Property Insurance Compensates You for Losses
Liability insurance exists to shield your assets from the grasp other others. Property insurance exists to protect you when your assets are lost or distroyed. General property insurance covers the most common risks, but in certain situations, you should consider specialized insurance, such as business interruption coverage or fidelity insurance.
In determining the types and amount of insurance your business must have, you must distinguish liability coverage, which protects against losses that arise from damages to another person or the person's property, and property insurance, which protects against losses that arise from damages to property owned by the insured. This is especially important because a single comprehensive policy may include both types of coverage, but with each subject to separate limitations.
Hazard/fire insurance and and automobile insurance are common types of property insurance. Other specialized types of property insurance are
- fidelity insurance,
- long-term care insurance, and
- various types of mortgage insurance
Before considering specific types of insurance, it is helpful to be familiar with some of the common terms and requirements.
"All-risk" versus "named peril" coverage. Most property insurance policies are issued on an "all-risk" basis. This means the policy covers all damages to property, subject to the specific exclusions in the policy. If you want coverage for an excluded occurrence, you must purchase an endorsement or a separate specialized policy to cover that risk.
However, a property insurance policy may be issued on a "named-peril" basis. This form insures only against the specific risks listed. Any risk not specifically listed is automatically excluded. The distinction is critical: make sure you know what you are buying!
Deductibles. Property insurance may contain a deductible, which is the amount of a loss borne by the insured. Various deductibles should be compared. A higher deductible can significantly lower your premiums, but you are still covered for any large or catastrophic loss. For example, a $500 deductible for collision coverage on an automobile property policy can yield significant premium savings, in comparison to, say a $250 or $100 deductible. The same holds true for virtually any property insurance policy.
Co-insurance clauses. property insurance policy may contain a "co-insurance" clause. When triggered, this clause reduces the amount paid by insurance which makes you a "co-insurer" for your own loss.
The co-insurance clause will be triggered when the policy amount is less than the replacement cost or actual cash value of the property (as outlined in the policy) multiplied by the co-insurance percentage (which is usually 80 percent.) To avoid triggering the co-insurance clause, you must carry insurance that is at least the amount of the property's replacement or cash value of the property multiplied by the co-insurance percentage.
John Smith owns a commercial building valued at $800,000. To save on insurance premiums, he insures the building for only $600,000. When Smith's building suffers $600,000 worth of damage in a fire, he is confident that the loss will be fully covered.
However, he is sadly mistaken because his insurance policy contains an 80 percent co-insurance clause. The amount Smith receives will equal the amount of the insurance divided by the co-insurance percentage multiplied by the value of the property and then multiplied by the amount of the loss.
insurance amount/(co-insurance % * value of property)*amount of loss
In this example, $600,000 / (80 percent x $800,000 = $640,000) = 0.9375. Then, 0.9375 x $600,000 = $562,500.
Smith is a co-insurer (along with the insurance company) for the loss. Specifically, Smith's share of the loss is $37,500 ($600,000 less $562,500).
Note that there will be a full recovery (subject to the policy limit, of course), if the amount of the insurance is equal to, or higher than, the value of the property multiplied by the co-insurance percentage. Thus, in this example, Smith would have received a full recovery for his loss ($600,000), had he insured the building for at least 80 percent of its fair market value ($800,000 x 80% = $640,000).
In general, when there is a co-insurance clause, the insured will recover the lowest of the policy limit, the value of the loss or the amount derived from the co-insurance calculation.
You Must Prove Loss To Collect Insurance
To receive payment under a policy, you must prove that a loss occurred and the amount of the loss. An inventory of all property owned, along with records evidencing ownership and value, including receipts, documents of title and appraisals, if available, is essential. Photographs or videotape are sometimes used to establish the existence, physical condition and, thus, the value of the property.
Prepare for the worst case scenario.
If there is a catastrophe such as a fire, flood or tornado, you will need these records. So, keep them in a bank safe deposit box. Or, at the very least in a fireproof box, with a duplicate set of records maintained in a separate location.
All Businesses Need Hazard Insurance
Hazard insurance, or fire insurance as it is frequently called, covers losses caused by acts of nature or accidents. Hazard/fire insurance, with liability and property coverage, should always be maintained on real property. Generally, the policy limits need to cover only the value of the building, and not the land since it usually cannot be lost to hazards, such as fire.
Typically, a single comprehensive policy is issued offering both liability and property protection. Property protection in a hazard insurance policy covering a building will apply to the real property (i.e., the building) and to the personal property associated with the real property (i.e., the building's contents). The real property and personal property coverage will be subject to separate limits and exclusions.
Property coverage in a hazard insurance policy usually is issued on an all-risk basis. However, a universal exclusion from property coverage involves losses (to the building and its contents) due to flooding. To obtain property coverage for thus type of loss, a separate specialized flood insurance policy, which is underwritten by the federal government, must be purchased.
