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FIN 512
Giulio Iacobelli

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 household  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  Overview: - 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. 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 unintended  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) - 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 85% 20% or less 10% 21% to 49% 5% 50% or more 100% - 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%  Structure of Policy Coverage: before an organization looks at the structure of its commercial insurance policy, it must go through the risk management process which involves the following: 1. Determining the objectives 2. Identifying the risks 3. Evaluating the potential losses 4. Considering the alternatives 5. Implementing the risk-management techniques 6. Performing ongoing evaluation and review - The biggest obstacle an organization faces in the risk-management process is not thoroughly going through the 6 steps - A business could inadvertently overstate or understate its objectives and miss large-risk exposures that leave it susceptible to large losses - Brokers often specialize in certain types of organizations, and one appropriate for your organization can be found by asking an association, friendly competitors, bankers, and accountants - A broker with experience in the insured’s business can help in the evaluation process and also can provide a warning if a certain business has certain requirements that will reduce the cost or even make the insurance coverage possible - Obvious items include monitored smoke detectors and sprinkler systems, but an art gallery or jewelry store, for instance, might require a certain type of burglar alarm system before insurance is even possible - Once all the potential losses have been evaluated, the organization will determine which risk- management tools it wants to implement. The risk-management tools, are: 1. Risk avoidance, which is the oldest and most commonly used risk-management tool. Deciding not to operate in a specific geographical area or not to sell a certain product avoids risk exposures a business might face. 2. Loss control allows an organization to reduce the severity or frequency of a loss by, for instance, limiting the products sold or the hours of operations. 3. Retaining the risk is another common form of risk management that large corporations use to limit their expenditures. This is a form of self-insuring since the insured sets aside funds to pay out large future claims and pay smaller claims out of operating cash flows. 4. Sharing the risk is done by incorporating, hedging, and hold-harmless clauses 5. Insuring the risk is used for large-risk exposures. Commercial policies can be custom tailored to meet the needs of the insured. Not only does the organization need to buy the right kind of insurance, it also needs to buy the right amount- don’t risk more than you can afford to loss, but do not insure that which you can afford to lose. - There are many ways an insurer can customize policies to meet the needs of the insured entity:  Pure captives or group captives  Various structures of the coverage itself: o Umbrella policies o Blanket Insurance o Multiple-lines insurance  Captive Insurers: are insurance companies owned by a firm or firms. The insurer insures the firm and perhaps other non-related companies to capitalize on the principle of risk pooling. There are two types: 1. Pure captives: insure only parents and parent’s subsidiaries 2. Group captives: are insurers having many parents.  Structure of the Policy: commercial coverage can be structured in many ways to help the insured obtain the broadest possible coverage at the least cost. - Umbrella Policies: provide protection against a catastrophic lawsuit by providing broad blanket coverage to areas not covered by the underlying policy.  Excess insurance, described in the auto policy for liability insurance, provides an additional dollar amount of coverage based on the underlying policy while the coverage of an umbrella policy goes beyond the scope of the underlying policy, providing coverage where there is no primary coverage at all (this is the same as the optional coverage in personal auto insurance)  Many umbrella policies provide a very broad definition of personal injury such as mental anguish and injury, shock, discrimination, and/or humiliation  Typically they provide coverage anywhere in the world  Umbrella policies cover both of the following: 1. Personal injury- bodily injury, libel, slander, defamation of character, invasion of privacy, wrongful eviction or detention, false arrest, false imprisonment, and malicious prosecution 2. Property damage- physical damage to tangible property, including the loss of use or the damage property - Blanket Insurance: provides coverage under a single limit for:  Two or more items, for example, the building and it contents  Two or more locations, for example, Location A and Location B  A combination of items and/or locations - Multiple-lines Insurance: covers property and casualty in one contract. It could provide insurance for property, general liability, business income, equipment breakdown, and crime.  Examples for personal coverage are both auto policy and the homeowners policy, which cover several areas  Commercial Property Insurance: cover damage and loss to property - A loss has occurred when something is entirely destroyed, damaged, or missing - Property risk is the risk of loss- either a direct loss (the loss of the property itself) or an indirect or consequential loss (added expenses that are incurred as a result of the direct loss) - The loss can be reduced by the salvage, that portion not damaged, which reduces the amount of the claim  Direct Losses: there are two categories of loss or damage: 1. Losses due to perils 2. Losses due to dishonesty 1. Direct Losses Due to Perils - The direct loss an organization might incur depends on the nature of its operations - Extended Coverage insurance provides protection against perils not covered by the basic policy, such as riots and civil commotion - Specified Perils coverage covers the list of perils named while open perils provides coverage for every peril except for a list of exclusions 1. Building and Personal Property covers direct losses from fire, windstorm, explosions and other perils on three insuring agreements: a) Real Property: I. The building(s), extensions, and additions; II. Permanently installed fixtures and equipment, and III. Property improvements to