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## 11.1 Property Risks

### Learning Objectives

In this section we elaborate on the following:

• How insurable property is classified
• The ways in which valuation, deductibles, and coinsurance clauses influence property coverage and premiums

Property can be classified in a number of ways, including its mobility, use value, and ownership. Sometimes these varying characteristics affect potential losses, which in turn affect decisions about which risk management options work best. A discussion of these classifying characteristics, including consideration of the hot topic of electronic commerce (e-risk) exposures and global property exposures, follows.

Physical propertyConsists of real or personal property. generally is categorized as either real or personal. Real propertyPermanent structures (realty) that if removed would alter the functioning of the property. represents permanent structures (realty) that if removed would alter the functioning of the property. Any building, therefore, is real property. In addition, built-in appliances, fences, and other such items typically are considered real property.

Physical property that is mobile (not permanently attached to something else) is considered personal propertyPhysical property that is mobile (not permanently attached to something else).. Included in this category are motorized vehicles, furniture, business inventory, clothing, and similar items. Thus, a house is real property, while a stereo and a car are personal property. Some property, such as carpeting, is not easily categorized. The risk manager needs to consider the various factors discussed below in determining how best to manage such property.

Why is this distinction between real and personal property relevant? One reason is that dissimilar properties are exposed to perils with dissimilar likelihoods. When flood threatens a house, the opportunities to protect it are limited. Yet the threat of flood damage to something mobile may be thwarted by movement of the item away from flood waters. For example, you may be able to drive your car out of the exposed area and to move your clothes to higher ground.

A second reason to distinguish between real and personal property is that appropriate valuation mechanisms may differ between the two. We will discuss later in this chapter the concepts of actual cash value and replacement cost new. Because of moral hazard issues, an insurer may prefer to value personal property at actual cash value (a depreciated amount). The amount of depreciation on real property, however, may outweigh concerns about moral hazard. Because of the distinction, valuation often varies between personal and real property.

When property is physically damaged or lost, the cost associated with being unable to use that property may go beyond the physical loss. Indirect loss and business interruption losses discussed in the box “Business Interruption with and without Direct Physical Loss” provides a glimpse into the impact of this coverage on businesses and the importance of the appropriate wording in the policies. In many cases, only loss of use of property that is directly damaged leads to coverage; in other cases, the loss of property itself is not a prerequisite to trigger loss of use coverage. As a student in this field, you will become aware of the importance of the exact meaning of the words in the insurance policy.

## General Property Coverage

The first standard fire policy (SFP)The generally accepted method of insuring against property loss due to fire until being replaced by homeowners policies and commercial insurance options. came into effect during the late 1800s and came to be described as the generally accepted manner of underwriting for property loss due to fire. Two revisions of the SFP were made in 1918 and 1943. Most recently, the SFP has largely been removed from circulation, replaced by homeowners policies for residential property owners, discussed in Chapter 1 "The Nature of Risk: Losses and Opportunities", and the commercial package policy (CPP), featured in Chapter 1 "The Nature of Risk: Losses and Opportunities". The SFP was simple and relatively clear. Most of its original provisions are still found in current policies, updated for the needs of today’s insured. In light of the changes regarding terrorism exclusion that occurred after September 11, 2001 (discussed in Chapter 1 "The Nature of Risk: Losses and Opportunities"), the topic of standard fire policies came under review. The issue at hand is that, under current laws, standard fire policies cannot exclude fires resulting from terrorism or nuclear attacks without legislative intervention.For more information, read the article “Standard Fire Policy Dates Back to 19th Century,” featured in Best’s Review, April 2002.

### Business Interruption with and without Direct Physical Loss

When there is a direct physical loss, insurance coverage for business interruption is more likely to exist than when the interruption is not from direct physical loss. The New Orleans hotels that suffered damage due to flooding and wind caused by Hurricane Katrina on August 30, 2005, are more likely to have had business interruption coverage. The oil industry, including its refineries and rigs that were shut down as both hurricanes Katrina and Rita ripped through the Gulf Coast, also had insurance coverage for business interruption. The stop in oil production was associated with a physical loss. Not all business interruptions are covered by insurance. The economic losses suffered by many New York businesses during the New York City transportation strike of December 2005 were not a direct loss from physical damage. As such, these businesses did not have insurance to cover the losses. Nonrelated causes of loss that affect the continued viability of businesses usually do not have insurance remedies. The avian flu pandemic is expected to disrupt many businesses’ activities indirectly. Employees are expected to be afraid to show up for work, and some industries—such as shipping—will be vulnerable. A key problem in these cases would be lack of insurance coverage.

