it replaces. This valuation option may be appropriate:
• When the insured cannot rebuild the same square footage, usually due to the application of building codes, and a smaller building will be built in its place;
• When the insured does not want to rebuild the same square footage;
• When lower cost building materials can or should be used (i.e. masonry/non-combustible vs. fire resistive); or
• If the insured does not need all the functions available on a particular piece of machinery or equipment (they found a great bargain on a top-of-the-line model, but don't need or use all the functions available and the insured does not want to pay the premium to insure it for cost new).
Both functional replacement cost endorsements allow the insured to purchase a lower amount of coverage (enjoying some premium savings) while retaining a form of replacement cost coverage for partial losses (subject to "lesser of" policy provisions). Other advantages within these forms include: 1) Coinsurance is waived; and 2) Ordinance or Law coverage is included in the form (no need for a separate endorsement).
Agreed Value
As the name suggests, this is the amount the insured and the insurer agree the property is worth. Since it is a "pre-negotiated" limit, the coinsurance condition does not apply provided the insured carries the amount of coverage agreed upon by both parties. The face amount is paid in the event of a total loss and partial losses are paid on a repair or replacement basis without the customary "lesser of" conditions common to other valuation methods.
Commercial property policies contain agreed value language. To trigger coverage the insured must 1) request the agreed value option in the application; and 2) complete and sign a statement of values for the insurance company to prove the values. The statement of values must be completed every 12 months in order to maintain agreed value coverage. If the statement of values is not completed, the coinsurance condition is reinstated.
Agreed value is appropriate anytime the insured wants to avoid potential coinsurance penalties. Such problems may arise when property is difficult to value due to its unique nature, availability or unstable values (which may trigger value and coinsurance issues as the cost at the time of loss may not be predictable). Retail or manufacturing operations which experience broad swings in stock value should avoid agreed value coverage on stock as limits may not be adequate to cover the amount on hand at the time of the loss.
Stated Amount
Stated amount is oft times confused with agreed value when discussing and planning coverage with the insured; these terms are not synonymous. In fact, stated amount valuation is detrimental to the insured as it is wholly subject to the "lesser of" limitation with no available option to increase payment.
Most often applied in inland marine policies and auto physical damage coverage, stated amount will only pay the lesser of:
• The stated amount on the policy;
• The actual cash value; or
• The cost to repair the item.
There is rarely a situation where this valuation method is advantageous to the insured. Stated amount endorsements should be avoided, and every attempt should be made to negotiate a different settlement option in policies using this as the primary valuation method (mostly inland marine coverage). If the only way an underwriter will agree to write the coverage is use of the stated value method and there are no other viable options, then the provisions must be clearly explained to the insured.
Coinsurance and Inflation Guard
Coinsurance provisions, requirements and penalties were addressed in a previous article. Not discussed were the available coinsurance options along with the benefits and pitfalls of each. Remember, coinsurance was introduced to penalize the insured for failure to purchase a required minimum amount of property coverage.
Standard commercial property policy coinsurance is 80 percent. That is, the insured must insure to at least 80 percent of the property's "value" to receive full payment for partial losses. "Value" can be either actual cash value or replacement cost value based on the insured's indicated desire in the application. Ninety percent and 100 percent are the other commonly used coinsurance percentages in property policies.
Rate credits are granted when the insured increases the coinsurance percentage. However, increasing the coinsurance percentage requires the insured to confirm that the limits of coverage correspond to the new "minimum" limit of protection created. The potential to suffer the coinsurance penalty increases as the insured increases the coinsurance percentage. If the insured opts to use 100 percent coinsurance, they must be absolutely sure that the limit of coverage equals 100 percent of the "value" (however defined in the particular policy) to avoid a coinsurance penalty. Opinions differ, but the rate credit is not worth the potential penalty for miscalculation.
Insure the property at 100 percent insurance to value (again, whichever definition of value is applied), but use 90 percent coinsurance as the basis. This accomplishes two goals: 1) guarantees that the insured is fully insured for all partial losses (subject to the deductible); and 2) assures the insured will be fully covered for total losses since the policy will never pay more than the limit purchased.
Agents and insureds that insist on using 100 percent coinsurance do have an optional coverage to allow the property limit to increase throughout the year. The optional inflation guard coverage increases the limit of coverage over the course of the policy year. Coverage is increased by the percentage selected by the insured. Annual inflation factors generally range between 2 percent and 8 percent and are prorated throughout the year (i.e. after six months, property values have been increased by one-half of the factor applied). Using 8 percent, property valued at $100,000 at the beginning of the policy period will be valued at $104,000 after six months and $108,000 at the end of the 12-month policy period.
The inflation guard optional coverage is essentially required when the insured insists on 100 percent coinsurance or in volatile economic times.
Conclusion
Property has many different values; some relate to insurance and many do not. Accurately valuing property for insurance, and even market, purposes is as much an art as a science. Insureds depend on their agents to protect them against devastating financial consequences following a loss. If the correct amount or the right type of coverage is not there, insured's can be bankrupted by the costs.
Insureds must understand the definition of "value," how to calculate the correct "value" and how policy provisions truly apply. Coverage gaps and solutions to close those holes must also be explained to insureds.
Christopher J. Boggs, CPCU, ARM, ALCM
June 11, 2008
Property insurance valuation options are not limited to replacement cost, actual cash value or even market value (although market value is not a customary insurance value). Insureds can choose among several specialized options to meet specific needs: functional replacement cost, agreed amount and stated value. Each valuation method has a specific use and meets a unique need as highlighted in the next several paragraphs.
Functional Replacement Cost
Building codes may not allow or the realistic needs of the insured may not require that a building be rebuilt to the same square footage or utilizing the same materials existing prior to a major loss. Likewise, the insured may not need furniture, fixtures or equipment with a myriad of additional features. ISO offers two endorsements which allow insureds to value real and personal property at less than replacement cost, but in amounts adequate to rebuild or replace with property that is operationally equivalent:
• CP 04 38 - Functional Building Valuation; and
• CP 04 39 - Functional Personal Property Valuation - Other Than Stock.
Functional replacement cost endorsements value property at the cost necessary to replace damaged or destroyed property with new property of unlike kind and quality which perform the same general function allowing the insured to accomplish their business objectives. Property replaced using functionally equivalent materials and products are less expensive and often require a shorter replacement schedule. Buildings may be smaller or built using less expensive building materials; and business personal property will perform the essential functions, but may not have the amenities of the furniture or equipment it replaces. This valuation option may be appropriate:
• When the insured cannot rebuild the same square footage, usually due to the application of building codes, and a smaller building will be built in its place;
• When the insured does not want to rebuild the same square footage;
• When lower cost building materials can or should be used (i.e. masonry/non-combustible vs. fire resistive); or
• If the insured does not need all the functions available on a particular piece of machinery or equipment (they found a great bargain on a top-of-the-line model, but don't need or use all the functions available and the insured does not want to pay the premium to insure it for cost new).
Both functional replacement cost endorsements allow the insured to purchase a lower amount of coverage (enjoying some premium savings) while retaining a form of replacement cost coverage for partial losses (subject to "lesser of" policy provisions). Other advantages within these forms include: 1) Coinsurance is waived; and 2) Ordinance or Law coverage is included in the form (no need for a separate endorsement).
Agreed Value
As the name suggests, this is the amount the insured and the insurer agree the property is worth. Since it is a "pre-negotiated" limit, the coinsurance condition does not apply provided the insured carries the amount of coverage agreed upon by both parties. The face amount is paid in the event of a total loss and partial losses are paid on a repair or replacement basis without the customary "lesser of" conditions common to other valuation methods.
Commercial property policies contain agreed value language. To trigger coverage the insured must 1) request the agreed value option in the application; and 2) complete and sign a statement of values for the insurance company to prove the values. The statement of values must be completed every 12 months in order to maintain agreed value coverage. If the statement of values is not completed, the coinsurance condition is reinstated.
Agreed value is appropriate anytime the insured wants to avoid potential coinsurance penalties. Such problems may arise when property is difficult to value due to its unique nature, availability or unstable values (which may trigger value and coinsurance issues as the cost at the time of loss may not be predictable). Retail or manufacturing operations which experience broad swings in stock value should avoid agreed value coverage on stock as limits may not be adequate to cover the amount on hand at the time of the loss.
Stated Amount
Stated amount is oft times confused with agreed value when discussing and planning coverage with the insured; these terms are not synonymous. In fact, stated amount valuation is detrimental to the insured as it is wholly subject to the "lesser of" limitation with no available option to increase payment.
Most often applied in inland marine policies and auto physical damage coverage, stated amount will only pay the lesser of:
• The stated amount on the policy;
• The actual cash value; or
• The cost to repair the item.
There is rarely a situation where this valuation method is advantageous to the insured. Stated amount endorsements should be avoided, and every attempt should be made to negotiate a different settlement option in policies using this as the primary valuation method (mostly inland marine coverage). If the only way an underwriter will agree to write the coverage is use of the stated value method and there are no other viable options, then the provisions must be clearly explained to the insured.
Coinsurance and Inflation Guard
Coinsurance provisions, requirements and penalties were addressed in a previous article. Not discussed were the available coinsurance options along with the benefits and pitfalls of each. Remember, coinsurance was introduced to penalize the insured for failure to purchase a required minimum amount of property coverage.
Standard commercial property policy coinsurance is 80 percent. That is, the insured must insure to at least 80 percent of the property's "value" to receive full payment for partial losses. "Value" can be either actual cash value or replacement cost value based on the insured's indicated desire in the application. Ninety percent and 100 percent are the other commonly used coinsurance percentages in property policies.
Rate credits are granted when the insured increases the coinsurance percentage. However, increasing the coinsurance percentage requires the insured to confirm that the limits of coverage correspond to the new "minimum" limit of protection created. The potential to suffer the coinsurance penalty increases as the insured increases the coinsurance percentage. If the insured opts to use 100 percent coinsurance, they must be absolutely sure that the limit of coverage equals 100 percent of the "value" (however defined in the particular policy) to avoid a coinsurance penalty. Opinions differ, but the rate credit is not worth the potential penalty for miscalculation.
Insure the property at 100 percent insurance to value (again, whichever definition of value is applied), but use 90 percent coinsurance as the basis. This accomplishes two goals: 1) guarantees that the insured is fully insured for all partial losses (subject to the deductible); and 2) assures the insured will be fully covered for total losses since the policy will never pay more than the limit purchased.
Agents and insureds that insist on using 100 percent coinsurance do have an optional coverage to allow the property limit to increase throughout the year. The optional inflation guard coverage increases the limit of coverage over the course of the policy year. Coverage is increased by the percentage selected by the insured. Annual inflation factors generally range between 2 percent and 8 percent and are prorated throughout the year (i.e. after six months, property values have been increased by one-half of the factor applied). Using 8 percent, property valued at $100,000 at the beginning of the policy period will be valued at $104,000 after six months and $108,000 at the end of the 12-month policy period.
The inflation guard optional coverage is essentially required when the insured insists on 100 percent coinsurance or in volatile economic times.
Conclusion
Property has many different values; some relate to insurance and many do not. Accurately valuing property for insurance, and even market, purposes is as much an art as a science. Insureds depend on their agents to protect them against devastating financial consequences following a loss. If the correct amount or the right type of coverage is not there, insured's can be bankrupted by the costs.
Insureds must understand the definition of "value," how to calculate the correct "value" and how policy provisions truly apply. Coverage gaps and solutions to close those holes must also be explained to insureds.
When Government Strikes - Ordinance or Law
When Government Strikes - Ordinance or Law
Christopher J. Boggs, CPCU, ARM, ALCM
June 9, 2008
Ordinance or law endorsements fill a major gap between the insured's belief about replacement cost and the commercial property policy's actual application of this valuation method. Disparity between the insured's concept and the true operation of replacement cost often arises from the development, codification and enforcement of building codes.
Building ordinances and laws are enforced by local jurisdictions but the codes are promulgated by an assortment of contributors including: state government, federal codes and regulations and advisory organizations such as the National Fire Protection Association (NFPA). States use these sources to create the statutory infrastructure but endow local jurisdictions with the authority to adopt and customize building codes to meet local preferences as necessary.
Specific legal requirements stipulate the point at which a structure must be brought into compliance with local building codes. Correction of life safety issues presenting an imminent danger is generally required immediately regardless of surrounding circumstances; otherwise existing structures are usually granted "grandfather" status and are not required to comply with all applicable building codes unless certain statutorily specified events occur. "Major damage" to the building is one of those qualifying events.
Major damage does not have a universal definition; each jurisdiction establishes and applies its own meaning. There are, however, two broad categories of major damage into which most state and local building codes fall:
• The Jurisdictional Authority Rule: States using this as the measure of major damage allow the authority having jurisdiction (the local government) to judge when a damaged building must be brought into compliance with the current building code; and
• The Percentage Rule: When a building is damaged beyond a certain percentage of its "value," the entire structure must be brought into compliance with local building code.
