Comprehensive Notes on Property Insurance Basics

Property Insurance Basics

Overview

• Property insurance (sometimes called fire insurance) provides financial protection for damage to or loss of:

  • Real property (buildings)

  • Fixed property

  • Personal property

• A property policy is a two-party contract between:

  • First party: insured

  • Second party: insurer

• Property insurance is often regarded as first party insurance because it covers loss to the insured's own property from covered perils.

• When a claim is submitted, the insured acts as a first-party claimant.

Learning Objectives

• Define basic property insurance terms.

• Recognize the types of property losses.

• Define the scope of coverage.

• Identify types of loss valuation.

• Recognize the methods of determining appropriate property insurance limits.

• Apply important property insurance provisions and conditions.

Property Insurance Terminology

Fire Protection

• Fire is an essential covered peril.

• Policies cover damage from a hostile fire:

  • A fire that burns outside its intended boundaries.

  • A fire that becomes uncontrollable.

• Property insurance does not cover damage from a friendly fire:

  • A fire that was intentionally set.

  • A fire that stays within its intended boundaries.

• Example:

  • Friendly fire: fire in a fireplace.

  • Hostile fire: a spark from a fireplace ignites furniture, wildfire.

Theft

• Property policies may exclude or provide coverage for theft, depending on the type of theft.

• Theft: any act of stealing, including burglary and robbery.

• Burglary: taking property from inside a premises by forcibly entering or exiting the property.

• Robbery: taking property from the care and custody of a person who has been threatened with bodily harm.

• Mysterious disappearance: when property goes missing and the cause of loss is unknown and may be excluded by property policies.

Crime Definitions

• Burglary: Taking property by forcibly entering/exiting the property.

  • Signs of force must be visible (e.g., broken lock, window).

• Robbery: Taking property from someone's care/custody by harming/threatening them.

  • Force is threatened or used against a person.

• Theft: Any act of stealing (broad term including burglary and robbery).

• Mysterious Disappearance: Cause of loss is unknown.

  • No physical evidence of burglary, robbery, or theft.

Examples of Crimes

• Robbery: Armed thief threatens bank tellers and demands money.

• Burglary: Thief breaks into a locked vault in a bank, causing property damage.

• Theft: Customer takes another's wallet (seen on security camera).

• Mysterious Disappearance: Ring goes missing after a party, no proof of theft.

Occupancy and Vacancy

• Occupancy: A property contains personal property but has no occupants.

• Vacancy: A property contains no personal property and has no occupants.

• Vacancy provision: Specifies how coverage is affected after an extended period of vacancy (typically >60 days).

Bailor and Bailee

• Bailee: A person/organization that has taken the property of another into their care, custody, or control for servicing, repair, or storage.

• Bailor: The person who retains ownership of the property in the bailee's care.

• No Benefit to Bailee Condition: Property insurance policies exclude coverage that would benefit a bailee; bailees are legally responsible for property in their care.

Types of Property Losses

Categories of Losses

• Real Property:

  • Residential dwellings, commercial buildings, detached garage.

• Personal Property:

  • Furniture, machinery, merchandise.

• Rights of possession or use.

Direct and Indirect Losses

• Direct Loss: Immediate result of a peril; policies typically require a direct physical loss to covered property.

• Indirect Loss (Consequential Loss): A consequence of a direct physical loss.

  • Financial losses such as loss of income or additional expenses during repairs.

• Example:

  • Direct Loss: Hailstorm damages a hotel.

  • Indirect Loss: Loss of use and income due to shutdown for repairs.

Causes of Loss

Proximate Cause

• Primary cause of loss.

• If only one peril: the first event in an unbroken chain of events that resulted in loss.

• If multiple perils: the one with the most significant impact in generating the loss.

• The proximate cause must be a covered peril for coverage to apply.

• Example:

  • A house fire causes fire, smoke, and water damage. The fire is the proximate cause, and a fire insurance policy would cover all resulting damage.

Concurrent Causation

• When two perils simultaneously cause a loss, the insurer must pay even if one peril is excluded.

• Example:

  • A homeowner's policy covers fire but excludes earth movement. An earthquake causes a wire to short, starting a fire. Under concurrent causation, the fire damage would be covered.

Inherent Vice

• A quality within property that causes it to damage or destroy itself (e.g., spoiled food, rusting, wear and tear).

• Inherent vice is not covered by property policies.

Scope of Coverage

Named Perils Coverage

• Provides insurance only for causes of loss listed in the policy.

• If the peril is not named, there is no coverage unless added by endorsement.

• The insured has the burden of proof to demonstrate that the loss was caused by an insured peril.

Open Perils Coverage (All Risk Coverage)

• Provides insurance for all causes of loss that are not specifically excluded.

• The insurer has the burden of proof to demonstrate that a loss was caused by an excluded peril.

Common Forms of Coverage

• Basic and Broad Forms: Named perils coverage (broad form covers more perils).

• Special Forms: Open perils coverage.

Methods of Valuing Losses and Writing Limits

Loss Valuation

• A property policy pays for losses based on the valuation method in the policy.

Actual Cash Value (ACV)

• Pays to repair or replace damaged property at the time of loss, minus depreciation.

Replacement Cost

• Pays the full cost to repair or replace damaged property with like kind and quality at current pricing, without deducting depreciation.

• Many policies require the property to be insured to a certain percentage of its replacement value (e.g., 80%).

• Available via endorsement for policies that automatically pay ACV.

• Example:

  • A TV purchased 5 years ago for $1,500$ is destroyed by fire. It has a useful life of 10 years. A comparable TV costs $2,000$. With replacement cost coverage, the insurer pays $2,000$. With ACV coverage, the insurer pays $2,000 - (0.5 \times 2,000) = 1,000$.