Guaranteed Replacement Value Provides Best Coverage
When at all possible, you should obtain guaranteed replacement value property coverage. This may be standard, but it usually requires an endorsement. With guaranteed replacement value, you can replace each item of covered property, at the current replacement cost. If the policy does not provide for guaranteed replacement value, the insured will recover only the depreciated value of the property, which is likely to be only a fraction of the replacement cost.
Lenders May Require Insurance on Mortgaged Property
When there is a mortgage on the property, the mortgage agreement typically will require the mortgagor/owner to purchase property coverage, and name the mortgagee/lender in the policy as a co-insured. In this case, ordinarily it is not necessary to obtain property coverage equal to the full purchase price of the property, although this could trigger a "co-insurance clause." and reduce the amount you will receive under the policy. To satisfy the lender, property coverage should be purchased at the appraised value of the building itself, excluding the value of the land.
Coverage for Data Is Increasingly Necessary
Loss of the insured's data on its computers should be covered by the general property policy. However, insurance companies sometimes attempt to deny this type of coverage on the grounds that data does not meet the definition of "tangible" property that can suffer a "physical" loss. The courts, however, have rejected this argument.
Nevertheless, prudence dictates that you carefully reviews the definitions of "property" and "physical" loss, along with exclusions, in any proposed property insurance policy to determine if the proposed policy specifically excludes data from coverage. A specific and clear-cut exclusion in a policy will be enforced. In this event, an endorsement including this coverage should be considered.
You May Want Coverage for Defective Property
Insurance companies sometimes attempt to deny property insurance coverage for repair and replacement of a defective product, or the attendant decrease in value of the defective product, on the grounds that such losses are not the result of a "physical" loss, similar to their arguments against data as property. The small business owner should be aware that generally, insurance companies have also lost this argument in court.
However, property insurance policies may exclude coverage for this type of loss under a clause that applies to "defective design," "faulty workmanship," or "manufacturing error" exclusion. This type of clause will be enforced. The insured's main argument would have to be that the terms of the clause were not met (i.e., that the product was not defectively designed, etc.). Of course, in any of these situations, the insured may have recourse against the party from whom it bought the defective product.
Business Interruption Coverage Goes Beyond "Fire Insurance"
Property insurance, for the business owner, should include business interruption coverage. This covers the losses associated with a business being unable to operate normally (e.g., due to a fire, a loss of electricity, etc.)--namely, the lost profits, additional extraordinary operating expenses incurred (e.g., rent of temporary space), and the cost of re-starting the business.
Generally, the same exclusions that apply to the property coverage (e.g., design defects) also will apply to the business interruption coverage. In addition, some policies may offer business interruption only if the business cannot operate at all. A policy that covers even a partial shutdown of the business is superior to no coverage at all. Whether the coverage requires a complete or only a partial shutdown of the business usually will depend on the language in the policy. A careful reading of the policy's provisions governing business interruption coverage is required.
Title Insurance Protects Your Ownership of Property
As the name implies, title insurance protects the title to property. It does not protect against loss due to fire or any other hazard. It protects only against the possibility that a purchaser of real property (land and buildings) has obtained an invalid legal title. The policy pays off if the owner loses ownership of the property because his title to the property turns out to be defective.
Unlike virtually every other form of insurance, title insurance requires only the payment of a single, lump-sum premium, which is due upon the purchase of the property, as opposed to ongoing premiums. Usually, the owner's policy will contain an inflation endorsement that automatically raises the policy limit each year, in accordance with a prescribed formula.
A title search (i.e., an examination of the chain of title, as it appears on the land records) should always be done before real property is purchased. Most states require that an unbroken chain of title go back 40 or 60 years. The title searcher will determine that the seller's signature appeared on each deed, that it was properly witnessed and acknowledged, and that the legal description of the property is identical in each deed.
Why is title insurance necessary if a title search is completed? A title search cannot absolutely ensure that the title is valid. For example, there is no way of determining, through a title search, that every signature on a deed is genuine. If one signature anywhere in the chain of title was forged, the chain is broken and the current owner holds an invalid title. A holder of an invalid title cannot, as a general rule, make a transfer to a buyer.
When the real property is collateral for a loan, the mortgagee (the lender) usually will require that the purchaser obtain a mortgagee title insurance policy. The mortgagee title policy, which will be issued in the amount of the mortgage, only pays off to the mortgagee in the event of a covered loss. Thus, a mortgagee title policy protects the lender's property interest in the real property. (It also will relieve you of having to make payments on property that you no longer own.) Ultimately, a mortgagee title insurance policy alone is not sufficient protection. Therefore, you should to purchase an owner's title insurance policy that will protect your equity in the property and will pay off if a covered loss occurs.
