Calculating the Correct Business Income Coinsurance

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by Christopher J. Boggs, CPCU, ARM, ALCM

Each line (A – I) of the business income report/worksheet was detailed in the previous three commentaries; including an in-depth description of the worksheet’s method for calculating the cost of goods sold (COGS). The only remaining business-income-related line is Line “J” – the business income exposure for 12 months.

Line “J” is simply total revenues minus production-related expenses. With this amount and an honest estimation of the time necessary to resume operations following a loss, the correct coinsurance percentage can be calculated (and doing so is much simpler than has been historically taught).

The business income section of the worksheet is completed in this post; and possibly more importantly, how the correct business income coinsurance percentage is developed is explained below.

Not discussed in this commentary are the two remaining lines of the business income report/worksheet: the Extra Expense amount (“K.1.”); and the Extended Business Income/Extended Period of Indemnity (“K.2.”). A detailed discussion of these concepts and coverages is left for future discussion.

The 12-Month Business Income Exposure

Production-related expenses (Section “I”) are subtracted from total revenues (Line “H”) to yield the insured’s 12-month business income exposure. All the hard work is done; the next step is surprisingly easy – calculating the business income coinsurance.

Before moving to the coinsurance calculation, the purpose of the two “J” lines must first be clarified. The CP 15 15 provides spaces for “J.1.” and “J.2.” totals; the worksheet explains the purpose for these two “totals,” but the reason deserves a quick mention.

If the insured is solely a manufacturing operation or exclusively a non-manufacturing operation, “J.2.” can be ignored. “J.2.” is necessary only when the insured is a dual purpose operation, that is, they receive income from both manufacturing and non-manufacturing operations which are not directly relatable to the manufacturing process.

A dual purpose operation is required to complete all four columns of the worksheet; the manufacturing AND non-manufacturing data. “Single-purpose” operations, which is most frequently the case, need only provide the “J.1.” total.

Note that the “J.1.” (or “J.2.” if a dual purpose operation) amount is the total business income exposure for a 12-month period of time. This fact becomes important as the coinsurance and ultimately the limit of coverage are developed.

Calculating Coinsurance – Revealing the Man Behind the Curtain

Commercial property coinsurance is based almost exclusively on the property values at risk. Did the insured carry adequate insurance to value (based on the valuation method chosen)? No other factor or information is necessary.

In contrast, the amount of income at risk is secondary to and not even required to develop the business income coinsurance. Business income’s coinsurance percentage can be decided upon even BEFORE the CP 15 15 worksheet is completed. In short, the amount subject to loss has no bearing on the coinsurance percentage; in fact, the amount subject to loss is a function of the coinsurance percentage (the exact opposite of the property coverage). Sounds like insurance heresy.

Business income coinsurance is solely a function of time; a 12-month period of time to be more specific. How long will it take, following a worst-case-scenario loss, to return the operation to pre-loss condition and capabilities? Knowing this allows the insured to accomplish two tasks: 1) pick the correct coinsurance; and 2) ultimately decide on the limit of business income coverage to purchase (again, the amount subject to loss is a function of the coinsurance percentage and the percentage a function of time).

ISO-published coinsurance percentages are 50, 60, 70, 80, 90, 100 and 125 percent; each representing a proportion of one year. For a point of reference, the coinsurance equivalents of 12 months are:
• 50 percent = 6 months (12 months x 50%)
• 60 percent = 7.2 months (12 months x 60%)
• 70 percent = 8.4 months (12 months x 70%)
• 80 percent = 9.6 months (12 months x 80%)
• 90 percent = 10.8 months (12 months x 90%)
• 100 percent = 12 months (12 months x 100%)
• 125 percent = 15 months (12 months x 125%)

This information provides the necessary visual representation of the time concept inherent in business income coverage. Four major objectives must be accomplished during the chosen number of months represented by the coinsurance percentages above:
1) The building must be rebuilt or an alternate location found;
2) New/replacement equipment must be located and installed;
3) Stock must be replenished; and
4) The insured must return to the same level of “operational capability.”

Collectively, these four requirements make up the estimated “Period of Restoration” (more specifically defined in the next post). Insureds tend to be overly optomistic regarding the true “period of restoration.” Agents must understand the requirements and be able to explain to their clients that it is unlikely that all four objectives can be accomplished in as short a time period as most insureds first postulate. The legitimate time required and the roadblocks to accomplishing each of these four tasks are individually detailed in the next several articles.

