J & N REALTY, INC.

Commercial Insurance  

Basic Insurance Concepts 

Financial and Legal Definitions of Insurance 

Insurance professionals and attorneys do not always agree on the definition of insurance.  This particular disagreement has led to hundreds if not thousands of court cases.  Whether a transaction or product is considered to be insurance can make a huge difference because insurance is subject to specific tax laws, accounting rules, and regulation.  Note that insurance transactions are regulated by state laws and statutes. 

Many insurance scholars believe there are two distinct definitions of insurance—a financial definition and a legal definition.  Before jumping into the insurance definitions, however, two other terms need to be defined.  First, the insurance company is referred to as the insurer.  Second, the policyholder (e.g., owner of the business) is referred to as the “named insured” or “insured.”  The “named insured” is the business entity specifically named in the policy declarations and an “insured” can be a related party (e.g., directors and officers of the company) covered by the insurance, based on the policy’s definition of an “insured.”  Note that the “named insured” is often referred to simply as the “insured.” 

Financial Definition 

The financial definition of insurance specifies that insurance is a financial agreement involving the redistribution of financial losses.  This process involves shifting potential losses that persons or businesses may face into an insurance pool.  The pool, typically operated by the insurer, combines all of these possible losses and then shifts the cost of the predicted losses back to those parties exposed to the loss. 

Legal Definition 

This definition stipulates that insurance is a contractual agreement in which one party (the insurer) agrees to compensate or indemnify another party (the insured) for fortuitous losses. 

Fundamental Characteristics of Insurance 

Insurance contains several unique characteristics, including (a) loss pooling, (b) payment of accidental losses, (c) transfer of risk, and (d) indemnification. 

Loss Pooling 

Pooling involves the sharing of total losses sustained by a few overall members.  This pooling facilitates risk reduction, which can be defined as a decrease in the amount of uncertainty present in a given situation.  Pooling also involves the combining of a large number of similar but independent exposure units.  This process takes advantage of the law of large numbers, which states that as the number of homogeneous but separate exposure units (e.g., commercial buildings insured) increases, the predictability of future losses also increases. 

Payment of Accidental Losses 

Payment of accidental or fortuitous losses is another key characteristic of insurance.  An accidental loss is unexpected and is the result of sheer chance.  This characteristic allows the insurer to more accurately predict future losses.  Note that intentional losses committed by the insured are typically excluded under commercial lines policies. 

Transfer of Risk 

This characteristic involves the transfer of risk from the insured to the insurer, which is normally a larger entity more financially able to absorb the loss. 

Indemnification 

This process involves the act of an insurer compensating the insured for a covered loss.  The goal is to put the insured back in the same financial position he or she was in prior to the loss.  This topic will be addressed in detail later in this chapter. 

Basic Insurance Terminology 

It is important in an introductory insurance course to discuss some basic insurance terms, including the following. 

• Loss 

• Peril 

• Hazard 

• Proximate cause 

• Risk, including pure and speculative risk 

• Risk classification 

• Tort 

• Reinsurance 

Loss 

A loss, in insurance terms, refers to the basis of a claim for damages under the terms of the policy.  It also refers to the loss of assets resulting from a pure risk, such as a fire loss.  (Pure risk is discussed later in this chapter.)  Planned losses include expenses such as depreciation on a piece of factory equipment or on a commercial vehicle.  Insurance is not designed to cover planned losses, only accidental ones.  Insurable losses include direct and indirect losses.  A direct loss is the immediate result of a covered cause of loss.  An indirect loss is a consequential result of a direct loss.  Note that there cannot be an indirect loss if there is no direct loss.  For example, a direct loss would be a fire to an office building and the indirect loss would be expenses entailed in renting other commercial property until the office building is repaired. 

Peril 

A peril is defined as the cause of the loss.  Thus, if a pawnshop is burglarized, theft is the peril.  Commercial property policies such as the building and personal property form cover losses on either a named perils basis or an all risks basis.  A named perils policy is one in which the policy specifically lists the covered perils.  An all risks policy provides broader protection and covers any accidental loss, subject to a host of policy exclusions.  An exclusion is a policy provision that identifies losses that are not covered. 

Hazard 

A hazard is defined as a condition or conditions that increase the possibility of a loss.  A hazard can result in increases in the frequency of losses and/or the severity of losses.  The three types of hazards are physical hazards, moral hazards, and morale hazards. 

Physical Hazard 

A physical hazard can be defined as a physical condition or situation that increases the possibility of a loss.  For example, outdated or frayed wiring in a factory is a physical hazard.  Concerning commercial auto loss exposures, driving a large commercial vehicle in heavy fog is another physical hazard.  Note that if an accident occurs, the fog is the hazard and the collision is the peril. 

Moral Hazard 

A moral hazard concerns intentional acts committed by the insured that either create or exaggerate a loss.  Moral hazard is measured by the character of the insured and the circumstances surrounding the subject of the insurance.  Two examples of moral hazards will illustrate.  First, if a business owner is unable to make the payments on his delivery trucks, he may torch one of the vehicles in order to receive the insurance proceeds.  This event is the creation of a loss.  Second, assume the insured’s convenience store is burglarized and the thieves steal cash.  The thieves, however, do not touch the cigarettes.  The insured exaggerates the loss by telling the adjuster that the thieves also stole the cigarettes, a valuable commodity on the black market. 

Morale Hazard 

Morale hazard, as contrasted to moral hazard, does not imply a propensity to cause a loss, but implies an indifference to loss simply because of the existence of insurance.  For example, an insured’s attitude may be indifferent to a potential loss because he or she has insurance coverage.  To illustrate, a small business owner who fails to replace missing shingles on his commercial property is unconcerned with hail or water losses because of the existence of a commercial property policy.  One way to mitigate this hazard is for the insurer to insist on high deductibles so that the insured has to participate in each loss. 

Proximate Cause 

This term refers to a substantial factor in setting events in motion that cause a loss.  For example, assume a fire partially damages one major section of a restaurant, weakening a retaining wall in the process.  If a windstorm a few hours later were to cause the wall to collapse, fire would be considered the proximate cause of the loss. 

Risk 

This term is often used in two ways.  First, it is considered the uncertainty arising from the possible occurrence of given events, such as vandalism to a strip center.  Insurers bear the burden of assuming risk in return for an established premium paid by the insured.  Second, many insurance professionals refer to a risk as the insured or the property to which an insurance policy applies.  For example, if a commercial auto insurance applicant had numerous severe liability losses in the last 3 years, the insurer would likely decline that “risk.” 

Risks are typically organized into two types—pure risk and speculative risk.  Pure risk is the risk involved in situations that present the opportunity for loss but no opportunity for gain.  Thus, there are two possibilities—(a) loss or (b) no loss.  Pure risks are generally insurable.  Examples of pure risks include the uncertainty of loss to property by flood or lightning.  In contrast, a speculative risk is the uncertainty about an event under consideration that could produce either a profit, no change in a financial position, or a loss, such as investing in the stock market or a new business venture. 

Speculative risks often create risks in which there were none previously; thus, they are generally uninsurable. 

Risk Classification 

Most insurers place their applicants for insurance in well-defined homogeneous classes based on the probability of loss.  For example, commercial property is classified (and rated) based on the type of construction (e.g., wood, brick), occupancy (e.g., office building, warehouse, etc.), protection (e.g., voluntary fire department versus paid fire department), and exposure (types of property adjacent to the commercial building).  For workers compensation policies, there are separate classifications for different types of occupations.  For example, a retail store will have a different classification and rate compared to a factory.  With a proper risk classification system, each class of homogeneous insureds should theoretically pay their mathematically fair share of the insurance pool’s losses. 

Tort 

A tort is a civil wrong, other than a breach of contract or a criminal act, giving rise to legal liability. 

(Liability is the obligation to pay a monetary award for injury or damage caused by one’s negligence.)  A tort can result from (a) negligence, (b) intentional acts, or (c) strict liability. 

Negligence 

Negligence involves the failure to use a reasonable degree of care under a given set of circumstances.  

The four elements of negligence are (1) a duty owed to a plaintiff (the party bringing suit or seeking damages), (2) an unintentional breach of that duty by the defendant (the party against whom the suit has been brought), (3) an injury or damage suffered by the plaintiff, and (4) a sufficient causal connection between the defendant’s unintentional negligence and the plaintiff’s injury or damage. 

Negligence is virtually always covered by commercial lines insurance coverage, subject to certain exclusions. 

Intentional Acts 

If an act is committed with the purpose of injuring someone or damaging another’s property, the result is an intentional injury.  Many of these types of actions are excluded under commercial lines insurance policies.  Examples of these acts are assault and battery.  Conversely, some intentional acts may be covered such as libel and slander, subject to certain restrictions. 

Strict Liability 

Strict liability is a doctrine that concerns liability for damages regardless of fault.  An example is a business owner who keeps a tiger he owns at his business premises.  If a teenager cuts a hole in the fence and taunts the tiger, resulting in a mauling, no negligence has to be established for the insured to be held legally liable.  Strict liability often deals with inherently dangerous property or situations. 

Reinsurance 

Reinsurance is a transaction in which one party, the reinsurer, in consideration of a premium paid to it, agrees to indemnify another party (the insurer) for part or all of the liability assumed by the insured under a policy it has issued.  In simpler terms, reinsurance is insurance protection for insurers.  For extremely large risks, such as a $10 million office complex, the insurer often procures reinsurance to protect itself from a potentially huge loss. 

Elements of a Valid Contract 

A contract is a binding agreement between two or more persons that is enforceable by law.  This agreement must be made under certain conditions before a court can enforce it.  There are four requirements common to all contracts, including (a) offer and acceptance, (b) consideration, (c) legal capacity, and (d) legal purpose. 

Offer and Acceptance 

An offer is an expression of the willingness to enter into an agreement with another party.  The offer must be made in a clear and well-communicated manner.  An acceptance is the assent of the offer and it must be unconditional and communicated clearly as well.  Legal experts refer to this process as a “meeting of the minds” since both parties must agree to the identical terms of the agreement. 

In an insurance transaction, the applicant for insurance makes the offer by completing an application.  The insurance agent normally is the party that conveys this offer to the insurer.  The insurer has three options in this situation.  It may (a) accept the offer and issue a policy, (b) reject the offer because the applicant does not meet its underwriting guidelines for some reason, or (c) accept the offer with modifications.  This last option is often referred to as a counteroffer.  For example, the insurer’s underwriter may agree to insure a factory if a state-of-the-art burglar and fire alarm system is installed. 

Consideration 

Consideration is a legal term referring to the value that each party gives to the other when making the contract.  Each party must give something of value in order for the transaction to be enforceable.  In an insurance contract, the insurer promises to pay for a covered loss, to defend the insured in litigation, or to perform other services such as an inspection.  The insured agrees to pay the premium and abide by the requirements of the insurance policy. 

Legal Capacity 

Legal capacity is the right to make binding agreements for oneself.  Parties who have no legal capacity include minors, intoxicated individuals, and insane persons because these people normally cannot understand the agreement itself.  A court would not recognize them as competent parties.  In addition, corporations acting outside the scope of their articles of incorporation or outside the scope of authority granted by a governmental body lack legal capacity.  For example, an insurer would lack legal capacity in a certain state if it did not have a license to operate in that jurisdiction. 

Legal Purpose 

A final requirement for a valid contract is that the agreement must be for a legal purpose.  For example, a written agreement regarding child pornography or drug dealing is not considered a contract by a court of law.  It would be considered unenforceable from its very beginning. 

Other Legal Terminology 

A few extra terms merit a brief discussion, including a (1) valid contract, (2) voidable contract, and (3) void contract. 

A valid contract is a contract that complies with all the essentials of a contract and is binding and enforceable on all parties to it.  A voidable contract is a contract that appears to be valid on the surface but may be voided by one or both of the parties.  For example, in an insurance contract, if the insured commits fraud, the insurer may be able to successfully break the agreement due to the insured’s illegal actions.  In contrast, a void contract is one that has no legal force because it does not meet the essential elements of a contract.  For example, a court would declare an insurance contract with a minor void from its very beginning. 

Distinctive Characteristics of Insurance Contracts 

Insurance contracts contain a set of distinctive characteristics, including the following. 

• Principle of indemnity 

• Insurable interest 

• Subrogation 

• Unilateral contract 

• Conditional contract 

• Personal contract 

• Aleatory contract 

• Contract of adhesion 

• Doctrine of utmost good faith 

Principle of Indemnity 

This principle stipulates that an insured will be reimbursed for his or her loss, subject to the policy’s limits and terms.  The goal of indemnity is to put the insured back in the same financial condition he or she was in prior to the loss.  In other words, the insured should not profit from the loss, since this over-indemnification increases the moral hazard.  For commercial lines policies, there are two key exceptions to this rule. 

First, the policy, such as a business and personal property form, may provide replacement cost coverage, which means the cost to replace the damaged or stolen property with new property without any deduction for depreciation.  This is in contrast to paying the claim on an actual cash value basis, which is defined as replacement cost less depreciation.  With replacement cost coverage, the insured can be over-indemnified or overcompensated.  For example, if the insured has replacement cost coverage on his office building and his 15-year-old roof is destroyed by a hailstorm, the old roof is replaced with brand new shingles. 

Second, the policy may provide coverage on a valued basis.  Valued coverage is property coverage that pays a stipulated dollar amount (rather than the actual cash value or replacement cost of the property) in the event of a total loss.  Fine arts coverage is often written on a valued basis because it is typically difficult to ascertain the exact value of the artwork. 

Insurable Interest 

Insurable interest is the insured’s financial interest in the value of the subject of insurance, such as an owned building used as a warehouse or a tractor-trailer rig.  In other words, an insured must clearly prove a personal stake in the item being insured or else be unable to collect compensation due when an insured peril causes a loss.  Insurable interest usually results from property rights, contract rights, and potential legal liability. 

For example, assume that a person could procure an insurance policy on a friend’s commercial property.  If this same person (the insured) collects payment when this property burns down, a moral hazard is created because monies are provided for an event in which the insured did not suffer a financial loss.  As a result, a person can buy insurance on his own commercial property because if the structure suffers a major loss, the insured’s financial condition also suffers. 

Subrogation 

Subrogation is defined as the assignment to an insurer, after the insurer’s payment of a loss to the named insured, of the rights of the insured to recover the amount of the loss from one legally liable for it.  This right is based on the principle that if a party must pay for the debt for which another party is liable, such payment should give the party providing payment the right to collect the debt from the guilty party.  The right of subrogation is automatically recognized by the courts and in statutes, and is often additionally specified in insurance policies themselves.  For example, assume the insured purchases commercial property designed to be used as a gym.  After this purchase, he has to replace a defective gas hot water heater in this property.  The contractor improperly installs a new hot water heater, which later explodes and starts a major fire at the gym.  If the insured chooses to collect payment from her commercial property policy, her insurer will be subrogated to her right to sue the responsible contractor.  Thus, subrogation prevents the insured from collecting twice (double indemnification) for the loss.  If this over-indemnification were allowed to occur, the moral hazard of insuring property would be greatly heightened. 

Unilateral Contract 

An insurance contract is a unilateral one.  This type of contract is one in which only one party (the insurer) makes an enforceable promise (to pay a covered loss).  By contrast, the insured makes few, if any, enforceable promises to the insurer.  Instead, the insured must only fulfill certain conditions—such as paying premiums and reporting accidents—to keep the policy in force.  Conversely, a bilateral contract is one in which the parties involved give mutual promises. 

Conditional Contract 

A conditional contract is one in which the performance of some or all of the terms of the agreement are dependent upon a condition.  A “condition” is an event, not certain to happen, which must occur before performance under a contract becomes due.  For example, the insured is required to cooperate with the insurer in the investigation of a claim as a condition for the loss to be paid. 

Personal Contract 

This term means that the contract is solely between the named insured and the insurer.  Since the contract is personal, the insured applicant must meet certain underwriting standards such as loss history, moral character, and credit history.  A personal contract is one in which the named insured cannot assign or transfer to another party.  For example, if the named insured sells his business to a friend, he cannot simply assign his commercial general liability policy to his friend.  His insurer will want to cancel the policy and request that the friend complete an application to the insurer’s agent for review. 

Aleatory Contract 

This distinctive characteristic refers to an agreement concerned with an uncertain event that provides for unequal transfer of value between the parties.  Insurance policies are aleatory contracts because an insured can pay premiums for many years without sustaining a covered loss.  Conversely, insureds sometimes pay relatively small premiums for a short period of time and then receive payment for a substantial loss. 

Contract of Adhesion 

This characteristic stipulates that the insured must accept or adhere to the entire contract, with all of its terms and conditions.  The insurer develops and prints the contract or policy and the insured typically has to accept it in its entirety or reject it.  The insured cannot insist that it be rewritten or that certain phrases be added or removed.  Note, however, that some amendments are allowed, such as endorsements that restrict or expand coverage.  The insurer, though, also writes these endorsements. 

As a result, the courts normally rule that any ambiguities within the policy should be ruled in favor of the party with lesser knowledge (i.e., the named insured).  This encourages insurers to draft policies that are clearly written and it also promotes the effective usage of definitions to help clarify important terms. 

Doctrine of Good Faith 

This is a type of contract in which one party is in particular possession of facts unknown to the other party at the time the contract is negotiated.  As a result, a higher standard of honesty is imposed on parties to an insurance transaction than is imposed on regular commercial contracts.  The level of good faith an insured owes to an insurer is best explained through the concept of representation. 

An integral part of an insurance transaction is the named insured’s truthful completion of an insurance application.  Courts refer to the applicant’s answers as representations.  If the insurer relies upon the insured’s dishonest answer, the insurer may be able to void the contract, depending on the materiality of the facts.  The test as to the materiality of a particular fact is whether the answer on the application, if honestly rather than dishonestly disclosed, would have influenced an insurer to decline the applicant or to have caused the insurer to write the applicant’s policy for a higher premium. 

Note that the duty of good faith also applies to the insurer in its promise to pay for a covered loss. 

Requirements of Ideally Insurable Loss Exposures 

From the insurer’s perspective, there are five key requirements of ideally insurable loss exposures, including the following. 

• Large number of similar exposure units 

• Accidental and unintentional loss 

• Definite and measurable loss 

• Low probability of a catastrophic loss 

• Calculable probability of loss 

Large Number of Similar Exposure Units 

An insurer needs a large number of homogeneous but independent loss exposure units to achieve predictive accuracy, taking advantage of the law of large numbers. 

Accidental and Unintentional Loss 

The loss should be fortuitous and generally outside the insured’s control.  If intentional losses were covered, the moral hazard would greatly increase, leading to even more losses. 

Definite and measurable loss 

The loss must be specific as to time and place.  For this reason, many commercial property policies do not cover mysterious disappearance of property, but cover instead definite theft losses.  The loss also must be measurable to aid in the claims adjusting process.  Thus, termite damage is not covered under virtually all commercial property policies because ascertaining the exact date of the initial occurrence and the extent of the damage is very difficult. 

Low Probability of a Catastrophic Loss 

Insurers want to avoid situations in which most of the risks in the insured pool might suffer losses at the same time from the same peril, such as earthquake or flood.  This event can lead to major financial problems for the insurer.  For this reason, the federal government is closely involved in flood insurance and provides reinsurance for insurers. 