When government has the opportunity or feels the need to inject itself into issues related to property values - problems erupt as evidenced by these rules. Both rules present unique problems regarding insurance coverage and common policy provisions.
The jurisdictional authority rule is subjective in its application. Each jurisdiction applies its own standard to define major damage and determine a structure's fitness for continued use. Decisions can be based on the amount of damage, the age of the building coupled with pre-loss compliance shortfalls or simple safety concerns. There is no one criteria upon which building owners and agents can depend, making risk management and insurance planning very difficult in these states.
Even the percentage rule's definition of "value" differs among the states that apply this rule. "Value" could mean actual cash value, appraised value or market value. (Market value is negotiated between and agreed to by a willing buyer and a willing seller. It can fluctuate up and down based on the economy, condition, use or need and has little relation to the true cost to rebuild a particular structure. However, if market value is the rule applied, the agent must be prepared for and be able to explain this concept.)
Agents must know which rule of "major damage" is applied and how the individual jurisdictions apply the rule. Knowing this, the agent can explain the exposure and how replacement cost in the unendorsed property policy will and will not respond to losses triggering jurisdictional ordinance or law requirements.
Three Coverages
Replacement cost alone falls far short of paying much of the additional costs necessitated by a major loss (as defined above and by the applicable law). Damage crossing the threshold of "major" effectively creates a constructive total loss of the structure; however, the unendorsed commercial property policy only pays to repair or replace the damaged property back to the condition that existed prior to the loss.
No coverage exists in the unendorsed policy to pay the loss in value of the undamaged portion of the building no longer useable (the insured loses the use and value of the undamaged part). The cost to tear down and remove the undamaged portion of the building from the site is also borne by the insured. Finally, the additional cost necessary to bring the building into compliance with the current building code is wholly paid from the insured's financial resources.
Ordinance or Law endorsed to the commercial property policy assures the insured is indemnified (put back into the same condition enjoyed before the loss) for these expenses which would otherwise out-of-pocket. The endorsement's three coverage parts close the commercial property policy coverage gaps highlighted above:
• Coverage A - Loss to the Undamaged Portion of the Building: The remaining portion of the building cannot be used due to application of the local building code; the insured is out the use value of this section making the building a functional total loss. This coverage part pays that loss of value;
• Coverage B - Demolition Cost: Once the undamaged portion of the building has been torn down it must be removed from the site. The commercial property policy only pays to remove damaged property, Coverage B pays the cost to tear down and remove the undamaged part of the building; and
• Coverage C - Increased Cost of Construction: All buildings must be built in compliance with applicable building codes. Buildings that suffer major damage are no exception. Replacement cost coverage only pays to put back what was there; this coverage part pays the additional cost necessary to bring the building into full compliance with current building codes.
Ordinance or Law coverage also fills the gap between the insured's belief about replacement cost is and its customary application. Insureds must be informed of the exposures faced and the solutions available.
Building codes change and are updated frequently; the insured's building can become non-compliant very quickly. Most commercial properties over five years old fail to meet current building codes. Major damage triggering the application of the jurisdiction's laws or ordinances has the potential to cost the insured a large amount of out of pocket expense if the correct coverage is not provided; and the older the building is, the more expensive this gap in coverage.
Christopher J. Boggs, CPCU, ARM, ALCM
June 9, 2008
Ordinance or law endorsements fill a major gap between the insured's belief about replacement cost and the commercial property policy's actual application of this valuation method. Disparity between the insured's concept and the true operation of replacement cost often arises from the development, codification and enforcement of building codes.
Building ordinances and laws are enforced by local jurisdictions but the codes are promulgated by an assortment of contributors including: state government, federal codes and regulations and advisory organizations such as the National Fire Protection Association (NFPA). States use these sources to create the statutory infrastructure but endow local jurisdictions with the authority to adopt and customize building codes to meet local preferences as necessary.
Specific legal requirements stipulate the point at which a structure must be brought into compliance with local building codes. Correction of life safety issues presenting an imminent danger is generally required immediately regardless of surrounding circumstances; otherwise existing structures are usually granted "grandfather" status and are not required to comply with all applicable building codes unless certain statutorily specified events occur. "Major damage" to the building is one of those qualifying events.
Major damage does not have a universal definition; each jurisdiction establishes and applies its own meaning. There are, however, two broad categories of major damage into which most state and local building codes fall:
• The Jurisdictional Authority Rule: States using this as the measure of major damage allow the authority having jurisdiction (the local government) to judge when a damaged building must be brought into compliance with the current building code; and
• The Percentage Rule: When a building is damaged beyond a certain percentage of its "value," the entire structure must be brought into compliance with local building code.
When government has the opportunity or feels the need to inject itself into issues related to property values - problems erupt as evidenced by these rules. Both rules present unique problems regarding insurance coverage and common policy provisions.
The jurisdictional authority rule is subjective in its application. Each jurisdiction applies its own standard to define major damage and determine a structure's fitness for continued use. Decisions can be based on the amount of damage, the age of the building coupled with pre-loss compliance shortfalls or simple safety concerns. There is no one criteria upon which building owners and agents can depend, making risk management and insurance planning very difficult in these states.
Even the percentage rule's definition of "value" differs among the states that apply this rule. "Value" could mean actual cash value, appraised value or market value. (Market value is negotiated between and agreed to by a willing buyer and a willing seller. It can fluctuate up and down based on the economy, condition, use or need and has little relation to the true cost to rebuild a particular structure. However, if market value is the rule applied, the agent must be prepared for and be able to explain this concept.)
Agents must know which rule of "major damage" is applied and how the individual jurisdictions apply the rule. Knowing this, the agent can explain the exposure and how replacement cost in the unendorsed property policy will and will not respond to losses triggering jurisdictional ordinance or law requirements.
Three Coverages
Replacement cost alone falls far short of paying much of the additional costs necessitated by a major loss (as defined above and by the applicable law). Damage crossing the threshold of "major" effectively creates a constructive total loss of the structure; however, the unendorsed commercial property policy only pays to repair or replace the damaged property back to the condition that existed prior to the loss.
No coverage exists in the unendorsed policy to pay the loss in value of the undamaged portion of the building no longer useable (the insured loses the use and value of the undamaged part). The cost to tear down and remove the undamaged portion of the building from the site is also borne by the insured. Finally, the additional cost necessary to bring the building into compliance with the current building code is wholly paid from the insured's financial resources.
Ordinance or Law endorsed to the commercial property policy assures the insured is indemnified (put back into the same condition enjoyed before the loss) for these expenses which would otherwise out-of-pocket. The endorsement's three coverage parts close the commercial property policy coverage gaps highlighted above:
• Coverage A - Loss to the Undamaged Portion of the Building: The remaining portion of the building cannot be used due to application of the local building code; the insured is out the use value of this section making the building a functional total loss. This coverage part pays that loss of value;
• Coverage B - Demolition Cost: Once the undamaged portion of the building has been torn down it must be removed from the site. The commercial property policy only pays to remove damaged property, Coverage B pays the cost to tear down and remove the undamaged part of the building; and
• Coverage C - Increased Cost of Construction: All buildings must be built in compliance with applicable building codes. Buildings that suffer major damage are no exception. Replacement cost coverage only pays to put back what was there; this coverage part pays the additional cost necessary to bring the building into full compliance with current building codes.
Ordinance or Law coverage also fills the gap between the insured's belief about replacement cost is and its customary application. Insureds must be informed of the exposures faced and the solutions available.
Building codes change and are updated frequently; the insured's building can become non-compliant very quickly. Most commercial properties over five years old fail to meet current building codes. Major damage triggering the application of the jurisdiction's laws or ordinances has the potential to cost the insured a large amount of out of pocket expense if the correct coverage is not provided; and the older the building is, the more expensive this gap in coverage.
Replacement Cost Not Always 'Replacement'
Replacement Cost Not Always 'Replacement'
Christopher J. Boggs, CPCU, ARM, ALCM
June 6, 2008
Replacement cost is optional in the commercial property policy, its use is activated by checking the right box on the application. It is, however, the "standard" valuation clause applied to eligible property in a Businessowners Policy (BOP). Even when this option is chosen, the insured does not automatically receive the item's replacement cost, as they understand it, for one of several reasons:
1) Replacement cost is not paid UNTIL the property is repaired or replaced;
2) Some types of property are limited by policy provisions and do not qualify for replacement cost, or are limited in the amount of coverage under replacement cost;
3) If the insured does a poor job calculating the limits, a coinsurance penalty could be applied; and
4) "Replacement cost" does not necessarily guarantee payment for the ultimate cost to rebuild.
Ineligible for Replacement Cost
Property not contractually eligible for replacement cost includes: personal property of others; contents of a residence (remember this is a discussion of the commercial property policy); works of art, antiques or rare articles, including etchings, pictures, statuary, marbles, bronzes, porcelains and bric-a-brac*; and "stock." Loss to items in this list is settled at actual cash value. However, the opton exists for two classes of the property listed above to be valued at replacement cost.
(*Bric-a-brac is defined in the American Heritage Dictionary and other sources as small articles, usually ornamental in nature valuable due to their antiquity, rarity, originality or sentimental nature. The term carries with it the idea of obsolescence - receiving the cost new for an obsolete article would be a violation of indemnification and the broad evidence rule. In addition to being potentially obsolete, this type of property as well as antiques, artwork, etc. may not be replaceable at any price, thus the insurance carrier is unwilling to extend replacement cost coverage to these types of articles.)
Replacement Cost Optional
Stock and personal property of others can be changed to replacement cost value rather than ACV by indicating such desire on the application. Insureds in possession of a large amount of personal property of others should consider this extension for two reasons: to avoid good will problems with clients; and to satisfy any contractual or legal requirements.
Valuing stock at replacement cost is a function of the circumstances and rarely do the circumstances necessitate the use of the replacement cost option. Stock subject to quick turnover or with very little fluctuation in value likely does not need to be valued at replacement cost as there is no real depreciation. Even products with a long shelf life or greatly fluctuating values may not require a change to replacement cost valuation. Remember, actual cash value is defined as the cost new on the date of the loss less physical depreciation; since the products are not being used, there is no physical depreciation. The insured to essentially being paid replacement cost on stock anyway. Actual cash value may provide adequate protection for stock, provided correct limits are maintained. If values fluctuate substantially from one month to the next, there are two property endorsements the insured should consider: 1) the Peak Season Limit of Insurance or 2) the Value Reporting Form (these forms are outside the scope of this discussion).
Limited Replacement Cost
Several specific types of property are valued at replacement cost, but are limited in the amount of coverage available. These classes include but are not limited to outdoor property, property off premises and outdoor signs attached to the building. Vacant property is included in this class list and coverage for these properties is severely limited.
Vacancy is defined in the commercial property policy, along with the coverage penalty appied to vacanct property. Insured's may expect to be paid replacement cost following a loss, but the policy states that any loss payment will be reduced by 15 percent, and some causes of loss otherwise covered are specifically excluded when the propterty is vacant. This policy provision needs to be clearly addressed with the client once the agent learn that an insured property is vacant.
Coinsurance - Everyone's Favorite
Coinsurance is the third barrier to the insured's receiving full replacement cost. Coinsurance was created to assure that the insurance carrier would receive adequate premium for the risk being insured. Without this penalty, an insured might be tempted to buy only a small amount of coverage on a large building because of the difference between maximum possible loss and maximum probable loss.
The maximum possible loss of any structure is the entire building; but depending on the construction and fire protection in place the maximum probable loss might be only half of the building. Without the coinsurance requirement, insureds might be tempted to purchase coverage equaling only 50 percent of the value of the building. The insured would be fully compensated for all losses falling under that amount; and statistically, most losses would fall within these parameters.
Coinsurance provisions were created to eliminate this practice and to penalize insureds that fail to adequately insure their property. In effect, violators of the provision become co-insurers of the property; they self-insure part of the loss.
Insureds failing to meet coinsurance requirements are once again subject to the problem of "lesser of." If the limits of insurance purchased do not equal or exceed the value of the insured property on the date of loss (regardless if the property policy applies ACV or replacement cost) multiplied by the coinsurance percentage shown; the insured receives the lesser of: 1) the amount of insurance purchased, or 2) the result of the coinsurance calculation, both minus the applicable deductible.
The Government Strikes Again
Jurisdictional involvement is the fourth barrier alluded to above. Insureds believe, because it is what they have been taught, that replacement cost means new for old. It does, but not when exclusions intervene.
Following a covered cause of loss, the unendorsed property policy written on a replacement cost basis will pay exactly that, the cost to replace the damaged property - but no more. This policy will pay to rebuilding the building exactly as it stood; any additional cost necessary to bring the building up to current building code will be borne by the insured.
Having to explain that to the insured is tough enough, but try explaining that the cost of tearing down the undamaged portion of the building so that the entire building can be brought up to current building code is not covered by the policy, even though the policy is written on replacement cost.
