Canada: Co-Dependant

When it comes to business interruption co-insurance, there are a number of common mistakes that insurance professionals make. A clear understanding of co-insurance, a complex component of business interruption losses, is key to avoiding miscalculations that can have a significant impact on a claim for both the insurer and the policyholder.

Many insurance professionals involved in commercial insurance claims cringe when it comes to co-insurance because, stated bluntly, they do not understand the mechanics of its application in a claim. Miscalculating co-insurance leads to the insured's claim being either over- or under-paid.

Perhaps fortunately for the insurer, most policyholders are not savvy enough to verify whether or not co-insurance was calculated correctly, which is punitive to the policyholder. On the other hand, overpayment results in unnecessary expense to the insurer. In either situation, one party is penalized.

That being the case, insurance professionals should know some of the most common mistakes they make in calculating co-insurance under a standard profits form. Knowing some of the things to avoid will help simplify a seemingly complicated issue.

Under a standard profits form, the policyholder is required to have insurance in force equal to 100% of the projected annual defined gross profit. If the policyholder does not have 100% of the required insurance, any business interruption (BI) loss is proportionately reduced by the amount of under-insurance.

This reduction is known as the co-insurance penalty. Consider the simple calculation below:

Insurance in force: $1 million
Insurance required (annual defined gross profit): $1.5 million
Business interruption loss: $500,000
Rate of recovery: $1 million (did have) / $1.5 million (should have) = 66.67%
Recoverable loss: $500,000 × 66.67% = $333,350
Co-insurance penalty: $500,000 - $333,350 = $166,650


#1: insurance required (annual defined gross profit) is calculated entirely based on historical financial results

The BI policy insures future profits, not historic profits. The most common mistake made by experts calculating the insurance required is basing the calculation entirely on the historic, instead of projected, financial results of the business.

The reason for this error lies in the policy wording, which indicates that the annual defined gross profit should be "based on the financial results of the business in the most recent 12 months or fiscal year immediately prior to the incident, adjusted for trends, variations and other circumstances that, but for the incident, would have occurred during the relative period after the incident."

Many insurance professionals ignore the impact of the adjustment clause and simply rely on the financial results achieved by the policyholder in the most recent 12 months or last fiscal year.

What is the possible impact of calculating the co-insurance penalty based on historical versus projected financial results? Consider the example below of a policyholder that experiences an incident on June 30, 2015, and whose last fiscal year was December 31, 2014. In May of 2015, the policyholder entered a new agreement with a supplier that would reduce its cost of goods sold by 20% for the next three years. No other changes to revenue or expenses were expected in the 12 months following the incident (see chart below)

In this instance, if the insurer relied upon the historic financial results instead of the projected financial results, it would overpay the claim by 9.8%.

Historic Results
Last Fiscal Year
Forecasted Results
20% Reduction in Cost of Goods Sold
Sales $1,000,000 $1,000,000
Cost of goods sold (variable expense) $400,000 $320,000
Insured standing charges (fixed expenses) $500,000 $500,000
Annual net profit $100,000 $180,000
Historic Results (Incorrect)
Last Fiscal Year
Forecasted Results (Correct)
12 Months Post-Incident
Annual net profit $100,000 $180,000 A
Insured standing charges $500,000 $500,000 B
Annual defined gross profit (insurance required) $600,000 $680,000 C = A + B
Insurance in force $500,000 $500,000 D
Rate of recovery 83.3% 73.5% E = D / C
Co-insurance penalty 16.7% 26.5% 100% E

#2: annual defined gross profit (insurance required) does not include ordinary payroll as a standing charge when it is insured or ignores the period of ordinary payroll coverage

Unlike the gross earnings form, which includes ordinary payroll (unless specifically excluded) in the calculation of insurance required, the standard profits form may or may not include ordinary payroll coverage. When ordinary payroll is insured under a profits form, it is either fully insured throughout the indemnity period or it is purchased for a specified coverage period, typically ranging from 30 to 180 days.

When ordinary payroll is fully insured throughout the entire indemnity period, it is included as a standing charge for the purpose of calculating the insurance required. However, when coverage is included for only 30 to 180 days, it creates confusion for many claims professionals.