Calculable Probability of Loss 

The chances of a loss must be reasonably calculable.  The insurer must be able to calculate with some degree of accuracy the average frequency (the likelihood that a loss will occur) and average severity (amount of damage) of upcoming losses.  This estimate is essential in order for the insurer to charge the correct premium that will cover losses and expenses, as well as provide a profit margin. 

Costs and Benefits of Insurance 

There are various costs and benefits of the insurance system to society.  It is generally agreed that the benefits of insurance far exceed the costs of insurance. 

Costs 

There are two main costs to society of operating an insurance system, including the following. 

• Cost of the resources utilized by the system, including land, capital investment, and labor. 

• Costs arising from increased losses due to the morale and moral hazards.  For example, there would be less arson if there were no insurance proceeds to be possibly collected from this act. 

Benefits 

There are several benefits that the insurance system provides to society, including the following: 

• Stability to families and businesses—through the indemnification process, a family or business can be restored to their pre-loss financial condition. 

• Peace of mind—insurance provides comfort to business owners that may worry about losing their business or getting sued due to an automobile accident.  In other words, they experience less fear and worry about financial matters. 

• Facilitates credit transactions—creditors are more willing to loan funds if they know the business property they are financing will be replaced or repaired if damaged.  Thus, the creditor’s collateral remains intact. 

• Risk control—insurers are often involved in loss prevention and reduction programs.  Many insurers employ inspectors and loss control engineers to make recommendations to insured businesses on ways to reduce the frequency and severity of losses. 

• Source of investment capital—insurers collect premium in advance and do not necessarily pay for incurred losses immediately.  This net cash flow between premium collections and loss payments can be invested in the stock market and other financial products, thus bolstering the economy. 

Distinctions between Types of Insurance 

The insurance industry is typically organized into two separate arenas—(a) property and casualty and (b) life and health.  Most insurance professionals work in only one area, with some exceptions.  For example, some agents deal with property and casualty insurance as well as life, health, and disability insurance.  Other agents, however, deal exclusively with one or the other.  Most other insurance occupations focus solely in one of these two areas. 

Property and Casualty Insurance 

Property insurance deals with first-party insurance that indemnifies the owner or user of property (e.g., business owner) for his or her loss, if caused by a covered peril such as fire or windstorm.  First party refers to a situation in which the insured (the “first party” to the insurance contract) has an issue directly with his or her own insurer (the “second party” to the insurance contract). 

In contrast, casualty insurance deals with third-party insurance that is primarily concerned with the losses caused by injuries to persons, and legal liability imposed on the insured for such injury or for damage to property of others.  Third party refers to the addition of the claimant (e.g., party that has been injured due to the insured’s negligence) into the mix along with the insured and insurer.  Thus, the claimant is the “third party” to the insurance contract.  Note that the term “casualty” insurance has gradually been replaced by the term “liability” insurance. 

Many commercial lines policies, such as the businessowners policy (BOP), contain property and liability coverages packaged together.  In contrast, the building and personal property form deals solely with property coverage and a commercial umbrella policy deals exclusively with liability coverage.  These two policies will be discussed later in this course. 

How the Insurance Industry Operates 

On the surface, the process for obtaining insurance is simple.  A salesperson, typically called an “agent,” “producer,” or “account executive,” works with the prospective insured or policyholder to complete an application for insurance.  The agent provides this information to underwriters at one or more insurers, and they (1) accept the offer, (2) reject the offer, or (3) accept the offer with modifications.  For the third option, an underwriter may agree to insure a commercial property risk if the named insured is willing to choose and maintain a high deductible on his property.  If the insurer agrees to write the business, there is a “meeting of the minds” and coverage is then “bound” and in force. 

When the insured experiences a loss, it is reported to the insurer, and a claims adjuster is assigned to handle the claim.  The adjuster investigates the claim and determines if the loss falls within the coverage parameters of the insurance policy.  Assuming coverage applies, the adjuster will determine how much to pay the insured to resolve the loss for property insurance claims or coordinate the defense of liability insurance claims. 

This chapter explores the insurance procurement process and claims adjusting process in more detail. 

Its objectives are to (a) provide an overview of the insurance distribution system, (b) make suggestions on choosing an insurer, (c) make suggestions on selecting a professional agent or broker, (d) discuss agency services and compensation, (e) outline the process of arranging coverage and determining premium, (f) discuss underwriting cycles, and (g) review some of the important aspects of the claims adjusting process. 

Insurance Distribution Systems 

In the United States, property and liability insurance is distributed by three types of systems: the direct writer system, the exclusive agency system, and the independent agency system. The direct writer and exclusive agency insurance companies market insurance through salaried salespeople or commissioned agents who sell only the insurance products of a particular company. Examples of direct writer and exclusive agency companies include Farmers Group, Liberty Mutual, Nationwide, and State Farm. The independent agency system insurance companies, conversely, depend on independent insurance agents to sell their products. These agents often represent many insurance companies. A few examples of the many independent agency system insurance companies are American International Group (AIG), CNA, Chubb, The Hartford, Travelers/St. Paul, Safeco, and Zurich. In a few instances, certain companies such as Liberty Mutual are represented by both exclusive and independent producers. 

From the standpoint of the insurance buyer, each of these alternatives for marketing insurance offers both advantages and disadvantages. The principal advantages of the direct writer/exclusive agency system over the independent agency system are higher quality claims, risk control, and similar services typically provided by these companies. Another key advantage of most direct writers is lower expense ratios, a fact that should ultimately be reflected in lower premiums. Conversely, the sales representatives of direct writers and exclusive agency companies may not be as skilled and knowledgeable as independent agents. In addition, direct writers and exclusive agency companies’ representatives can offer only the services and products that their employer provides.  However, both segments are making improvements in their deficient areas, and, consequently, the advantages of one system over another in a particular area are diminishing. 

Probably the most important advantage of using independent agents—as compared to direct writers and exclusive agents—is that independent agents can place insurance with any one company or a combination of many insurance companies with which they do business.  An independent agency generally has contracts with the insurers it represents.  Not being employees of the insurance company, some independent agents are more oriented toward representing the buyer of insurance than the insurance company. 

The insurance buyer should keep in mind, however, that an insurance agent is legally an agent of the insurance company and not of the insurance buyer.  In contrast, a true insurance broker is legally an agent of the insured and not of the insurance company.  In practice, the legal distinctions between insurance agents and brokers probably make little difference in the level of service provided to insurance buyers and should not be an important consideration in choosing an insurance representative. 

Selecting an Insurer 

The named insured’s selection of a financially strong insurance company is a very important factor.  Insurance is simply a promise the insurer makes to pay for a covered loss, a loss that can occur far into the future.  Like all promises, the promise to pay a covered loss is worth no more than the financial strength of the insurer that makes it. 

The insured should also look for an insurer that is fair and prompt in settling claims and is able and willing to provide excellent service before and after a loss.  Selecting an insurer based solely on low cost may result in unfortunate consequences.  Gaining recommendations from friends and business colleagues is a good first step in selecting an insurer. 

Selecting an Agent or Broker 

The most visible function of an insurance representative—i.e., an agent, broker or direct sales representative—is to procure coverage for clients.  Most businesses, however, look to their agent or broker for a variety of additional services.  For example, most businesses rely on their broker to perform certain risk management functions, such as identifying coverage gaps and advising them on loss control and risk financing matters.  As the commercial insurance market becomes more specialized, the business’ need for knowledgeable and experienced insurance advisors has grown accordingly. 

Because the agent or broker plays such an important role in the risk management program, businesses should exercise considerable diligence in selecting a representative.  A common approach to selecting an insurance representative is to invite a limited number of agents and brokers to submit proposals outlining their recommendations for the program and the markets they would use in arranging the coverages.  The participants are then evaluated on the quality of their proposals, including their demonstrated knowledge, creativity in the areas of risk financing and handling unusual or hazardous exposures, access to markets, and level of commitment.  This competitive process may or may not include actually obtaining price quotes from insurers.  The evaluation process should encompass all personnel who will work with the insured, including assistants and anyone involved in providing ancillary services.  More often than not, assistants (often called Customer Service Representatives or “CSRs”) will handle much of the day-to-day activity on the account and will have some authority and responsibility to act alone. 

Unfortunately, some business insureds choose a representative without careful consideration of the perils of engaging an inexperienced or incompetent representative.  For example, many agents and brokers are engaged because of social or family relationships with the insured.  Others are retained based purely on the price quoted.  While cost and comfortable relationships are important, they are not the only criteria on which the selection should be based.  Naturally, insureds want to minimize their insurance costs.  However, until all other factors are equal, price should not be the determining factor in selecting a representative.  More important is the agent or broker’s knowledge, access to reputable and specialized insurance markets, education, experience in dealing with commercial lines, and service capabilities.  These and other important criteria for selecting an insurance adviser are listed below. 

Selection Criteria 

• Demonstrated knowledge in commercial lines insurance coverage 

• Technical proficiency 

• Creativity and flexibility in designing coverage and pricing programs 

• Risk management orientation 

• Size of account relative to other accounts 

• Length of time in business 

• Education and experience of everyone who will be working on the account 

• Staff assistance 

• Service oriented 

• Location of branches and correspondent offices 

• Adequate errors and omissions insurance 

• Responsive 

While knowledge cannot be measured directly, insureds can look at a number of other factors for evidence of the representative’s knowledge.  Most agents would agree that the majority of what they know is learned “in the trenches.”  Therefore, length of time in the insurance business is one measure of a representative’s overall familiarity with the markets (e.g., what a particular insurer’s policy form does and does not provide).  The amount and types of education, particularly continuing education, also shed light on the representative’s commitment to getting the proper background and staying current on developments in loss exposures, coverages, and markets.  Designations such as the CPCU (Chartered Property Casualty Underwriter), CIC (Certified Insurance Counselor), and ARM (Associate in Risk Management) demonstrate that the agent or broker has completed a rigorous course of study in general insurance and risk management. 

The key point to remember is that the agent or broker is the primary interface/supplier of insurance protection; therefore, it is important to choose a knowledgeable and professional representative experienced in commercial lines coverage. 

Agent/Broker Services 

Most agents and brokers perform a host of services beyond simply delivering an insurance policy.  These services may include risk management program reviews, alternative risk finance feasibility studies, policy reviews, and assisting in getting claims settled and paid.  These types of services are often called “value-added” services because they are performed as part of a general agreement between the representative and the insured, and they do not carry extra charges.  The term “value-added services” describes any services the agent or broker performs as part of their role as adviser, over and above delivering a policy, such as performing risk analysis, maintaining a database, and calculating test modifiers for workers compensation insurance rating. 

Agent/Broker Compensation 

The compensation paid to independent agents or brokers by the businesses for which they procure insurance is usually in the form of commissions paid by the insurance company (and passed through as part of the premium).  In some cases, a fee is paid directly to the agent/broker by the insured business, and in some cases a combination of these two approaches is used. 

Commissions vary from insurance company to insurance company, agent to agent, and region to region.  They are also different for different lines of insurance.  They are, to some extent, a function of the size of an account, with larger ones generating lower commission percentages.  In general, however, insurance companies will pay a commission of around 8 to 15 percent of the premium on commercial auto insurance, 10 to 15 percent on commercial fire insurance, 8 to 10 percent on commercial general liability, 10 to 15 percent on commercial package policies, and 3 to 10 percent on workers compensation.  Risk managers of larger businesses may have the bargaining power to negotiate the commission percentage with their agent or broker.  In addition, sometimes an agent or broker will initiate reduced commissions from the insurance company to compete on medium size accounts against other agents and brokers in a competitive bidding situation. 

In addition to commissions, it is common for agents/brokers to derive additional income known as “contingent commissions.”  These commissions stem from agreements the agents/brokers enter with insurers called “placement service agreements” (PSAs).  These are payable, usually on a preset, sliding scale, when the agent’s book of business with an insurer generates especially favorable loss experience during a given year.  Contingency commission plans have been criticized by the risk management community and have received increased scrutiny by regulators and state attorneys general with concerns that they create conflicts of interest.  While the future of this system may be in question, it remains in place today.  Insurance brokers will disclose the existence of these agreements upon request, and many now proactively disclose them without being requested to do so.  It also is likely that many states will pass legislation requiring the voluntary disclosure of these commissions by agents and brokers. 

Large businesses may be able to negotiate with their agent or broker to operate on a fee basis.  This could be a negotiated flat fee or a fee based on time and expense.  Since income to the agent or broker computed in this manner is not a function of the insurance premium, possible disincentives to reducing premiums that are inherent in the commission system are eliminated.  This approach can also smooth out the income of the agent/broker rather than having it subject to the cyclical nature of the insurance business.  One problem in attempting to place agents/brokers on such a system, however, is that they are not accustomed to accounting for their time and expenses and frequently do not have the systems in place to efficiently do so. 

Regardless of the compensation system(s) used, full disclosure of compensation benefits both the agent/broker (by removing the mystery from the process for the client) and the business (by facilitating an assessment of the agent’s/broker’s performance).  It is a good practice for the agent to provide an annual stewardship report reviewing the services provided during the year and the compensation received for this work.  This practice is very common with large accounts and much less so for small accounts.  However, it is a good practice regardless of the size of the account, and there is a general trend in this direction as agents/brokers take a more professional approach to their work. 

Arranging Coverage and Determining Premiums 

The process generally used to purchase insurance is illustrated in Exhibit 3.2.  The insured asks an agent or broker to obtain a quotation.  Underwriting data necessary to determine whether or not the risk is insurable is assembled by the insured and the agent.  The agent may or may not then ask a surplus lines broker (a “wholesaler”) to assist in approaching insurers.  Surplus lines brokers are most often used for specialty coverages (professional liability, umbrella liability, aircraft insurance, and marine insurance, for example) or for insureds who are in very high-risk businesses (like environmental contractors and homebuilders in some states).  The independent agent and surplus lines broker are usually paid commissions that are included in the insurance premium. 

Underwriting 

The insurer’s underwriter reviews the underwriting data and determines whether the insurer wants to write the policy.  In general, the underwriter’s objective is to write a book of business in which the actual losses approximate the expected losses.  In some cases, particularly in professional liability or other specialty lines, the underwriter will be an employee of a managing general agency (MGA) or managing general underwriter (MGU) with authority from the insurer to underwrite on its behalf. 

The underwriter who agrees to write the policy also decides how the premium will be determined.  Sometimes, particularly with large accounts, the local branch office underwriter must seek home office approval of a decision. 

Rating technicians generally perform the actual mechanics of rating the policy based on the underwriter’s instructions.  For workers compensation, general liability, and auto insurance, the initial premiums are derived using an exposure base, such as payroll or number of vehicles, that will change during the policy year.  Since the initial premiums are based on estimates of the business’ exposure bases at policy inception, a premium audit is conducted at the end of the policy period to determine actual exposures and premiums. 

Note that the underwriter does not become involved in paying claims.  For this reason, all understandings related to the insurance coverage should be put in writing.  This will greatly facilitate any necessary negotiations with claims adjusters with respect to special arrangements made with the underwriter.  However, it is important that any changes in the coverage provided by the policies issued be implemented by endorsement to the policies rather than through side agreements.  Side agreements may not be enforceable in court should there be a claims dispute. 

Often, the insurer wants to write a particular policy but does not want to bear the responsibility of paying all the losses.  In such a situation, the insurer may arrange with one or more reinsurers to share a portion of the premium and of the insured losses.  Usually the insured will not know whether or not its risks are reinsured or the identities of any reinsurers on the risk.  The primary insurer is the only party to the insurance contract with the insured and bears all responsibility for insured losses, whether or not the reinsurer(s) pays. 

Underwriting Cycles 

The property and casualty insurance industry is cyclical in nature.  It cycles through periods of being a buyer’s market (usually called a “soft market”) and seller’s market (usually called a “hard market”). 

There are many factors affecting these market cycles.  Some of the most important include the following. 

• Industry competition 

• Investment returns 

• Occurrence of catastrophic losses 

• Overall loss trends 

Until the early 1980s, the industry’s cycles seemed to change every 5 years or so.  However, the dynamics changed following the very hard market of the mid-1980s, and the industry was in an extended soft market cycle from 1986 until 2001.  A number of factors caused the extended soft market, including the ability to earn substantial investment returns, relatively low occurrence of catastrophic events (e.g., hurricanes) in most years, and substantial industry competition.  However, the stock market’s downward spiral teamed with rising loss costs eliminated profits for many insurers and the marketplace swung back towards a hard market in the first half of 2001.  Then came the horrible events of September 11, 2001, which caused more than $35 billion in insured losses (they were thought to be much higher at the time).  The substantial losses of September 11 put the overall insurance industry results for that year in the red for the first time in recent history. 

The resulting hard market began to ease for many types of insureds during 2004.  However, the risks and complexities of certain industries caused the market to remain difficult for many types of businesses for an even longer period of time. 

During hard markets, insured businesses will see their premiums rise substantially, insurers will require higher deductibles and retentions, and insurers will pare back the scope of the insurance coverages offered.  Some types of insurance will be difficult or even impossible to obtain.  In these markets, it is important to be proactive and creative, and to have a very knowledgeable and experienced insurance representative.  It takes longer for insurers to respond with proposals, and additional time should be built into the renewal process.  Alternative ways to finance risks, such as with loss sensitive plans or industry-owned insurers, pools, or risk retention groups must be considered. 

It is much easier to manage an insurance program in soft insurance markets.  Underwriters have much more flexibility to negotiate coverage terms, deductibles, and premiums.  It is usually possible to broaden the scope of coverage provided in the policies purchased, reduce deductibles, and secure lower rates.  Insurers also respond to competitive proposal processes with more attractive terms. 

In summary, insurance cycles are not very predictable in the long run, but there are usually advance signals when a change is imminent.  An experienced risk manager or agent/broker will recognize these signs and forewarn of the impending change.  By proactively managing the insurance and risk management program, the effects of market swings can be mitigated. 

Claims 

When losses occur, insurers are expected to respond in a professional manner to rapidly settle the resulting claim or claims.  Claims are the major cost component of insurance premiums and the reason businesses purchase insurance.  Depending on the line of insurance, claims costs generally consume between 50 and 90 percent of the premium dollar. 

For all but the very smallest commercial insureds, insurance is simply a cost-stabilizing device.  Most insureds will eventually pay all of their losses back to insurance companies in the form of premium dollars.  This becomes most obvious in the liability lines (workers compensation, auto, and general liability) wherein experience rating, retrospective rating, deductibles, and other loss-sensitive rating programs make the impact of claims on ultimate premiums quite obvious.  However, this general rule is also true in other lines of insurance, such as property insurance. 

The Claims Adjusting Process 

When an insured business suffers a loss, a claim should be made to the insurer.  It is important to promptly report losses (and in some cases even potential losses) to insurers because failing to do so will violate the claim notice provision of most policies and may result in a denial of the claim. 

Except for very small claims, in which an insurer sometimes gives settlement authority to the agent, the insurer assigns a claims adjuster to the case.  The adjuster may be an employee of the insurer, or the insurer may contract with an outside company to perform this service.  Outside companies that provide these services are called third-party administrators (TPAs).  Whether an employee of the insurer or TPA, the adjuster’s primary allegiance is to the insurer. 