These additional costs are covered by the ordinance or law endorsement. This coverage and how it prevents an errors and omissions problem will be detailed in the next article. More property value options and definitions will be included in upcoming articles.
Christopher J. Boggs, CPCU, ARM, ALCM
June 6, 2008
Replacement cost is optional in the commercial property policy, its use is activated by checking the right box on the application. It is, however, the "standard" valuation clause applied to eligible property in a Businessowners Policy (BOP). Even when this option is chosen, the insured does not automatically receive the item's replacement cost, as they understand it, for one of several reasons:
1) Replacement cost is not paid UNTIL the property is repaired or replaced;
2) Some types of property are limited by policy provisions and do not qualify for replacement cost, or are limited in the amount of coverage under replacement cost;
3) If the insured does a poor job calculating the limits, a coinsurance penalty could be applied; and
4) "Replacement cost" does not necessarily guarantee payment for the ultimate cost to rebuild.
Ineligible for Replacement Cost
Property not contractually eligible for replacement cost includes: personal property of others; contents of a residence (remember this is a discussion of the commercial property policy); works of art, antiques or rare articles, including etchings, pictures, statuary, marbles, bronzes, porcelains and bric-a-brac*; and "stock." Loss to items in this list is settled at actual cash value. However, the opton exists for two classes of the property listed above to be valued at replacement cost.
(*Bric-a-brac is defined in the American Heritage Dictionary and other sources as small articles, usually ornamental in nature valuable due to their antiquity, rarity, originality or sentimental nature. The term carries with it the idea of obsolescence - receiving the cost new for an obsolete article would be a violation of indemnification and the broad evidence rule. In addition to being potentially obsolete, this type of property as well as antiques, artwork, etc. may not be replaceable at any price, thus the insurance carrier is unwilling to extend replacement cost coverage to these types of articles.)
Replacement Cost Optional
Stock and personal property of others can be changed to replacement cost value rather than ACV by indicating such desire on the application. Insureds in possession of a large amount of personal property of others should consider this extension for two reasons: to avoid good will problems with clients; and to satisfy any contractual or legal requirements.
Valuing stock at replacement cost is a function of the circumstances and rarely do the circumstances necessitate the use of the replacement cost option. Stock subject to quick turnover or with very little fluctuation in value likely does not need to be valued at replacement cost as there is no real depreciation. Even products with a long shelf life or greatly fluctuating values may not require a change to replacement cost valuation. Remember, actual cash value is defined as the cost new on the date of the loss less physical depreciation; since the products are not being used, there is no physical depreciation. The insured to essentially being paid replacement cost on stock anyway. Actual cash value may provide adequate protection for stock, provided correct limits are maintained. If values fluctuate substantially from one month to the next, there are two property endorsements the insured should consider: 1) the Peak Season Limit of Insurance or 2) the Value Reporting Form (these forms are outside the scope of this discussion).
Limited Replacement Cost
Several specific types of property are valued at replacement cost, but are limited in the amount of coverage available. These classes include but are not limited to outdoor property, property off premises and outdoor signs attached to the building. Vacant property is included in this class list and coverage for these properties is severely limited.
Vacancy is defined in the commercial property policy, along with the coverage penalty appied to vacanct property. Insured's may expect to be paid replacement cost following a loss, but the policy states that any loss payment will be reduced by 15 percent, and some causes of loss otherwise covered are specifically excluded when the propterty is vacant. This policy provision needs to be clearly addressed with the client once the agent learn that an insured property is vacant.
Coinsurance - Everyone's Favorite
Coinsurance is the third barrier to the insured's receiving full replacement cost. Coinsurance was created to assure that the insurance carrier would receive adequate premium for the risk being insured. Without this penalty, an insured might be tempted to buy only a small amount of coverage on a large building because of the difference between maximum possible loss and maximum probable loss.
The maximum possible loss of any structure is the entire building; but depending on the construction and fire protection in place the maximum probable loss might be only half of the building. Without the coinsurance requirement, insureds might be tempted to purchase coverage equaling only 50 percent of the value of the building. The insured would be fully compensated for all losses falling under that amount; and statistically, most losses would fall within these parameters.
Coinsurance provisions were created to eliminate this practice and to penalize insureds that fail to adequately insure their property. In effect, violators of the provision become co-insurers of the property; they self-insure part of the loss.
Insureds failing to meet coinsurance requirements are once again subject to the problem of "lesser of." If the limits of insurance purchased do not equal or exceed the value of the insured property on the date of loss (regardless if the property policy applies ACV or replacement cost) multiplied by the coinsurance percentage shown; the insured receives the lesser of: 1) the amount of insurance purchased, or 2) the result of the coinsurance calculation, both minus the applicable deductible.
The Government Strikes Again
Jurisdictional involvement is the fourth barrier alluded to above. Insureds believe, because it is what they have been taught, that replacement cost means new for old. It does, but not when exclusions intervene.
Following a covered cause of loss, the unendorsed property policy written on a replacement cost basis will pay exactly that, the cost to replace the damaged property - but no more. This policy will pay to rebuilding the building exactly as it stood; any additional cost necessary to bring the building up to current building code will be borne by the insured.
Having to explain that to the insured is tough enough, but try explaining that the cost of tearing down the undamaged portion of the building so that the entire building can be brought up to current building code is not covered by the policy, even though the policy is written on replacement cost.
These additional costs are covered by the ordinance or law endorsement. This coverage and how it prevents an errors and omissions problem will be detailed in the next article. More property value options and definitions will be included in upcoming articles.
Replacement Cost Violates Indemnification Rule
Replacement Cost Violates Indemnification Rule
Christopher J. Boggs, CPCU, ARM, ALCM
June 4, 2008
Assertion: Replacement cost violates the principle of indemnification as the insured is placed in a better position than existed immediately prior to the loss. For instance, the insured's five-year-old production machine is destroyed by a covered cause of loss and they get a new one in its place. This is an abuse of the insurance mechanism.
Point of Fact: Replacement cost may be the truest form of property indemnification available when considered this way: the insured's machinery is destroyed by fire, now they have no means to manufacture products and conduct business; money doesn't necessarily do any good, they need the equipment. Same with the building, the insured needs a building to operate in, not the money. Replacement cost is the best mechanism for returning the building and contents to the insured, regardless of the type of operation (manufacturer or office), with the only out-of-pocket expense being the deductible chosen by the insured, provided limits have been chosen correctly. This is the best demonstration of the goal, purpose and representation of indemnification.
Still, how can replacement cost embody the principle of indemnification? Why is the insured not better off than before the loss? Valid questions both which relate to the due diligence required to calculate property limits.
Insuring to Cost
Indemnification principles are not violated and are, in fact, upheld because the amount of insurance purchased is intended to equal the cost new of all eligible and insured property on the day of the loss. To illustrate, the machinery involved in the loss exampled above cost $100,000 new five years ago; it has a current resale (market) value of $50,000; but to buy a new piece of equipment of like kind and quality cost $150,000 today. The only amount that matters when insuring on replacement cost basis is what it cost on the date of the loss; thus, the insured would insure that machine for $150,000. The same process is applied to all real and personal property insured to develop the true value or its full replacement cost. To insure to value requires calculating the current cost to buy or build another one like it (whatever "it" is) on the date of loss.
Too often the level of calculation required to develop this amount is thumbed by the insured and even the agent. While it may not be reasonable to expect the insured or the agent to take time to calculate the cost new of every piece of machinery, equipment, furniture, stock or other covered property, this is the level of due diligence required to develop the correct replacement cost of the business personal property. Insurers certainly apply this level of diligence when investigating and settling a property loss; particularly when confirming compliance with coinsurance provisions.
Insureds, or their agents, often simply guess at the replacement cost of personal property. Guessing can create or heighten the coinsurance penalty. The coinsurance penalty and its relation to indemnification will be discussed in a future article. Insureds can hire an appraisal services to undertake this due diligence, for a fee.
Developing an accurate replacement cost for building coverage is much easier than precisely calculating the value of contents (business personal property) due largely to building cost estimators. Cost estimators coupled with knowledge of usual and customary square footage costs within the particular locale generally produce highly accurate insurance to value figures. But even this does not guarantee the insured will be paid their idea of replacement cost (see part 3).
"Going Out Of Business"
Insureds occasionally decide not to rebuild or replace lost property following a loss and instead elect to go out of business. Property policy provisions guard against violating the principal of indemnification when this decison is made. Insureds choosing not to rebuild or return to previous operations will receive the property's actual cash value. The principal of indemnification remains intact because the insured gets no more than the remaining value of the insured property - the remaining use (cash) value of what they lost.
Indemnification is complete when the insured is returned to essentially the same condition that existed prior to the loss (subject to policy provisions and exclusiion). Replacement cost accomplishes this by providing the insured a fully furnished and equipped operation and no better. If the insured chooses not to reopen, they are out "nothing," they don't need the lost contents any more, and are essentially made whole by being paid the remaining use value (depreciated value) of what they had.
Defined Values
Three distinctly different property "values" were highlighted in the above paragraphs: actual cash value, replacement cost and market value. Two are common to insurance, and one generally has no relevance in insurance, until the government gets involved.
Actual cash value (ACV) is the initial valuation method applied in the commercial property policy. Even if the replacement cost option is chosen, some property continues to be valued at ACV. Actual cash value is defined as the cost new (replacement cost) on the date of the loss minus physical depreciation. "Physical" is highlighted because there are many different types of depreciation: depreciation due to obsolescence, accounting depreciation and economic depreciation. None of these relate to the insurance definition of depreciation. Physical depreciation results from use and ultimate wear and tear meaning that the insured does not get paid for the "used up" value of the property.
Attention must be paid to the beginning point in the calculation of ACV, the cost new on the date of the loss. ACV is not based on the value when it was purchased or at any point between that date and the date of the loss. The cost new on the date of the loss is the figure that matters. This is key when choosing limits, the insured must still calculate the cost new even if using ACV as the loss settlement option.
Replacement cost was defined above, the cost to replace new with like kind and quality on the date of the loss. There is no allowance or penalty for age, depreciation or condition. The insured must simply insure the property at what it will cost to buy or build it today.
Market value is what a willing buyer will pay a willing seller on the open market, it is not normally a value with any relationship to insurance. The rise and fall of the market value does not necessarily change the cost to rebuild a building following a loss.
Understanding that this discussion mainly revolves around commercial property, the housing market is still a good example the problem inherent to market value, and why it's not a good value for insurance purposes. Residential real estate markets have seen steep declines over the last several months. Census department statistics report that the average market value of a home fell 11.2 percent from March 2007 to March 2008; and statistics published by the National Association of Realtors showed a 7.68 percent decrease in housing prices in 2007. Does this mean that the cost to rebuild a particular house has changed? No! It simply indicates that the person could not sell it for as much as they could a year ago. However, it would still cost the same or even more to rebuild the house if it burned down.
Market value has nothing necessarily to do with insurance value, except in ordinance or law issues and flood coverage (both of which will be discussed in future articles).
Some of the twists and turns in property values, along with the problems governments bring to property values will be detailed in upcoming property value articles. Continue to check back regularly as we continue to dissect property values and what it means to your clients.
Christopher J. Boggs, CPCU, ARM, ALCM
June 4, 2008
Assertion: Replacement cost violates the principle of indemnification as the insured is placed in a better position than existed immediately prior to the loss. For instance, the insured's five-year-old production machine is destroyed by a covered cause of loss and they get a new one in its place. This is an abuse of the insurance mechanism.
Point of Fact: Replacement cost may be the truest form of property indemnification available when considered this way: the insured's machinery is destroyed by fire, now they have no means to manufacture products and conduct business; money doesn't necessarily do any good, they need the equipment. Same with the building, the insured needs a building to operate in, not the money. Replacement cost is the best mechanism for returning the building and contents to the insured, regardless of the type of operation (manufacturer or office), with the only out-of-pocket expense being the deductible chosen by the insured, provided limits have been chosen correctly. This is the best demonstration of the goal, purpose and representation of indemnification.
Still, how can replacement cost embody the principle of indemnification? Why is the insured not better off than before the loss? Valid questions both which relate to the due diligence required to calculate property limits.
Insuring to Cost
Indemnification principles are not violated and are, in fact, upheld because the amount of insurance purchased is intended to equal the cost new of all eligible and insured property on the day of the loss. To illustrate, the machinery involved in the loss exampled above cost $100,000 new five years ago; it has a current resale (market) value of $50,000; but to buy a new piece of equipment of like kind and quality cost $150,000 today. The only amount that matters when insuring on replacement cost basis is what it cost on the date of the loss; thus, the insured would insure that machine for $150,000. The same process is applied to all real and personal property insured to develop the true value or its full replacement cost. To insure to value requires calculating the current cost to buy or build another one like it (whatever "it" is) on the date of loss.
