Insurers and policyholders should heed the critical insurance issues that arise in the aftermath of natural disasters.
Over the past two months, Hurricanes Harvey and Irma battered Texas and Florida, and Typhoon Hato brought calamity to southern China, Hong Kong, and Macau. In addition to the tragic loss of life, property damage and business interruption losses resulting from these catastrophes are estimated in the tens of billions of dollars, and businesses are likely to run into complex insurance issues in the coming days and months.
Morgan Lewis Stamford has acted on behalf of various stakeholders in the handling, presentation, and assessment of property damage as well as bodily injury and business interruption insurance claims arising from natural catastrophes such as earthquakes, hurricanes, typhoons, and flooding. We have worked closely with claims managers, loss adjusters, forensic accountants, brokers, and technical experts to assess policy liability, quantify the indemnity payable, advise on interim payments, and secure payment from reinsurers.
We examine in this LawFlash a typical “nat-cat” claim lifecycle and discuss five key steps in handling a claim effectively from notification of loss to settlement. We then turn to the critical claims handling issues arising from nat-cat insurance claims.
1. The “Nat-Cat” Claim Lifecycle
Effective Claims Handling
The phalanx of issues that typically arise in the aftermath of a natural catastrophe underscore the importance of proper and effective claims handling and particularly close cooperation and open communication between the policyholder and insurer.
First, following notification of the loss by the policyholder or its broker, the focus is on loss mitigation. The policyholder and its insurers must consider whether any surviving property can be saved, whether any damaged property can be repaired, or must be replaced, and how the business can continue to operate, if at all, to minimize interruption and loss of profits.
Second, the most efficient method of repair, without compromising the quality of the repair, must be agreed. This will usually require the assistance of experts or consultants. If the property cannot be repaired, the policyholder and loss adjuster should agree the salvage value, the most appropriate replacement equipment, and any issues of betterment.
Third, the policyholder and adjuster should identify the documents and information relevant to the loss. This exercise is particularly important in business interruption claims because, in projecting the future performance of the business, it is necessary to review historical performance and then make adjustments for seasonal fluctuation or other events.
Fourth, based on the documents and information provided, the loss adjuster will produce a preliminary report setting out its views on the amount of the indemnity for the insurers’ consideration. The policyholder should be provided with copies of the loss adjuster reports to understand the insurer’s quantification of the claim. If liability is admitted, insurers should be requested to make an interim payment of up to 50% of their quantification of the claim.
Fifth, following the final adjustment of the claim, the insurer will present the insured with a full and final settlement offer. The final adjustment may take time given that the costs of repair, replacement, and the interruption to the business may not crystallize for some months after the natural catastrophe has occurred. Some allowance may be made for claims preparation costs and interest if covered by the policy.
In summary, insurers are well equipped to handle natural catastrophe claims. They are able to call on the assistance of experienced loss adjusters and technical experts to understand the policy and adjust the claim. The policyholder should also retain legal counsel as well as technical and forensic accounting experts at an early stage. This assistance is critical in working with loss adjusters to ensure the reasonableness of the indemnity and fair compensation for the loss.
2. Critical Nat-Cat Insurance Claims Handling Issues
Wide area events such as hurricanes and flooding often involve six critical insurance issues: (i) underinsurance (or average); (ii) loss mitigation; (iii) depreciation; (iv) betterment; (v) salvage; and (vi) business interruption and the impact of wide area damage.
Underinsurance and Average
Underinsurance is always a critical issue in wide area damage claims. It often arises when the policyholder’s asset registers do not reflect the (greater) actual value or the (much greater) replacement value of the policyholder’s property. As a result, the premiums paid and the sums insured are inadequate and insurers would be entitled to apply “average” by reducing the claim amount in accordance with the following percentage calculation:
SUM INSURED/ACTUAL OR REPLACEMENT VALUE X 100%
Policies containing average relief clauses enable some policyholders to avoid the application of average if the sum insured exceeds that percentage specified within the average relief clause. However, if the total sum insured is less than the threshold percentage, average will be applied to the whole claim, significantly reducing the amount of the indemnity.
Depreciation is the reduction in value of an insured item based on age, condition, wear and tear, obsolescence, and design life. It is calculated using the Straight-line or Reducing Balance methodologies and produces the actual (or indemnity) value of the insured property at the time of the loss. The indemnity value enables insurers to calculate whether the insured property is adequately insured and, if it is under insured, whether average should be applied.