The adjuster investigates the loss and compares the facts of the case to the terms of the insurance policy.  If the adjuster determines that the policy does not cover the loss, the claim is denied.  If the adjuster determines that the loss is covered, the adjuster will negotiate with the insured to settle a property claim or with the claimant to settle a liability or workers compensation claim.  In the case of potentially severe liability or workers compensation claims, the adjuster may retain a law firm to investigate, defend, and/or settle. 

In some cases, it may not be clear to the adjuster whether or not the claim is covered by the policy.  This situation often happens with very complex liability claims that have elements that may be excluded and elements that may be covered.  For example, construction defect claims often fall into the gray areas of insurance coverage.  In these cases, the insurer will usually send a “reservation of rights” letter indicating that it will undertake a defense of the liability claim but reserves its rights to later deny coverage as additional facts become known.  Insured businesses should consult with their legal counsel to determine their options when a reservation of rights letter is received. 

The agent/broker will usually work with their client to present the claim to the insurer.  However, the agent or broker ordinarily cannot commit the insurer to a particular response.  Likewise, the underwriter who negotiated the insurance policy does not normally become involved in the claims adjusting process. 

One of the responsibilities of adjusters is to estimate the amount for which open claims are likely to be settled or adjudicated.  This estimate is called a “case reserve.”  Workers compensation and liability insurance claims costs include not only the amount actually paid on claims but also the case reserves. 

When the portions of a claim that have been paid are combined with the case reserve, the resulting number is called the “incurred loss.”  Incurred losses affect the amount of premiums paid by insured businesses.  They are given to competing insurers quoting on the insured’s account and often used to calculate workers compensation experience rating modifiers.  Therefore, these estimated case reserves have a substantial effect on premiums, and any “over-reserving” by the insurer will cause undeserved, often unrecoverable, premium increases. 

Because claim costs are such a large percentage of the insurance premium, they should be monitored, evaluated, and managed.  In property insurance, claims recoveries are also negotiable with the insurer, and the insured’s goal when presenting the case to the insurance company is to maximize a recovery following a loss.  Since paid claims in workers compensation and liability insurance directly affect future premium costs, it is important to monitor the loss adjustment activity of the insurance company to ensure that only legitimate claims are paid, that unpaid claims are not being over-reserved, and that claim costs are accurately recorded. 

One last point to recognize concerning claims administration is the close correlation between the quality of claims handling and adjuster file counts.  This fact affects both insureds and self-insureds.  On one hand, insurance companies have been cutting the size of their adjusting staffs in recent years. 

On the other, the claims administration business is extremely competitive, and firms sometimes slash prices to “buy business.”  The net effect is that whether a business self-insures or purchases coverage from a commercial insurer, it is wise to monitor the average file counts of its adjusters.  This statistic is perhaps the single most important factor affecting the quality of the claims handling that a business will receive. 

Insurance Regulation 

Regulation can be defined as a law, rule, or other order prescribed by authority, especially to regulate or control conduct.  Maintaining insurance solvency is the most important objective of insurance regulation because the insured is totally reliant on the financial backing of the insurer’s promise to pay for a covered loss.  If the insurer becomes insolvent, it will no longer be able to pay the loss, possibly leading to a financial catastrophe for the insured.  In addition, the typical insured is not able to adequately gauge the financial strength of the insurer.  Thus, the state insurance department has to monitor each insurer for the benefit of all policyholders in its state.  Note that there are guaranteed funds established by the states in which insurers have to contribute money which is paid out when a bankrupt insurer cannot honor its promise.  These funds, however, often contain numerous restrictions. 

Complex Product and Unequal Knowledge 

Regulation is also necessary due to the complexities of insurance policies and the typical insured’s lack of understanding of this technical subject.  Without any regulation, an unethical insurer could draft a policy with countless restrictions and exclusions, making it virtually useless to the insured. 

Regulators thus normally have to approve newly drafted insurance policies to verify that they are fair and understandable to the general public. 

Ensure Fair Rates 

State insurance regulators must verify that rates are reasonable and adequate.  This process is difficult because insurers must establish these rates before their future losses are realized.  Rates must be fair so that the insured is not exploited by overpaying for the insurance coverage.  Conversely, rates should be adequate in order for the insurer to pay all covered claims and make a fair profit.  Inadequate rates can lead to insurer insolvency.  States normally require that rates be filed in one of two ways.  In a prior approval state, the insurer must file the rate and wait until it is approved before it can use the rate.  In a file and use state, the insurer can start to use the rate after it has been filed; however, if the state insurance department later rejects it, the insurer has to stop using that rate and must refile it. 

Promote Social Objectives 

A key aspect of regulation is to ensure that insurance coverage is widely available and to end unfair and undesirable discrimination.  Insurers may be unwilling to insure high-risk applicants such as brain surgeons because of the higher likelihood of losses and inadequate rates for that applicant.  However, the public interest in having surgeons with the proper insurance may take precedence over the insurer’s desire to make mathematically sound business decisions. 

This issue comes up more often in personal lines situations as compared to commercial lines situations.  For example, insurers are required to write homes in high-crime, inner city areas through specific state programs, provided the homes are fairly well maintained.  In this case, the social objective of making insurance widely available is seen as more important than giving insurers complete freedom to contract with whomever they desire. 

Legal Background of Regulation 

A state’s department of insurance has historically regulated the insurance industry.  This tradition was solidified by an important 1868 United States Supreme Court decision, Paul v. Virginia, 8 Wall 168, 183 (1868), which concluded that insurance was not interstate commerce and thus did not fall under federal jurisdiction.  A 1944 ruling, entitled the South-Eastern Underwriters Association case, found that insurance was interstate commerce and should accordingly by regulated by the federal government.  There was no federal regulatory body, however, established to handle this.  In addition, the insurance industry and the states were adamantly opposed to this ruling.  As a result, Congress passed the McCarran Ferguson Act in 1945, returning insurance regulation to the states, with narrow or limited applicability of specified federal laws to insurance. 

State versus Federal Regulation 

Since the passage of McCarran Ferguson, Congress has attempted to repeal this act several times, since some Congress members believe the states have performed poorly in regulating insurers.  These efforts, however, have failed for various reasons.  To further explore this matter, a review of the pros and cons of state regulation is helpful. 

Advantages of State Regulation 

The following are the advantages of state regulation. 

• State regulation is well established, with most jurisdictions performing reasonably well in this area.  In addition, most states have made strong efforts to strengthen the regulatory process, particularly through the use of technology. 

• State regulation of the industry is more flexible than federal regulation and is more adaptable to changes in the state insurance climate.  It also allows for more experimentation at a local level.  If the experiment is successful, other state regulatory bodies can adopt the improved measures.  If it is unsuccessful, then only one state is negatively impacted. 

• Although lack of uniformity of insurance laws occurs, important strides have occurred in reducing this problem through organizations such as the National Association of Insurance Commissioners (NAIC).  The goal of the NAIC is to make the various state laws more uniform and efficient for insurers, agents, and other parties. 

• If federal regulation were reenacted, state regulation would still be necessary to monitor insurers that write insurance in only one state.  Such intrastate insurer operations would not be considered interstate commerce and would thus not fall under federal jurisdiction if McCarran Ferguson were repealed.  The end result would be two insurance regulatory bodies—the states and the federal government. 

• State regulation allows a decentralization of political influence.  Federal regulation of insurance would result in a further dilution of states’ rights. 

Advantages of Federal Regulation 

The following are the advantages of federal regulation. 

• Some states have inadequate personnel to properly regulate the industry.  In addition, many states lack funding due to budget deficits to properly monitor all the activities of insurers and agents. 

• Many of the larger insurers have to deal with unique, cumbersome, and expensive regulations from all 50 states, including the District of Columbia.  For example, a national insurer may have to file rates and forms and gain approval from 51 jurisdictions for a variety of insurance policies.  Having one regulatory body would result in greater operating efficiencies for insurers and agents, putting a downward pressure on rates for consumers and businesses. 

• Some large and influential insurers may be able to exert strong pressure on state regulators and legislators to agree to their requests.  For example, these insurers may be more successful in getting smaller states to accept their rate and form filings without challenge.  This would not be an issue with federal regulation. 

• Many states have struggled with the problem of insurer insolvencies.  The federal government has the financial resources to deal with this situation and could establish a more consistent and uniform way of successfully addressing this issue, thus providing greater protection for consumers. 

Entities Involved in Regulation 

There are three entities actively involved in insurance regulation, including (a) the courts, (b) legislative bodies, and (c) state insurance departments. 

Courts 

If an insured business believes its insurer has treated it unfairly, the insured has the option to file suit in a court of law.  If the insured wins the case, the court will force the insurer to remedy the situation, often through the payment of a judgment.  In addition, state and federal courts occasionally rule on the constitutionality of state insurance statutes, the interpretation of policy provisions, and the legality of state insurance department actions.  Note that most insurance cases involve the state courts; however, the federal courts become involved if the matter concerns parties from different states or class action lawsuits. 

Courts often rely on the doctrine of stare decisis.  This principle of law refers to courts adhering to precedents and not changing established rulings.  However, courts occasionally find major flaws in previous court rulings and thus overrule precedent.  Court decisions exert a strong influence on an insurer’s claim handling. 

Legislative Bodies 

State insurance laws or statutes also regulate insurers.  Legislative bodies pass detailed laws included in the state insurance code or statutes.  These statutes regulate areas such as (a) the licensing and formation of insurers, including the establishment of stringent financial requirements, (b) licensing of insurance agents and brokers, (c) consumer rights, (d) claims handling practices of insurers, (e) insurance rates and forms, (f) agency and brokerage sales practices, and (g) taxation. 

State Insurance Departments 

The third entity involved in insurance regulation is the individual state insurance departments.  The insurance commissioner is the person who leads this regulatory body.  The commissioner, who can be either elected or appointed, has the authority to (a) conduct hearings, (b) stop insurers, agents, and brokers from engaging in a particularly unfair or unethical activity, (c) or suspend an insurer’s, agent’s, or broker’s license to transact business. 

The insurance commissioner is a member of the NAIC, which meets on a regular basis to discuss and resolve insurance industry problems that might necessitate legislative or regulatory action. 

Regulated Insurance Activities 

The primary regulatory activities in which the insurance departments are engaged include the following. 

• Solvency regulation 

• Investment regulation 

• Rate regulation 

• Policy form regulation 

• Agency/brokerage practices 

• Adjuster practices 

• Consumer protection 

Solvency Regulation 

This activity is considered the most important one for insurance departments.  An insurer that cannot keep its promise to pay for a covered loss because of its bankrupt condition can be devastating to an insured business.  Areas in which insurer solvency is regulated include (a) insurer licensing and capital requirements and (b) financial regulation.  These regulatory activities are conducted through a variety of audits and solvency testing. 

Insurer Licensing and Capital Requirements 

An insurer must meet certain capital or surplus standards to be granted a license to write insurance in a particular jurisdiction.  Capital or surplus refers to the assets of an entity remaining after deduction of liabilities (i.e., the net worth of a business or person).  Minimal capital requirements are established in each state and can vary from jurisdiction to jurisdiction and also are based on the type of insurer. 

For example, some states may require $1 million in surplus for insurers and others may require $3 million in surplus. 

Financial Regulation 

Besides these surplus requirements, insurers are also continuously subject to additional financial requirements in order to maintain their financial strength and solvency.  These include (a) admitted assets, (b) unearned premium reserves, (c) loss reserves, (d) and risk-based capital. 

Admitted Assets 

An insurer’s assets must easily exceed its liability to remain financially viable.  Assets, for insurance regulation purposes, can be either admitted or nonadmitted.  Admitted assets are those assets whose value is included in the annual statement of an insurer to the state insurance department.  These assets are ones that can readily be used to pay claims, including cash, stocks, bonds, real estate, and money market funds.  All other assets fall into the nonadmitted category, such as an insurer’s office supplies, furniture, and uncollectible agency debt.  Nonadmitted assets are viewed as relatively illiquid assets. 

Only admitted assets are utilized to determine an insurer’s surplus position. 

Unearned Premium Reserves 

This is an insurer’s liability for its unearned premium on any given valuation date.  This amount is typically the largest liability of an insurer.  An unearned premium is that portion of the policy premium the insurer has not yet “earned” because the policy still has some time to run before expiration.  An insurer must carry all unearned premiums as a liability in its financial statement since, if the policy is canceled, the insurer would have to pay back a certain part of the original premium. 

For example, when an annual policy has been in force for one month, the insurer has earned approximately one-twelfth of the total premium and it must thus list eleven-twelfths of the premium in its liability ledger. 

Loss Reserves 

This term refers to an estimate of the value of a claim or group of claims not yet paid.  Unpaid claims may be ones that recently occurred and are still being handled by the adjuster or older claims that are being litigated.  A case reserve is an estimate of the amount for which a particular claim will ultimately be settled or adjudicated.  Insurers will also set reserves for their entire books of business to estimate future liabilities. 

Risk-Based Capital 

This is a method developed to determine the minimum amount of capital required of an insurer to support its operations and write coverage.  The insurer’s risk profile (i.e., the amount and classes of business it writes) is used to determine its risk-based capital requirement.  Categories of risk analyzed in arriving at an insurer’s minimum capital requirements include types of assets, financial and credit ranking, and the strictness of its underwriting guidelines. 

Investment Regulation 

Insurance regulators closely review the types of investments insurers make.  They analyze the quality, types, and percentage of total surplus or assets that are invested in various financial instruments.  The goal is to thwart insurers from making risky investments that could threaten the insurer’s financial condition and potentially affect its promise to pay for covered losses.  For example, many states place tough restrictions on an insurer’s investments in junk bonds or stocks for start-up companies.  State regulators stipulate the categories of acceptable and unacceptable investments and the asset valuation method. 

Rate Regulation 

State insurance regulators typically establish three objectives in the rate regulatory process.  First, the rate should be reasonable, so that price gouging by insurers does not negatively impact insurance consumers.  Extremely high rates could result in extravagant profits for insurers, resulting in economic hardship particularly for smaller and less profitable businesses. 

 Second, rates should be adequate to properly cover the insurer’s expected losses and expenses while also allowing a fair rate of return.  If rates were inadequate, this could result in insurer bankruptcies, creating financial havoc for unassuming insureds. 

Third, rates should not be unfairly discriminatory among various insured classes.  For example, commercial insurance premiums for minority-owned businesses should not be higher simply based on the race of the business owner.  In contrast, commercial insurance such as workers compensation will be more expensive for a construction company as compared to a retail store but this difference is based solely on actuarial data concluding that the risk of loss is greater for construction companies. 

As a result, this higher rate is not viewed as unfairly discriminatory.  States have two ways of handling rate filings—prior approval laws or open competition laws.  Prior approval laws stipulate that a rate must initially be filed with the state insurance department and approved before the insurer can use it.  Under open competition laws, an insurer can use whatever rate it selects after filing the rate and the supporting datum with the insurance department.  The regulator has the right to later disapprove the rate, thus prohibiting the insurer from using it.  Under open competition laws, insurers have greater flexibility to compete on prices. 

Insurance Regulation 

Policy Form Regulation 

Virtually all state insurance departments must approve an insurer’s new and amended policy forms.  The main goal is to protect insureds from overly complex, confusing, or unfair provisions.  Virtually all states frown on forms written at a level that only a person with several university degrees could understand.  State regulators also want to assure that the rates utilized by insurers are fair.  For instance, an insurer could obtain an unauthorized rate increase by simply eliminating or restricting some coverage in its revised form instead of filing for a higher rate. 

Agency/Brokerage Practices 

Most small business owners have their first contact with a property and casualty insurer through an insurance agent.  Agents sell individuals, families, and businesses insurance policies that provide the proper protection for their home, auto, and business loss exposures.  Larger businesses often utilize the services of insurance brokers, who represent the insured’s interest as compared to the insurer’s interests.  State regulators closely monitor the sales practices of insurance agents and brokers.  An important aspect of this regulation concerns the licensing requirements that agents and brokers in virtually every state must fulfill.  These requirements are typically the same whether a person is an agent or a broker.  The licensing requirements help insurers because ignorant agents/brokers can prove costly to insurers, resulting in public ill will and potential litigation. 

Insurance agents and brokers must obtain licenses in the states in which they plan to perform their sales operations.  In most states, licenses are granted only to applicants who complete specific prelicensing classes and who pass state examinations covering insurance fundamentals and state insurance laws.  The insurance industry is now adopting uniform state licensing standards and thus allowing agents who obtain a license in one state to become licensed in other states upon passing the necessary courses and tests. 

In addition, almost all states require insurance agents and brokers to complete a specified number of hours of continuing education (CE) to maintain their license.  The number of hours required on a biennial (every 24 months) basis ranges from 12 to 40.  The CE courses need to be approved by the appropriate state insurance licensing department. 

Adjuster Practices 

Claims adjusters, examiners, and investigators work primarily for property and casualty insurers, for whom they handle a variety of property and liability claims.  Their main role is to determine whether the insured’s policy covers the loss and the amount to be paid.  Adjusters must also be careful not to violate the claimant’s rights under state privacy laws. 

Licensing requirements for adjusters vary by state.  Some states have few requirements, while others require the completion of prelicensing classes or by passing a state licensing exam.  In addition, some states apply these testing requirements only to adjusters not employed by an insurer.  Separate or additional requirements may apply to public adjusters, who are parties that represent the interests of the insured in a loss. 

CE credit for adjusters is important because new state laws and court decisions frequently affect how claims are handled or who is covered under various insurance policies.  Some states that require licensing also require a specified number of CE credits per year in order to renew the license. 

Consumer Protection 

Insurance departments are concerned about the rights of insurance consumers.  The purpose of the agency licensing requirements is to help assure that consumers are being provided accurate information about their insurance coverages.  Other agency regulation also protects insurance consumers from misrepresentation, deceptive or false advertising, and unfair discrimination. 

The purpose of adjuster licensing requirements is to ensure that consumers are dealing with knowledgeable claim representatives, increasing the likelihood that the insured business will receive a fair settlement.  Well-educated and properly trained adjusters can reduce the frequency of bad faith claims.  These are claims involving blatantly unfair insurer conduct that exceeds the insurer’s mere negligence.  For example, a bad faith claim may arise if an auto liability insurer arbitrarily refuses to settle a claim within policy limits, where an insured’s liability is indisputable. 

Anatomy of an Insurance Policy 

For many lines of property casualty insurance, standard policy forms are promulgated by industry supported organizations on behalf of all member insurers.  The most widely recognized provider of standard forms is Insurance Services Office, Inc. (ISO).  ISO prepares standard policy forms portfolios for all major lines of commercial insurance except workers compensation.  The only major competitor of ISO in most commercial lines is the American Association of Insurance Services (AAIS), which has a similar but less complete product offering to ISO.  The National Council on Compensation  

Insurance (NCCI) promulgates the standard workers compensation policy.  Because standard forms are drafted with the needs of the average insured in mind, most of them can be utilized across all industries, with some modification by endorsements to meet specific industry needs.  The standard commercial general liability (CGL), business auto policy (BAP), workers compensation, and commercial crime policies are appropriate for use by most commercial insureds. 