Too often the level of calculation required to develop this amount is thumbed by the insured and even the agent. While it may not be reasonable to expect the insured or the agent to take time to calculate the cost new of every piece of machinery, equipment, furniture, stock or other covered property, this is the level of due diligence required to develop the correct replacement cost of the business personal property. Insurers certainly apply this level of diligence when investigating and settling a property loss; particularly when confirming compliance with coinsurance provisions.
Insureds, or their agents, often simply guess at the replacement cost of personal property. Guessing can create or heighten the coinsurance penalty. The coinsurance penalty and its relation to indemnification will be discussed in a future article. Insureds can hire an appraisal services to undertake this due diligence, for a fee.
Developing an accurate replacement cost for building coverage is much easier than precisely calculating the value of contents (business personal property) due largely to building cost estimators. Cost estimators coupled with knowledge of usual and customary square footage costs within the particular locale generally produce highly accurate insurance to value figures. But even this does not guarantee the insured will be paid their idea of replacement cost (see part 3).
"Going Out Of Business"
Insureds occasionally decide not to rebuild or replace lost property following a loss and instead elect to go out of business. Property policy provisions guard against violating the principal of indemnification when this decison is made. Insureds choosing not to rebuild or return to previous operations will receive the property's actual cash value. The principal of indemnification remains intact because the insured gets no more than the remaining value of the insured property - the remaining use (cash) value of what they lost.
Indemnification is complete when the insured is returned to essentially the same condition that existed prior to the loss (subject to policy provisions and exclusiion). Replacement cost accomplishes this by providing the insured a fully furnished and equipped operation and no better. If the insured chooses not to reopen, they are out "nothing," they don't need the lost contents any more, and are essentially made whole by being paid the remaining use value (depreciated value) of what they had.
Defined Values
Three distinctly different property "values" were highlighted in the above paragraphs: actual cash value, replacement cost and market value. Two are common to insurance, and one generally has no relevance in insurance, until the government gets involved.
Actual cash value (ACV) is the initial valuation method applied in the commercial property policy. Even if the replacement cost option is chosen, some property continues to be valued at ACV. Actual cash value is defined as the cost new (replacement cost) on the date of the loss minus physical depreciation. "Physical" is highlighted because there are many different types of depreciation: depreciation due to obsolescence, accounting depreciation and economic depreciation. None of these relate to the insurance definition of depreciation. Physical depreciation results from use and ultimate wear and tear meaning that the insured does not get paid for the "used up" value of the property.
Attention must be paid to the beginning point in the calculation of ACV, the cost new on the date of the loss. ACV is not based on the value when it was purchased or at any point between that date and the date of the loss. The cost new on the date of the loss is the figure that matters. This is key when choosing limits, the insured must still calculate the cost new even if using ACV as the loss settlement option.
Replacement cost was defined above, the cost to replace new with like kind and quality on the date of the loss. There is no allowance or penalty for age, depreciation or condition. The insured must simply insure the property at what it will cost to buy or build it today.
Market value is what a willing buyer will pay a willing seller on the open market, it is not normally a value with any relationship to insurance. The rise and fall of the market value does not necessarily change the cost to rebuild a building following a loss.
Understanding that this discussion mainly revolves around commercial property, the housing market is still a good example the problem inherent to market value, and why it's not a good value for insurance purposes. Residential real estate markets have seen steep declines over the last several months. Census department statistics report that the average market value of a home fell 11.2 percent from March 2007 to March 2008; and statistics published by the National Association of Realtors showed a 7.68 percent decrease in housing prices in 2007. Does this mean that the cost to rebuild a particular house has changed? No! It simply indicates that the person could not sell it for as much as they could a year ago. However, it would still cost the same or even more to rebuild the house if it burned down.
Market value has nothing necessarily to do with insurance value, except in ordinance or law issues and flood coverage (both of which will be discussed in future articles).
Some of the twists and turns in property values, along with the problems governments bring to property values will be detailed in upcoming property value articles. Continue to check back regularly as we continue to dissect property values and what it means to your clients.
Insurance Rules for Valuing Damaged or Destroyed Property
Insurance Rules for Valuing Damaged or Destroyed Property
Christopher J. Boggs, CPCU, ARM, ALCM
June 2, 2008
Replacement cost does not mean what the client believes or has been told. Insureds assume replacement cost translates into new stuff for old junk - because agents have told them that's how it works. Well, to be fair this is a partially true definition, but partially true definitions coupled with only partially met expectations can lead to wholly dissatisfied clients and a possible court date.
Real and personal property can have many "values," replacement cost is only one possibility. Other values include the amount the item could bring on the open market, what an expert thinks it is worth, what it actually costs to replace or rebuild, and the value an individual places on the property. Not all of these relate to insurance or the application of insurance coverage.
Indemnification
Before disecting values assignable to property and how each value relates to insurance, an understanding of the founding and guiding principal of property insurance must be established. Beginning with the earliest property policies, through the creation of the New York standard fire policy in 1918, up to and including the property insurance policies in use today; the goal of property insurance has been and remains the "indemnification" of the insured party.
Indemnification is the contractual obligation of one party (the indemnitor) to return another party (the indemnitee) to essentially the same condition (financial or otherwise) enjoyed before the loss with no improvement or betterment. Within property policies the insurer is the "indemnitor" and the "indemnitee" is the insured.
A key phrase in this definition is "…the same condition…." Insurance was not and is not designed to improve the indemitee's financial condition after a loss. Improvement or enrichment following a loss increases the potential for moral or morale hazards.
Traditional indemnification is a function of "the lesser of…." Historically, the most the insured (indemnitee) receives following a loss is the lesser of several amounts specified in the policy. The commercial property policy, for instance, states that the insurer's payment options are:
• Pay the "value" of lost or damaged property;
• Pay the cost of repairing or replacing the lost or damaged property;
• Take all or any part of the property at an agreed or appraised value; or
• Repair, rebuild or replace the property with other property of like kind and quality.
"Value" is initially defined as "Actual Cash Value" in the commercial property policy. Actual cash value (ACV) is the cost new less depreciation. A simplified application of ACV is a 5-year-old piece of machinery with a 10 year useful life. If this ficticious machine were destroyed by fire its ACV would be 50 percent of what a new machine would cost. If a new machine cost $100,000, the insured would be paid $50,000 provided all other conditions are met. The concepts of ACV and some property value conditions will be expounded upon in future articles.
Note that the definition of "value" can be changed by choosing options already available in the policy, including replacement cost or agreed value.
Since the insurance carrier has the right to choose among the four payment options, payment is genrally limited to the least of these calculated amounts - unless there are laws or external circumstances that dictate the use of a different value or limit.
Broad Evidence Rule - External Circumstances
Laws in several states require all external evidence surrounding the use and value of property be considered when establishing the true value or lack of value of insured property; this is known as the Broad Evidence Rule. Application of the broad evidence rule is intended for the insured's benefit, but it is just as likely to be detrimental to the insured.
Insured's advantage: How does the insurer arrive at the 10 year useful life used in the ACV example above? Such calculations are usually derived from a chart, computer program or some other long-established method. Any method used is based on averages. Such chart or program probably does not take into account any specialized maintenance or upgrades done by the insured.
If the insured has performed routine plus extraordinary maintenance and/or upgrades, the example machine may actually have a useful life closer to 20 years. The insured would have only used up 1/4th of the machine's "value" after five years. Without the application of the broad evidence rule, the insured could be out 25 percent of the value; that's $25,000 on the example machine with a $100,000 replacement cost. The broad evidence rule coupled wth ACV loss valuation would allow the insured to be paid $75,000 rather than the previous $50,000 ACV-only calculation.
Insured's detriment: Consider a recently-purchased building where the land on which the building is located has all the value and the new owner has no need for the building. The new owner wants to tear the building down and a demolition team has been scheduled to remove the building from the premises. Due to the team's schedule, it will be three months before tear down can begin. During that time, the owner begins removing fixtures, equipment and disconnects the power.
Because there is a loan on the property, the mortgagee requires a property insurance policy be purchased. Such policy is in full force on the day the building burns down - two weeks before slated demolition. How much does the insurer owe for this building?
Case law in some states suggests that the insurer owes nothing because the building had no use and no real value to the insured. Since it was already slated to be torn down, the owner was benefited by "free" demolition. All the evidence surrounding the building and its value, the broad evidence, suggests the building is valueless. Few would argue this building, as described, has little to no value and the insurance carrier should not be expected to enrich the property owner (we are obviously ignoring underwriting questions for sake of the example). This is the other side of the broad evidence rule.
Coming Up!
What, then, is the definition and application of replacement cost, actual cash value, or even functional replacement cost? How does depreciation fit into insurance? Does everything depreciate? Is any of this affected by the faltering real estate market?
These and other property value questions will be explored in more detail in upcoming articles. Be sure to check your daily email from MyNewMarkets.com and the website as articles answering these questions will be available soon.
Christopher J. Boggs, CPCU, ARM, ALCM
June 2, 2008
Replacement cost does not mean what the client believes or has been told. Insureds assume replacement cost translates into new stuff for old junk - because agents have told them that's how it works. Well, to be fair this is a partially true definition, but partially true definitions coupled with only partially met expectations can lead to wholly dissatisfied clients and a possible court date.
Real and personal property can have many "values," replacement cost is only one possibility. Other values include the amount the item could bring on the open market, what an expert thinks it is worth, what it actually costs to replace or rebuild, and the value an individual places on the property. Not all of these relate to insurance or the application of insurance coverage.
Indemnification
Before disecting values assignable to property and how each value relates to insurance, an understanding of the founding and guiding principal of property insurance must be established. Beginning with the earliest property policies, through the creation of the New York standard fire policy in 1918, up to and including the property insurance policies in use today; the goal of property insurance has been and remains the "indemnification" of the insured party.
Indemnification is the contractual obligation of one party (the indemnitor) to return another party (the indemnitee) to essentially the same condition (financial or otherwise) enjoyed before the loss with no improvement or betterment. Within property policies the insurer is the "indemnitor" and the "indemnitee" is the insured.
A key phrase in this definition is "…the same condition…." Insurance was not and is not designed to improve the indemitee's financial condition after a loss. Improvement or enrichment following a loss increases the potential for moral or morale hazards.
Traditional indemnification is a function of "the lesser of…." Historically, the most the insured (indemnitee) receives following a loss is the lesser of several amounts specified in the policy. The commercial property policy, for instance, states that the insurer's payment options are:
• Pay the "value" of lost or damaged property;
• Pay the cost of repairing or replacing the lost or damaged property;
• Take all or any part of the property at an agreed or appraised value; or
• Repair, rebuild or replace the property with other property of like kind and quality.
"Value" is initially defined as "Actual Cash Value" in the commercial property policy. Actual cash value (ACV) is the cost new less depreciation. A simplified application of ACV is a 5-year-old piece of machinery with a 10 year useful life. If this ficticious machine were destroyed by fire its ACV would be 50 percent of what a new machine would cost. If a new machine cost $100,000, the insured would be paid $50,000 provided all other conditions are met. The concepts of ACV and some property value conditions will be expounded upon in future articles.
Note that the definition of "value" can be changed by choosing options already available in the policy, including replacement cost or agreed value.
Since the insurance carrier has the right to choose among the four payment options, payment is genrally limited to the least of these calculated amounts - unless there are laws or external circumstances that dictate the use of a different value or limit.
Broad Evidence Rule - External Circumstances
Laws in several states require all external evidence surrounding the use and value of property be considered when establishing the true value or lack of value of insured property; this is known as the Broad Evidence Rule. Application of the broad evidence rule is intended for the insured's benefit, but it is just as likely to be detrimental to the insured.
Insured's advantage: How does the insurer arrive at the 10 year useful life used in the ACV example above? Such calculations are usually derived from a chart, computer program or some other long-established method. Any method used is based on averages. Such chart or program probably does not take into account any specialized maintenance or upgrades done by the insured.
If the insured has performed routine plus extraordinary maintenance and/or upgrades, the example machine may actually have a useful life closer to 20 years. The insured would have only used up 1/4th of the machine's "value" after five years. Without the application of the broad evidence rule, the insured could be out 25 percent of the value; that's $25,000 on the example machine with a $100,000 replacement cost. The broad evidence rule coupled wth ACV loss valuation would allow the insured to be paid $75,000 rather than the previous $50,000 ACV-only calculation.
Insured's detriment: Consider a recently-purchased building where the land on which the building is located has all the value and the new owner has no need for the building. The new owner wants to tear the building down and a demolition team has been scheduled to remove the building from the premises. Due to the team's schedule, it will be three months before tear down can begin. During that time, the owner begins removing fixtures, equipment and disconnects the power.
Because there is a loan on the property, the mortgagee requires a property insurance policy be purchased. Such policy is in full force on the day the building burns down - two weeks before slated demolition. How much does the insurer owe for this building?