In the past, some policyholders submitted business-interruption claims for nondirect economic loss. They were not successful in court. A case in point is the lawsuit filed in August 2002 by the luxury hotel chain Wyndham International against half a dozen of its insurers and the brokerage firm Marsh & McLennan. Wyndham claimed that it had suffered $44 million in lost revenue following the terrorist acts of September 11, 2001, and that the insurers had acted in bad faith in failing to pay the corporation’s business-interruption claims. The Wyndham properties that reported September 11-related losses included hotels in Chicago and Philadelphia and three Puerto Rico beach resorts. Wyndham owns no properties in downtown New York City. September 11 was the wake-up call. It’s estimated that some$10 billion in claims have been filed for business-interruption losses, much of them far away from Ground Zero. With the Federal Aviation Administration—ordered closing of airports nationwide, the travel industry bore major losses. Resort hotels like Wyndham’s saw business fall dramatically.

Are losses recoverable if the business sustained no physical damage? It depends, of course, on the policy. Most small and midsize businesses have commercial policies based on standard forms developed by the Insurance Services Office (ISO). The ISO’s customary phrase is that the suspension of business to which the income loss relates must be caused by “direct physical loss of or damage to property at the premises described in the Declarations.” Larger companies often have custom-written manuscript policies that may not be so restrictive. Whatever the wording is, it is likely to be debated in court.

### From Coast to Coast: Who Is Responsible for Earthquake and Flood Losses?

No region of the United States is safe from environmental catastrophes. Floods and flash floods, the most common of all natural disasters, occur in every state. The Midwest’s designated Tornado Alley ranges from Texas to the Dakotas, though twisters feel free to land just about anywhere. The Pacific Rim states of Hawaii, Alaska, Washington, Oregon, and California are hosts to volcanic activity, most famously the May 1980 eruption of Mount St. Helens in southwestern Washington, which took the lives of more than fifty-eight people. California is also home to the San Andreas Fault, whose seismic movements have caused nine major earthquakes in the past one hundred years; the January 1994 Northridge quake was the most costly in U.S. history, causing an estimated $20 billion in total property damage. (By comparison, the famous San Francisco earthquake of 1906 caused direct losses of$24 million, which would be about $10 billion in today’s dollars.) Along the Gulf and Atlantic coasts, natural disaster means hurricanes. Insurers paid out more money for Hurricane Katrina in 2005 than they collected in premiums in twenty-five years from Louisiana insureds. California insurers paid out more in Northridge claims than they had collected in earthquake premiums over the previous thirty years. The year 2005 saw an unprecedented number of losses because of hurricanes Katrina, Rita, and Wilma. The record number of hurricanes included twenty-seven named storms. The insured losses from Hurricane Katrina alone were estimated between$40 and $60 billion, while the economic losses were estimated to be more than$100 billion. Theses losses are the largest catastrophic losses in U.S. history, surpassing Hurricane Andrew’s record cost to the industry of $20.9 billion in 2004 dollars. This record also surpasses the worst human-made catastrophe of September 11, 2001, which stands at$34.7 billion in losses in 2004 dollars.

Fearing that the suffering housing, construction, and related industries would impair economic growth, state government stepped in. The state-run California Earthquake Authority was established in 1996 to provide coverage to residential property owners in high-risk areas. Disaster insurance then went to the federal level. In the aftermath of Katrina, in December 2005, a proposal for a national catastrophe insurance program was pushed by four big state regulators during the National Insurance Commissioners meeting in Chicago. The idea was to change the exclusion in the policies and allow for flood coverage, while calling for a private-state-federal partnership to fund megacatastrophe losses and the creation of a new all-perils homeowners policy that would cover the cost of flood losses.