There are also other standard forms that focus on the needs of a specific industry.  For example, the standard owners and contractors protective (OCP) liability policy is used in the construction industry and the motor carriers liability policy is used instead of the commercial auto policy to insure truckers. 

Although the use of standard forms has been criticized by some as anticompetitive, they serve many useful purposes.  For example, they allow the use of loss data from many insurers for ratemaking purposes, which is particularly crucial for small insurers.  Other advantages of standard policies are summarized in Exhibit 5.1.  Note, however, that even when standard policies are available, there are differences between the AAIS and ISO forms and some insurers will still develop their own nonstandard forms.  For this reason, it is important to verify which type of form is being offered by a given insurer. 

Advantages of Standard Policy Forms 

• Ability to set rates using pooled loss data is enhanced 

• Increases ability to make generalizations about coverages 

• Reduces the need to compare numerous insurers’ policies word for word to determine which provides the most favorable coverage 

• Application of case law to consistent policy terms helps define the scope of coverage 

• Simplifies the claims-settling process 

Standard forms are periodically revised by their drafters in response to changing loss exposures faced by business, changing underwriting philosophies of insurers, and the development of case law interpreting coverage.  As an example of the first scenario, insurers in the late 1990s added policy provisions addressing exposures arising from the increasing use of the Internet.  Restrictions incorporated into standard additional insured endorsements in 2004 reflected a change in underwriting philosophy (prompted by a substantial increase in additional insured claims).  With respect to the last item, courts may interpret a policy provision as allowing broader or more restrictive coverage than the drafters intended.  In this case, the standard language will be revised in an attempt to more appropriately codify the intent.  An example of this was the inclusion of policy language in the CGL to preclude coverage for losses known to have occurred at the inception of the policy, responding to a California case that had gone the other way. 

New editions of standard policies are assigned an edition date to make them identifiable.  Since the revisions from one edition to another may be substantial, it is important to ascertain which edition you are reviewing when considering the coverage it applies.  It is particularly important to check edition dates when relying on published analyses or court decisions interpreting coverage. 

Where no standard forms are available, or where the terms of the standard forms are unacceptable, insurers often develop their own policy forms.  Additionally, the large brokerage firms have drafted their own forms for certain lines of insurance, most commonly property.  Builders risk insurance is often written on nonstandard forms despite the existence of standard builders risk policies. 

Commercial umbrella and professional liability policies are additional examples of coverages that are usually written on insurer forms. 

In some cases, particularly when the insured is a very large company with substantial bargaining clout, manuscript policies are used.  The insurer and the insured usually jointly draft manuscript policies.  These policies are used when no existing form is adequate for the insured’s needs.  Rather than attempting to piece together the desired coverage by attaching a host of endorsements, many of which would also have to be manuscripted, to modify the terms of the basic policy, a unique policy is drafted for that insured.  When they are jointly drafted, or “fairly bargained,” manuscript policies may be subject to different rules of interpretation when a coverage dispute arises than are forms drafted unilaterally by the insurer. 

In most states, insurers must place the forms they intend to use for each line they write in that state on file with the state insurance department.  (The states vary in regard to whether forms must be approved by the department prior to use.  Some lines are exempt from this filing requirement altogether.) 

Insurers must submit either a standard ISO or other bureau-promulgated form or their own nonstandard form.  (Most states require that the NCCI form be used by all insurers writing workers compensation insurance in that state.) 

Policy Format 

Whether standard or nonstandard, insurance policies tend to be structured similarly, even when their outward appearance is very different.  For example, all insurance policies must have a section where the insured persons or property are identified.  Further, the policy must contain a grant of coverage that describes the insurer’s promises under the contract.  Sometimes, when more than one type of coverage is provided by the policy, the contract will contain several separate coverage grants.  When multiple coverages are included in one policy, understanding how to read a policy is even more critical. 

Insurance policies contain the following parts. 

• Declarations (sometimes called the information page) 

• Insuring agreement 

• Covered perils (property policies) 

• Exclusions 

• Definitions 

• Conditions 

• Endorsements 

Each component serves a separate and distinct purpose.  As stated above, some policies may contain more than one of each type of component.  For example, it is common for each separate coverage to have its own insuring agreement, exclusions, definitions, and conditions.  However, the policy may also contain a set of “master” exclusions, definitions, and conditions that apply to all coverages (unless otherwise specified).  This concept is explained further below. 

Declarations 

The declarations provide information about the insured, the policy, and the insurer.  Included are items such as the name and address of the insured business, the type of organization (e.g., partnership, corporation, LLC), the policy period, policy limits, deductible(s), and premium.  Any endorsements attached to the policy are also normally listed in the declarations. 

Because the information in the declarations can be binding, it is extremely important that this information is correct.  Examine this part of the policy carefully to ensure the information conforms to the specifications used to procure the coverage from the insurer.  For each endorsement listed, make sure the corresponding endorsement is actually attached; likewise, make sure no additional and unexpected endorsements are attached. 

Insuring Agreement 

The insuring agreement grants the coverage provided by the policy.  Typically very broad in scope, this agreement sets forth the insurer’s basic promises under the policy.  For example, the standard commercial general liability insurance policy insuring agreement promises that the insurer will pay for all liability arising from bodily injury or property damage occurring during the policy period and in the policy territory.  A commercial property policy might promise to pay for all direct damage to insured property arising from any cause. 

The insuring agreement places only a few restrictions on the coverage provided by the policy.  The real scope of coverage, therefore, is determined by the policy’s exclusions and definitions.  Where multiple coverages are provided in a single policy, each coverage is likely to have its own insuring agreement.  This allows the policy drafters to tailor the insurer’s promise for each coverage area. 

Covered Perils 

Most property policies contain a covered perils section.  Some forms include this as part of the coverage grant in the insuring agreement, but it is always addressed somewhere in the policy.  All risk policies, also called “open perils policies,” will address this matter by agreeing to cover all causes of loss except those that are excluded.  These policies then rely on the exclusions to avoid covering certain perils, such as flood, earthquake, and inherent vice.  Named peril policies, conversely, agree to cover “the following causes of loss,” and list exactly which perils are covered.  They avoid covering certain perils, such as flood, earthquake and inherent vice, by simply not including them in the list of covered perils.  In most cases, all risk policies provide the broader scope of coverage. 

Exclusions 

Exclusions limit the coverage granted in the insuring agreement.  Exclusions can apply to specified perils (e.g., earthquake or flood), certain types of property (e.g., trees or money), or specified types of losses (e.g., testing losses or intentional losses).  For example, the standard workers compensation and employers liability policy excludes bodily injury occurring outside the United States, its territories or possessions, or Canada; however, the exclusion does not apply if the injury is to a citizen of the United States or Canada who is temporarily outside these countries.  Most exclusions serve one of the following purposes.  They are described in detail below. 

• Eliminating or reducing overlapping coverage 

• Removing coverage not needed by typical insureds 

• Reducing the incentive to create losses and providing the insured with an incentive to try to prevent losses 

• Removing coverage for uninsurable risks 

Eliminating or Reducing Overlapping Coverage 

Without exclusions, many different policies could easily respond to the same loss.  For example, the CGL excludes employers liability losses, except those that are assumed in an insured contract; the workers compensation and employers liability policy, in contrast, covers employers liability losses except employers liability assumed in a contract.  (An employers liability claim is a liability claim brought by an injured employee in lieu of accepting workers compensation benefits.)  Arranging these policies to “dovetail” instead of overlap avoids charging the insured twice for the same coverage and reduces the number of conflicts between insurers.  Similar approaches are taken to coordinate the CGL policy with specific auto, aircraft, and watercraft polices.  Likewise, the business auto policy contains exclusions to cause it to coordinate with CGL and workers compensation policies. 

Removing Coverage Not Needed by Typical Insureds 

Sometimes the insurer is willing to provide coverages most insureds are not interested in obtaining because they have no real exposure.  Because the rating structure, which is generally based on some general exposure basis such as payroll or revenues, does not always reflect an insured’s actual exposure, some insureds could end up paying for quite a bit of coverage they do not need.  In this case, the standard policy will have an exclusion for the exposure and an optional endorsement will be available to buy back the coverage. 

Reducing the Incentive To Create Losses and Providing the Insured with an Incentive To Try To Prevent Losses 

These motivational factors are often referred to as moral hazards and morale hazards.  Moral hazards refer to the insured’s incentive to try to profit from the insurance, often by engaging in an illegal activity.  For example, in a highly publicized scandal in Texas, over a dozen vehicles were discovered at the bottom of a swampy pit.  All of the vehicles were reported stolen by the owners, and all of the thefts were submitted to their insurers as claims.  Upon investigation, many of the owners admitted to dumping the vehicles and lying about the theft to collect the insurance.  A morale hazard, on the other hand, simply reduces the insured’s incentive to diligently protect against loss because the insurance will pay for it.  For example, the CGL policy excludes coverage for property damage to a contractor’s own work to avoid encouraging poor quality workmanship which it would then be required to cover. 

Removing Coverage for Uninsurable Risks 

Some risks, such as general business risks, are considered uninsurable.  For example, a company cannot buy insurance to reimburse any expenses it incurs in developing and marketing a product that fails in the marketplace.  This is part of the risk of doing business.  Other types of risks are uninsurable simply because insurers are unwilling to write the coverage, such as flood insurance in a flood zone. 

The federal government stepped in to underwrite this coverage because the private market refused to do so because of its catastrophic nature. 

Definitions 

Key words and phrases in insurance policies are often assigned precise definitions as they are used in the policy.  Undefined terms are assigned their ordinary meanings, such as those found in a regular dictionary.  The definitions of key terms should be carefully studied, as they can play just as important a role as exclusions in determining coverage under a policy. 

Defined terms are usually marked in some way when they appear in the policy; some policies use bold print, while others use italics or quotation marks to denote defined terms.  Most policies define terms in a separate “Definitions” section, but sometimes the same term will be assigned different meanings in different sections of the policy.  In that instance, the term may be defined separately in each section, or under each coverage section of the policy. 

Conditions 

The conditions section enumerates both the insured’s and the insurer’s rights and responsibilities under the policy.  For example, the terms under which the policy may be canceled are set forth here.  Other items typically addressed in the conditions section of an insurance policy include subrogation rights, the insured’s duties in the event of a loss, and how losses will be apportioned between insurers when more than one policy applies to a loss.  It is important to make note of the conditions and abide by them, particularly the notice of loss provision, since a violation of a condition can lead to a coverage denial. 

Endorsements 

Because most insurance policies are drafted to meet the common need of a variety of insured businesses, some insureds’ needs will not be adequately addressed by the policies.  Rather than drafting a manuscript policy for each insured with special needs, insurers use endorsements to tailor the terms of the standard and nonstandard policies to the needs of the individual insured businesses.  (Sometimes endorsements are called “riders,” most commonly in commercial crime insurance.) 

Some of the purposes for which endorsements are used include the following. 

• Granting additional coverage 

• Restricting or eliminating coverage provided in the basic policy 

• Changing coverage by changing or adding definitions 

• Modifying the rights of the insurer or insured by changing or adding conditions 

• Scheduling covered persons, projects, or property 

Standard endorsements exist for many common modifications, such as adding another party as an additional insured on the policy.  For example, manufacturers are commonly required to add vendors as additional insureds on their general liability policies and standard endorsements are available for achieving this. 

If no standard endorsement is available for making the desired modifications, a manuscript endorsement can be drafted and added to the policy.  For example, until recently, there was no standard endorsement for removing coverage from a contractor’s general liability policy for operations covered by a wrap-up insurance program.  (Under a wrap-up, the owner or prime contractor buys most of the needed insurance for nearly all the involved contractors.)  Legal counsel should be consulted in drafting manuscript endorsements to ensure they accomplish the intended purpose, and to avoid making unintended alterations to the policy. 

Some endorsements are straightforward and brief; others resemble a separate insurance policy, having their own grant of coverage, exclusions, and conditions.  Although they may seem to stand on their own, endorsements are attached to the policy, and are thus subject to the same terms and conditions of the policy, except where they specifically declare the terms of the basic policy to be changed or replaced by those in the endorsement. 

Endorsements are often added to policies during the policy term.  Any such endorsements that are added mid-term should be carefully reviewed to assure their impact is understood and agreeable to the insured business.  Insurers have very limited rights to alter the coverage provided by an insurance policy after its proposal is accepted and bound, and any mid-term coverage restrictions may be negotiable.  Once any discrepancies have been explained or corrected, all endorsements should be physically attached to the policy. 

Package Policies 

Business insurance programs are often written under some type of package policy.  A package policy is a single policy that includes two or more coverages that are otherwise typically written as separate policies.  Usually the term refers to policies that provide both property coverage and general liability coverage under one master policy. 

There are two types of package policies.  A commercial package policy (CPP) utilizes separate, standalone monoline forms each with its own declarations page as well as a master CPP declarations page detailing all of the coverage parts.  A businessowners policy (BOP) is a package policy focused on providing both property and general liability coverage for eligible small businesses.  It is written on a separate portfolio of specific businessowners policy forms. 

The Insurance Services Office, Inc. (ISO) promulgates its own commercial package policy and businessowners policy.  The American Association of Insurance Services (AAIS) also provides these two types of policies.  In addition, many insurers promulgate their own commercial package policies and businessowners policies.  Brief examinations of the ISO commercial package policy and businessowners policy follows. 

ISO Commercial Package Policy 

An ISO commercial package policy (CPP) is a single policy that includes two or more of the following ISO coverage parts. 

Coverage Parts—Commercial Package Policy 

Coverage Part Description 

Commercial property 

Commercial property loss exposures are often covered under a building and personal property coverage form.  This form protects the insured’s buildings, business personal property, and personal property of others.  

Boiler and machinery 

Insurance for this exposure covers loss caused by mechanical or electrical equipment breakdown. 

Inland Marine 

Inland marine policies comprise a group of property insurance coverages designed to insure exposures that cannot be conveniently or reasonably confined to a fixed location or insured at a standard rate under a standard form. 

Commercial general liability 

Insurance for this exposure is designed to protect the insured against liability claims for bodily injury and property damage arising out of premises, operations, products, and completed operations; and advertising and personal injury liability.  

Pollution liability 

Since the CGL often contains a broad pollution exclusion, this loss exposure is often written on a separate pollution liability policy. 

Commercial automobile 

This exposure includes first-party and third-party losses arising out of the business’s ownership and use of cars, trucks, and trailers.  These loss exposures are often covered under a business auto policy. 

The ISO CPP is issued using separate, stand-alone monoline ISO coverage forms (e.g., business and personal property form and the commercial general liability form) each with its own declaration page, coupled with a master CPP declaration page listing all of the coverage parts.  The major advantage of an ISO commercial package policy over monoline policies is the package discount that is applied to eligible policies.  To be eligible for the package discount, the policy must include the following. 

• A commercial coverage part that provides building or business personal property coverage, written at 80 percent coinsurance (90 percent if limits are blanket). 

• A coverage part that provides bodily injury and property damage liability coverage for the premises and operations hazard at locations where property insurance is provided.  Either of the commercial general liability forms (claims- made or occurrence) would qualify. 

A CPP has several potential advantages. 

• Fewer gaps in coverage 

• Business insureds pay relatively lower premiums because individual policies are not purchased 

• Savings in insurer expenses are passed on to the insured in the form of a package discount • Named insured has the convenience of a single policy 

ISO Businessowners Policy 

The ISO businessowners policy (BOP) is a package policy designed to provide both property and general liability coverage for eligible small businesses.  Unlike the ISO CPP, it is written on a separate portfolio of special businessowners policy forms.  The businessowners coverage form, composed of 43 pages, is divided into three sections: property, liability, and common policy conditions. 

In general, the BOP is designed for insuring small businesses.  However, eligibility is based on the nature as well as the size of the insured’s business.  For a business to be eligible for coverage under an ISO BOP, none of its locations can exceed 25,000 in square footage (excluding basements not open to the public) and $3 million in annual gross sales. 

Insurance Policy Review 

When an insurance policy is received, it should be reviewed thoroughly to ensure it complies with the specifications used to obtain proposals (if it is a new policy), or to make sure no unexpected changes have been made from the previous policy (if it is a renewal policy).  The information on the declarations page should be verified, and all requested endorsements should be attached (verify these by both name and number).  Any questions regarding the policy, such as additional or unexpected endorsements, should be explained by the insurance representative or underwriter before the policy is filed away.  In some cases, it may be prudent to ask the underwriter for a letter or endorsement clarifying any discrepancies or apparently conflicting policy provisions rather than relying on verbal assurances.  (The underwriter may or may not agree to this, but it is worthwhile to ask for it.  At a minimum, take detailed notes from conversations with the underwriter regarding questions of coverage, and keep them with the policy.) 

Because insurance policies can get very long and complicated, it is useful to make a photocopy of the policy on which notes can be made in the margins.  For example, if the commercial policy includes an endorsement that adds coverage for borrowed property, that fact should be noted in the margin next to the definition of covered property.  This makes determining whether a loss is covered much easier, and can help assure important information is not missed when filing a claim or in fighting an insurer’s denial of a claim.  Also, make note of coverage available in other policies next to exclusions for those types of losses.  For example, the general liability policy excludes employers liability claims, but there may very well be coverage (depending on the circumstances of the loss) under the workers compensation and employers liability policy. 

Checklists are a useful tool for verifying coverages, particularly in nonstandard forms, and for identifying necessary coverage modifications.  While these can be very helpful, no cookie-cutter document can address all the unique aspects of a particular risk.  Therefore, these checklists should be considered only one tool in implementing and managing an insurance program. 

Commercial Property 

For insurance purposes, property can be divided into two broad categories—real property and personal property.  Real property is considered land and permanent attachments, such as a house or a commercial building.  Personal property includes all other types of property, such as groceries in a grocery store.  A commercial property insurance policy is a policy that a business purchases to pay for damage to its own buildings and the personal property in them. 

Commercial property policies can be written on standard, insurer, or manuscript forms.  Standard forms are developed by insurance advisory organizations for use by the insurers that purchase their services.  The commercial property insurance forms drafted by Insurance Services Office, Inc. (ISO) are generally recognized as the industry standard forms. 

If an organization's facilities are damaged or destroyed by a fire or a tornado, the physical damage to the buildings and contents is said to be a direct damage loss.  Direct damage property insurance provides funds to pay for the repair or replacement of the damaged property.  An organization that suffers a direct damage loss also may suffer a loss of income or an increase in operating expenses as a result of not being able to use the damaged property while it is being repaired or replaced.  These losses are called time element losses, because the amount of the income loss or expense increase depends on how long it takes to repair or replace the damaged property.  Time element property insurance pays for the loss of income or the increase in operating expenses that result from suspended or makeshift operations while the damaged property is being repaired or replaced. 

Direct damage and time element coverage are usually provided in a single commercial property policy, such as the building and personal property form.  This chapter provides an overview of direct damage property insurance and time element property insurance, primarily in the context of the building and personal property form.  A brief review of other types of commercial property forms concludes this chapter. 

Direct Damage Coverage 

This direct damage discussion of the building and personal property form reviews the insuring agreement, covered property, excluded property, property subject to limitations, covered locations, covered causes of loss, and property valuation.  