Case law in some states suggests that the insurer owes nothing because the building had no use and no real value to the insured. Since it was already slated to be torn down, the owner was benefited by "free" demolition. All the evidence surrounding the building and its value, the broad evidence, suggests the building is valueless. Few would argue this building, as described, has little to no value and the insurance carrier should not be expected to enrich the property owner (we are obviously ignoring underwriting questions for sake of the example). This is the other side of the broad evidence rule.
Coming Up!
What, then, is the definition and application of replacement cost, actual cash value, or even functional replacement cost? How does depreciation fit into insurance? Does everything depreciate? Is any of this affected by the faltering real estate market?
These and other property value questions will be explored in more detail in upcoming articles. Be sure to check your daily email from MyNewMarkets.com and the website as articles answering these questions will be available soon.
Workers' Compensation Coverage Checklist
Workers' Compensation Coverage Checklist
Christopher J. Boggs, CPCU, ARM, ALCM
September 22, 2008
MyNewMarkets.com, over the last several weeks, has provided a series of articles exploring workers' compensation and employers' liability. Topics have included contractual risk transfer, the course and scope rule, injury gray areas, combinability, premium audits and many other work comp specific information.
Attached to this link is the workers' compensation and employers' liability coverage checklist for your use with your clients. A series of questions and some explanatory footnotes are included for use. The series of articles will be kept on www.mynewmarkets.com for a period of time should you desire clarification of any points in the checklist.
* See checklist at http://www.mynewmarkets.com/articles/93831/workers-compensation-coverage-checklist
Christopher J. Boggs, CPCU, ARM, ALCM
September 22, 2008
MyNewMarkets.com, over the last several weeks, has provided a series of articles exploring workers' compensation and employers' liability. Topics have included contractual risk transfer, the course and scope rule, injury gray areas, combinability, premium audits and many other work comp specific information.
Attached to this link is the workers' compensation and employers' liability coverage checklist for your use with your clients. A series of questions and some explanatory footnotes are included for use. The series of articles will be kept on www.mynewmarkets.com for a period of time should you desire clarification of any points in the checklist.
* See checklist at http://www.mynewmarkets.com/articles/93831/workers-compensation-coverage-checklist
Workers' Compensation Audit Conclusion
Workers' Compensation Audit Conclusion
Christopher J. Boggs, CPCU, ARM, ALCM
September 19, 2008
Exceptions to the Governing Classification Rules
As discussed previously, the governing classification to which a particular employer's payroll is assigned is intended to represent the analogous exposure of the entire operation. Each individual job or duty is not split out and assigned a specific code…except in specific circumstances. These four circumstantial exceptions to the governing classification rule are discussed in the following paragraphs:
• The "Standard Exception" classifications;
• The "Interchange of Labor" rules;
• The "General Exclusion" classes; and
• Employers eligible for classification under the "Multiple Enterprise" rule.
"Standard Exception" Classifications
Some duties/activities are considered so common to most business and such duties may be so far outside the operational activities of the business that employees engaged in certain jobs are considered exceptions to the governing classification rules. Payroll for these "standard exception" classes of employees is subtracted from the governing classification and assigned to the applicable standard exception code and rated separately from the governing class. The standard exception classes include:
• Clerical Employees- Class Code 8810;
• Clerical Telecommuter - Class Code 8871;
• Drafting Employees - Class Code 8810;
• Salespersons - Class Code 8742; and
• Drivers - Class Code 7380.
For a particular employee or group of employees to qualify for assignment into one of the standard exception classifications, he/she must be physically separated from the operative hazards of the business by means of walls, floors, partitions or counters. Such separation requirement does not negate the assignment of an employee to a standard exception class if he is only entering the area of operation to conduct duties consistent with his class code; such as a clerical employee entering the operations area to deliver paychecks.
Standard exception classifications are not necessarily limited to these five class codes; some states utilize state-specific class codes that are also eligible for assignment as a standard exception. For example, Texas allows certain employees to be assigned to "Executive Officers NOC" (class code 8809) and the payroll for these employees is pulled out of the governing classification and rated as a standard exception.
Employees falling into a standard exception classification may not always be eligible for "standard exception" separation. Attention must be paid to the governing classification description; at times, the governing classification may state "…&…" or "…including…." If such wording appears, the payroll for the standard exception employee is included in the governing classification. The reason for such inclusion, the analogy of that particular operation requires the presence of the standard exception employees to accomplish the goals of such business. A few examples of this include (not an exhaustive list):
• Farm: Nursery Employees & Drivers (Class Code 0005);
• Chemical manufacturing NOC - all operations & Drivers (Class Code 4829);
• Carpet, rug or upholstery cleaning & Drivers (Class Code 2585);
• Physicians & Clerical (Class Code 8832);
• Photographer - All employees & Clerical, Salespersons and Drivers (Class Code 4361); and
• School: Professional Employees & Clerical (Class Code 8868).
Interchange of Labor
A second exception to the governing classification rule is the "interchange of labor" rule. The applicability of the interchange of labor rule varies by state; some states only allow its use in the construction, erection or stevedoring classes of business while other states permit the interchange of labor rule to apply to any type of business operation.
Interchange of labor rules allow a single employee's payroll to be split between or among several class codes that may be present within the operations. The advantage to the employer (premium payer) of such allowance is an ultimately lower premium. Without the interchange of labor rule, the employee's entire payroll would be assigned to the governing (likely highest rate) classification. With the interchange of labor rule in effect, the employer is charged based on the employee's actual exposure to injury.
For instance, an employee in the construction industry who does framing work (5645) and hardwood floor installation (5437) can see his payroll divided between these different operations and realize a reduction in premium provided the following specific provisions are met:
• All classifications used for an employee are appropriate to the job performed;
• Payroll records exist that allocate the employee's wages between/among the different classes. This requires an actual, dollar amount payroll split, a percentage of payroll is not allowed; and
• The division of payroll is not available with any of the standard exception classifications (with the possible exception of the driver code).
Continuing the above example using assigned risk rates of $25 for code 5645 and $14 for code 5437, an employee earning an annual payroll of $30,000 will cost the employer $7,500 if there is no interchange of labor. If, however, all the interchange of labor guidelines are met, and the employee's payroll is split as follows: $20,000 for framing and $10,000 for hardwood floor installation; the employee will only cost $6,400 in workers' compensation premium (ignoring expense constants, modification factors and debits or credits).
The interchange of labor rule is great for the employer due to the premium savings and is fair for the insurance carrier because exposures differ based on activity. When the employee is on scaffolding he is more like to suffer a severe injury than when installing flooring.
Employers and their agents must understand and take advantage of the interchange of labor rules allowed in each subject state. Large payrolls can greatly benefit from such splits thus agents should encourage detailed payroll records be kept and the audits should be checked closely.
General Exclusion Classifications
Some operational activities do not fit into the analogous assignment of the governing classification due to the unexpected existence of such an operation as part of a particular business. It is not reasonable to expect the hardware store code (8010) to pick up the exposure created by an on-site sawmill operation (2710) for example.
Such operations are known as "general exclusion" classes. General exclusion classes are listed separately on the workers' compensation policy and a separate rate (based on the class code) is charged for the employees within these classes of operations.
General exclusion classes are the opposite of "standard exception" classes. General exclusion classes are completely unexpected and not considered part of the analogy of the governing classification of an operation requiring separation to allow the insurer to garner the, usually, higher premium for the increased exposure. Standard exceptions represent operations common to most business and are of such minimal hazard that the insured should not be punished by having the payroll for these classes included in the governing classification, but should rather enjoy a lower premium for the reduced exposure.
Operations and activities falling within the general exclusion classification are:
• Employees working in aircraft operations;
• Employees performing new construction or alterations;
• Stevedoring employees;
• Sawmill operation employees; and
• Employees working in an employer-owned daycare.
Multiple Enterprise Rule
The single enterprise rule introduced in the previous article requires that all activities usual and customary to a particular operation be assigned to one "governing" class code (with the exceptions described above). However, a particular entity may conduct additional operations not usual or customary to such an enterprise; such disparate activities may allow the insured to qualify for the separation of payroll into multiple classifications under the "multiple enterprise rule."
A secondary operation producing a basic premium equal to or higher than the governing class code (the code generating the highest payroll) premium automatically qualifies for separation under the multiple enterprise rule with the only requirement being segregation of payrolls.
If, however, the basic premium generated by the secondary operation is less than the governing class code basic premium, four tests must be satisfied before the insured can make use of the multiple enterprise rule. These are:
1. The operation to be separately classed is not commonly found within the operation of the subject insured's business;
2. The operations could each exist as a separate entity;
3. Financial records are kept separately for each operation; and
4. The operations are physically separated by means of a partition, wall or placement in a separate building.
Such separation of payrolls may benefit the insured employer by a reduction in premium if the secondary enterprises carry a lower rate per $100 of payroll. Additionally, employers that qualify for separation of payrolls under the multiple enterprise rule may also be able to benefit from the application of the interchange of labor rule presented above (based on the state).
ABC's of Premium Audits
There are specific guidelines that agents and the employer should apply to every audit. These are the "ABC's" of premium audits.
"A": Always be there. A representative from the company familiar with the financial records and the operations of the company should be present at every audit. The auditor will likely have questions and unless someone is available to answer these questions and explain the financial documents, the auditor is likely to make some assumptions and potentially some costly mistakes. This duty should not be delegated to any member of the staff not intimately familiar with the business.
"B": Be prepared. The auditor will need all the necessary financial records to conduct the audit and will likely ask for a tour of the facility. Prepare a place for the auditor to work and help them complete their job as quickly as possible. Some data that will need to be ready includes:
• Payroll records: Payroll journal and summary; 941's; state unemployment reports; an explanation and break out of overtime payments; and the general ledger.
• Employee records: Include a detailed description of job duties; the number of employees; employee hire and fire dates; and class code splits if applicable.
• Cash disbursements: Cost of and payments to subcontractors; cost of materials; and the cost of any casual labor hired.
• Certificates of Insurance: Make sure to supply current certificates of insurance covering the entire period of the audit or the entire period of time the contractor has worked for the insured. If the sub's policy renews in the middle of the audit period, a new certificate should be requested covering the remainder of the insured's policy period.
• OCIP projects: If the insured has been a part of any wrap-up, the auditor needs this information in order to remove the payroll from the calculation.
"C": Copy of the auditor's work papers. Don't let the auditor leave without getting a copy of the audit work papers. This will allow the insured and their agent to review the audit and confirm that there are no errors BEFORE the audit is processed and billed (fixing it "after-the-fact" is more difficult).
"D": Don't volunteer more information than asked. The auditor will ask questions, this is expected. Insureds should be advised to only answer the questions ask, do not lead the auditor down a path that may be detrimental to the insured.
"E": Exceptions to the single entity rule. The exceptions listed above should be capitalized on by the insured. Audits should, at the very minimum, contain at least one standard exception code. If the insured is eligible for any of the other payroll splits described above, those codes should also be included.
Knowing the rules and exceptions, giving the auditor everything they need to complete the audit quickly and following the above rules will increase the chances of a favorable audit.
The next article will be the long-awaited workers' compensation and employers' liability coverage checklist.
Christopher J. Boggs, CPCU, ARM, ALCM
September 19, 2008
Exceptions to the Governing Classification Rules
As discussed previously, the governing classification to which a particular employer's payroll is assigned is intended to represent the analogous exposure of the entire operation. Each individual job or duty is not split out and assigned a specific code…except in specific circumstances. These four circumstantial exceptions to the governing classification rule are discussed in the following paragraphs:
• The "Standard Exception" classifications;
• The "Interchange of Labor" rules;
• The "General Exclusion" classes; and
• Employers eligible for classification under the "Multiple Enterprise" rule.
"Standard Exception" Classifications
Some duties/activities are considered so common to most business and such duties may be so far outside the operational activities of the business that employees engaged in certain jobs are considered exceptions to the governing classification rules. Payroll for these "standard exception" classes of employees is subtracted from the governing classification and assigned to the applicable standard exception code and rated separately from the governing class. The standard exception classes include:
• Clerical Employees- Class Code 8810;
• Clerical Telecommuter - Class Code 8871;
• Drafting Employees - Class Code 8810;
• Salespersons - Class Code 8742; and
• Drivers - Class Code 7380.
For a particular employee or group of employees to qualify for assignment into one of the standard exception classifications, he/she must be physically separated from the operative hazards of the business by means of walls, floors, partitions or counters. Such separation requirement does not negate the assignment of an employee to a standard exception class if he is only entering the area of operation to conduct duties consistent with his class code; such as a clerical employee entering the operations area to deliver paychecks.
Standard exception classifications are not necessarily limited to these five class codes; some states utilize state-specific class codes that are also eligible for assignment as a standard exception. For example, Texas allows certain employees to be assigned to "Executive Officers NOC" (class code 8809) and the payroll for these employees is pulled out of the governing classification and rated as a standard exception.