The most common mistake made in claims when ordinary payroll coverage is purchased for a specified period is that it is not included as an insured standing charge in the calculation of annual defined gross profit (insurance required). The proper methodology is to calculate the defined gross profit for the period of ordinary payroll coverage and prepare a separate calculation during the period when ordinary payroll coverage ceases within the indemnity period.

To illustrate, consider a situation in which a policyholder has 90 days of ordinary payroll coverage, and the policyholder's sales and expenses are incurred evenly throughout the year. In this case, projected financial results are as per first chart below.

Insurance professionals should take note that the incorrect methodology (see second chart below) is to calculate a single annual defined gross profit (insurance required), either excluding or including the entire annual ordinary payroll as an insured standing charge. There is a clear difference in outcome when using the correct methodology (see third chart below).

Forecasted Results
Sales $12,000,000
Cost of goods sold (variable expense) $3,600,000
Key payroll $2,400,000
Ordinary payroll $1,200,000
Other insured standing charges $3,600,000
Annual net profit $1,200,000


(Exclude Ordinary Payroll) (Include Ordinary Payroll)
Sales $12,000,000 $12,000,000
Cost of goods sold (variable expense) $3,600,000 $3,600,000
Key payroll $2,400,000 $2,400,000 A
Ordinary payroll - $1,200,000 B
Other insured standing charges $3,600,000 $3,600,000 C
Annual net profit $1,200,000 $1,200,000 D
Annual defined gross profit $7,200,000 $8,400,000 A+B+C+D

This involves preparing two calculations of annual defined gross profit (insurance required), segregated at the 90-day mark, including ordinary payroll for the first 90 days (assumed to be equivalent to three months) and excluding ordinary payroll for the remaining nine months of the indemnity period.

 In this instance, if the insurer incorrectly excludes ordinary payroll as an insured standing charge in the calculation of annual defined gross profit, the insurance required for the purpose of calculating co-insurance would be $300,000 less than the correct amount, which would result in an overpayment. Conversely, if the insurer included all ordinary payroll and not just for the first 90 days, the annual defined gross profit would be $900,000 higher and would result in an underpayment for the policyholder (increased co-insurance penalty).

(First 90 Days)
(Include ordinary payroll)
(Remaining Nine Months)
(Exclude ordinary payroll)
Sales $3,000,000 $9,000,000
Cost of goods sold (variable expense) $900,000 $2,700,000
Key payroll $600,000 $1,800,000 A
Ordinary payroll $300,000 - B
Other insured standing charges $900,000 $2,700,000 C
Annual net profit $300,000 $900,000 D
Defined gross profit $2,100,000 $5,400,000 A+B+C+D
Annual defined gross profit $7,500,000

#3: the co-insurance penalty is not applied when the BI loss is less than the insurance in force

A misconception with co-insurance is that if the insurance in force is greater than the BI loss, then the co-insurance penalty does not apply. This is incorrect, since the insurance in force and the insurance required are both determined on an annual basis, whereas a BI loss may relate to a period of time that is less than a year. 

An apples-to-apples comparison must be made between the BI loss and the limits of insurance. As such, the proper methodology is to calculate a rate of recovery, based on the insurance in force and the annual insurance required (the projected annual defined gross profit) and apply the rate of recovery to the BI.

The most common mistake made in claims when ordinary payroll coverage is purchased for a specified period is that it is not included as an insured standing charge in the calculation of annual defined gross profit (insurance required).

#4: extra expense is included as a component of the BI loss and reduced by co-insurance

Extra expense coverage is often included in commercial insurance policies and is frequently incurred by an insured in conjunction with a BI claim. In addition, extra expense coverage is often confused with an increase in the cost of working, which is included in the standard profits form and is subject to co-insurance. Further, an increase in cost of working is also assessed on a mitigated recovered loss basis, which requires the insured to reduce its profits loss by an amount in excess of the increase in cost of working.

For these reasons, it is often thought to be included with BI coverage. However, extra expense coverage is a separate stand-alone coverage and is not subject to any co-insurance requirements.

Co-insurance is a complex component of BI losses and miscalculating the insurance required can have a significant impact on a claim for both the insurer and the policyholder. Professional advice may help with ensuring that the proper insurance required is calculated, the policyholder is indemnified for the loss and an equitable outcome is achieved for all parties involved.

This article was originally written for and published by Canadian Underwriter, October 2015.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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