Insuring Agreement 

The insuring agreement establishes in general terms under what conditions the insurer will pay the insured.  In ISO commercial property policies, the insuring agreement is the first provision of the Commercial Lines 101 policy’s basic coverage form.  It states that the insurer will pay for direct physical loss or damage from a covered cause to covered property that is located at premises described in the policy. 

Note that coverage is provided only for direct physical loss or damage to covered property.  Financial loss suffered by the insured as a consequence of the direct property damage is not covered, unless coverage has been added by endorsement or by activation of a coverage option in the policy.  The insuring agreement also establishes the following requirements: the insurer will pay only for loss to property that qualifies as covered property; this property must be at premises described in the policy as covered; and coverage applies only to loss or damage from a covered cause of loss.  In addition, the loss must begin during the policy period shown in the declarations and must occur within the coverage territory (which usually is the United States, including its territories and possessions; Puerto Rico; and Canada). 

Covered Property 

Covered property provisions vary from form to form in their specificity.  A standard commercial property policy, however, provides fairly detailed descriptions of covered property.  The ISO building and personal property coverage form establishes three categories of covered property: building property, business personal property of the insured, and personal property of others.  Coverage applies to each category for which a limit of insurance is indicated in the declarations.  

Standard ISO Covered Property Categories 

• Building property, as follows: 

o Buildings and structures identified in the declarations 

o Completed additions 

o Fixtures (indoors and outdoors) 

o Permanently installed machinery and equipment 

• Business personal property located on or in the premises or in the open or a vehicle within 100 feet of the described premises, as follows: 

o Furniture and fixtures 

o Machinery and equipment 

o Stock 

o All other personal property owned by the insured and used in the business 

• Personal property of others in the insured's care, custody, or control, located on or in the premises or in the open or a vehicle within 100 feet of the described premises 

Excluded Property 

There are some categories of property that are not covered under a commercial property insurance policy.  These property categories are usually listed under an “Excluded Property” or “Property Not Covered” heading.  Exhibit 6.2 summarizes the categories of property that are typically excluded from coverage under a standard commercial property policy.  If coverage is needed for an excluded property type, sometimes it can be added by endorsement.  Some excluded property categories are excluded not because they are considered uninsurable but only because they are typically covered under other types of insurance policies.  For example, physical damage coverage for automobiles is typically arranged under a commercial auto policy. 

Commercial Property 

Key Excluded Property Categories 

• Accounts, bills, currency, food stamps, money, notes, and securities 

• Foundations of buildings 

• Underground pipes, flues, or drains 

• Roads, bridges, walks, patios, and other paved surfaces 

• Bulkheads, pilings, piers, wharves, or docks 

• Retaining walls that are not part of a building 

• Water, land, growing crops, and lawns 

• Cost of grading, excavation, or filling 

• Vehicles licensed for road use, watercraft, and aircraft 

• Personal property while airborne or waterborne 

• Any property insured more specifically under another policy 

Property Subject to Limitations 

Under most commercial property policies, there are certain types of property that are covered only to a limited extent, with respect to the limit of insurance, the covered perils, or both.  Examples of property that may be subject to coverage limitations include the following: 

• Electronic data 

• Detached signs, antennas, fences, and other outdoor property 

• Trees, shrubs, and plants 

• Animals 

• Fragile articles, such as statuary, porcelains, and china 

• Jewelry, watches, precious stones, precious metals, and furs 

Covered Locations 

Commercial property insurance policies are generally designed to cover property that is at locations that are listed in the declarations page as covered locations.  If there are too many to list there, a separate schedule of covered locations is attached.  Note that coverage on property in transit is often limited or nonexistent under the building and personal property form.  Coverage, however, is available for this loss exposure under commercial inland marine policies, discussed later in this chapter. 

Coverage also applies to property that is in the open or in a vehicle within a specified number of feet (e.g., 100 feet) of the premises.  Although unscheduled buildings are usually not covered at all, most commercial property policies provide a small amount of coverage ($10,000 limit) on personal property at unscheduled locations.  Most commercial property policies also provide temporary coverage (typically, for up to 90 days) for newly acquired buildings and for personal property at newly acquired locations. 

Covered Causes of Loss 

Property insurance covers losses that result from certain perils.  Commercial property policies may be written on a “named perils” basis or an “all risks” basis.  Named perils forms cover only losses that are caused by the perils that are specifically listed in the policy as covered.  All risks forms, conversely, cover losses from all causes except those that are specifically listed in the policy as excluded.  Of course, an “all risks” policy does not provide coverage for all the risks of loss that the business faces.  In fact, most of today's all risks forms omit the word “all” from the phrase “all risks” in an attempt to prevent expansive court interpretations of the coverage provided. 

Nevertheless, all risks coverage is generally broader than named perils coverage.  For one thing, few, if any, named perils forms provide theft coverage, whereas all risks policies generally do cover many types of theft losses.  Also, while some named perils forms do provide limited water damage and collapse coverage, broader coverage for water damage and collapse is sometimes available under an all risks policy. 

Another advantage of the all risks approach is that it is more difficult for insurers to deny coverage under an all risks form.  With an all risks form, the burden is on the insurer to show that coverage does not apply to a particular loss, whereas with a named perils form, the insured must show that loss was caused by a specifically named peril. 

Since all risks policies provide coverage for loss from all causes except those that are specifically excluded, it follows that every all risks form contains a long list of excluded perils.  In fact, all risks coverage can be thought of as “named exclusions” coverage.  The exclusions and limitations help determine the coverage provided by an all risk form. 

Summary of Key All Risks Exclusions and Limitations 

• Nuclear hazard 

• War and military action 

• Governmental seizure or destruction of property 

• Building ordinance enforcement 

• Off-premises utility service interruption 

• Earth movement 

• Water (flood, mudslide, seepage, and sewer backup) 

• Smoke, vapor, or gas from agricultural or industrial operations 

• Wear and tear, rust, corrosion, fungus, and related perils 

• Dampness, dryness, or changes or extremes of temperature 

• Damage to electrical devices by artificially generated electric current 

• Mechanical breakdown 

• Boiler explosion 

• Loss to steam and hot water equipment from any condition within the equipment 

• Seepage or leakage of water, or the presence of moisture or humidity 

• Rain, snow, ice, or sleet damage to personal property in the open 

• Weight of snow, ice, or sleet on gutters and downspouts 

Property Valuation 

For a commercial property insurance program, there are basically two types of property valuation from which to choose: replacement cost value and actual cash value.  Replacement cost value is defined as the cost to replace new today with materials of like kind and quality.  The term “actual cash value” is typically considered the cost to replace new today with materials of like kind and quality, less depreciation.  Note that the only difference between replacement cost value and actual cash value is depreciation.  For property that has not suffered any depreciation, there is no difference between the two.  The choice of valuation does not affect the rate charged for the insurance.  Therefore, it is wise to insure on a replacement cost value basis, unless the insured business does not intend to replace damaged property. 

Most property insurance policies contain a coinsurance provision.  A coinsurance provision requires the insured to insure the covered property to some specified percentage of its full value—typically 80, 90, or 100 percent—in exchange for a coinsurance rate credit.  If at the time of loss it is determined that the limits carried are less than those required by the coinsurance provision, the loss recovery will be limited to the same percentage of loss as the ratio of the amount of insurance carried to the amount of insurance required.  The coinsurance clause affects the amount of recovery only in partial loss situations.  In the event of a total loss, the policy would pay the total limit of liability applicable to that property. 

It is sometimes possible to effectively void the coinsurance clause in a property insurance policy with an agreed value provision.  An agreed value provision essentially states that the requirements of the coinsurance clause have been met by the insurance amounts shown in the policy.  Insurers usually require a signed statement of property values as a condition of activating or including an agreed value provision in a commercial property policy.  A recent property appraisal or an explanation of how the values were determined may also be required. 

Time Element Coverage 

An organization may also suffer a loss of income or an increase in operating expenses as a result of not being able to use the damaged property while it is being repaired or replaced.  These losses are called time element losses, because the amount of the income loss or expense increase depends on how long it takes to repair or replace the damaged property.  Time element property insurance pays for the loss of income or the increase in operating expenses that results from suspended or makeshift operations while the damaged property is being repaired or replaced. 

For many organizations, the time element loss exposure associated with their buildings, contents, and equipment is as important as the direct property damage loss exposure.  The destruction of the property might bring business operations to a halt or cause the organization to incur substantial unbudgeted expenditures to continue operations despite the damage.  In either case, the continued existence of the organization may be threatened if the exposure is not properly identified and insured. 

Time element coverage is typically added to a standard commercial property policy by including the appropriate coverage form and endorsements. 

This discussion provides an overview of time element property loss exposures and the insurance coverages that are available to address these loss exposures.  There are three principal types of time element loss exposures, discussed below. 

• Loss of income (including rents) 

• Extra expense 

• Contingent loss of income and contingent extra expense 

Loss of Income (Including Rents) 

Loss of income is the principal time element exposure for organizations whose operations depend on particular buildings and specialized equipment.  In the event of severe damage to their facilities, these organizations would likely shut down until the buildings were repaired and the contents replaced.  The shutdown would undoubtedly cause a loss of income.  Manufacturers are the classic example of businesses in this category, because of their dependence on specialized production equipment. 

The insurance coverage that addresses the loss of income loss exposure is called business income coverage (also referred to as business interruption coverage).  Business income coverage is designed to replace the income that would otherwise have been earned by the business during the time when repairs are being made. 

Extra Expense 

Organizations that provide services, and whose property is not a key source of their income, would generally be able to function out of temporary quarters in the event of damage to their own, with little or no resulting loss of income.  However, the expenses associated with arranging, equipping, and operating out of the temporary quarters on a moment's notice are likely to be far in excess of normal operating expenses.  The principal time element loss exposure for these organizations is extra expenses.  Contractors, insurance agencies, and law firms are just a few examples of organizations whose principal time element loss exposure is extra expenses. 

The insurance coverage that addresses this time element loss exposure is called extra expense coverage.  Extra expense coverage is designed to pay for increases in operating expenses that result from continuing operations on a makeshift basis while permanent repairs are being made. 

Contingent Business Interruption and Extra Expense 

Organizations with a single source supplier could be susceptible to an income or expense loss as a result of a fire or other catastrophe at the supplier's facility.  The same is true for organizations with one or two major customers: a serious fire at the customer's facility could prevent the customer from purchasing the organization's goods as expected. 

These types of loss exposures are called contingent time element loss exposures.  If the damage to the other organization's property would cause the insured to lose income, it is a contingent business interruption exposure.  If the damage to the other organization's property would cause the insured to incur extra costs, it is a contingent extra expense exposure.  Such organizations would need to procure contingent business interruption and extra expense coverage. 

Other Types of Commercial Property Insurance 

There are a host of additional commercial property insurance policies to address, including the following. 

• Inland Marine 

• Equipment Breakdown 

• Crime 

• Package 

A brief overview of each of these policies follows. 

Inland Marine Insurance 

Inland marine coverage is simply property insurance for property loss exposures that cannot be conveniently or reasonably confined to a fixed location, or a standard form.  In its pure form, property insurance (which has its origins in fire insurance) provides coverage only at fixed locations specified in the policy.  Property in transit over land and certain movable property has traditionally been covered by inland marine policies, sometimes called “floater” policies.  Inland marine insurance has its origins in ocean marine insurance; it developed out of a need for insurance for property transported over water or land—by railroad or by truck. 

Due in large measure to the inflexible and restrictive coverage forms and rates available from the fire insurers of an earlier era, inland marine insurance expanded over time to include insurance for certain movable property, instrumentalities of transportation and communication (such as bridges, roads, piers, and television and radio towers), and legal liability coverage for bailees.  This eclectic group of coverages was established as the domain of inland marine insurance by agreement between fire and marine insurers in the “Nationwide Marine Definition.” 

In today's insurance regulatory environment, nearly all insurers can write all lines of insurance.  As a result, the value of the nationwide marine definition lies principally in its delineation of current customary divisions between property and inland marine coverages.  As a practical matter, each insurer decides for itself whether traditional inland marine insurance will be written on a separate inland marine policy and handled by inland marine experts.  It is increasingly common to provide the inland marine coverages that nearly every business needs by adding an inland marine coverage form to a property insurance package. 

Sometimes there are advantages to selecting a separate inland marine policy, even when coverage could be included in a property policy.  Inland marine coverage forms are generally broader than property coverage forms.  The relative freedom from rate and form regulation that inland marine underwriters enjoy can be a real plus.  An all risks inland marine policy, for example, usually contains significantly fewer excluded perils than an all risks property policy.  Also, because of the nature of the coverages they typically underwrite, inland marine underwriters may have both wider latitude and a more flexible approach in determining coverage terms than their property insurance counterparts. 

Equipment Breakdown Insurance 

If it were possible to turn back the clock, the coverage that has traditionally been called “boiler and machinery insurance” would probably have been called “equipment breakdown insurance” right from the very start.  Boiler and machinery insurance experts previously spent much time explaining that boiler and machinery insurance policies cover more than just boiler explosions and that many organizations that don't own or operate any steam boilers should purchase this type of coverage. 

Fortunately, what used to be called boiler and machinery insurance is increasingly being called “equipment breakdown insurance,” precisely because that title provides a better description of what is covered.  Of course, equipment breakdown policies cover loss resulting from boiler explosions—but they also cover mechanical breakdown and electrical damage (such as electrical arcing) losses that can be suffered by almost any type of organization, regardless of the type of equipment used. 

Mechanical breakdowns and electrical damage losses are relatively commonplace occurrences that are not covered under standard commercial property policies.  As a result, equipment breakdown insurance typically provides the following coverage, protection that is normally excluded under the building and personal property form. 

• Loss or damage caused by explosion of steam boilers, steam pipes, steam engines, or steam turbines owned, leased, or operated by the insured 

• Loss or damage to steam boilers, steam pipes, steam engines, or steam turbines caused by or resulting from a condition or event inside this equipment 

• Loss or damage to hot water boilers or other water heating equipment caused by an event within the equipment, other than an explosion 

• Loss or damage caused by artificially generated electric current (but not damage from lightning) 

• Loss or damage caused by mechanical breakdown, including rupture or bursting caused by centrifugal force 

Note that equipment breakdown insurance can also cover loss of income and extra expenses resulting from the excluded direct damage losses.  Essentially, the equipment breakdown insurance policy fills important coverage gaps that are present if only the building and personal property policy were purchased. 

Commercial Crime Insurance 

Most organizations need crime insurance of some kind.  While commercial property policies written on an all risks basis do cover most types of theft, money and securities do not qualify as covered property, and employee theft—of money or any other type of property—is virtually always excluded.  Theft via transfer of property on the basis of unauthorized instructions is usually excluded as well.  

Finally, some businesses elect to purchase named perils (rather than all risks) property insurance, and named perils forms seldom provide coverage for theft losses. 

The need for separate crime insurance, then, can be summarized as follows.  

• Most organizations need crime insurance to cover employee theft losses, since property policies universally exclude employee dishonesty as a cause of loss. 

• Any organization that handles a significant amount of money and securities needs crime insurance, since money and securities do not qualify as covered property under a property policy. 

• Any organization purchasing named perils property coverage, whose inventory, equipment, or other property is susceptible to theft, needs crime coverage even if little or no money is exposed to loss, since named perils property policies do not cover theft as a cause of loss. 

Crime insurance that is designed to meet the needs of organizations other than banks, savings and loans, insurers, and other financial institutions is written on what are typically referred to as commercial crime coverage forms.  Crime insurance for financial institutions is written on financial institution coverage forms that are designed to meet the specialized needs of these organizations. 

Key commercial crime coverages include the following: 

• Employee dishonesty coverage 

• Forgery or alteration coverage 

• Money and securities coverage 

• Computer fraud coverage 

• Kidnap, ransom, and extortion coverage 

Package Policy 

A package policy is a single policy that includes two or more coverages that are otherwise typically written as separate policies.  Usually the term refers to policies that provide both property coverage and general liability coverage. 

ISO offers the following two types of commercial package policies. 

• Businessowners policies (BOPs), for small businesses that qualify in terms of size and type of operations.  BOPs are written on special businessowners policy forms and are rated in accordance with special businessowners rules and rates. 

• Commercial package or combination policies, for businesses that are not eligible for the BOP due to their larger size or type of operations.  These policies are written on monoline coverage forms, and each component is rated in accordance with monoline rules and rates, but a package policy discount is applied to eligible policies. 

Commercial Liability Insurance 

This subject of this chapter is commercial liability insurance, with the chief focus being on general liability concepts as well as a review of the commercial general liability (CGL) policy.  In addition, an overview of the commercial umbrella policy and professional liability insurance will be provided near the end of this chapter. 

General Liability Concepts 

The unpredictable event against which general liability insurance provides protection is a lawsuit or the threat of a lawsuit.  Some might define the unpredictable event as the incurring of legal liability, but that, in fact, is only part of the financial loss to which a general liability policy will respond. 

Individuals and organizations incur huge financial losses every day from lawsuits or the threat of lawsuits without ever having any actual legal liability imposed on them.  Being sued can represent a financial catastrophe whether you win or lose the suit. 

General liability insurance provides protection against two types of financial loss arising out of a lawsuit against the company.  First, it covers damages awarded to a third party because of injury or damage for which the insured is legally responsible, including loss of use of property claims.  Second, it covers the cost of defending the insured against the charges alleged in the suit, including attorney fees, investigation costs, and other legal expenses.  Defense costs can amount to huge sums even when the insured is cleared of any legal liability for damages.  Together the indemnity (payment of damages on the insured’s behalf) and defense (payment of legal expenses) obligations comprise the insurer’s key contractual promises to the insured. 

Liability loss exposures arise out of legal wrongs.  The three broad classes of legal wrongs are crime, breach of contract, and tort, each being addressed by a different branch of the law.  General liability insurance concerns itself with tort liability.  Tort law protects the rights of individuals from civil wrongs, and generally provides monetary remedies to tort victims.  In some instances, a criminal act may give rise to civil as well as criminal liability, with monetary awards as remedies.  For example, while fraud is punishable under criminal law, the individual victims may also be permitted to sue for monetary damages, such as restitution of losses and even noneconomic damages such as punitive damages or emotional distress.  Whether liabilities involving criminal activities are covered by general liability insurance often comes down to whether the insured had knowledge of the criminal actions and intent. 

In addition to common law, contractual agreements also create legal duties, such as an agreement to perform in a certain manner, to complete a project in a specified length of time, to deliver a quality product, or to assume responsibility for liabilities that legally fall on another contracting party.  Any violation or breach of a contractual agreement is a civil (as opposed to a criminal) wrong, with an award of monetary damages as a potential remedy. 

Commercial General Liability Insurance 

This section provides a review of the major coverage components of the Insurance Services Office, Inc., CGL policy, a commonly used form.  This discussion first takes a look at the four groups of general liability loss exposures.  It then discusses each of the three coverage parts of the commercial general liability (CGL) policy—bodily injury and property damage (Coverage A), personal and advertising injury (Coverage B), and medical payments (Coverage C)—including the insuring agreement and exclusions.  Although businessowners may avail themselves of the coverage provided under all of the coverage parts, the most significant coverage section for business entities is Coverage A—”bodily injury and property damage.”  Consequently, that section of the policy will receive more emphasis in this course than other coverage parts.  This section then concludes with a review of the “who is an insured” clause, limits of insurance, and key policy conditions. 

