Property Insurance – A Primer

Introduction

All persons having an interest in real estate containing a building or other improvement, whether as owner (landlord), tenant, manager or lender, need to be concerned about property insurance. There are few contracts involving property (whether leases, purchase agreements, property management agreements or otherwise) that do not have insurance provisions. These contracts often use insurance industry terms that may not be familiar to most people. The purpose of this article is to describe the types of property insurance and certain information about property insurance, including important but infrequently used options and amendments that are available. Hopefully this will assist the reader in reviewing insurance requirements and making better and more informed decisions about the appropriate insurance in each case.

A. Perils Insured Against

The most important distinction between the different forms of property policies is derived from the perils insured against and results in three basic types of property policies.

1. Fire Policy

The fire policy insures only against loss from the perils of fire, lightning and explosion of natural, coal and manufactured gas. The fire policy is the original property policy. Because of its limited coverage, it is rarely used today.

2. Fire and Extended Coverage Policy

The Fire & E.C. (“Fire & E.C.”) policy extends the coverage of the fire policy to include certain additional risks including:

• smoke;
• impact by aircraft or land vehicles;
• riot;
• vandalism or malicious act;
• sprinkler leakage; and
• windstorm or hail.

If a building is not classified as a preferred risk, there is no coverage for vandalism and malicious acts causing damage; however, vandalism and malicious damage can be covered by specific endorsement.
Some policies may expand the coverage. For example, the coverage of Factory Mutual insures against the following additional perils:

• acts of destruction by civil authority to prevent the spread of fire;
• accidental discharge, leakage, backup or overflow of liquids originating on the premises;
• heat from molten material accidentally escaped from equipment;
• radioactive contamination from materials or processes conducted on the premises; and
• volcanic eruption.

Coverage of these additional perils may be important, especially having regard to operations that may be conducted on the premises.

The coverage under a Fire & E.C. policy is subject to a number of exclusions, such as war and related activities, changes in by-laws preventing repair to pre-loss condition and loss caused by vehicles belonging to or under the control of the insured. Many exclusions may be deleted, often without extra cost. Other exclusions may be covered by other insurance, for example, the exclusion of explosion of pressure vessels owned, operated or controlled by the insured may be covered by boiler and machinery insurance and the exclusion of loss due to theft may be covered by crime coverage.

3. All-Risk Policy

The all-risk policy insures against all property loss perils, subject to exclusions, and generally provides broader coverage than the Fire & E.C. policy. The perils that are excluded under different policies will differ depending upon the insurance company and on the activities carried on by the insured. The following are some examples of exclusions:

• earthquake, snowslide, landslide, subsidence and flooding by the overflow of any body of water, except for ensuing loss or damage which results from fire, explosion, smoke or leakage from fire protection equipment;
• smoke from industrial operations;
• wear and tear; and
• the cost of making good faulty or improper material or workmanship.

Certain exclusions may be covered by another policy specifically designed for the peril, for example, employee theft and explosion of pressure vessels.

B. Type of Property Insured

Coverage under a property policy generally includes building, equipment, stock (product intended for sale) and contents. Coverage of any type of property is optional, so that, for example, an insured who owns a number of buildings could limit coverage to buildings only at one location and equipment and stock only at another location (where the insured may be a tenant in a building that the landlord carries insurance on).
The property covered is subject to exclusions, including the following:

• money, bullion, securities, evidence of debt or title;
• watercraft (except stock held for sale);
• licensed vehicles; and
• aircraft.

Other types of policies offer coverage of these types of property.

There is an exclusion for property at locations that, to the knowledge of the insured, are vacant, unoccupied or shut down for more than 30 consecutive days. An endorsement permitting vacancy may be available.

It is important to note that most all-risk policies exclude more types of property than are excluded by the standard Fire & E.C. policy. Many of the additional exclusions may be deleted and, in some cases, at no additional premium cost. Examples of additional property exclusions in all-risk policies include sewers, drains or watermains located beyond the outside walls or foundations of the property insured, plants (except for decorative purposes within buildings), animals, fur garments and jewellery.