Employees falling into a standard exception classification may not always be eligible for "standard exception" separation. Attention must be paid to the governing classification description; at times, the governing classification may state "…&…" or "…including…." If such wording appears, the payroll for the standard exception employee is included in the governing classification. The reason for such inclusion, the analogy of that particular operation requires the presence of the standard exception employees to accomplish the goals of such business. A few examples of this include (not an exhaustive list):
• Farm: Nursery Employees & Drivers (Class Code 0005);
• Chemical manufacturing NOC - all operations & Drivers (Class Code 4829);
• Carpet, rug or upholstery cleaning & Drivers (Class Code 2585);
• Physicians & Clerical (Class Code 8832);
• Photographer - All employees & Clerical, Salespersons and Drivers (Class Code 4361); and
• School: Professional Employees & Clerical (Class Code 8868).
Interchange of Labor
A second exception to the governing classification rule is the "interchange of labor" rule. The applicability of the interchange of labor rule varies by state; some states only allow its use in the construction, erection or stevedoring classes of business while other states permit the interchange of labor rule to apply to any type of business operation.
Interchange of labor rules allow a single employee's payroll to be split between or among several class codes that may be present within the operations. The advantage to the employer (premium payer) of such allowance is an ultimately lower premium. Without the interchange of labor rule, the employee's entire payroll would be assigned to the governing (likely highest rate) classification. With the interchange of labor rule in effect, the employer is charged based on the employee's actual exposure to injury.
For instance, an employee in the construction industry who does framing work (5645) and hardwood floor installation (5437) can see his payroll divided between these different operations and realize a reduction in premium provided the following specific provisions are met:
• All classifications used for an employee are appropriate to the job performed;
• Payroll records exist that allocate the employee's wages between/among the different classes. This requires an actual, dollar amount payroll split, a percentage of payroll is not allowed; and
• The division of payroll is not available with any of the standard exception classifications (with the possible exception of the driver code).
Continuing the above example using assigned risk rates of $25 for code 5645 and $14 for code 5437, an employee earning an annual payroll of $30,000 will cost the employer $7,500 if there is no interchange of labor. If, however, all the interchange of labor guidelines are met, and the employee's payroll is split as follows: $20,000 for framing and $10,000 for hardwood floor installation; the employee will only cost $6,400 in workers' compensation premium (ignoring expense constants, modification factors and debits or credits).
The interchange of labor rule is great for the employer due to the premium savings and is fair for the insurance carrier because exposures differ based on activity. When the employee is on scaffolding he is more like to suffer a severe injury than when installing flooring.
Employers and their agents must understand and take advantage of the interchange of labor rules allowed in each subject state. Large payrolls can greatly benefit from such splits thus agents should encourage detailed payroll records be kept and the audits should be checked closely.
General Exclusion Classifications
Some operational activities do not fit into the analogous assignment of the governing classification due to the unexpected existence of such an operation as part of a particular business. It is not reasonable to expect the hardware store code (8010) to pick up the exposure created by an on-site sawmill operation (2710) for example.
Such operations are known as "general exclusion" classes. General exclusion classes are listed separately on the workers' compensation policy and a separate rate (based on the class code) is charged for the employees within these classes of operations.
General exclusion classes are the opposite of "standard exception" classes. General exclusion classes are completely unexpected and not considered part of the analogy of the governing classification of an operation requiring separation to allow the insurer to garner the, usually, higher premium for the increased exposure. Standard exceptions represent operations common to most business and are of such minimal hazard that the insured should not be punished by having the payroll for these classes included in the governing classification, but should rather enjoy a lower premium for the reduced exposure.
Operations and activities falling within the general exclusion classification are:
• Employees working in aircraft operations;
• Employees performing new construction or alterations;
• Stevedoring employees;
• Sawmill operation employees; and
• Employees working in an employer-owned daycare.
Multiple Enterprise Rule
The single enterprise rule introduced in the previous article requires that all activities usual and customary to a particular operation be assigned to one "governing" class code (with the exceptions described above). However, a particular entity may conduct additional operations not usual or customary to such an enterprise; such disparate activities may allow the insured to qualify for the separation of payroll into multiple classifications under the "multiple enterprise rule."
A secondary operation producing a basic premium equal to or higher than the governing class code (the code generating the highest payroll) premium automatically qualifies for separation under the multiple enterprise rule with the only requirement being segregation of payrolls.
If, however, the basic premium generated by the secondary operation is less than the governing class code basic premium, four tests must be satisfied before the insured can make use of the multiple enterprise rule. These are:
1. The operation to be separately classed is not commonly found within the operation of the subject insured's business;
2. The operations could each exist as a separate entity;
3. Financial records are kept separately for each operation; and
4. The operations are physically separated by means of a partition, wall or placement in a separate building.
Such separation of payrolls may benefit the insured employer by a reduction in premium if the secondary enterprises carry a lower rate per $100 of payroll. Additionally, employers that qualify for separation of payrolls under the multiple enterprise rule may also be able to benefit from the application of the interchange of labor rule presented above (based on the state).
ABC's of Premium Audits
There are specific guidelines that agents and the employer should apply to every audit. These are the "ABC's" of premium audits.
"A": Always be there. A representative from the company familiar with the financial records and the operations of the company should be present at every audit. The auditor will likely have questions and unless someone is available to answer these questions and explain the financial documents, the auditor is likely to make some assumptions and potentially some costly mistakes. This duty should not be delegated to any member of the staff not intimately familiar with the business.
"B": Be prepared. The auditor will need all the necessary financial records to conduct the audit and will likely ask for a tour of the facility. Prepare a place for the auditor to work and help them complete their job as quickly as possible. Some data that will need to be ready includes:
• Payroll records: Payroll journal and summary; 941's; state unemployment reports; an explanation and break out of overtime payments; and the general ledger.
• Employee records: Include a detailed description of job duties; the number of employees; employee hire and fire dates; and class code splits if applicable.
• Cash disbursements: Cost of and payments to subcontractors; cost of materials; and the cost of any casual labor hired.
• Certificates of Insurance: Make sure to supply current certificates of insurance covering the entire period of the audit or the entire period of time the contractor has worked for the insured. If the sub's policy renews in the middle of the audit period, a new certificate should be requested covering the remainder of the insured's policy period.
• OCIP projects: If the insured has been a part of any wrap-up, the auditor needs this information in order to remove the payroll from the calculation.
"C": Copy of the auditor's work papers. Don't let the auditor leave without getting a copy of the audit work papers. This will allow the insured and their agent to review the audit and confirm that there are no errors BEFORE the audit is processed and billed (fixing it "after-the-fact" is more difficult).
"D": Don't volunteer more information than asked. The auditor will ask questions, this is expected. Insureds should be advised to only answer the questions ask, do not lead the auditor down a path that may be detrimental to the insured.
"E": Exceptions to the single entity rule. The exceptions listed above should be capitalized on by the insured. Audits should, at the very minimum, contain at least one standard exception code. If the insured is eligible for any of the other payroll splits described above, those codes should also be included.
Knowing the rules and exceptions, giving the auditor everything they need to complete the audit quickly and following the above rules will increase the chances of a favorable audit.
The next article will be the long-awaited workers' compensation and employers' liability coverage checklist.
Workers' Compensation Audit Rules And Guidelines
Workers' Compensation Audit Rules And Guidelines
Christopher J. Boggs, CPCU, ARM, ALCM
September 17, 2008
Workers' compensation coverage is initially priced on an estimated basis. The insured estimates payrolls (and sometime class codes) at the beginning of the policy period for the upcoming year on which the insurance carrier charges a premium using the prescribed rates. After the close of the policy year, the insurance carrier desires to firm up the numbers to confirm collection of the actual premium earned for the actual exposure insured. This "firming-up" is known as the premium audit.
Premium audits are addressed by Part Five, paragraph G. of NCCI's Workers' Compensation and Employers' Liability Insurance Policy. The form reads as follows:
G. Audit: You will let us examine and audit all your records that relate to this policy. These records include ledgers, journals, registers, vouchers, contracts, tax reports, payroll and disbursement records, and programs for storing and retrieving data. We may conduct the audits during regular business hours during the policy period and within three years after the policy period ends. Information developed by audit will be used to determine final premium. Insurance rate service organizations have the same rights we have under this provision.
Premium Basis
Premium, with rare exception, is based on payroll also known as remuneration. Below are the common remuneration inclusions and exclusions:
Remuneration Included:
• Wages/Salaries;
• Commissions - If on draw, and draw greater than commissions earned - use the entire amount of the draw;
• Bonuses, unless awarded for individual invention or discovery;
• Overtime - One-third of amount is subtracted from the total amount (one-half if it is double-time pay);
• Pay for holidays, vacations, or periods of sickness;
• Pay for time not worked (i.e. paid for an 8 hour day when only 7 hours worked);
• Pay for travel time to or from work or specific job site;
• Employer payments of amounts otherwise required by law (i.e. Statutory insurance, Social Security, etc.);
• Contributions to a savings plan or vacation fund required by a union contract;
• IRS Qualified Salary Reduction Plan (i.e. 401K) (refers to the employees contribution and any qualified agreement between the employer and the employee to pay into a retirement plan in lieu of direct wages);
• Employee Savings Plans - only the amount given by the employee, not the employer's match, if any;
• Contributions to an IRA made by the employee;
• Payment on any basis other than time worked such as piecework, incentive plans or profit sharing plans;
• Payment or allowance for tools;
• Value of housing/lodging;
• Value of meals; and
• Substitutes for money (merchandise certificates, store credit, etc).
Remuneration Excluded:
• Tips and other gratuities (if the employer has to make up difference between hourly pay plus tips and the specified minimum wage, the additional funds are counted);
• Payments by employer to Group Insurance or Pension Plans (employer matching);
• Special rewards for individual invention or discovery; and
• Severance pay.
Special Payroll Considerations - Sole Proprietors, Partners, LLC Members and Executive Officers
Actual payroll for each employee is used in the calculation of the final workers' compensation premium with just a few common exceptions. Sole proprietors, partners, LLC members and executive officers are treated differently than regular employees.
Sole proprietors and partners in states that allow these persons to choose to be subject to the workers' compensation law and covered by the policy are generally assigned a payroll regardless of their actual gross income. This amount is adjusted annually to account for inflation and other cost of living factors. Each state which allows these individuals to "opt in" assigns its own payroll limit (it is not the same throughout the country).
Executive officers are generally subject to an upper and lower weekly payroll limit rather than a set annual payroll like sole proprietors and partners. In North Carolina, for instance, the minimum weekly payroll assignable to an executive officer is $331 per week ($17,212 per year) with a maximum weekly payroll of $1,300 per week ($67,600 per year). An executive office paid $300,000 per year will appear on the audit at $67,600 per year. Remember, not all officers are executive officers. Executive officers are generally limited to the president or CEO, the CFO and certain levels of vice presidents. The delineation is a function of the articles of incorporation and can vary from entity to entity.
Members and managers of an LLC are, once again, subject to state laws. Some states treat these individuals as sole proprietors/partners while others view them as executive officers. The subject law should be reviewed to confirm how these individuals are classified and thus how payrolls will be assigned based on the descriptions above.
Three operational and actuarial reasons for such payroll limitations are:
1) Getting paid more does not increase the likelihood that an injury will occur. A plumbing company executive officer actually engaged in plumbing work and earning $150,000 per year is no more likely to get hurt than the $15 per hour "plumber's helper." In fact, he is probably less likely to get hurt due to experience and personal interest. The amount of pay does not increase the chance of injury;
2) Medical costs, theoretically, don't fluctuate based on the individual's income. A broken leg costs the same to set for the owner and the hourly employee;
3) Indemnity payments are limited to a minimum and maximum in each state. As discussed in an earlier article on workers' compensation benefits, each state sets the minimum and maximum weekly indemnity benefits. If the maximum that an injured executive or employee can receive in any given year is $75,000 (just for example sake), it is not reasonable to expect the insured to pay a premium based on a gross income of $200,000. This operational rule is combined with the previous two to limit the amount of payroll assignable to these special classes of people.
Governing Classification and the Single Enterprise Rule
Once final payrolls are calculated, a "Governing Classification" is assigned to the employer. The governing classification is generally based on the class code generating the largest payroll; rarely the highest rated code is used as the governing class (usually only used in construction-related operations if used at all). All employee payroll, with certain exclusions and exceptions expounded upon later, are assigned to the governing classification.
The governing classification is intended to represent the exposure created by the overall operation business, not the exposure of each individual employee. Applying the single enterprise rule, the governing classification is designed to anticipate all the normal activities conducted by a particular operation or business. For example, a steel fabrication plant may have employees that rivet, others that bend and shape the steel, others that paint the finished product and still others that add braces and brackets. Even though there are different exposures presented by each of these operations, all payroll is assigned to the same class code.