General Liability Exposures 

The property, circumstances, activities, and events that can give rise to an insured loss are referred to in insurance terminology as loss exposures—the conditions that expose the insured to loss.  The insurance industry broadly categorizes general liability loss exposures into four groups.  Premises and operations liability encompasses liability arising out of conditions in and around the insured’s premises as well as its current on- and off-premises business operations.  Products and completed operations liability refers to just that—liability arising out of the insured’s products or its completed work.  This contemporaneous grouping of exposures—those that are based on current activities and generally in close proximity to the insured and those that arise out of past activities and are remote in both time and distance from the insured—reflects the different risks and challenges these exposures present for insurers.  Contractual liability involves the voluntary assumption of obligations that do not exist under common law, and independent contractor liability describes liability imposed upon the person who hires an independent contractor to perform work on its behalf. 

Coverage A (Bodily Injury and Property Damage) 

Coverage A of the ISO CGL policy provides coverage for “bodily injury” or “property damage” arising out of many different sources of liability, including premises and operations liability, products and completed operations liability, contractual liability, and independent contractor liability.  Although there is no specific coverage part that grants coverage for these sources of liability, they all fall within the parameters of the CGL policy’s Coverage A insuring agreement.  The insuring agreement (where coverage is granted) and the exclusions (where coverage is taken away) define the scope of coverage provided under each of the coverage parts. 

The Coverage A insuring agreement sets the outer parameters within which coverage may apply with respect to causation, location, and timing.  

Elements of a Covered Loss 

Bodily Injury and Property Damage Liability (Coverage A) 

• “Bodily Injury” or “property damage” occurs during the policy period. 

• “Bodily Injury” or “property damage” is caused by an “occurrence.” 

• The “occurrence” takes place in the “coverage territory.” 

• The insured is legally liable for the loss. 

• The insured was not aware of the “bodily injury” or “property damage” prior to the policy period. 

In addition to covered “bodily injury” or “property damage,” the CGL will pay costs incurred in defending or settling a claim.  In the standard CGL policy, and most nonstandard policies, defense costs are payable outside the policy limit, which means they do not reduce the amount of insurance available to pay claims. 

Coverage Trigger 

Most businesses carry insurance continuously from year to year.  Each time the policy is renewed, a fresh set of coverage limits will apply, and various changes may be made to the policy terms and provisions.  For example, new exclusions may be added, policy definitions may be changed, new endorsements may be attached, and different deductibles may apply, among other possible variations. 

Determining the coverage available for a given claim, therefore, requires determining which policy applies to a given claim.  The insurance industry uses what is called a coverage “trigger” to indicate the event that is required for the policy to respond to a claim.  In this way, both the insurer and the insured can determine which policy’s terms apply. 

ISO publishes two versions of the CGL policy.  The primary difference between the two forms is the event that triggers coverage for bodily injury or property damage (Coverage A).  Under the occurrence form, coverage is triggered if the injury or damage occurs during the policy period.  Under the claimsmade form, it is the filing of a claim during the policy period that triggers coverage. 

The practical impact of this difference is that under an occurrence-based policy, the insured is covered for injury or damage that occurred during the policy period even if that policy has been expired for years when the actual claim is filed.  Claims-made coverage, however, applies only if there is a policy in force when the claim is made, and even then it may place restrictions on coverage with respect to operations performed before a specified date.  For this and other reasons, claims-made coverage is generally unpopular with insureds; therefore, most CGL policies are written with an occurrence trigger.  Consequently, the remainder of this discussion assumes an occurrence trigger.  The claims-made coverage trigger is prevalent in other lines of coverage, including professional liability and pollution liability. 

While the insuring agreement also imposes other requirements for coverage to apply (e.g., that the injury or damage is caused by an “occurrence” that takes place in the “coverage territory”), it is the timing of the injury or damage, not the event that produces the bodily injury or property damage, that triggers the policy.  The time of the “occurrence”—the accident out of which the injury or damage arises—is irrelevant to coverage under the occurrence form of the CGL, as is the time at which the claim is filed.  Many insurance professionals fail to recognize this distinction. 

Covered Damages 

The Coverage A insuring agreement provides that coverage applies to liability for “bodily injury” or “property damage.”  The policy’s definition of bodily injury includes sickness, disease, and death, as well as physical injury to a person.  Mental injuries, such as mental anguish and emotional distress and other disorders, are covered if the applicable jurisdiction recognizes these types of injuries as bodily injuries.  (In most jurisdictions, these types of injuries are covered only if there is accompanying physical injury.) 

Insurance professionals must distinguish between “bodily injury” and “personal injury.”  While attorneys frequently use the latter term to refer to physical injuries to a person (what the CGL refers to as “bodily injury”), insurance policies clearly distinguish the two.  In the CGL policy, “personal injury” refers to a variety of offenses against a person other than a physical injury, such as invasion of privacy, slander, libel, trespass, and false imprisonment.  Personal injury (along with advertising injury) is the subject of an entirely separate coverage part under the CGL (Coverage B), with its own insuring agreement and exclusions. 

The policy’s definition of “property damage” includes physical damage to property and the accompanying loss of use of that property, as well as loss of use of property that has not been physically damaged.  Loss of use claims can include loss of revenues, increased rent or living expenses, and even diminution of value. 

Coverage A Exclusions 

Once the insuring agreement’s conditions have been met, any damages meeting the definitions of “bodily injury” or “property damage” are covered, subject to the policy limit, unless an exclusion applies.  Most of the CGL exclusions are designed to remove coverage for exposures that are not common to most insureds, that are customarily covered under other insurance policies, that underwriters are not willing to cover on a blanket basis, or that are considered uninsurable. 

Some of the more important exclusions include the following. 

Expected or Intended Injury or Damage—Insurance is designed to indemnify insureds for losses suffered fortuitously, not intentionally.  CGL insurance does not cover bodily injury or property damage that was expected or intended from the standpoint of the insured. 

Contractual Liability—This exclusion has two key exceptions.  First, it does not apply to liability that is both accepted in a contract and that would be imposed on the insured even if no contract existed.  The second, and more significant, exception applies to liability assumed in an “insured contract.”  Examples of “insured contracts” include lease of premises, sidetrack agreements, certain easement agreements, certain ordinance-related obligations to indemnify a municipality, and elevator maintenance agreements. 

Liquor Liability—Precludes coverage for bodily injury or property damage for which any insured may be held liable relating to the furnishing of alcoholic beverages.  However, the exclusion applies only if the named insured is in the business of manufacturing, distributing, selling, serving, or furnishing alcoholic beverages. 

Workers Compensation and Similar Laws—Precludes coverage for any obligation the insured may have under workers compensation, disability benefits, and unemployment compensation laws.  These coverages are provided under separate policies designed specifically to handle these exposures.  The exclusion in the CGL policy, therefore, avoids a potential overlap in coverage. 

Employers Liability—Removes coverage for any claim arising out of bodily injury to an employee of the insured if the injury is sustained as a result of that employment.  Injuries to workers are normally covered by workers compensation insurance, but even if they fall outside the workers compensation statute, they are not covered by the CGL policy. 

Pollution—Omits coverage for damages arising out of the “discharge, dispersal, seepage, migration, release or escape of pollutants.”  This wording is designed to encompass virtually any means by which pollutants enter or are spread through the environment—ground, water, or air.  The term “pollutants” is defined in the exclusion as “any solid, liquid, gaseous or thermal irritant or contaminant, including smoke, vapor, soot, fumes, acids, alkalis, chemicals and waste.” 

Aircraft, Auto, or Watercraft—Precludes coverage for injury or damage arising out of the ownership, maintenance, or use of aircraft, auto, or watercraft.  Liability arising out of the loading or unloading of an automobile is also excluded.  These exposures are more appropriately covered under policies specifically designed to insure them. 

Transportation of Mobile Equipment—Although the CGL provides coverage with respect to “mobile equipment,” an exclusion does apply with respect to the transportation of such equipment. 

War—Applies to war itself; other warlike action; and insurrection, rebellion, revolution, and usurped power. 

Damage to Property—The CGL does not cover damage to the insured’s own property.  Nor does it cover damage to certain other types of property where the risks are more representative of first-party property than third-party property, such as premises that the business rents or leases. 

Damage to “Your Product”—Eliminates coverage for property damage to the named insured’s product arising out of that product or any portion of it.  This exclusion is intended to apply only to manufacturers and other entities that produce “products” rather than service companies. 

Damage to “Your Work”—Applies only to liability arising out of the “products-completed operations hazard,” which limits its application to completed work.  The “damage to property” exclusion, discussed above, addresses coverage for damage to work in progress. 

Coverage B (Personal and Advertising Injury) 

Coverage B of the CGL policy expands the form’s scope of coverage to include “personal and advertising injury” liability.  The policy’s definition of “personal and advertising injury” cites a number of different types of offenses that may produce covered damages.  

Personal and Advertising Injury 

• False arrest, detention, or imprisonment 

• Malicious prosecution 

• Wrongful eviction 

• Wrongful entry 

• Invasion of privacy 

• Libel or slander of a person, organization, product, or service 

• Advertising infringement 

• Copyright infringement in advertisements 

• Consequential “bodily injury” arising out of any of the above offenses 

Coverage B Exclusions 

Coverage B contains 14 exclusions, which are listed in Exhibit 7.3.  Many of these exclusions pertain to offenses that were committed with knowledge of the fact that they violate the rights of another.  Criminal acts committed at the direction of the insured are likewise excluded. 

Coverage B Exclusions 

• Knowing Violation of Rights of Another 

• Material Published with Knowledge of Falsity 

• Material Published Prior to Policy Period 

• Criminal Acts 

• Contractual Liability 

• Breach of Contract 

• Quality or Performance of Goods—Failure To Conform to Statements 

• Wrong Description of Prices 

• Infringement of Copyright, Patent, Trademark, or Trade Secret 

• Insureds in Media and Internet Type Businesses 

• Electronic Chatrooms or Bulletin Boards 

• Unauthorized Use of Another’s Name or Product 

• Pollution 

• Pollution-Related Costs 

Coverage C (Medical Payments) 

Coverage C reimburses medical expenses incurred by the general public who are injured on the insured business’ premises, or because of the business’ operations.  This coverage pays without regard to legal liability.  If, for example, a customer is injured in the lobby of the insured’s business office, the CGL insurer will pay for reasonable medical expenses incurred regardless of whether the business is legally liable for the injury.  The rationale for this “no fault” coverage is that injured parties may be less inclined to sue if they receive treatment for their injuries at the time of the accident. 

Who Is an Insured 

In addition to the person or entity listed on the policy as the named insured, the CGL automatically provides coverage for various other persons or entities.  While it would not be beneficial to grant insured status to just anyone, where certain legal or contractual relationships exist, it makes sense to do so.  In most instances, an individual’s or organization’s status as an insured is limited to liability that results directly from the described relationship with the named insured business.  Covered insureds, based on the type of business, can include the spouse of the named insured, stockholders, partners, volunteer workers, employees, and newly acquired organizations. 

Limits of Insurance 

The CGL policy contains different limits of insurance.  Unless otherwise stipulated, policy limits apply separately to each consecutive year the policy is in force.  Thus, with each renewal, the insured business has a fresh set of limits with respect to claims that occur during that policy period.  Remember, however, that claims filed during the current policy period may actually be payable under previous policies if the actual “bodily injury” or “property damage” is deemed to have occurred during their coverage periods. 

CGL Limits of Liability 

General Aggregate 

The most the policy will pay for all bodily injury, property damage (other than that involving the products-completed operations hazard), personal and advertising injury, and medical payments claims. 

Products-Completed Operations 

Aggregate 

The most the policy will pay for all bodily injury and property damage claims included in the “products completed operations hazard.” 

Personal and Advertising Injury 

Provides for a per person (or per organization) limit of liability for claims involving covered personal and advertising injury.  These payments are also subject to the general aggregate limit. 

Each Occurrence 

Establishes a maximum the insurer will pay for all bodily injury, property damage, or medical payments arising out of any one occurrence. 

Key Policy Conditions 

While some of the CGL conditions represent true “conditions” of coverage (actions that, if not performed, void the contractual obligations of the parties), many policy conditions merely stipulate various terms of the agreement.  It is a miscellaneous group of contract provisions that define specific rights and duties of both the insured and the insurer, or give more detailed explanations of how the policy’s coverage or limits will apply.  Important conditions are briefly explained below. 

Duties in the Event of Occurrence, Claim, or Suit—Insurers require prompt notice of any claim or suit filed against the insured, as well as any occurrence or offense that could potentially give rise to a claim.  Further, insureds must cooperate in the investigation and defense of any claim, including supplying copies of all legal papers as well as any needed documents and records of the insured.  Failure to comply with these conditions may be grounds for denial of the claim, particularly if this failure prejudices or harms the insurer’s ability to properly handle the claim. 

Other Insurance Provision—Spells out how the insurer’s obligations to pay claims and provide a defense are impacted when the insured has other insurance that is also triggered by a claim.  The standard CGL policy provides that coverage on a primary basis except in a few specified situations. 

Subrogation Provision—Insurers routinely pay claims on behalf of their insureds that someone other than the insured is legally responsible to pay.  For example, if an electrician’s shoddy work causes a fire in a building, the owner’s property insurer will pay the cost of repairing the fire damage.  When such a payment is made, however, the insurer receives the insured’s legal right to pursue recovery from the responsible party. 

Umbrella Liability Insurance 

In addition to CGL insurance, most businesses should procure excess liability coverage, typically in the form of a commercial umbrella policy.  An umbrella liability policy provides excess limits of coverage, over and above the limits provided in various basic liability policies.  Specifically, most umbrella liability policies provide excess coverage over the business’s general liability, auto liability and employer’s liability insurance.  The umbrella policy is a crucial element of a business’s insurance program as it provides protection for catastrophic losses.  In addition to its high limits of liability, the umbrella policy may afford a broader scope of coverage than do the primary liability policies. 

Unlike primary (underlying) liability policies, umbrella liability forms are not standardized, which means each insurer develops its own form.  Although similarities exist, substantial differences also exist.  Many insurance professionals mistakenly believe that if a particular coverage is provided in an underlying policy, then it is automatically provided in the umbrella policy.  This is not true.  The only way to know for sure what a particular umbrella form covers is to read it in its entirety. 

The insuring agreement of virtually all umbrellas provides coverage for “personal injury,” “property damage,” and “advertising liability.”  Personal injury has a different meaning in the umbrella than it does in the CGL policy.  In the CGL, personal injury refers to nonbodily injuries such as false arrest, libel, and slander.  In the umbrella, “personal injury” encompasses both bodily injury and nonbodily injury.  The umbrella definition of “personal injury” usually includes perils such as shock, mental anguish, mental injury, and, in some policies, humiliation and discrimination.  “Property damage” usually includes liability for actual damage to or destruction of tangible property as well as loss of use of property. 

Umbrella coverage is written on an “occurrence” basis, and the definition of “occurrence” is typically similar to that found in the CGL policy.  That is, it applies to an “accident,” including continuous or repeated exposure to harmful conditions.  However, because the CGL also provides excess coverage for personal and advertising injury, as well as employers liability and auto liability claims, the umbrella definition should also include broader terms that will trigger coverage, such as “happenings or events.” 

The policy exclusions contained in umbrellas are of two basic types: conditional exclusions and absolute exclusions.  Conditional exclusions do not apply if there is underlying coverage available for that exposure.  Absolute exclusions apply regardless of the existence of underlying coverage.  Virtually all umbrella policies contain exclusions for nuclear energy liability, pollution, workers compensation, war, business risks, products recall, and certain advertising injuries. 

Professional Liability Insurance 

In recent years, several trends have caused a substantial increase in the frequency and severity of liability claims against professionals as well as the need for specific professional liability insurance coverage in the United States.  First, American society is becoming ever more litigious.  Second, changes in legal doctrines are increasing the scope of the liability exposures faced by professionals.  Third, more occupations are being considered professional or at least quasi-professional. 

When taken together, these factors have dramatically increased the number of liability claims against professionals, a situation that accentuates the need for broad insurance coverage.  At the same time, underwriters of “traditional” liability coverage forms, such as CGL and umbrella liability policies, are becoming more conservative in their treatment of professional liability exposures.  Admittedly, general liability underwriters never intended to insure the professional liability exposures of doctors, attorneys, and architects and engineers.  However, they are now attaching “professional services exclusions” to the policies of insureds in vocations that are not typically considered professional. 

Professional liability insurance focuses on the policies used to protect professionals against claims involving performance of their services.  “Professionals” are held to a higher standard of care than people engaged in other occupations.  However, people engaged in other occupations may also be held liable for the mistakes they make.  The insurance industry has long differentiated between the types of insurance written for the true professions and other types of occupations.  “Professional liability insurance” has traditionally been the label attached to the insurance written to cover accountants, doctors, and lawyers.  On the other hand, insurance written to cover losses arising from mistakes made by people in quasi-professional occupations—such as real estate agents, insurance agents, directors and officers, and public officials—has typically been referred to as “errors and omissions” (E&O) insurance. 

Professional liability experts often segment professional liability and E&O policies into three broad categories.  These include (1) executive liability, (2) medical malpractice liability insurance, and (3) non-medical professional liability insurance. 

Executive Liability 

Executive liability insurance policies generally pertain to professional activities concerning directors and officers, employment practices, and fiduciary liability.  A brief description of each of these loss exposures follows. 

Directors and Officers 

This policy insures corporate directors and officers (D&O) against claims, most often by stockholders and employees, alleging financial loss arising from mismanagement.  The policies contain two coverages: the first reimburses the insured organization when it is legally obligated (typically by corporate charter or state statute) to indemnify corporate directors and officers for their acts.  The second provides direct coverage to directors and officers when the organization is not legally obligated to indemnify them. 

Employment Practices 

This policy covers wrongful acts arising from the employment process.  The most frequent types of claims alleged under such policies include: wrongful termination, discrimination, and sexual harassment.  The forms are written on a claims-made basis and generally exclude coverage for large-scale, companywide layoffs.  This coverage is also frequently available as an endorsement to a D&O policy. 

Fiduciary Liability 

This policy pertains to the responsibility on trustees, employers, fiduciaries, professional administrators, and the plan itself with respect to errors and omissions in the administration of employee benefit programs as imposed by the Employee Retirement Income Security Act (ERISA). 

Medical Malpractice Insurance 

This insurance covers the acts, errors, and omissions of physicians and surgeons, encompassing physicians’ professional liability insurance, hospital professional liability insurance, allied health care (e.g., nurses), managed care, and long-term care.  Coverage is often provided on a claims-made basis. 

Physicians’ Professional Liability 

This policy pays all sums which the physician shall be legally obligated to pay as damages arising from a medical incident.  The insuring agreement refers to “medical incident” rather than “bodily injury.”  As a result, the clause covers a wide spectrum of claims (e.g., mental anguish) based on professional acts or omissions. 

Hospital Professional Liability 

This insurance is purchased by hospitals to cover their liability for professional acts, errors, or omissions.  This coverage is usually written on a combined basis with the CGL to avoid “gray area” situations in which coverage could apply under either policy.  This policy covers hospital employees but not independent contractor staff physicians who have been granted admitting privileges. 

