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Chapter 5

FIN 512 Chapter Notes - Chapter 5: Home Insurance, Liability Insurance, Risk Management Tools

Course Code
FIN 512
Giulio Iacobelli

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Chapter 5: Commercial Insurance
Provides a more comprehensive version of the coverage found in automobile and homeowners insurance, and is
sold to businesses and other non-personal enterprises because they face greater risk exposures than the average
General insurance is the name given to all insurance except life and health is often referred to as Property
and Casualty Insurance or P&C
- Property Insurance is first-party coverage providing protection against risks to the policyholder’s own
property. It covers risks such as fire, theft, or weather damage.
- Casualty Insurance is broadly defined as “third-party” coverage providing protection against losses
that the policyholder may cause to others but has come to mean any coverage that is not related to life,
marine or property. It includes but is not limited to the following:
Product liability insurance
Liquor liability insurance
Errors and omissions insurance
Directors and officers insurance
Malpractice insurance
- Commercial insurance is bought by businesses and non-commercial organizations to protect themselves
against possible loss or damage to their assets
- Coverage varies from insurer to insurer and is based on the risk exposures the organization faces
coupled with the level of protection it wants
- Commercial insurance is a cost effective form of risk management that corporations and non-profits use
to effectively limit the risk exposures that can arise from damage to their operations, from consumer
lawsuits, as well as from their employees
Types of Commercial Insurance:
- Property Insurance
- Liability Insurance
Commercial Property Insurance: used by organizations to protect property such as buildings, equipment, and
machinery from loss or damage.
- Coverage offered by a commercial property insurance policy is comprehensive and can be structured to
provide coverage to property owned by a firm but not located on its physical premises
- There are a variety of risks that property is exposed to every day, and these risks can result in two types
of losses:
1. A direct loss resulting from a hazard or a peril, and
2. An indirect loss, which is contingent on an event or a repeated occurrence and is usually the result
of a direct loss
Commercial Liability Insurance: used by corporations and non-profits of all sizes to protect themselves
against legal liability risks that might require them to financially compensate a third party as a result of a
wrongful act, injury, or damage.
- These types of risks could significantly damage a firm’s working capital, impairing its ability to cover
payables, which is critical to its day-to-day operations
- Prudent firms implement appropriate risk management tools to minimize the financial impact that might
arise from these risk exposures
- Although liability can be broken down into numerous categories, we will use three broad classifications:
1. General liability: the legal liability that an enterprise faces when running day-to-day operations
There are 5 defined areas of operations that are exposed to risk and for which a firm can
be held legally liable: premises and operations, product, completed operations, contingent
liability, and contractual liability.

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2. Professional Liability: arises from negligent acts, errors, omissions, and poor performances by
employees when performing their professional duties
Provides the firm- a corporation, non-profit organization, partnership, or sole proprietor-
with coverage that is a result of litigation by unsatisfied clients and customers
There are many different forms of professional liability and, as a result, there are many
different forms of insurance coverage that an organization can obtain to protect itself
against those risks
Example: a chartered bank that employs financial advisors can be held liable for the
financial advice its employees provides to customers, even if the advice is contrary to
bank policy
3. Employer Liability: covers the various risk exposures that an organization faces when it employs
people to complete various tasks.
One of the greatest liabilities that a firm is exposed to when it hires employees is their
health and safety while they are on company premises or away on a site to complete a job
In addition, part of the employer’s responsibility is to ensure that employees are treated
equally and fairly
An employer must also ensure that employee duties are clearly defined and that employees
are property trained and adequately compensated for the work they do
Fundamentals of Commercial Policies:
- Many of the commercial policies have evolved to provide more coverage and more options for the
insured because the risk exposures are more complex and many companies have large financial
resources enabling insured’s to absorb larger losses than individuals can absorb
- These include the following:
A broader definition of the occurrence- the cause of the harm or loss
Choices as to the timing of the occurrence with respect to the coverage, and
Options for the deductible
Occurrence: commercial policies require that the loss or bodily harm be caused by an occurrence which
includes the following:
- Events that happen over a period of time, resulting in continuous or repeated exposure to essentially the
same harmful conditions
- An accident, or
- A series of accidents. An accident is an event that causes a loss and is sudden, unexpected, and
Bases of Paying Out: there are two bases for commercial liability policies to pay out:
1. Occurrence Policies pay for losses that occurred during the policy period regardless of when the claim
is filed. This type of policy is appropriate for a drug manufacturer who produces a drug whose harmful
effects might not be know for some time after it is taken.
2. Claims made Policies pay for losses after a certain date (some specific time before the beginning o the
policy period) but the claims are made during the policy period. This type is appropriate for an oil
producer who is at risk for oil spills.
Deductible: is the same as personal insurance- it is an amount subtracted from the total payment. Its purposes
are to reduce:
- Small claims
- Premiums, and
- Moral and morale hazard.
There are several types of deductibles in commercial insurance:
- Aggregate deductible- the firm pays all the losses for the year until the deductible limit is reached
- Straight deductible or per occurrence deductible- the firm pays the deductible for each separate loss
(example page 174)

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- Franchise deductible- is found only in ocean marine insurance. It is either a dollar amount or a
percentage of the loss and the entire loss is paid once the loss is greater than the deductible- a
disappearing deductible.
The firm must decide how much risk to retain, either by
- Having a high deductible
- Including a stop-loss provision that caps the amount the insured pays in total throughout the policy
period; or
- Self-insuring, which is a risk management technique whereby the firm retains part of the risk exposure
and usually, but not always, has a fund set aside to cover losses- instead of insuring the risk, they retain
the risk. Smaller losses are paid out of operations. A deductible is also called self-insured retention.
Coinsurance in Commercial Property Insurance: the coinsurance is not the same as the 80% rule for the
homeowners’ property. As with one’s home, most losses are partial losses as shown in the following table for
commercial property losses.
# Of Losses
Loss as % of Replacement Cost
20% or less
21% to 49%
50% or more
- Commercial property owners are different from homeowners in two important ways:
1. They often have buildings in several locations. While the probability of loss may be similar for most
locations, the probability of a partial or total loss in all locations at the same time is virtually small.
2. Companies can afford to take more risk on all their properties combined.
- As a result, an insured can elect to underinsure but will pay a high premium for doing so and is expected
to keep the amount of the coverage based on current replacement value
- If the coverage is kept at replacement cost, the insurer will pay all losses up the limits of the policy
- 4 examples on page 176- 178
 
  
- Another possible method for applying the coinsurance requirement in commercial insurance is to use
this formula:
 
 
- Coinsurance for Indirect Losses: indirect loss coverage such as extra expenses coverage to cover
additional costs incurred as a result of a direct loss (for instance, renting other premises) can be
purchased with a coinsurance requirement, which is based on the amount of time a firm would be shut
down if it incurred a loss. The formula is as follows:
   
Where y% is how long the firm would be shut down
If the firm might be shut down for more than a year, y might be 125%
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