Further, there are some activities a business conducts that appear to be so unrelated to the primary operations as to require or allow separate classification be assigned. However, NCCI considers some of these activities to be an integral part of the business' operations thus the payroll of the individuals engaged in these activities is included in the governing classification. Known as "General Inclusions" these included activities are:
• Employees that work in a restaurant, cafeteria or commissary run by the business for use by the employees (this does not apply to such establishments at construction sites);
• Employees manufacturing containers such as boxes, bags, can or cartons for the employer's use in shipping its own products;
• Staff working in hospitals or medical facilities operated by the employer for use by the employees;
• Maintenance or repair shop employees; and
• Printing or lithography employees engaged in printing for the employer's own products.
Payroll for any employee engaged in the above activities is assigned to the governing classification.
Exceptions to the Governing Classification Rules
There are exceptions to the governing classification and single enterprise rules. These are:
• The "Standard Exception" classifications;
• The "Interchange of Labor" rules;
• The "General Exclusion" classes; and
• Employers eligible for classification under the "Multiple Enterprise" rule.
Each of these will be detailed in the next article. Additionally, the "ABC's" of premiums audits will be presented.
Christopher J. Boggs, CPCU, ARM, ALCM
September 17, 2008
Workers' compensation coverage is initially priced on an estimated basis. The insured estimates payrolls (and sometime class codes) at the beginning of the policy period for the upcoming year on which the insurance carrier charges a premium using the prescribed rates. After the close of the policy year, the insurance carrier desires to firm up the numbers to confirm collection of the actual premium earned for the actual exposure insured. This "firming-up" is known as the premium audit.
Premium audits are addressed by Part Five, paragraph G. of NCCI's Workers' Compensation and Employers' Liability Insurance Policy. The form reads as follows:
G. Audit: You will let us examine and audit all your records that relate to this policy. These records include ledgers, journals, registers, vouchers, contracts, tax reports, payroll and disbursement records, and programs for storing and retrieving data. We may conduct the audits during regular business hours during the policy period and within three years after the policy period ends. Information developed by audit will be used to determine final premium. Insurance rate service organizations have the same rights we have under this provision.
Premium Basis
Premium, with rare exception, is based on payroll also known as remuneration. Below are the common remuneration inclusions and exclusions:
Remuneration Included:
• Wages/Salaries;
• Commissions - If on draw, and draw greater than commissions earned - use the entire amount of the draw;
• Bonuses, unless awarded for individual invention or discovery;
• Overtime - One-third of amount is subtracted from the total amount (one-half if it is double-time pay);
• Pay for holidays, vacations, or periods of sickness;
• Pay for time not worked (i.e. paid for an 8 hour day when only 7 hours worked);
• Pay for travel time to or from work or specific job site;
• Employer payments of amounts otherwise required by law (i.e. Statutory insurance, Social Security, etc.);
• Contributions to a savings plan or vacation fund required by a union contract;
• IRS Qualified Salary Reduction Plan (i.e. 401K) (refers to the employees contribution and any qualified agreement between the employer and the employee to pay into a retirement plan in lieu of direct wages);
• Employee Savings Plans - only the amount given by the employee, not the employer's match, if any;
• Contributions to an IRA made by the employee;
• Payment on any basis other than time worked such as piecework, incentive plans or profit sharing plans;
• Payment or allowance for tools;
• Value of housing/lodging;
• Value of meals; and
• Substitutes for money (merchandise certificates, store credit, etc).
Remuneration Excluded:
• Tips and other gratuities (if the employer has to make up difference between hourly pay plus tips and the specified minimum wage, the additional funds are counted);
• Payments by employer to Group Insurance or Pension Plans (employer matching);
• Special rewards for individual invention or discovery; and
• Severance pay.
Special Payroll Considerations - Sole Proprietors, Partners, LLC Members and Executive Officers
Actual payroll for each employee is used in the calculation of the final workers' compensation premium with just a few common exceptions. Sole proprietors, partners, LLC members and executive officers are treated differently than regular employees.
Sole proprietors and partners in states that allow these persons to choose to be subject to the workers' compensation law and covered by the policy are generally assigned a payroll regardless of their actual gross income. This amount is adjusted annually to account for inflation and other cost of living factors. Each state which allows these individuals to "opt in" assigns its own payroll limit (it is not the same throughout the country).
Executive officers are generally subject to an upper and lower weekly payroll limit rather than a set annual payroll like sole proprietors and partners. In North Carolina, for instance, the minimum weekly payroll assignable to an executive officer is $331 per week ($17,212 per year) with a maximum weekly payroll of $1,300 per week ($67,600 per year). An executive office paid $300,000 per year will appear on the audit at $67,600 per year. Remember, not all officers are executive officers. Executive officers are generally limited to the president or CEO, the CFO and certain levels of vice presidents. The delineation is a function of the articles of incorporation and can vary from entity to entity.
Members and managers of an LLC are, once again, subject to state laws. Some states treat these individuals as sole proprietors/partners while others view them as executive officers. The subject law should be reviewed to confirm how these individuals are classified and thus how payrolls will be assigned based on the descriptions above.
Three operational and actuarial reasons for such payroll limitations are:
1) Getting paid more does not increase the likelihood that an injury will occur. A plumbing company executive officer actually engaged in plumbing work and earning $150,000 per year is no more likely to get hurt than the $15 per hour "plumber's helper." In fact, he is probably less likely to get hurt due to experience and personal interest. The amount of pay does not increase the chance of injury;
2) Medical costs, theoretically, don't fluctuate based on the individual's income. A broken leg costs the same to set for the owner and the hourly employee;
3) Indemnity payments are limited to a minimum and maximum in each state. As discussed in an earlier article on workers' compensation benefits, each state sets the minimum and maximum weekly indemnity benefits. If the maximum that an injured executive or employee can receive in any given year is $75,000 (just for example sake), it is not reasonable to expect the insured to pay a premium based on a gross income of $200,000. This operational rule is combined with the previous two to limit the amount of payroll assignable to these special classes of people.
Governing Classification and the Single Enterprise Rule
Once final payrolls are calculated, a "Governing Classification" is assigned to the employer. The governing classification is generally based on the class code generating the largest payroll; rarely the highest rated code is used as the governing class (usually only used in construction-related operations if used at all). All employee payroll, with certain exclusions and exceptions expounded upon later, are assigned to the governing classification.
The governing classification is intended to represent the exposure created by the overall operation business, not the exposure of each individual employee. Applying the single enterprise rule, the governing classification is designed to anticipate all the normal activities conducted by a particular operation or business. For example, a steel fabrication plant may have employees that rivet, others that bend and shape the steel, others that paint the finished product and still others that add braces and brackets. Even though there are different exposures presented by each of these operations, all payroll is assigned to the same class code.
Further, there are some activities a business conducts that appear to be so unrelated to the primary operations as to require or allow separate classification be assigned. However, NCCI considers some of these activities to be an integral part of the business' operations thus the payroll of the individuals engaged in these activities is included in the governing classification. Known as "General Inclusions" these included activities are:
• Employees that work in a restaurant, cafeteria or commissary run by the business for use by the employees (this does not apply to such establishments at construction sites);
• Employees manufacturing containers such as boxes, bags, can or cartons for the employer's use in shipping its own products;
• Staff working in hospitals or medical facilities operated by the employer for use by the employees;
• Maintenance or repair shop employees; and
• Printing or lithography employees engaged in printing for the employer's own products.
Payroll for any employee engaged in the above activities is assigned to the governing classification.
Exceptions to the Governing Classification Rules
There are exceptions to the governing classification and single enterprise rules. These are:
• The "Standard Exception" classifications;
• The "Interchange of Labor" rules;
• The "General Exclusion" classes; and
• Employers eligible for classification under the "Multiple Enterprise" rule.
Each of these will be detailed in the next article. Additionally, the "ABC's" of premiums audits will be presented.
Workers' Compensation - Combinability Conclusion
Workers' Compensation - Combinability Conclusion
Christopher J. Boggs, CPCU, ARM, ALCM
September 15, 2008
Combinability rules were introduced and explored in the previous article; this commentary will discuss combinability guidelines as they relate to specific insureds. Several combinability concepts will clarified and relevant terms defined.
Combinability Guidelines
Common majority ownership is the basic rule of combinability. When the same person, group of persons or a corporation owns a majority interest in another entity, the owned entity's loss experience is combined with the owning entity to develop a common (combined) experience modification factor.
The combinability concept seems simple enough, however achieving "common majority ownership" can be accomplished in one of several relational constructs:
• The corporation (a "legal person") owns a majority interest in other entities. When Corp "A" owns a "majority interest" (this term will be defined in upcoming paragraphs) in Corp "B," the loss experience of both corporations is pooled to produce a single, combined experience modification factor;
• The business' owner(s) ("natural person(s)") individually or collectively maintain majority interest in more than one entity. If John holds majority interest in Corp "A" and he individually gains majority interest in Corp "B," the two entities are combined for experience rating. However, if John has majority interest in only one of the two entities, they are not combinable (i.e. John maintains 75 percent interest in Corp "A" but only 25 percent in Corp "B"). To continue, assume that John and Joe combine to own majority interest in Corp "A" and Corp "B;" common majority ownership exists and the experience is combinable;
• The corporation combines with some or all of its owners to hold a majority interest in another entity. Corp "A" (again, a "legal person") maintains 30 percent interest in Corp "B;" John and Joe (100 percent owners of Corp "A") hold 25 percent of Corp "B." The combined ownership of the legal person and the natural persons result in common majority ownership (55 percent) of Corp "B" making the two entities combinable ; or
• The business owns a majority interest in another entity which, itself, owns or owned a majority interest in a third entity currently operating or which operated in the last five years.
This is not an exhaustive list of relationships that can lead to combinability of loss experience; it is but a representation of the most common. These guidelines are subject to NCCI and/or individual state rating bureau interpretations. Agents, brokers and carriers should use these descriptions only for informational purposes as final determination rests in these other advisory bodies.
Natural and Legal Persons
Notice the repeated use of the natural and legal person(s) concept in the above paragraphs. Common majority interest can be created when a single "person" or a group of "persons" combine to hold a majority interest in multiple entities. It matters little whether the owners of other entities are natural persons, legal persons or a combination. Nor does it matter how they combine to create common majority interest between or among two or more entities.
Legal persons are generally created by the actions and desires of natural persons. Some legal persons are owned by one or only a few natural persons (a small business) while some are "owned" by many shareholders (traded on the stock exchanges). Natural and legal persons are defined as follows:
• Natural person: A flesh and blood human being. In workers compensation the employer is a natural person(s) in sole proprietorships and partnerships. Managers and members of an LLC are viewed as natural persons in a majority of states making these persons the employers.
• Legal person (a.k.a. juridical person): A legal fiction, a "person" created by statute and born with the filing of articles of incorporation. These legal persons are given the right to own property, sue and be sued. Corporations are legal persons and several states consider LLC's a legal person.
"Majority Interest"
Majority interest is created when the same person or group of person(s) combine to own more than 50 percent of an entity. But majority interest can be created in many ways. NCCI lists the following:
• An entity or persons (as detailed above) owns the majority of the voting stock of another entity; or
• Both entities share a majority of the same owners (if there is no voting stock). Generally these are natural persons that own multiple entities.
• If neither of the above applies, majority interest is created if a majority of the board is common between two or among several entities.
• Participation of each general partner in the profits of the partnership (limited partners are excluded). Or
• When ownership interest is held by an entity as a fiduciary (excludes a debtor in possession, a trustee under an irrevocable trust or a franchisor).
Combinability Conclusion
Based on and applying the above common majority interest rules, the possibility exists for more than one combination of common related entities. Deciding which combination of entities applies is based on the following two rules (presented in order of importance):
1. Which combination involves the most entities?
2. If the above does not apply, the combination is based on the group that produces the largest estimated standard premium.
Regardless of how a group is created and combined, no entity's experience will be used more than once.
Finally, although separate entities may be combinable for experience modification calculation; this does not exclude them from having separate workers' compensation policies. Separate legal entities are entitled (and really required) to be written on separate workers' compensation policies; combinability rules exist merely to assure that loss histories are not escaped by the creation of multiple legal entities or the closing of one and opening of a new one.
Christopher J. Boggs, CPCU, ARM, ALCM
September 15, 2008
Combinability rules were introduced and explored in the previous article; this commentary will discuss combinability guidelines as they relate to specific insureds. Several combinability concepts will clarified and relevant terms defined.
Combinability Guidelines
Common majority ownership is the basic rule of combinability. When the same person, group of persons or a corporation owns a majority interest in another entity, the owned entity's loss experience is combined with the owning entity to develop a common (combined) experience modification factor.