Allied Healthcare Professional Liability 

This professional liability insurance is designed to cover nonphysician health care professionals including nurses, dentists, physical therapists, technicians, and a variety of other persons providing medical services.  Allied healthcare professional liability policy forms are similar to those used to cover physicians. 

Managed Care Professional Liability 

This liability coverage is written to cover organizations engaged in delivering medical services on a managed-care basis, such as health maintenance organizations (HMOs).  Representative types of claims covered by the policies include allegations of negligent provider selection, direct professional liability, and wrongful denial of treatment. 

Long-Term Care 

This professional liability insurance is designed to cover the providers of long-term care (e.g., nursing home care).  Coverage is modeled after that granted in hospital professional liability policies since the settings and services provided are similar. 

Non-Medical Professional Liability 

This insurance covers the acts, errors, and omissions of nonmedical professionals (e.g., accountants, attorneys, and architects) and quasi-professionals such as real estate brokers and computer consultants.  Other covered occupations include insurance agents, travel agents, Web masters, media professionals, engineers, bankers, and environmental consultants. 

Commercial Auto Insurance 

The ownership or operation of an auto (defined as a land motor vehicle, trailer, or semi-trailer designed for travel on public roads) exposes a business to potentially large financial losses.  The business might be held legally liable to others for bodily injury or property damage arising out of an auto, or the business’s vehicle(s) could be lost, stolen, damaged, or destroyed by any number of perils.  Most businesses insure these loss exposures by purchasing a business auto policy (BAP).  This chapter provides an overview of the coverage parts of the BAP, explains the concept of insured vehicles and symbols, discusses the intricacies of the all-important liability coverage, and offers a snapshot of the other types of commercial automobile policies—the motor carrier/truckers forms and the garage form. 

Business Auto Policy 

The BAP offers a variety of coverages including liability, physical damage, medical payments, nofault, and uninsured/underinsured motorists (UM/UIM) coverages. 

Liability 

“Liability” is the legally enforceable obligation to pay a monetary award for injury or damage caused by one’s negligent or statutorily prohibited action.  The policy insures against legal liability arising from the ownership, operation, or use of covered autos.  This important coverage will be discussed at greater length later in this chapter. 

Physical Damage 

Physical damage coverage deals with the exposure of direct and accidental loss of, or damage to, an insured’s own vehicle.  The major physical damage coverages include specified causes of loss, comprehensive, and collision. 

Specified Causes of Loss 

Specified causes of loss coverage applies to damage from specific named perils, such as fire, lightning, theft, windstorm, flood, and vandalism.  It is a less broad, and thus less expensive, alternative to comprehensive coverage.  Larger businesses commonly purchase specified causes of loss coverage to apply to their fleet of vehicles.  They may also prefer this coverage for older private passenger autos because of cost considerations. 

Comprehensive 

When comprehensive coverage applies, the policy will pay for direct and accidental loss or damage from any cause except collision or overturn, subject to specified exclusions.  Businesses frequently procure this coverage to insure owned private passenger type vehicles.  The cost of this “all-risk” insurance is understandably greater than for specified causes of loss coverage, which is more limited in scope. 

When an auto is covered by both comprehensive and collision coverage, it is covered for all sources of direct and accidental loss or damage except those specifically excluded, such as war, nuclear hazard, and wear and tear.  The following list illustrates examples of some types of loss that could be covered under comprehensive coverage that in most circumstances would not be covered under specified causes of loss coverage. 

• Sinkhole—a business’s truck is parked on the street and sinks into a roadbed and is damaged. 

• Accidental spray paint—an employee of the business next door to the insured business is spray painting a vehicle in the open, which results in residual paint blowing onto the insured business’s fleet of pickups located in its yard. 

• Vermin—Mice damage a vehicle’s seats and door panels. 

• Heat—Sunlight greenhouse effect causes a vehicle’s glass to shatter. 

• Odor—An animal expires in a vehicle’s interior. 

• Pollutants—Acid rain damages a vehicle’s paint. 

Collision 

When collision coverage is afforded, it insures against losses caused by the covered auto's collision with another object or the covered auto's overturn. 

When a covered auto suffers glass breakage in conjunction with a collision loss, and the glass breakage would also be covered under comprehensive coverage, the insured has the option of choosing which coverage applies.  This option affords the insured the broadest possible coverage, i.e., since either coverage applies, the one with the lower deductible (usually comprehensive) can be chosen.  However, the glass breakage would not be subject to an additional deductible above the collision deductible if it is considered a part of the collision loss. 

Insureds typically desire to purchase collision coverage to protect private passenger autos unless they are older and have limited cash value.  They may also desire coverage for commercial vehicles, especially if those vehicles are newer and of high value. 

Medical Payments 

Medical payments coverage provides reasonable expenses incurred by an insured for necessary medical and funeral services, regardless of fault.  It is normally added to the BAP via an endorsement.  These reasonable expenses must be connected with “bodily injury” caused by an “accident,” as both those terms are defined in the applicable coverage form.  There is no requirement, however, that the named insured be legally liable for the bodily injury before medical payments coverage applies.  The insurer will pay only those expenses that are incurred within 3 years following the date of the accident. 

Under this coverage, the named insured (and any family member, if the named insured is an individual) is covered for medical payments if struck by an auto, even while on foot.  (This coverage does not pertain to employees.)  The coverage also applies if the named insured or family member is injured while occupying any auto.  For any other insured, the coverage applies only to injuries sustained while the other insured person is occupying a covered auto or a temporary substitute for a covered auto. 

No-Fault 

No-fault coverage, often referred to as personal injury protection (PIP), is a form of auto insurance designed to reduce auto liability coverage costs (bodily injury liability, in particular) and related litigation costs and use the savings to operate a first-party coverage system, similar to the workers compensation system.  In short, its goal is to create a better system to compensate persons involved in automobile accidents. 

This coverage, which is promulgated and controlled by state statutes, is available and often required in over 20 states.  These statutes restrict, at least to some extent, a claimant’s right to sue in tort for damages.  PIP benefits available to insureds typically include reimbursement for medical expenses, rehabilitation expenses, loss of income, death benefits, and funeral expenses.  This coverage is added via an endorsement. 

Uninsured/Underinsured Motorists 

Uninsured motorists (UM) insurance provides coverage for bodily injury, and in some states property damage, incurred by an insured when an accident is caused by a negligent motorist who is not insured.  Underinsured motorists (UIM) coverage is designed to more fully protect an insured in a not-at-fault accident when the tortfeasor’s limits of liability have been exhausted.  The UM and UIM coverages are not designed to stack on top of each other; they are meant to apply to different fact situations but insureds either purchase both coverages or reject both.  This coverage is often recommended due to the high number of uninsured motorists on the road.  UM/UIM coverage is added via endorsement. 

Insured Vehicles and Symbols 

The BAP provides both liability and physical damage coverages.  Medical payments coverage, PIP coverage, and UM/UIM coverage can be added by endorsements, which are often state-specific.  Businesses can choose to purchase different coverages on different types of autos.  The declarations page shows not only which coverages have been selected, but also to what types of autos each coverage applies. 

Commercial auto insurance uses a set of ten coverage symbols (nine standard, plus one customized) to stipulate a category of “covered autos.”  One or more symbols are assigned to each coverage purchased; this indicates the autos for which that coverage applies.  For example, Symbol 1 denotes coverage with respect to “any auto” and Symbol 2 denotes coverage with respect to “owned autos only.”  If Symbol 1 is assigned to the liability coverage, and Symbol 2 is assigned to medical payments coverage, the business has liability coverage for the use of any auto, but medical payments coverage only with regard to autos it owns.  

Commercial Auto Coverage Symbols 

Any Auto—Symbol 1 can be used only for liability coverage.  When it is selected, any auto, whether owned, nonowned, or hired, is considered a “covered” auto.  This symbol is usually selected for liability coverage. 

Owned Autos Only—Symbol 2 covers all autos owned at the beginning of the policy period, plus any owned autos acquired during the policy period.  If Symbol 2 is used for liability coverage, any nonowned trailer attached to an owned power unit is also a covered auto.  This symbol is often used to designate UM/UIM and physical damage collision coverages. 

Owned Private Passenger Autos Only—Symbol 3 covers all private passenger autos owned by the insured business, plus any such autos acquired during the policy period.  The symbol is frequently used to designate auto medical payments and physical damage comprehensive coverage.  If physical damage towing and labor coverage is purchased, this symbol may be used for that coverage. 

Owned Autos Other Than Private Passenger Autos Only—Symbol 4 covers all owned autos except private passenger autos.  Similar autos acquired during the policy period are also covered.  If this symbol is used for liability coverage, any nonowned trailer attached to an owned power unit is covered.  The most common use for this symbol is for physical damage specified causes of loss coverage. 

Owned Autos Subject to No-Fault—Symbol 5 covers only owned autos that are required to have no-fault benefits in the state in which they are licensed or principally garaged.  This symbol also indicates coverage for autos acquired during the policy period, provided they are required to have no-fault benefits.  The use of the symbol is restricted to compulsory no-fault coverage. 

Owned Autos Subject to a Compulsory Uninsured Motorists Law—Symbol 6 signals coverage for owned autos that are required to have UM insurance because of the law in the state where they are licensed or principally garaged.  (Some states’ UM laws allow vehicle owners to reject the required coverage.  Symbol 6 does not apply to vehicles licensed or principally garaged in such states.)  Autos acquired during the policy period are also covered autos when Symbol 6 is used, provided they are subject to the same state UM law and the required coverage cannot be rejected. 

Specifically Described Autos—Symbol 7 provides coverage only for autos that are specifically described in a schedule of covered autos in the policy declarations (item 3).  If this symbol is used for a particular coverage, a newly acquired auto will be included for that coverage only if: the insurer already provides that coverage on all autos the business owns, or the auto replaces one that was previously owned and insured for the same coverage; and the insured business informs the insurance company within 30 days after acquiring it that coverage is desired on the new auto. 

When Symbol 7 is used for liability coverage, liability arising from the business’s nonowned trailers attached to a power unit described in item 3 of the declarations is covered. 

Hired Autos Only—Symbol 8 applies coverage only to autos that the insured business leases, hires, rents, or borrows.  It does not include any auto that is leased, hired, rented, or borrowed from an employee of the insured business or a partner in the business, or members of their households. 

Nonowned Autos Only—Symbol 9 gives “covered auto” status to autos used in connection with the insured’s business if they are not owned, leased, hired, or borrowed by the business.  This symbol includes autos owned by the insured’s employees or partners, or members of their households while such autos are used in the insured’s business or personal affairs.  Symbol 9 is used for liability coverage only. 

Custom Symbol—This symbol allows for any designation that is agreeable between the insured business and the insurer.  It is used to either include or exclude any category of owned autos not precisely described by any of the other standard symbols (e.g., autos with book values below a specified amount) from physical damage coverage.  Use of this symbol requires the attachment of the covered auto designation symbol endorsement filled in to describe the custom symbol. 

With the exception of Symbol 7, “specifically described autos,” all symbols have restrictions as to coverages for which they can be used.  (Symbol 7 allows the insured business to choose specific autos within a class to which coverage applies.)  For example, Symbols 1 (“any auto”) and 9 (“nonowned autos only”) are not to be used in conjunction with physical damage coverages, since insurers do not want to provide blanket first-party physical damage coverage for others’ autos.  (If the insured negligently damages someone else's car, that is a liability loss and payable under the insured’s policy as long as the damages arose out of the use of a covered auto, as dictated by the symbol corresponding to the policy’s liability coverage.) 

Symbol 1 (any auto) affords the broadest liability coverage available under the business auto policy.  If a symbol other than Symbol 1 is selected for liability coverage, it is important for the insured to set up a system for monitoring the firm’s auto use to identify uninsured liability exposures in connection with vehicles that are not “covered autos” under the policy.  Because 100 percent accuracy in such a monitoring system is difficult, and because of the potentially catastrophic nature of liability claims, Symbol 1 should be used for liability coverage in almost all circumstances. 

Symbols 2, 3, 4, 7, and 8 are used in connection with the policy’s physical damage coverages, and sometimes in connection with liability and optional coverages such as medical payments and UM/UIM.  Various combinations of these symbols are possible, although some should never be used together.  For example, Symbol 2 “owned autos” and Symbol 3 “owned private passenger autos only” should not be used together as they contradict each other. 

For most symbols, some coverage is automatically provided with respect to autos the insured acquires during the policy period.  Symbols 1, 2, 3, and 4 afford coverage for the remainder of the policy period with respect to autos of the type described that are acquired during the policy period.  However, to maintain a good faith relationship with the insurer, agents should make sure that business insureds diligently report changes in its fleet to the insurer, and pay any corresponding premium increases. 

(Premiums can be adjusted at audit in any case, so the benefit of delaying reporting is minimal.)  For coverages indicating Symbol 7, newly acquired autos are automatically covered for a maximum of 30 days, and only if the coverage currently applies to all owned autos, or if the new vehicle is replacing a vehicle that was insured for that coverage.  If the insured fails to notify the insurer of the new acquisition, the applicable coverage expires after 30 days. 

The various coverages and symbols must be fully understood and selected with care.  For example, assume that a business wants liability coverage for all owned, nonowned, and hired autos; physical damage comprehensive coverage for all owned private passenger autos; physical damage specified causes of loss coverage for the company trucks; and physical damage collision coverage for all owned autos.  Symbol 1 should be placed next to liability coverage in the declarations page; Symbol 3 should be placed next to physical damage comprehensive coverage; Symbol 4 should be placed next to physical damage specified causes of loss coverage; and Symbol 2 should be placed next to physical damage collision coverage. 

Most businesses purchase liability coverage for all vehicles (Symbol 1), and a combination of other coverages on different categories of vehicles.  With respect to physical damage, agents should assist businesses in deciding which (if any) vehicles the business can afford to retain the risk of loss and which should be insured.  Various symbols are available for use in establishing coverage for physical damage, medical payments, and other optional coverages. 

Most of the business-specific auto insurance issues fall within the liability section of the policy.  For that reason, the remainder of the BAP discussion focuses on liability coverage.  Note that variations in coverage exist across states, based on state-specific endorsements that modify coverage as needed to comply with state laws. 

Intricacies of Liability Coverage 

Liability coverage is typically viewed as the most important coverage provided in the BAP.  Key topics to address in this coverage include the elements of a covered loss, covered autos, categories of insureds, and key liability exclusions. 

Elements of a Covered Loss 

The Section I insuring agreement stipulates the required conditions for liability coverage to apply, such as what events will trigger the coverage, and what types of damages are covered.  

Elements of a Covered Loss 

• “Bodily Injury” or “property damage” resulting from the ownership, maintenance, or use of a covered “auto”. 

• “Bodily Injury” or “property damage” is caused by an “accident”. 

• The insured is legally liable for the loss. 

In addition to covered “bodily injury” or “property damage,” the BAP pays costs incurred in defending an insured or settling a claim against the insured.  Note that these defense costs are payable outside the policy limit. 

Covered Autos 

Generally speaking, agents should recommend that businesses select Symbol 1 (any auto) for liability coverage, to ensure compliance with state financial responsibility laws and avoid oversights in keeping the list of covered autos up-to-date.  The BAP provides that with respect to all autos insured for liability coverage, various other categories of vehicles are also covered “autos” under that section of the policy.  

Additional Covered Autos—Section I (Liability) 

• An “auto” of the type indicated by the liability coverage symbol that you acquire during the policy period. 

• “Trailers” with a load capacity of 2,000 pounds or less designed primarily for travel on public roads. 

• “Mobile equipment” while being carried or towed by a covered “auto.” 

• Any nonowned “auto” used as a temporary substitute for your covered “auto” that is out of service because of its breakdown, repair, servicing, loss, or destruction, when used with the owner’s permission. 

Who Is an Insured 

The BAP’s liability coverage applies to amounts that an “insured” is legally obligated to pay.  The definition of “insured” is organized into three segments—the named insured, permissive users, and anyone liable for the conduct of an insured.  The named insured—the person or entity listed on the policy declarations—enjoys the broadest scope of coverage of the three classes of insureds, with coverage for the use of any covered auto. 

The second category, permissive users, includes most persons (a list of exceptions applies) while using the named insured’s covered auto with the named insured’s permission.  For example, an insured business’s employees are insureds when operating the insured’s autos with permission of the insured. 

The third category of insureds—anyone else liable for the conduct of an insured—includes any person or organization not otherwise included or excluded by the first two categories of insureds, to the extent this third category of insureds is vicariously or statutorily liable for another insured’s conduct.  Commonly referred to as the Omnibus Clause, this provision is important to anyone who may be held liable for injury or damage arising from the insured business’s use of an auto.  Consequently, additional insured endorsements are not needed for coverage to be afforded to another party who is liable for the conduct of an insured. 

Liability Exclusions 

Once the insuring agreement’s conditions have been met, any damages meeting the definitions of “bodily injury” or “property damage” are covered, subject to the policy limit, unless an exclusion applies.  Many of these exclusions dovetail to the coverage provided in the CGL.  That is, the reason certain exclusions are in the policy is to avoid duplicating coverage that the CGL grants. 

Some of the more important exclusions include the following: 

 Expected or Intended Injury or Damage—Insurance is designed to indemnify insureds for losses suffered fortuitously, not intentionally.  Commercial auto insurance does not cover bodily injury or property damage that was expected or intended from the standpoint of the insured. 

Contractual Liability Exclusion—The business auto policy provides coverage for the insured’s contractual liabilities in a manner identical to that used in the CGL policy.  That is, the insured has coverage for contractual liability arising out of the ownership, maintenance, or use of an auto if the liability would have existed even in the absence of the contract, or if the liability was assumed in an “insured contract.”  The BAP’s definition of an “insured contract” is similar, but not identical, to the CGL policy’s definition of that term. 

Owned Property/Care, Custody, or Control Exclusion—The exclusion for damage to property owned or transported by the insured business, or in the insured’s care, custody, or control, with limited exceptions.  Note that this exclusion also precludes coverage for damage to rented or borrowed vehicles since these are under the care, custody, or control of the insured. 

Mobile Equipment Exclusion—Mobile equipment, such as cranes, cherry pickers, loaders, diggers, and snow plows, presents an insurance challenge since at times they more closely resemble the exposures that are insured under a CGL policy—e.g., when being used to raise or lower machinery or people—and at other times, they more closely resemble an auto exposure—e.g., when being driven from one location to another.  The approach often taken is to split the coverage into the most appropriate policies with the primary use of the equipment/vehicle being the distinguishing factor. 

The intent is to separate the liability arising out of these types of equipment into automobile exposures and operating exposures, and to insure them accordingly.  The coverage provided under the two policies is dovetailed by using the same definition of the term “mobile equipment.”  This is one of many good reasons for agents to encourage businesses to place their auto and general liability coverages with the same insurer whenever feasible. 

Pollution Exclusion—With two minor exceptions, the BAP pollution exclusion can be viewed as constituting an almost total exclusion of coverage for incidents involving pollutants, even if the discharge of the pollutant is sudden and accidental.  (Keep in mind that in order for coverage to apply in the first place, the release of pollutants must somehow arise in connection with the ownership, operation, maintenance, or use of a covered auto.) 