Questions for Discussion

1. Lee is in favor of government-supported disaster reinsurance because it encourages economic growth and development. Chris believes that it encourages overgrowth and overdevelopment in environmentally fragile areas. Whose argument do you support?
2. The Gulf Coast town you live in has passed a building code requiring that new beachfront property be built on stilts. If your house is destroyed by a hurricane, rebuilding it on stilts will cost an extra $25,000. The standard homeowners policy excludes costs caused by ordinance or laws regulating the construction of buildings. Is this fair? Who should pay the extra expense? 3. Jupiter Island, located off the coast of south Florida, is the wealthiest town in the country. Its 620 year-round residents earn an average of just over$200,000 per year, per person. Thus, a typical household of two adults, two children, a housekeeper, a gardener/chauffeur, and a cook boasts an annual income of some $1.4 million. What is the reasoning for subsidizing hurricane insurance for residents of Jupiter Island? 4. In light of your understanding of the uninsurable nature of catastrophes, who should bear the financial burden of natural disasters? ## Types of Property Coverage and Determination of Payments Once it is determined that a covered peril has caused a covered loss to covered property, several other policy provisions are invoked to calculate the covered amount of compensation. As noted earlier, the topic of covered perils is very important. Catastrophes such as earthquakes are not considered covered perils for private insurance, but in many cases catastrophes such as hurricanes and other weather-related catastrophes are covered. The box Note 11.7 "From Coast to Coast: Who Is Responsible for Earthquake and Flood Losses?" is designed to stimulate discussions about the payment of losses caused by catastrophes. Important provisions in this calculation are the valuation clause, deductibles, and coinsurance. ## Valuation Clause The intent of insurance is to indemnify an insured. Payment on an actual cash value basis is most consistent with the indemnity principle, as discussed in Chapter 9 "Fundamental Doctrines Affecting Insurance Contracts". Yet the deduction of depreciation can be both severe and misunderstood. In response, property insurers often offer coverage on a replacement cost new (RCN) basis, which does not deduct depreciation in valuing the loss. Rather, replacement costIndemnification for a property loss with no deduction for depreciation. new is the value of the lost or destroyed property if it were bought new or rebuilt on the day of the loss. ## Deductibles The cost of insurance to cover frequent losses (as experienced by many property exposures) is high. To alleviate the financial strain of frequent small losses, many insurance policies include a deductible. A deductible requires the insured to bear some portion of a loss before the insurer is obligated to make any payment. The purpose of deductibles is to reduce costs for the insurer, thus making lower premiums possible. The insurer saves in three ways. First, the insurer is not responsible for the entire loss. Second, because most losses are small, the number of claims for loss payment is reduced, thereby reducing the claims processing costs. Third, the moral and morale hazards are lessened because there is greater incentive to prevent loss when the insured bears part of the burden.For example, residents of a housing development had full coverage for windstorm losses (that is, no deductible). Their storm doors did not latch properly, so wind damage to such doors was common. The insurer paid an average of$100 for each loss. After doing so for about six months, it added a $50 deductible to the policies as they were renewed. Storm door losses declined markedly when insureds were required to pay for the first$50 of each loss.

The small, frequent losses associated with property exposures are good candidates for deductibles because their frequency minimizes risk (the occurrence of a small loss is nearly certain) and their small magnitude makes retention affordable. The most common forms of deductibles in property insurance are the following:

1. Straight deductible
2. Franchise deductible
3. Disappearing deductible

A straight deductibleOne that requires payment for all losses less than a specified dollar amount. requires payment for all losses less than a specified dollar amount. For example, if you have a $200 deductible on the collision coverage part of your auto policy, you pay the total amount of any loss that does not exceed$200. In addition, you pay $200 of every loss in excess of that amount. If you have a loss of$800, therefore, you pay $200 and the insurer pays$600.

A franchise deductibleOne that pays the entire amount in full once the amount of loss equals the deductible. is similar to a straight deductible, except that once the amount of loss equals the deductible, the entire loss is paid in full. This type of deductible is common in ocean marine cargo insurance, although it is stated as a percentage of the value insured rather than a dollar amount. The franchise deductible is also used in crop hail insurance, which provides that losses less than, for example, 5 percent of the crop are not paid, but when a loss exceeds that percentage, the entire loss is paid.

The major disadvantage with the franchise deductible from the insurer’s point of view is that the insured is encouraged to inflate a claim that falls just short of the amount of the deductible. If the claims adjuster says that your crop loss is 4 percent, you may argue long and hard to get the estimate up to 5 percent. Because it invites moral hazard, a franchise deductible is appropriate only when the insured is unable to influence or control the amount of loss, such as in ocean marine cargo insurance.