The combinability concept seems simple enough, however achieving "common majority ownership" can be accomplished in one of several relational constructs:
• The corporation (a "legal person") owns a majority interest in other entities. When Corp "A" owns a "majority interest" (this term will be defined in upcoming paragraphs) in Corp "B," the loss experience of both corporations is pooled to produce a single, combined experience modification factor;
• The business' owner(s) ("natural person(s)") individually or collectively maintain majority interest in more than one entity. If John holds majority interest in Corp "A" and he individually gains majority interest in Corp "B," the two entities are combined for experience rating. However, if John has majority interest in only one of the two entities, they are not combinable (i.e. John maintains 75 percent interest in Corp "A" but only 25 percent in Corp "B"). To continue, assume that John and Joe combine to own majority interest in Corp "A" and Corp "B;" common majority ownership exists and the experience is combinable;
• The corporation combines with some or all of its owners to hold a majority interest in another entity. Corp "A" (again, a "legal person") maintains 30 percent interest in Corp "B;" John and Joe (100 percent owners of Corp "A") hold 25 percent of Corp "B." The combined ownership of the legal person and the natural persons result in common majority ownership (55 percent) of Corp "B" making the two entities combinable ; or
• The business owns a majority interest in another entity which, itself, owns or owned a majority interest in a third entity currently operating or which operated in the last five years.
This is not an exhaustive list of relationships that can lead to combinability of loss experience; it is but a representation of the most common. These guidelines are subject to NCCI and/or individual state rating bureau interpretations. Agents, brokers and carriers should use these descriptions only for informational purposes as final determination rests in these other advisory bodies.
Natural and Legal Persons
Notice the repeated use of the natural and legal person(s) concept in the above paragraphs. Common majority interest can be created when a single "person" or a group of "persons" combine to hold a majority interest in multiple entities. It matters little whether the owners of other entities are natural persons, legal persons or a combination. Nor does it matter how they combine to create common majority interest between or among two or more entities.
Legal persons are generally created by the actions and desires of natural persons. Some legal persons are owned by one or only a few natural persons (a small business) while some are "owned" by many shareholders (traded on the stock exchanges). Natural and legal persons are defined as follows:
• Natural person: A flesh and blood human being. In workers compensation the employer is a natural person(s) in sole proprietorships and partnerships. Managers and members of an LLC are viewed as natural persons in a majority of states making these persons the employers.
• Legal person (a.k.a. juridical person): A legal fiction, a "person" created by statute and born with the filing of articles of incorporation. These legal persons are given the right to own property, sue and be sued. Corporations are legal persons and several states consider LLC's a legal person.
"Majority Interest"
Majority interest is created when the same person or group of person(s) combine to own more than 50 percent of an entity. But majority interest can be created in many ways. NCCI lists the following:
• An entity or persons (as detailed above) owns the majority of the voting stock of another entity; or
• Both entities share a majority of the same owners (if there is no voting stock). Generally these are natural persons that own multiple entities.
• If neither of the above applies, majority interest is created if a majority of the board is common between two or among several entities.
• Participation of each general partner in the profits of the partnership (limited partners are excluded). Or
• When ownership interest is held by an entity as a fiduciary (excludes a debtor in possession, a trustee under an irrevocable trust or a franchisor).
Combinability Conclusion
Based on and applying the above common majority interest rules, the possibility exists for more than one combination of common related entities. Deciding which combination of entities applies is based on the following two rules (presented in order of importance):
1. Which combination involves the most entities?
2. If the above does not apply, the combination is based on the group that produces the largest estimated standard premium.
Regardless of how a group is created and combined, no entity's experience will be used more than once.
Finally, although separate entities may be combinable for experience modification calculation; this does not exclude them from having separate workers' compensation policies. Separate legal entities are entitled (and really required) to be written on separate workers' compensation policies; combinability rules exist merely to assure that loss histories are not escaped by the creation of multiple legal entities or the closing of one and opening of a new one.
Workers' Compensation - Combinability of Entities
Workers' Compensation - Combinability of Entities
Christopher J. Boggs, CPCU, ARM, ALCM
September 12, 2008
Consolidating separate legal entities' loss experience to develop a common experience modification factor has the potential to cause confusion for the client and sometimes the agent. Clients may view such mixing of loss experience due simply to common majority ownership as less than reasonable - especially if the commonly-owned entities substantially differ in regards to the relative hazard presented (i.e. the owners of a heavy equipment contracting company purchase a marina).
Further, combinability rules not only marry the experience of entities that are currently in operation and related via common majority ownership, they also assure that owners do not avoid their historically poor loss records simply by closing down one entity and reopening and operating under another corporate name. Few agents would argue that such a stunt is unethical at best and may actually be considered fraud. Changing the name of the operation does not change the operational methods of the owner(s).
Understanding combinability rules necessitate a basic understanding of the theory and practice behind the calculation of experience modification factors. Following is a brief synopsis of experience modification calculations.
Calculating Experience Modification Factors
Workers' compensation loss costs are calculated and charged based on the average expected losses for that particular business classification. All insureds in the same hazard class (based on the assigned code) are charged the same basic loss cost (individual carriers apply conversion factors to these loss costs to develop their individual rates). However, not all insureds within a particular hazard class operate in the same manner, nor does each experience the same losses. To adjust for these differences in operation and loss histories, a method had to be created allowing for premium/rate differentiation between the above average, average and below average insureds within any particular hazard class code.
Experience modification factors (experience mods) allow such "customizing" and individualization of the workers' compensation premium. Basing the standard premium on the insured's unique loss history allows the class' average rates to remain relatively constant and the subject insured to be rewarded or punished based on its own experience (rather than be subject solely to the experience of the group).
"Stop loss" limits used as part of the experience mod calculation makes loss frequency weightier than loss severity. One large claim will not damage an experience mod factor as drastically as three small claims in a single experience period (the "experience period" is usually the three years ending 12 months prior to the policy effective date - a 6/1/08 mod would apply the experience for the three years ending 6/1/07).
Calculating experience modification factors is far more complicated than presented in three short paragraphs. Mod calculations are a function of expected losses, actual losses, payrolls, class averages, loss limits (medical only vs. medical plus indemnity) and formulary factors applied by NCCI (or the applicable rating bureau) to all such collected data. Detailing this calculation is outside the scope of this commentary and is not an intended focus of this article.
Knowing and understanding that experience modification factor calculations allow for the reward or punishment of individual employers allows one to more clearly view the need for loss experience combinability. Employers should not be freed of their premium responsibility simply due to legal structure. And rarely are majority- owned entities not interrelated such that employees work for multiple entities even though they appear to be operating for just one employer in the course and scope of their daily duties (combinability avoids some of the problems created by the borrowed servant doctrine).
A Case For Combinability Rules
Owners theoretically run each and every operation (past and present) in essentially the same manner with the same attitudes. An employer that is concerned with safety and strives to provide the best equipment and training will likely always act the same way with each entity. Likewise, employers looking for the easiest and cheapest way out will likely continue down the same path in the future. Combinability rules are, to some extent, based around these theories:
• Employers that operate in the supposed best interest of their employees should have all their entities (current and future) rewarded due to such attitude. Commonly-owned operations will likely be managed in the same manner and the same care and concern is expected to be showed for all employees (regardless of the hazard of the operation).
• If an employer allows unsafe operations in one entity, it is reasonable to postulate that such attitude will carry over to the new entity and all commonly-owned entities (current and future). Employers not operating (or not appearing to operate) in the best interest of their employees should be subject to their past (or current) experience.
Past actions are not a guarantee of future actions, but they stand as a very good indicator. To not reward or punish allows employers/owners to act with impunity, knowing that as long as no law is broken, all that is necessary to escape a poor loss history is the killing off of an old and birthing a new corporation.
Without the ability to combine loss histories, workers' compensation carriers would potentially be victims of inadequate premiums. In like manner, average and above average risks would be victimized by higher premiums than necessary. The "average loss cost" balance would be tilted and all employers would likely see an increase in their rates rather than just the ones that "earned" the increase. Rate predictability and possibly rate adequacy may be compromised without combinability rules.
Granted, there are exceptions to every rule such as is demonstrated by the employer that had a hiccup in their loss history not indicative of their past. Not every injury can be avoided, even with top-notch safety and training, bad "things" sometimes just happen. This is why there is underwriting discretion and the availability of rate credits and debits. A historically above-average employer with a bad year or two in their experience modification calculation can have the debit mod negated by a rate credit.
Conversely, an average or below average employer that has been fortunate can be debited to account for the increased hazard presented to the insured. Employers that do not practice or refuse to comply with recommended safety practices, as reported by the loss control department, can see their rates increased by a debit factor in anticipation of the increased potential for employee injury.
Christopher J. Boggs, CPCU, ARM, ALCM
September 12, 2008
Consolidating separate legal entities' loss experience to develop a common experience modification factor has the potential to cause confusion for the client and sometimes the agent. Clients may view such mixing of loss experience due simply to common majority ownership as less than reasonable - especially if the commonly-owned entities substantially differ in regards to the relative hazard presented (i.e. the owners of a heavy equipment contracting company purchase a marina).
Further, combinability rules not only marry the experience of entities that are currently in operation and related via common majority ownership, they also assure that owners do not avoid their historically poor loss records simply by closing down one entity and reopening and operating under another corporate name. Few agents would argue that such a stunt is unethical at best and may actually be considered fraud. Changing the name of the operation does not change the operational methods of the owner(s).
Understanding combinability rules necessitate a basic understanding of the theory and practice behind the calculation of experience modification factors. Following is a brief synopsis of experience modification calculations.
Calculating Experience Modification Factors
Workers' compensation loss costs are calculated and charged based on the average expected losses for that particular business classification. All insureds in the same hazard class (based on the assigned code) are charged the same basic loss cost (individual carriers apply conversion factors to these loss costs to develop their individual rates). However, not all insureds within a particular hazard class operate in the same manner, nor does each experience the same losses. To adjust for these differences in operation and loss histories, a method had to be created allowing for premium/rate differentiation between the above average, average and below average insureds within any particular hazard class code.
Experience modification factors (experience mods) allow such "customizing" and individualization of the workers' compensation premium. Basing the standard premium on the insured's unique loss history allows the class' average rates to remain relatively constant and the subject insured to be rewarded or punished based on its own experience (rather than be subject solely to the experience of the group).
"Stop loss" limits used as part of the experience mod calculation makes loss frequency weightier than loss severity. One large claim will not damage an experience mod factor as drastically as three small claims in a single experience period (the "experience period" is usually the three years ending 12 months prior to the policy effective date - a 6/1/08 mod would apply the experience for the three years ending 6/1/07).
Calculating experience modification factors is far more complicated than presented in three short paragraphs. Mod calculations are a function of expected losses, actual losses, payrolls, class averages, loss limits (medical only vs. medical plus indemnity) and formulary factors applied by NCCI (or the applicable rating bureau) to all such collected data. Detailing this calculation is outside the scope of this commentary and is not an intended focus of this article.
Knowing and understanding that experience modification factor calculations allow for the reward or punishment of individual employers allows one to more clearly view the need for loss experience combinability. Employers should not be freed of their premium responsibility simply due to legal structure. And rarely are majority- owned entities not interrelated such that employees work for multiple entities even though they appear to be operating for just one employer in the course and scope of their daily duties (combinability avoids some of the problems created by the borrowed servant doctrine).
A Case For Combinability Rules
Owners theoretically run each and every operation (past and present) in essentially the same manner with the same attitudes. An employer that is concerned with safety and strives to provide the best equipment and training will likely always act the same way with each entity. Likewise, employers looking for the easiest and cheapest way out will likely continue down the same path in the future. Combinability rules are, to some extent, based around these theories:
• Employers that operate in the supposed best interest of their employees should have all their entities (current and future) rewarded due to such attitude. Commonly-owned operations will likely be managed in the same manner and the same care and concern is expected to be showed for all employees (regardless of the hazard of the operation).
• If an employer allows unsafe operations in one entity, it is reasonable to postulate that such attitude will carry over to the new entity and all commonly-owned entities (current and future). Employers not operating (or not appearing to operate) in the best interest of their employees should be subject to their past (or current) experience.
Past actions are not a guarantee of future actions, but they stand as a very good indicator. To not reward or punish allows employers/owners to act with impunity, knowing that as long as no law is broken, all that is necessary to escape a poor loss history is the killing off of an old and birthing a new corporation.
Without the ability to combine loss histories, workers' compensation carriers would potentially be victims of inadequate premiums. In like manner, average and above average risks would be victimized by higher premiums than necessary. The "average loss cost" balance would be tilted and all employers would likely see an increase in their rates rather than just the ones that "earned" the increase. Rate predictability and possibly rate adequacy may be compromised without combinability rules.
Granted, there are exceptions to every rule such as is demonstrated by the employer that had a hiccup in their loss history not indicative of their past. Not every injury can be avoided, even with top-notch safety and training, bad "things" sometimes just happen. This is why there is underwriting discretion and the availability of rate credits and debits. A historically above-average employer with a bad year or two in their experience modification calculation can have the debit mod negated by a rate credit.
Conversely, an average or below average employer that has been fortunate can be debited to account for the increased hazard presented to the insured. Employers that do not practice or refuse to comply with recommended safety practices, as reported by the loss control department, can see their rates increased by a debit factor in anticipation of the increased potential for employee injury.
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