Functional Replacement Cost

• Used for properties with obsolete materials/techniques (e.g., older dwellings).

• Pays to replace the property with its functional equivalent.

Agreed Value

• The policy limit is paid in the event of a total loss, regardless of the actual cash value.

• Useful for articles difficult to replace or value (e.g., vineyards, paintings, classic cars).

• Policies written on an agreed value basis are sometimes called valued policies.

Stated Value

• The insurer bases the premium on the insured's statement of the property's value.

• The insurer pays the lesser of the stated amount and the actual cash value at the time of loss.

• More affordable, but the property may not be fully insured.

Market Value

• The price a willing buyer would pay a willing seller under fair market conditions.

• Used for goods/commodities whose value fluctuates (e.g., agricultural products).

Salvage Value

• The amount property can be sold for at the end of its useful life (scrap value of damaged property).

Loss Settlement Condition

• Loss settlement condition specifies how the insurer will settle claims based on a particular loss valuation method.

• Methods offer various ways for insurers to determine the monetary value of property at the time of the loss and how much the policyholder is owed for the covered claim.

Agreed Value

• If an insurance policy covers property that is difficult to value or replace, the policy may settle losses on an agreed value basis, insurer and policyholder agree on a specific limit of insurance.

Stated Value

• However, stated valuation gives the insurer an option when it comes time to pay a claim: The insurer may pay the stated value or the actual cash value of the damaged property at the time of loss, whichever is less.

Property Insurance Limits

Specific Limit

• Ensures a single item of property for a single limit of insurance.

Blanket Limit

• Ensures multiple items of property for a single amount of insurance.

  • Properties could be at different locations and/or different types of property.

Deductible

• The insured pays a specified amount of each loss.

• Common in property insurance, less common in casualty/liability.

• Underwriting tool used to reduce small claims.

• Larger deductible = reduced premium.

Types of Deductibles

• Straight Deductible: Flat amount retained by the insured, regardless of the amount of loss.

• Franchise Deductible: Loss must equal or exceed a specified amount; after which, the loss is paid in full.

• Percentage Deductible: The amount retained is calculated as a percentage of the property value or the policy limit (often used with windstorm/hurricane losses).

• Examples:

  • Policy A: $250$ straight deductible. A $1,000$ loss results in a $750$ payment.

  • Policy B: $250$ franchise deductible. A $2,000$ loss results in a $2,000$ payment.

  • Policy C: 5% percentage deductible for windstorm losses. Policy limit is $100,000$. A $10,000$ windstorm loss results in a $5,000$ payment $10,000 - (0.05 \times 100,000) = 5,000$.

Common Property Policy Conditions

Insurance to Value

• The amount of insurance sufficient to cover a total loss.

• Lack of full insurance to value increases the risk of financial loss.

Coinsurance Provision

• Requires the insured to carry a percentage of the property's total valuation (usually 80%) for losses to be paid in full.

  • If the insured carries less, the policy pays an amount proportionate to the insurance carried.

• Coinsurance Formula:

  • Amount of Insurance Required = Coinsurance Percentage * Current Replacement Cost

  • Amount Payable (before deductible) = (Amount of Insurance Carried / Amount of Insurance Required) * Amount of Loss

• Coinsurance only applies to partial losses; in a total loss, the policy pays up to its limit.

• Example:

  • A building valued at $100,000$ is insured for $40,000$ with an 80% coinsurance provision. A fire causes a $10,000$ partial loss.

  • Insurance Required: $0.80 \times 100,000 = 80,000$

  • Amount Payable: $(40,000 / 80,000) \times 10,000 = 5,000$

  • The policy pays $5,000$, because the building was underinsured. If the building was insured for $80,000$ or more, the policy would have paid the full loss.

Insurer Provisions

Loss Settlement

• Specifies which loss valuation method applies.

• Payment is based on valuation method, but the insurer is not liable beyond the actual amount to repair, rebuild, or replace the damaged property.

• Also subject to the appropriate policy limit.

Loss Payment

• Specifies how the insurer will make payment and time frames for submitting claim documents.

Named Insured Provisions

Abandonment of Property

• The insured surrenders damaged property to the insurer for repair/disposal, which is prohibited.

• Arranging for repair/disposal is the insured's responsibility.

Third Party Provisions

Mortgage Clause

• Protects a mortgagee's financial interest in property policies.

• Payment can be made to mortgagees up to their insurable interest, in order of precedence.

• A mortgagee's interest is separate from the insurance; mortgagees may receive payments even if the insured's actions result in coverage denial.

• Mortgagee Requirements to collect under the policy, despite denial of the insured's claim:

  1. Pay any premium due under the policy on demand if the insured fails to do so.

  2. Notify the insurer of any change in ownership or occupancy or any substantial change in risk of which the mortgagee is aware.

  3. Submit a proof of loss to the insurer if the insurer fails to do so, typically within sixty days after receiving notice that the insured failed to do so.

• The insurer must give the mortgagee advance written notice (typically 10 days) before canceling/nonrenewing due to the insured's failure to pay the premium.

• Example:

  • An insured buys a home for $300,000$ with a $50,000$ down payment $250,000$ mortgage and insures it for $300,000$. A total loss by fire occurs.

  • The insurer would pay $250,000$ to the mortgagee and $50,000$ to the insured (if the insured complies with policy terms).

  • Even if the insured violated policy terms, the mortgagee can still be protected and receive up to $250,000$ by paying the premium.

• Bankruptcy of Insured: Mortgagee's interests continue to be protected in most cases.

  • The insured must report the claim to bankruptcy court, which will provide instructions on how bankruptcy law affects property claim payments.