Personal Mortgage Insurance Protects the Lender
Personal mortgage insurance (PMI) is entirely different from title insurance in that it offers protection only for the lender. This insurance pays off the lender in the event the borrower defaults on the mortgage.
Lenders generally require PMI whenever the down payment on a purchase is less that 20 percent of the purchase price. PMI premiums can be expensive. Usually, advance payment of the first year's premium is due, in one lump sum, upon purchase. A monthly premium is then added to the mortgage payment.
PMI can be terminated when the equity in the property reaches 20 percent due to payments of mortgage principal, appreciation in the value of the property, or both. Lenders require an appraisal to establish that the 20 percent threshold has been reached.
Note that hazard insurance, title insurance and PMI represent examples of the principle of relying on another person's insurance. The owner of the property will be compelled by the lender to pay for the insurance, even though the lender will be a beneficiary of the insurance.
Mortgage Life Insurance Pays Off Mortgage If Borrower Dies
An owner of real property, who has taken out a mortgage on that property, can purchase mortgage life insurance. This form of insurance pays off the mortgage upon the death of the mortgagor/owner. While this may seem desirable, the high-cost premiums are not usually justified by the benefit. Premiums remain level, even as the policy's benefit (i.e., the mortgage balance) decreases.
Usually, a separate term life insurance policy, with the party who will inherit the real property named as the beneficiary, will represent a better use of your insurance funds than mortgage life insurance.
Fidelity Insurance Protects Against Dishonest Employees
Fidelity insurance covers loss of property due to an employee's dishonesty, as well as a suspicious loss of property that cannot be directly attributed to a particular employee. Coverage usually extends to losses of property due to theft, embezzlement, forgery and computer crimes.
The policy generally covers loss of property while on the business's premises and while the property is in transit or temporarily in another location. Because policies differ and because employee dishonesty can take many forms, a thorough reading of the proposed policy, in advance, is required, to determine the scope of any exclusions.
Consider fidelity bonds instead. If you only want to cover your business's funds and the people who have access to them, you may be able to save on insurance premiums by buying a fidelity bond. This less expensive, but more specific and narrow, form of fidelity insurance is limited to the individual, or individuals, who are named in the policy.
Usually, a business's treasurer and other persons who have access to the entity's cash (and other vulnerable assets, such as securities) and accounting records are bonded. Because a fidelity bond is limited to particular individuals, premiums generally are lower, compared to fidelity insurance, which protects against losses due to employee dishonesty in general.
Evaluate Long-Term Care Insurance Carefully
Long-term care insurance pays for nursing home costs, thus it is a type of property insurance. Here, the insurance is protecting the property you own from nursing home costs.
Medicare, which is part of the Social Security system, pays only for the first 100 days of nursing home care. After this period expires, the individual must personally pay the cost of the nursing home or qualify for Medicaid, which is a government entitlement program available only to persons who have extremely limited resources.
Qualifying for Medicaid is extremely complex, especially for individuals who are not indigent. Planning strategies may have to be not only implemented but completed several years prior to the point when you actually may need long-term care (see our discussion of transferring assets to qualify for Medicaid). Be sure to consult with one of the many professionals who specialize in this area if you are looking to have Medicaid provide for your long-term care needs.
With nursing home costs averaging about $80,000 per year, long-term care insurance seems, at first glance, to be a sound choice. Such high costs per year can quickly deplete a family's resources. Even the family home, in some instances, may have to be sold to pay for the costs of the nursing home.
However, many advisers recommend against purchasing long-term care insurance. Simply put, premiums for long-term care insurance can be extreme. Despite government efforts at marketing this type of insurance, it has not proved popular, probably due the premium cost.
Other asset protection strategies, including asset transfers, can provide effective protection, but without the premium cost. Although the transferor must give up title to the assets transferred to family members and make the transfers years in advance of Medicaid qualification, the transfers can be cost-free to the family. Plus, certain--very limited--assets considered "exempt" and need not be transferred to gain protection.
The small business owner should investigate the cost of long-term care insurance and compare other strategies to the cost of long-term care insurance. The premium cost must be weighed against the possible benefits. Further, it must be considered that after paying very substantial premiums for long-term care insurance, a policyholder may very well never have to take advantage of the policy, if they die young and quickly. In short, long-term care insurance may represent (at this time anyway) one instance where the small business owner may want to rely on other asset protection strategies rather than purchase insurance.
Umbrella Policies Cover You When Other Policies Are Exhausted
An umbrella policy is always purchased as an adjunct to the coverage offered under standard policies. It pays off on a covered matter only after the primary insurance is exhausted.
Premiums typically are affordable because the risk to the insurance company that the policy will be activated usually is low, due to the existence of the primary insurance.
Because it offers comprehensive secondary coverage, an umbrella policy can cover losses due to very divergent causes, such as losses associated with a building or losses due to an automobile accident. As always, a careful advance reading of the policy is recommended to determine the breadth of coverage.
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