leased premises that cannot be removed if the firm moves out (carpeting, partitions, and walls) b) Business Personal Property of the insured: I. Furniture and fixtures; II. Inventory (raw material, work-in-progress, finished goods, and goods in transit); and III. Machinery and equipment c) Personal Property of others in the firm’s temporary custody- primarily leased machinery, equipment, and vehicles. - Coverage generally includes the following:  Valuable business records that have to be restored  Property off the premises such as property at trade fairs or in storage  Outdoor property such as trees, fences, detached signs, and antennas  Trailers of others such as trucks that transportation firms may leave on the premises over- night  Spoilage of your own or another firm’s perishable goods resulting from a power outage 2. Boiler and Machinery: insurance protects against the physical damage and financial loss that results from the sudden and accidental breakdowns of boilers, machinery, and equipment, including telephone systems, computer systems, refrigerating systems, air conditioning equipment, engines, pumps, pipes, compressors, blowers, electric motors, generators, and transformers - This coverage is also called mechanical breakdown or equipment breakdown - It is necessary because commercial property policies exclude breakdown of machinery and explosion of steam boilers - Coverage typically includes compensation for the physical damage, expediting costs to bring parts or equipment in by express transportation and business interruption losses - It might also include business income and extra expense coverage - Other types of insurance (other than boiler and machinery) provide protection for indirect losses such as the following: a) Lost time and profit (Business Interruption coverage) if not included, b) Spoiled food if a freezer breaks down (Consequential Damage or Refrigeration Interruption coverage), and c) Added cost to keep the business going while the equipment is being repaired (Extra Expenses coverage) - Boiler and machinery insurance might also provide regular inspections by the insurer using trained engineers to look for weaknesses and defects that can be repaired before the machine breaks down 3. Accounts Receivable: coverage provides protection for the following: a) Amounts owed to the insured from customers if the insured cannot collect as a direct result of loss or damage to receivable records. b) Interest charges on any loan needed to offset losses of amounts made uncollectible by the loss or damage. c) Any added collection expense in excess of normal made necessary by the loss or damage. d) Other expenses incurred to re-establish receivable records. 4. Builders risk insurance, also called Course of Construction for buildings under construction, provides fire insurance and optional coverage for risks like windstorms, floods, and earthquakes. Most policies are broad form, providing all-risk protection during construction, including coverage for fire and vandalism. 5. Condominium association insurance covers the building, equipment, common areas, and walls in each unit. 6. Credit insurance protects against customer insolvency and covers only abnormal losses. It is for manufacturers, wholesalers, and services organizations, not retailers. 7. Crop (hail) insurance covers damage to growing crops due to hail or other named perils. 8. Glass insurance covers plate-glass windows and doors, which are often excluded from building coverage. It is usually for full replacement cost and covers the expense of repairing frames, installing temporary plates, and boarding up openings. 9. Marine insurance covers means of transportation and communication as well as goods in transit. It is provided by marine insurers who can insure the following: a) Imports and exports b) Domestic shipments c) The means of transportation and communication d) Personal property floater risks e) Commercial property floater risks - There are two types of marine insurance: 1. Ocean Marine covers goods being transported over water and can include legal liability. 2. Inland Marine covers goods that are moveable or moving (being shipped on land, that is, domestic goods-in transit) as well as bridges and tunnels. - Ocean Marine: the major types of Ocean Marines insurance are as follows: 1. Cargo insurance covers the goods being shipped if they are damaged or lost. 2. Hull insurance covers the ship and is usually written on an all-risk basis. It includes a collision liability clause (a running down clause) in case the ship collides with another ship or damages the cargo of another ship. It does not include injury to people. 3. Protection and indemnity insurance covers: a) Damage to piers, docks, and the ship’s cargo; b) Illness or injury to passengers or crew; and c) Fines and penalties 4. Freight insurance covers loss of earnings to the ship’s owners if goods are damaged or lost and are not delivered.  When goods are shipped by sea, there are three implied warranties: 1. The vessel is seaworthy 2. The vessel will not deviate from its course 3. The voyage is for legal purposes, for example, it is not carrying goods that are being smuggled  Violation of any one of these can void the insurance if the insured was in a position to know about the deviation since the insured may not know which ship the cargo is on.  There are two ways of deciding who pays the loss: 1. General average or partial loss (average means partial loss) is a loss incurred for the common good, in which case the loss is shared by all parties - Example: it might be necessary to throw part of the cargo overboard to save the ship and crew. The loss must be necessary, voluntary, successful (the ship and crew were saved), and none of the participants caused the risk. The owner of the ship and the cargo share the loss in proportion to the total value of their interest. 2. Particular average is a loss that falls on one party. The loss is not covered unless the loss was caused only by certain perils such as stranding, sinking, burning, or collision with another vessel. (Ex: If the loss was caused by pirates taking over the ship to steal its cargo of gold chopsticks, the loss would not be covered) - It is often written as a franchise loss such as 5%- if the loss is less than 5%, the insurer pays nothing but if the loss if more than 5%, the insurer pays the entire loss with no deductible - Inland Marine: this covers articles in transit and also bridges and tunnels. The major types of inland marine insurance are as follows: 1. Bailee coverage f
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