Other Types of Commercial Auto Policies 

There are three other types of commercial auto policies, including the motor carrier, truckers, and garage policies. 

Motor Carrier/Truckers Policies 

These two policies are designed to provide commercial automobile insurance for entities that transport goods, materials, or commodities.  There are different types of motor carriers or trucking companies—private, “for hire,” or a combination of both types of operations.  A private carrier is a company that provides truck transportation of its own cargo, usually as a part of a business that produces, uses, sells and/or buys the cargo being hauled.  A “for hire” carrier is a company that provides truck transportation of cargo belonging to others and is paid for doing so. 

The truckers policy is the traditional form that has been existence prior to the deregulation of the trucking industry.  As a result of this deregulation, the motor carrier policy was developed.  It is similar in most ways to the truckers policy, but it differs from the truckers policy primarily in its applicability to a broader class of insureds.  The primary difference is that the “trucker” definition specifies that the transportation activity must be for hire.  The definition of “motor carrier” requires only that the activity be in the furtherance of commercial enterprise. 

The motor carrier and truckers forms afford liability, physical damage, and trailer interchange coverage, i.e., insurance for the trucker's liability for loss to a trailer in its possession under a written trailer interchange agreement.  Except for the trailer interchange section of the policy, both forms are very similar to the business auto coverage form.  For example, the symbols are nearly identical but the motor carrier and truckers forms have additional symbols for the following. 

• (Nonowned trailers in your (named insured’s) possession under a written trailer or equipment interchange agreement 

• Your (named insured’s) trailers in the possession of anyone else under a written trailer interchange agreement 

Garage Policy 

The garage policy is a specialized form designed to provide insurance to auto and trailer dealers—both franchised and nonfranchised—and, in some states, to commercial entities that are in some other type of business related to autos, e.g., servicing, repairing, parking, or storing autos.  (At one time, service stations were routinely covered under a garage policy, but the practice was reversed in 2002.)  The garage policy combines into one form coverage for liability for accidental injury or damages resulting from “garage operations” involving the ownership, maintenance, or use of covered autos, and also for liability resulting from other types of “garage operations,” e.g., ownership, maintenance, or use of a location for a garage business and all operations necessary or incidental to a garage business. 

Auto and trailer dealers sell, service, and repair new or used private passenger autos, trucks, truck tractors, motorcycles, recreational vehicles, other self-propelled land motor vehicles, and residence type mobile home and commercial trailers.  Franchised dealers typically sell new models produced by one or a limited number of manufacturers.  They usually offer a full range of services to their customers.  They also act as the manufacturer's contact point in a given locale for authorized services or repairs, including any that might be necessitated by a product recall.  Franchised dealers may also sell used vehicles taken as trade-ins in connection with their new car sales. 

Conversely, nonfranchised dealers do not have a specific arrangement with a manufacturer and generally sell used models.  It is unusual for them to offer any but the most routine services in connection with their vehicle sales.  In a few states, equipment and implement dealers may also be covered under a garage policy.  In most states, however, these types of businesses are not eligible for treatment under a garage form. 

The insured dealer may purchase coverage under the garage policy for exposures to loss related to physical damage to its own vehicles and also to vehicles in its possession on consignment for sale.  It may also purchase garagekeepers coverage for loss to vehicles left in its care; the garagekeepers coverage may be limited in such a way that it applies only when the insured is legally liable, or it may apply in a broader manner. 

Workers Compensation 

Workers compensation is the system by which no-fault statutory benefits prescribed in state law are provided by an employer to an employee (or the employee’s family) due to a job-related injury (including death) resulting from an accident or occupation disease.  Most employers meet their legal obligations through procuring workers compensation coverage from a private insurer but other sources may be available.  This chapter will provide a brief history of the origins of workers compensation laws, summarize some of the more important state workers compensation laws, highlight the major points of the workers compensation and employers liability policy, offer an overview of workers compensation markets, and summarize the process of rating workers compensation risks. 

History of Workers Compensation 

At the beginning of the twentieth century, the United States was emerging as an industrialized nation while society was developing a social conscience.  In those days, employees who were injured on the job had to sue their employer under common law to obtain benefits.  Employers had basic common law defenses, including assumption of risk, contributory negligence, and negligence of a fellow employee. 

The assumption of risk defense stated that an employee who voluntarily entered into a job knowing about the unsafe nature of the premises or the work and who understood the risks inherent in the job could not recover for a resulting injury.  The contributory negligence defense stated that if the employee’s negligence somehow contributed to his own injury, then the employee was not entitled to recover damages for his injury.  The negligence of a fellow employee defense stated that an employer was not liable for an injury to an employee that resulted solely from the negligence of a fellow employee. 

Note that these defenses were very difficult to overcome in court and, since many employees had very little, if any, savings, it was virtually impossible for them to hire an attorney.  As a result, injured employees and their families often ended up in the poorhouse. 

Starting in 1911 with Wisconsin, each state began to pass workers compensation statutes that amounted to a trade-off between the employer and the employee.  Under these statutes, the employers agreed to give up their common law defenses and, in return, enjoyed a limitation on their liability for weekly indemnity and medical benefits.  Employees gained by receiving “no fault” benefits if injured on the job.  Each state individually passed its own workers compensation statute and, in 1927, 

Congress passed the U.S. Longshore and Harbor Workers Compensation Act, providing benefits to longshoremen, who were not covered under the individual states’ statutes. 

Key Workers Compensation Laws 

Even though all 50 states and the District of Columbia now have workers compensation laws, and each law has the same basic objective of providing no-fault benefits to workers injured on the job, no two states’ workers compensation laws are the same.  In fact, variances are the norm.  Thus, the following discussion is general in nature.  Key workers compensation laws include the following: 

• Compulsory versus Elective Workers Compensation Laws 

• Exclusive remedy 

• Covered Employments 

• Number of Employees 

Compulsory versus Elective Workers Compensation Laws 

The vast majority of state workers compensation laws are compulsory, meaning that an employer must accept the law and pay workers compensation benefits, as specified by that state, to an injured employee who is covered under the law. 

Two states—Texas and New Jersey (in New Jersey, employers are required to purchase either workers compensation coverage or employers liability coverage)—currently have elective workers compensation laws, meaning that an employer has the choice of either accepting or rejecting the workers compensation law.  However, if an employer in one of these states decides to reject the law and an injured employee brings a negligence suit against the employer, the employer will be denied the use of the three common-law defenses of assumption of risk, contributory negligence, and negligence of a fellow employee.  In practice, because of the threat of facing a large liability suit without these three defenses, few employers in these states reject the workers compensation law. 

Exclusive Remedy 

Every state’s workers compensation law contains an exclusive remedy provision that stipulates that the benefits prescribed in the act are the sole remedy against the employer for covered injuries sustained on the job.  Note that many states, however, allow suits against the employer when the injury was intentionally caused by the employer.  Under these circumstances, most states deprive employers of the normal common-law defenses (assumption of risk, fellow-servant liability, and contributory negligence) against such allegations. 

Covered Employments 

In every state except Wyoming, the workers compensation act applies to all employments except those that are specifically excluded; Wyoming takes the opposite approach of listing those employments that are covered by the act.  Generally, exceptions apply to very small employers, employees performing specified types of work, or employees who work on a casual basis. 

Number of Employees 

Employers with less than a specified number of employees (typically three, four, or five) are exempt from the workers compensation law in 14 states.  However, in many of these states, numerical thresholds do not apply to construction industry employers.  In these states, contractors are subject to the act if there is even one employee. 

The Workers Compensation and Employers Liability Policy 

Benefits provided to employees are covered by the standard workers compensation and employers liability policy in most states.  This standard form was drafted by the National Council on Compensation Insurance (NCCI) and filed with most states on behalf of insurers.  Today’s workers compensation policy includes a general section, which is followed by six basic coverage parts. 

Endorsements are also a key part of the entire policy.  All of these coverage pieces are briefly addressed below. 

General Section 

The General Section begins by establishing that references in the policy to “you” mean the insured, and references to “us” or “we” mean the insurer.  The use of such terms is in keeping with most “plain English” policies.  The General Section then goes on to establish who is insured under the policy, what locations are covered, and the definitions of the important terms “workers compensation law” and “state.”  For example, the “insured” is the employer listed in Item 1 of the Information Page. 

Part One—Workers Compensation Insurance 

Part One provides coverage for the statutory liability of the employer under the specified state statutes.  Rather than insuring a specific individual or a class of individuals, the employer insures the liability created by state statutes.  However, some employees—such as domestic help and agricultural employees—as well as sole proprietors/partners are often excluded under the law and have to be specifically added to the policy for coverage to apply.  Since the state statute establishes how much injured workers receive in benefits, there is no limit of liability applicable to this coverage.  

Under workers compensation insurance, the insurer agrees to “pay promptly when due the benefits required of you by the workers compensation law” as long as the bodily injury or the last exposure to the conditions that cause or aggravate the occupational disease occurs during the policy period.  Because of this provision, a workers compensation policy can cover claims made long after its expiration date and therefore should never be discarded. 

Part Two—Employers Liability Insurance 

Part Two provides coverage for any liability to an employee presented to the employer under common law.  Such coverage is known as employers liability insurance.  It applies in those few situations where the employee can elect not to come under the workers compensation statute.  In most states, if the employee decides to press a common law liability suit, benefits under Part One are forfeited.  This coverage does have limits of liability.  There is an “each accident” limit which applies to all claims arising from a single accident, a “bodily injury by disease” limit applicable to each ill employee, and a “bodily injury by disease” aggregate limit, which is the maximum payable under the policy for all ill employees. 

Part Three—Other States Insurance 

Part Three provides for statutory benefits when employees can press claims in states other than those where they are working.  This “other states” coverage may come into play when, for example, an employee is injured while traveling in a state that provides higher benefits than the state in which he or she normally works.  This coverage should be structured to apply to all states except those specified in Part One and the monopolistic fund states addressed later in this chapter.  Note, however, that this coverage is only intended when there is incidental exposure in a state not scheduled for coverage under Part One.  When a company begins to operate in a state not scheduled for coverage under Part One, this information should be provided to the insurer. 

Part Four—Your Duties If Injury Occurs 

In the event of an injury that may be covered by the policy, the insured has the following duties. 

• Notify the insurer of the injury “at once.” 

• Supply the insurer or the insurer’s agent with the names and addresses of the injured parties and the witnesses and any other information the insurer may require. 

• Promptly give the insurer all notices, demands, and legal papers concerning the claimant’s suit. 

• Cooperate with the insurer and assist the insurer, if necessary, in investigating, settling, or defending a claimant’s suit. 

• Do nothing after an injury occurs that would interfere with the insurer’s right to recover from others. 

• Make no voluntary payments, assume no obligations, and incur no expenses, except at the insured’s own expense. 

• Provide immediate medical attention and any other services that are required by the workers compensation law. 

Part Five—Premium 

This section contains basic information regarding the calculation of the policy premium.  It describes how premiums are calculated according to the insurer’s manuals and how any changes in the manual can be applied to the policy if authorized by law or a governmental agency regulating workers compensation insurance.  It briefly describes the classification system used to establish employment classes for rating purposes and states that the classifications shown on the Information Page may be changed, via endorsement, if they do not accurately describe the work the insured engages in during the policy period. 

Part Six—Conditions 

The workers compensation policy contains several conditions, such as inspection, long-term policy, transfer of your rights and duties, cancellation, and sole representative. 

Workers Compensation 

Workers Compensation Policy Conditions 

Condition Description 

Inspection 

The insurer has the right to inspect the insured’s workplace in order to help determine the insurability of the workplace and premium to be charged.  However, the insurer is in no way obligated to perform such inspections. 

Long-term policy 

If a policy is issued for a period longer than 1 year and 16 days, the provisions of the policy will apply as if a new policy were issued on each anniversary date. 

Transfer of your rights and duties 

The insured’s rights or duties under the workers compensation policy cannot be transferred to another without the written consent of the insurer. 

Cancellation 

The insured can cancel the policy by simply mailing or delivering an advance written notice to the insurer that states when the coverage is to be terminated.  In order to cancel the policy, the insurer must give the insured not less than 10 days’ advance written notice.  However, if state law requires a longer notice of cancellation, the policy is changed to comply with that law. 

Sole Representative 

If there is more than one insured listed in the policy, the first insured named in Item 1 on the Information Page is authorized to act on behalf of the other insureds to change the policy, to receive unearned premium, and to give and receive notice of cancellation. 

Endorsements 

Modifications to the standard workers compensation and employers liability policy can be made by attaching a variety of standard and nonstandard endorsements to the policy.  Standard endorsements promulgated by the National Council on Compensation Insurance (NCCI) are commonly used to make certain modifications, such as adding a waiver of subrogation, broadening the definition of named insured, adding coverage for benefits payable under federal acts, and specifying coverage for joint ventures, to name a few. 

NCCI’s portfolio of standard endorsements is divided into the following categories. 

• Federal coverage endorsements 

• Maritime coverage endorsements 

• Other coverage and exclusion endorsements 

• Premium endorsements 

• Retrospective premium endorsements 

• Miscellaneous 

Workers Compensation Insurance Markets 

Depending on the state(s) where the business operates, workers compensation insurance is available from the following sources. 

• A monopolistic state fund 

• The voluntary private market 

• A competitive state fund organization 

• A state residual market plan 

Monopolistic State Funds 

In North Dakota, Ohio, Washington, West Virginia, and Wyoming, employers are required to purchase workers compensation coverage through a state workers compensation insurance fund.  These state funds are referred to as monopolistic state funds because the state fund is the only workers compensation insurer in these states.  Insurance companies are not involved in the workers compensation insurance systems in these jurisdictions. 

The Voluntary Private Market 

In all but the five monopolistic states, businesses can purchase workers compensation insurance from insurance companies that are licensed to write workers compensation insurance in the state.  Virtually all insurers that write other types of insurance for businesses (commercial property, commercial general liability, and commercial auto insurance, for example) also write workers compensation insurance. 

Competitive State Funds 

In approximately 20 states, employers also have the option of purchasing workers compensation insurance from a competitive state fund organization, an insurance facility established and (initially at least) funded by the state that competes with insurance companies for workers compensation business in that state only.  These competitive state fund organizations have been established in hopes of reducing the premiums businesses pay for workers compensation insurance.  In some states, the competitive state fund also serves as the state’s “market of last resort.” 

Residual Market Plans 

Employers that are unable to purchase workers compensation insurance in the voluntary private market can purchase it from the state residual market facility.  In about two-thirds of the states that have competitive state fund organizations, the competitive state fund serves as the state’s residual market facility.  In these states, the state fund must offer coverage to all eligible employers who apply, and there is no separate residual market facility.  In the majority of the remaining jurisdictions, the residual market facility is what is most often referred to as a state-assigned risk plan.  Assigned risk plans are state-mandated programs in which all insurers that write workers compensation insurance in the state must participate. 

Rating the Workers Compensation Insurance Policy 

Workers compensation insurance premiums are unwieldy to compute, and variations in methods exist across states.  However, the basics are similar and worthy of discussion.  Thus, this section will provide an overview of the fundamentals of the exposure base, classification, calculating the estimated annual premium, experience modification, loss constants, premium discounts, expense constants, minimum premium, and premium discount.  A numerical example of an estimated annual premium calculation will then be provided. 

Exposure Base 

The exposure base for workers compensation insurance is payroll.  An estimated payroll, based on historical records and expectations for the current period, is used to determine an estimated premium at the beginning of the policy period.  At policy expiration, the insured’s actual payroll records are audited to determine the final premium.  The insured will usually pay an additional premium or receive a premium refund or credit at that time. 

Classification 

The next step in calculating the workers compensation premium is to determine the operation of the employer, which in turn determines the appropriate classification(s) of the covered employees.  Classifications are designed to categorize employers who have common types of exposures.  The classification is then structured to rate the entire business of the employer, not the individual occupations of employees within the firm.  For example, a radio station employs disc jockeys, producers, advertisement salespersons, clerical staff, and technical personnel.  These employments are common to any radio station, and no radio station is considered particularly more hazardous than another; therefore, all radio stations will be classified under the same code.  The rates will vary based on the classification; for example, a contractor would likely have a higher rate than a retail operation because construction work is inherently more dangerous than retail work. 

Calculating Estimated Annual Premium 

Workers compensation insurance rates have traditionally been heavily regulated.  The NCCI, or an alternate rating bureau approved by the state, would compile industry wide loss and payroll information for each employee classification, project estimated losses for each classification, add an allowance for insurer expenses and profits, and issue advisory rates that all insurers were required to use in that state.  (Monopolistic states will not publish rates, since employers must purchase coverage from the state fund.)  Deviations from state-made rates had to be approved prior to use in most states. 

While a few states are still “administered pricing” states, the trend in the 1990s has been toward “competitive rating,” where insurers are allowed to determine their own rates.  The goal of competitive rating is to promote competition in the workers compensation insurance market.  Most competitive rating states still provide some form of advisory data for insurers to use as benchmarks or starting points in determining rates.  A few competitive rating states continue to publish advisory rates, but generally insurers do not need approval to deviate from the published rates.  Most competitive rating states, however, now publish only the loss costs, or “pure premium” component, for their respective states.  Each insurer then determines a multiplier that will be applied to the loss costs to determine a final rate.  

Rates are quoted per $100 of payroll.  A preliminary unmodified premium is determined by multiplying the appropriate rates by the premium basis (covered payroll divided by $100).  Depending on the employer’s size and the state of operation, some combination of additional factors must be applied to the unmodified premium to arrive at the estimated annual premium.  These factors include an experience modifier, an expense constant, a minimum premium, and a premium discount. 

Experience Modification 

Experience rating is a method of modifying employers’ workers compensation premiums based on their own loss history.  An experience modifier is an employer-specific multiplier that measures its loss experience relative to that of other employers in the same industry.  The experience modifier is applied to the unmodified premium to adjust for prior loss experience.  A modifier of 1.0 indicates average loss experience, and will consequently produce a modified premium that equals the unmodified premium.  A debit modifier (greater than 1.0) indicates higher-than-average losses and produces a corresponding increase in the premium.  Similarly, a credit modifier (less than 1.0) reduces the employer’s premium. 

Expense Constant 

The expense constant is designed to cover administrative expenses, such as issuance, record keeping, and auditing, that are common to all workers compensation policies, regardless of the amount of premium generated.  Expense constants range (and this is subject to change) roughly from around $120 to $250 per policy. 

Minimum Premium 

The minimum premium is the lowest premium required to issue a standard workers compensation policy for a period of 1 year.  Minimum premiums are required only in states that issue advisory rates.  States that have switched to loss costs no longer require minimum premiums.  Minimum premiums vary substantially across classification; however, most states have a “maximum” minimum premium that falls in the $500-$750 range. 

Premium Discount 

A premium discount acknowledges that the expenses associated with writing an insurance policy increase at a decreasing rate as premium increases.  The relative cost of issuing and servicing a policy, therefore, is smaller for policies generating large premiums than for those generating small premiums.  Premium discounts often apply to policies generating a premium (exclusive of the expense constant) of more than $5,000.  Discounts are granted at a graduated rate as premium increases.