Property Risk Management
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 property generally is categorized as either real or personal:
Physical property that is mobile (not permanently attached to something else) is considered personal property. 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.
Real 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.
Why is this distinction between real and personal property relevant? Two reasons for the distinction between real and personal property follow:
When property is physically damaged or lost, the cost associated with being unable to use that property may go beyond the physical loss.
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.
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 module 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.
General Property Coverage
The first standard fire policy (SFP) 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, and the commercial package policy (CPP).
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, 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. 
Case Study 01- Business Interruption with and without Direct Physical Loss
Please download and study the case study entitled “Business Interruption with and without Direct Physical Loss” from the module resources section for this module.
The case study describes the losses faced by certain sectors of the United States of America following a range of catastrophes.
Case Study 02- From Coast to Coast: Who is Responsible for Earthquake and Flood Losses
Please download and study the case study entitled “Who is Responsible for Earthquake and Flood Losses” from the module resources section for this module.
The case study describes the difficulties that US citizens encountered when trying to claim compensation for the damage caused by earthquakes and floods in the past.
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 intent of insurance is to indemnify an insured. Payment on an actual cash value basis is most consistent with the indemnity principle.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 cost new is the value of the lost or destroyed property if it were bought new or rebuilt on the day of the loss.
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.
By using deductibles, the insurer saves in three ways:
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 is not responsible for the entire loss.
Because most losses are small, the number of claims for loss payment is reduced, thereby reducing the claims processing costs.
The moral and morale hazards are lessened because there is greater incentive to prevent loss when the insured bears part of the burden. 
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:
A straight deductible 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 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 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 deductible 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.
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.
A coinsurance clause has two main provisions:
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
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:
Amount of insurance carried / Amount you agreed to carry × Loss =
$80,000 / ($96,000 (80% of $120,000)) × $10,000 = $8,333.33
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.
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
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?
 For more information, read the article “Standard Fire Policy Dates Back to 19th Century,” featured in Best’s Review, April 2002.
 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.
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