C. Basis of Settlement

In the event of an insured loss, the basis of settlement in the policy is an important factor governing the amount recoverable.

1. Actual Cash Value

Actual cash value is the purchase price less physical depreciation plus market appreciation, or in other words, the price at which property of the same type, age and condition can be purchased. This basis of recovery is not suitable where such property is not available for purchase.

2. Replacement Cost

Replacement cost means the amount of the recovery should be adequate to replace the property with new property of the same type and quality. Usually, if there is no replacement or if replacement is not carried out with due diligence and dispatch, the basis of settlement will revert to actual cash value. Also, often replacement must be on the same site or an adjacent site, which may cause hardship if there have been changes in building restrictions preventing construction of the same or similar buildings. This same-site condition may be deleted.

3. Valued Amount

In this case, the value of the property is set out in the policy as the amount to be paid in the event of a total loss. This method eliminates the need to determine value at the time of loss. Property such as antiques and works of art is often insured on this basis. In the event of a partial loss, the loss as a percentage of the valued amount must be established.

4. Selling Price

The selling price basis of settlement applies to finished product intended for sale. Recovery is based on the selling price at the time of loss and therefore includes profit on potential sales.

D. Policy Limits

1. Scheduled Limits and Blanket Limit

Separate limits, referred to as scheduled limits, may be established for each building, piece of equipment or other property insured. Separate limits may be set for the total value of equipment or stock in a building, a building including its contents or for each location (regardless of the number of buildings at the location).

As an alternative, a blanket limit may be used for all property insured by the policy. The limits are normally set at a level that represents either the total value of the property at the location of highest value (“limit of loss limit”) or the total value of all property insured by the policy (“100% blanket limit”), which provides full protection.

Scheduled and blanket limits may be combined in the same policy for different classes or groups of property.

2. Co-Insurance

If an insured is comfortable that any loss to its property will only be from partial damage, it could attempt to reduce its costs by underinsuring. For example, the insured could take out $500,000 of coverage on a $1,000,000 building, taking the risk that any damage would not exceed the covered amount. The co-insurance clause is the insurance industry’s response to this and requires the insured to maintain an amount of insurance equal to or greater than a stipulated percentage of the value of the insured property at the time of loss. If the percentage is not maintained, the policy will not pay the full amount of the loss (whether the loss is within the policy limit or not), but rather recovery will be a proportion of the loss in the ratio that the insurance obtained bears to the minimum amount of insurance required by the policy. In the above example, if the co-insurance clause required the insured to insure for the full value, in the event of $500,000 of damage, the insured would only recover $250,000 as the insured only insured for half of the value.

If the value of the property insured increases after the insurance is placed, the amount of insurance may have to be increased to maintain the required percentage.

The risk of not maintaining insurance equal to the required percentage of value may be eliminated by adding a stated amount clause in the policy, which fixes the required amount of insurance. There is usually no additional cost for this addition.

E. Specialized Policies

There are many specialized policies for property and perils not covered by standard policies without special amendment and which offer policy conditions different from those in standard policies. Such policies give an insured increased coverage and greater flexibility in structuring property insurance. Examples of specialized policies are as follows:

• office contents;
• fine arts floater;
• valuable papers;
• electronic data processing;
• transit (covering property while being transported);
• builders’ risk to cover construction activities;
• exhibition floater (covering property at trade shows or exhibitions); and
• contractors’ equipment.

Conclusion

Property insurance is technical and complex. We recommend that insurance should be placed in consultation with knowledgeable professional insurance advisors who will advise you on the types of insurance and options available to you. It is important to make sure you fully understand what property is covered by your insurance and to what extent.

This article appeared in Real Estate Brief Fall 2005. To subscribe to this publication, visit our Publications Request page.