How Much Business Income Coverage Do You Need?
Beware Coinsurance Penalties
If you are a business owner who has decided to purchase business income coverage, you will likely face a dilemma. What limit of insurance should you buy? Answering this question can be tricky as it requires some complex calculations.
Business income losses are calculated based on the amount of income your company actually loses during the time your business is shut down. The most your insurer will pay for a loss is the business income limit of insurance. To choose an adequate the limit, you must make the following two projections:
- The amount of income your company is expected to generate over the next twelve months. Your business income limit is calculated based on your estimate of future revenue.
- The amount of time you will need to repair damaged property after a physical loss. That is, if your business is forced to shut down because property has been damaged, how much time will you need to make repairs and get your business up and running again? In business income insurance, this time period is called the period of restoration.
These projections aren't easy to make. Both are essential for determining the right amount of coverage for your company.
One of the first challenges in choosing a business income limit is understanding the meaning of business income. Under many business income forms (including the standard ISO forms), this term means the sum of the following:
- Net income, meaning net profit or loss before income taxes
- Normal operating expenses that continue after a loss. This includes payroll.
If your business earns income by renting property to others, you can either include or exclude your rental income in your calculation of business income. When rental value is excluded in the calculation, no coverage will be provided for a loss of rental income. If your company generates all of its income from rental properties, your business income will consist of rental income only.
The most accurate way to project your 12-month income is to use a business income worksheet. You can use the standard ISO worksheet or one prepared by your insurer. If you need a worksheet, ask your agent or broker to obtain one for you.
The worksheet outlines a step-by-step process for calculating your business income exposure. The first step is to determine how much income your business generated in the previous twelve-month period. Next, you estimate your income for the future twelve months. You can make your projection by adjusting your 12-month historical figures to reflect any changes you expect over the coming year. For instance, if you expect your sales to increase by 10 percent, you can increase your income projection accordingly.
Some business owners may find a business income worksheet bewildering. If the worksheet seems too confusing, ask your accountant to complete it for you.
Projecting the Period of Restoration
Once you have completed your 12-month income projection, you need to estimate the period of restoration. To protect your business, your estimate should be based on a worst-case scenario.
For example, suppose you own a building in which you operate a warehouse. If the building is destroyed by a fire or a tornado, how much time will you need to get your business running again? Reconstructing a building involves many steps. First, an insurance adjuster will evaluate the loss. Next, you'll need an architect to design a new building and a contractor to do the construction. Once you've considered all the steps involved in rebuilding, you can estimate how much time they will take. Your estimated period of restoration may be six months, a year, or longer.
Beware Coinsurance Penalties!
Many business income forms include a coinsurance clause. This clause imposes a penalty if the limit on your policy is less than the required amount. Coinsurance applies to your policy if a coinsurance percentage is listed in the declarations. The percentage may be anywhere from 50% to 125%. It indicates the amount of insurance you must carry to avoid a penalty.
For example, suppose that you have purchased business income coverage based on an income projection of $1 million. Your policy includes a coinsurance requirement of 80%. To avoid a penalty, you must purchase a limit of at least $800,000 (.80 X $1 million). You purchase only $700,000 as a cost-saving measure.
Three months into your policy period a fire breaks out in your warehouse. The fire damages the building, forcing you to shut down your business for several weeks. You suffer a $175,000 income loss due to the shutdown. You have under-insured your business income exposure by $100,000. Here's how your insurer calculates your loss payment:
Maximum loss payment = loss amount X (limit purchased/ the limit required)
Amount paid by your insurer pays = $175,000 X (700,000 / 800,000) or $153,125
You must pay the remaining $21,875 yourself. This amount represents the coinsurance penalty. You can avoid a penalty by purchasing the required amount of business income coverage. Another option is to avoid coinsurance altogether by purchasing business income coverage on an agreed value basis.
Premium Adjustment Endorsement
As noted above, it is important to purchase enough business income coverage to avoid a coinsurance penalty. Yet, it is also possible to purchase too much insurance. If the limit you purchase exceeds the amount required by the coinsurance clause, you will have wasted money on unused insurance. The Premium Adjustment Endorsement provides a solution to this problem.
The endorsement provides a refund if your business income limit exceeds the amount required by the coinsurance clause. You must submit two reports of your business income values to your insurer. One must be filed when your policy begins (or when the endorsement is attached). The second must be submitted within 120 days of the date your policy ends. Your insurer will compare the limit you purchased to your required limit based on your actual values. If the limit you purchased exceeds the required limit, your insurer will return the excess premium.