From Business Income Losses…The Insurance Policy: Common Interpretations And Measurement Illustrations by: Steven J. Meils, CPA
Double Recovery and other recoveries which may result in the Enhancement of an insured’s Financial Condition
It is a long recognized principal of indemnity that an insured should be made whole for a covered loss, but should not profit from insurance recovery. The measure of recovery should correspond to the actual pecuniary loss sustained by the insured. Thus, an insured should recover only once for the items of damage resulting from a single loss occurrence.
A condition found in the Commercial Property Conditions Form CP 00 90 would preclude double recovery for losses under two or more coverages in a single policy. Form CP 00 90 is found in most policies under the Commercial Property Program.1
Double recovery may occur due to overlapping coverages, accounting error on the part of the loss preparer or evaluator or the use of accounting principles that are not relevant in economic loss measurement. In other cases, the circumstances of the loss or the application of improper practices or procedures will result in enhancement of the insured’s financial condition.
Claims for losses that would result in double recovery or enhancement of financial condition are described in the following paragraphs.
Overlapping Coverages
In some cases overlapping coverages for property and business income may result in double recovery. A manufacturer, for example, that insures finished goods at “sales value less un-incurred selling costs” under its property coverage, and at the same time maintains business income coverage, would, in effect, recover its business income loss twice if the normal profits and fixed manufacturing overheads included in the sales value of damaged inventory exceed the business income loss value, and both amounts are recovered.
Although under those circumstances, the insured could presumably recover any potential windfall resulting from property coverage (profits and fixed costs over the business income loss); the business income loss should not be paid if one adheres to the indemnity measurement objective.
Accounting Error
Insureds are often encouraged to “cut off” their books at the date of loss and to establish loss related ledger accounts in books to trap costs incurred for property replacement, extra expenses, repair, clean-up or other costs. When cut off is not achieved and the insured makes no effort to segregate loss activity from normal activity, loss activity may appear to be normal activity in the insured’s books and records. If allocations of labor and related costs, supplies, repairs, etc. are claimed under property or other coverages, and continuing normal expenses are not adjusted to remove any potential duplication for loss related items in business income loss calculations, then double recovery may result due to accounting error.
Use of Accounting Principles that are not relevant in Economic Loss Measurement
It is the measurement objective of the indemnity contract to find the amount of monetary loss that would result from a loss occurrence. In practice, insureds often claim fixed manufacturing overheads as part of the inventory replacement cost in property contents claims, when replacement cost is the basis for valuation. Although this method of valuation is appropriate in financial accounting, it is not an appropriate method of valuation in insurance indemnity accounting for inventory replacement costs. See Section 19, "Are Generally Accepted Accounting Principles always relevant when measuring Financial Damages under the Indemnity Contract?"
Because fixed manufacturing overheads remain constant and are normally not re-incurred with the replacement of inventory, they are not necessarily part of the monetary loss an insured would incur if destroyed inventories are replaced. The exposure for monetary losses of fixed overheads is typically covered in the business income form. To the extent that fixed manufacturing costs are incurred without sales, they are covered under the business income form. An insured that recovers fixed manufacturing costs as part of its contents claim and recovers its business income loss will enhance its financial condition to the extent of such overhead costs.
Other Items which may Result in the Enhancement of Financial Condition
When owner’s compensation continues at a greater rate than reflected in projected income calculations, the insured will have enhanced its financial condition to the extent of the increased compensation, if recovered.
When continuing expenses include payments for balance sheet items such as principal repayment or capital distributions, the insured will have enhanced its financial condition to the extent of such recovery.
When an insured insures business income and rental value, in the policy, some insurers or insureds will simply continue normal rents in business income calculations to provide the effect of rental coverage. When the lessor is a named insured in the policy and normally incurs operating expenses for depreciation, interest, real estate taxes or other expenses that will not continue during the period of restoration, the insured will have enhanced its financial condition to the extent of the recovery for such non continuing expenses.
When property is destroyed and applicable depreciation is continued in business income loss calculations, the insured will have enhanced its financial condition to the extent of claimed depreciation recovered.
When operations are partially continued and replacement property is depreciated at rates greater than normal, the excess depreciation over normal would result in double recovery if included in business income loss calculations.
If an insured purchases its own salvaged inventory from the insurer and reaps a substantial profit in a subsequent fire sale, the insured would enhance its financial condition, if such profits are not deducted from business income loss calculations.
If an insured repairs or self constructs its replacement property in property claims, the insured would profit to the extent that claimed repair or replacement costs exceed the variable costs of repair or reproduction. If such profit is allowed in a contents claim, it should be deducted from the business income loss.
Inclusion of the above items in claims will always serve to enhance the financial condition of an insured.
Notes
1FC&S Commercial Property, 1997. The National Underwriter, p. A. 4-3.
