April 2002 volume 6 issue 1 

As every client knows, most business policies contain a co-insurance clause limiting the insurance company’s liability by making the insured responsible for a percentage of the insured property value, or a stated amount.

The co-insurance clause stipulates that in order to be fully reimbursed for a loss, even a partial one, the insured must carry insurance for at least a specified percentage of the total value of the property. If the property is insured for less than that amount, the insured assumes some of the risk and becomes a co-insurer with the insurance company for losses within the policy coverage amount. This decision by the insured also has the effect of reducing the policy premium.

When determining what proportion of a claim will be paid for a partial loss, the insurer divides the amount of insurance carried, by the amount of insurance that should have been carried.

For example, if Jones & Company has an 80% co-insurance clause and his building is valued at $100,000, it should carry insurance in the amount of $80,000. If they then sustained a loss of $50,000, their claim would be paid in full:

Had Jones & Company only carried insurance coverage of $60,000, then the formula would apply as follows:

Even though the $50,000 loss falls within the monetary limits of the policy, Jones & Company would receive only three quarters of the amount claimed, or $37,500. If the building had been insured for at least $80,000 (or 80% of its value), the insurer would have reimbursed Jones & Company for the full amount of their loss.

It is the insured’s responsibility to ensure that the value of the coverage accurately reflects the true value of the property. If the property is undervalued inadvertently, or in a deliberate attempt to reduce insurance premiums, the insurance company will pay the claim only in proportion to the amount of coverage carried.

A forensic accountant working for the insurance company may perform valuations of commercial enterprises and professional practices to assist in determining the limits of the loss. He or she may also calculate inventory and business interruption losses, including loss of income.

The co-insurance clause affects the calculation of a business interruption insurance claim by limiting the insurance company’s liability to a stated percentage of the business income that would have been earned during the indemnity period following the loss, had no loss occurred. Although a different formula is used to calculate business income under Net Income and Gross Earnings policies, the co-insurance clause is applied to both in the same way.

Some policies contain a payroll exclusion endorsement to reduce the insurance coverage for businesses whose employees would necessarily be laid off in the event that the business was not operating. In these cases, “ordinary payroll expenses” can be deducted for the policy year, except for the number of days indicated on the endorsement form, and the amount of insurance in force can be lower without incurring a co-insurance penalty.

Sometimes original records may not be available, or records may have been too poorly kept to be useful. A forensic accountant can reconstruct accounting records. He or she can also evaluate the level of reliance that can be placed on existing financial statements and tax returns, including an investigative examination of books and records when addressing fraud concerns.

When necessary, a forensic accountant will also evaluate financial conditions of the insured business. This is an important consideration particularly when arson has been proved or is suspected.

Editor’s Note:
This article is reproduced from Accounting & Claims, a newsletter published in Canada by the National Association of Forensic Accountants.