Insurers and policyholders can disagree as to a reasonable rate of depreciation in circumstances where the policies do not contain any depreciation calculation methodology. As a compromise, both the Straight-line and Reducing Balance methodologies may be employed to produce a depreciation range that both the policyholders and insurers consider as reasonable in arriving at the indemnity value of the damaged property.
Policyholders are obliged to use reasonable care to prevent additional damage, and reduce the loss incurred, following an insured event. For example, they should source alternative power generators, suppliers, and distributors to keep their businesses operational. In return, the insurers are obliged to pay for the costs of mitigation provided that such steps were reasonable, whether or not the actual damage or loss to the business was reduced or prevented. In the aftermath of the event, it is important that the policyholder clearly document the steps taken to mitigate loss and damage to satisfy insurers that all reasonable steps had been taken.
Salvage is a form of mitigation. It is the amount that a prudent policyholder should recover in respect of damaged property. If the property is destroyed, the salvage value may be little more than the scrap value or a small percentage of the claimed amount. Loss adjusters will look to confirm that the policyholder has taken all reasonable steps in the circumstances of the loss in (i) determining that any damaged property could not be repaired; and (ii) securing a reasonable salvage value of that destroyed property.
The salvage value of damaged or destroyed property would often be dependent upon the nature of the policyholder’s business, the age and nature of the damaged property, and the facts and circumstances in the aftermath of the loss, such as the extent of similar equipment now on the salvage market. Valuation experts are frequently engaged to assess the salvage or scrap value that may be recovered from the insured event.
One of the cornerstones of insurance is that the policyholder should be placed in the position it would have enjoyed had the loss not occurred. In practice, this means that if the insured property is beyond repair and replaced with something better, an adjustment will be made to the amount of the indemnity paid to ensure that the policyholder is not enriched as a result of the loss. How, then, is that adjustment to be calculated?
In calculating betterment, insurers may take a broad brush approach in arriving at the percentage adjustment. A more scientific approach is to identify the particular factors that make the replacement property “better” and then apply a weighting to the factors identified.
For example, the relative performance of the original and replacement machinery may be compared to account for energy and production efficiency, maintenance and labor costs, depreciation, and other factors that impact the long term value of insured equipment. The criticality of the insured property to the policyholder’s business may then be considered to produce a percentage range reflecting the improved performance of the new machinery.
The percentage range reflecting the improved performance of the new machinery, and its impact on the insured business, may then be applied to adjust the claim for betterment.
Business Interruption or Loss of Profits
The business interruption or loss of profits claim can often exceed by several multiples the property damage claim depending on the extent of the cover secured.
Some policies provide for business interruption losses to be paid until such time that the results of the business return to the pre-incident state. Others provide for business interruption losses to be paid only up to the date the damaged property and machinery have been repaired and returned to service. As such, care must be taken to understand the scope of cover, the length of the indemnity period, and how the indemnity is to be calculated.
Given the scale and complexity of business interruption losses, policyholders should consider engaging the broker, forensic accountants, and legal counsel to ascertain the extent of the indemnity provided by the policy and the amount of the indemnity payable. An independent quantification will enable the reasonableness of the adjustment to be assessed.
Wide Area Damage
Many natural catastrophes give rise to wide area damage. Coupled with complex supply and customer chains of modern manufacturing industry, this damage often leads to numerous insured and uninsured events causing or contributing to the business interruption loss. Insured and uninsured causes can have a significant detrimental consequence on the amount of the indemnity payable. Some legal authorities have held that by reason of uninsured causes, the insured property damage did not result in any loss of business. As such, the amount of the indemnity was significantly reduced or extinguished entirely.
It is important to check that the policy provides for wide area damage cover or, alternatively, to ensure that any uninsured suppliers or customers do not have a material impact on the loss of profits or the business interruption. If they do, then the policyholder may want to consider a proportional approach to the calculation of the indemnity payable for the interruption.
Resolving claims efficiently requires the insurer and policyholder to understand the issues impacting the amount of the indemnity. While insurers have the expertise and experience to deal with claims handling issues associated with natural catastrophe claims, policyholders may not. Policyholders would be well equipped to understand and resolve the most complex claims if they retain legal counsel as well as technical and forensic accounting experts at an early stage.