The disappearing deductible is a modification of the franchise deductible. Instead of having one cut-off point beyond which losses are paid in full, a disappearing deductibleOne whose amount decreases as the amount of the loss increases. is a deductible whose amount decreases as the amount of the loss increases. For example, let’s say that the deductible is $500 to begin with; as the loss increases, the deductible amount decreases. This is illustrated in Table 11.1 "How the Disappearing Deductible Disappears". Table 11.1 How the Disappearing Deductible Disappears Amount of Loss ($) Loss Payment ($) Deductible ($)
500.00 0.00 500.00
1,000.00 555.00 445.00
2,000.00 1,665.00 335.00
4,000.00 3,885.00 115.00
5,000.00 4,955.00 5.00
5,045.00 5,045.00 0.00
6,000.00 6,000.00 0.00

At one time, homeowners policies had a disappearing deductible. Unfortunately, it took only a few years for insureds to learn enough about its operation to recognize the benefit of inflating claims. As a result, it was replaced by the straight deductible.

The small, frequent nature of most direct property losses makes deductibles particularly important. Deductibles help maintain reasonable premiums because they eliminate administrative expenses of the low-value, common losses. In addition, the nature of property losses causes the cost of property insurance per dollar of coverage to decline with the increasing percentage of coverage on the property. That is, the first 10 percent value of the property insurance is more expensive than the second (and so on) percent value. The cost of property insurance follows this pattern because most property losses are small, and so the expected loss does not increase in the same proportion as the increased percentage of the property value insured.

## Coinsurance

A coinsurance clauseClause that requires one to carry an amount of insurance equal to a specified percentage of the value of property in order to be paid the full amount of loss incurred and that stipulates a proportional payment of loss for failure to carry sufficient insurance. has two main provisions: first, it requires you to carry an amount of insurance equal to a specified percentage of the value of the property if you wish to be paid the amount of loss you incur in full, and second, it stipulates a proportional payment of loss for failure to carry sufficient insurance. It makes sense that if insurance coverage is less than the value of the property, losses will not be paid in full because the premiums charged are for lower values. For property insurance, as long as coverage is at least 80 percent of the value of the property, the property is considered fully covered under the coinsurance provision.

What happens when you fail to have the amount of insurance of at least 80 percent of the value of your building? Nothing happens until you have a partial loss. At that time, you are subject to a penalty. Suppose in January you bought an $80,000 policy for a building with an actual cash value of$100,000, and the policy has an 80 percent coinsurance clause, which requires at least 80 percent of the value to be covered in order to receive the actual loss. By the time the building suffers a $10,000 loss in November, its actual cash value has increased to$120,000. The coinsurance limit is calculated as follows:

The amount the insurer pays is $8,333.33. Who pays the other$1,666.67? You do. Your penalty for failing to carry at least 80 percent of the actual value is to bear part of the loss. You will see in Chapter 1 "The Nature of Risk: Losses and Opportunities" that you should buy coverage for the value of the home and also include an inflation guard endorsement so that the value of coverage will keep up with inflation.

What if you have a total loss at the time the building is worth $120,000, and you have only$80,000 worth of coverage? Applying the coinsurance formula yields the following:

$80,000 96,000 ×120,000=99,999.99$

You would not receive $99,999.99, however, because the total amount of insurance is$80,000, which is the maximum amount the insurer is obligated to pay. When a loss equals or exceeds the amount of insurance required by the applicable percentage of coinsurance, the coinsurance penalty is not part of the calculation because the limit is the amount of coverage. The insurer is not obligated to pay more than the face amount of insurance in any event because a typical policy specifies this amount as its maximum coverage responsibility.

You save money buying a policy with a coinsurance clause because the insurer charges a reduced premium rate, but you assume a significant obligation. The requirement is applicable to values only at the time of loss, and the insurer is not responsible for keeping you informed of value changes. That is your responsibility.

### Key Takeaways

In this section you studied the general features of property coverage:

• Insurable property is classified as either real or personal property, and this classification affects the property’s exposure to risks and basis for valuation
• Coverage amounts depend on valuation as either actual cash value or replacement cost new
• The use of deductibles reduces the cost of claims, the frequency of claims, and moral hazard; common forms of deductibles are straight, franchise, and disappearing
• A coinsurance clause requires insureds to carry an amount of insurance equal to a specified percentage of the value of the property in order to be paid the full amount of an incurred loss; otherwise insureds will be subject to penalty in the form of bearing a proportional amount of the loss

### Discussion Questions

1. What is the difference between real and personal property? Why do insurers make a distinction between them?
2. What is a deductible? Provide illustrative examples of straight, franchise, and disappearing deductibles.
3. What is the purpose of coinsurance? How does the policyholder become a coinsurer? Under what circumstances does this occur?