Business Income Coinsurance Examples

Time is intrinsic to the development of business income coinsurance and ultimately the choice of limits. Two worksheets/examples are attached for ease of review: 1) a sample of a completed business income report/worksheet (CP 15 15); and 2) several coinsurance calculation examples using the data from the sample worksheet. The two primary formulas used in the examples attached are the “maximum coinsurance percentage calculation” and the “estimated loss of income (amount subject to loss) calculation”:

Maximum Coinsurance Percentage Calculation:
• Number of months required to accomplish the four “period of restoration” objectives/12 (the number of months in a year) = Maximum Coinsurance Percentage

Use of the term “maximum coinsurance percentage” is intentioned to remind insureds and agents of potential coinsurance penalties for underestimating the upcoming policy year (remember, the next 12 months are being insured, not the previous 12).

Estimated Loss of Income (Amount Subject to Loss) Calculation:
• Maximum Coinsurance Percentage x 12 months business income calculation (“J.1.” or “J.2.” amount) = Amount Subject to Loss

The amount of business income purchased can and usually will match the calculated “amount subject to loss” or be slightly higher; but it should certainly never be lower. Two occasions may necessitate the need for the insured to purchase a higher business income limit than the developed “amount subject”:
1) The calculated “maximum coinsurance percentage” falls in between available options (see example 3). Should this occur, the insured can: a) raise the limit purchased to match the next higher coinsurance number with a corresponding coinsurance increase; or b) purchase the developed “amount subject to loss” but lower the coinsurance percentage to the next available lower limit; and
2) When the insured is not positive about the estimations for the upcoming year.

Picking the preferred amount of business income coverage is more specifically highlighted in a future post.

It Really Is That Easy

Calculating the business income coinsurance has been incorrectly taught for so long that this explanation may seem too simple; it’s not. Calculating coinsurance really is this easy and simple. It’s estimating the “period of restoration” leading to the correct choice of the maximum coinsurance percentage that’s hard (as is detailed beginning in the next few posts).

Some insurance educators and texts claim that the coinsurance calculation in some way involves the use of the insureds gross sales; it doesn’t. Both the policy wording and the business income report/worksheet are explicit that certain expenses do not apply to either the calculation of the 12-month business income or to the calculation of the coinsurance percentage or its penalty. Anyone that says otherwise is ignoring the forms.

This is called “time element” coverage for a reason- it’s based on time. What is the minimum amount of time required to return to full operational capability? That’s all the information necessary to develop the maximum coinsurance percentage.

Following

Each “Period of Restoration” objective is detailed in the next several commentaries. Some of the gaps and roadblocks to accurate estimation of the timing necessary to complete each objective are enumerated in these posts. Four posts are required to detail the period of restoration and the return to “operational capability.”

Once the period of restoration is fully vetted, this series turns to focus on choosing the appropriate amount of coverage in light of the period of restoration and the application of coinsurance.

For all the information on Business Income coverage, take a look at Insurance Journal’s book, “Business Income Insurance Demystified: The Simplified Guide to Time Element Coverages.”


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Comments

  • January 30, 2009 at 4:09 pm
    Eli Mishanie says:

    I think your article on coinsurance is very misleading and could possibly create an E&O exposure for someone not well versed in Business Interruption. What your article failed to mention is that your formulas were only relevant if you had an “Agreed Value” endorsement which not all insurance carriers are willing to write. No where in your article to you even refer to “agreed value”. On a non-agreed value income policy, coinsurance has an adverse effect on a partial loss if you are uninsured and is the same type of penalty as with a property policy with coinsurance..

  • January 30, 2009 at 5:02 pm
    Chris Boggs says:

    Eli,

    Hang in there, we are coming to all that and the calculation will become even clearer (as will the true application of the coinsurance penalty). That’s the hard part of having to break these up into chunks. So much to say at one time.

    After the Period of Restoration discussion is done, we talk about this again.

  • December 13, 2011 at 9:23 am
    Nancy Germond says:

    Thanks, Chris. These articles help make a difficult topic much clearer.

  • June 1, 2012 at 11:41 pm
    Rasheed says:

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