Consequences of Being Underinsured During an Ownership Transfer
December 6, 2018It’s nearly impossible to find an individual who doesn’t wish to save money on their insurance premium, whether for their home, autos, or business. Money savings can be obtained in several ways that do not leave the insurance buyer at the risk of being underinsured. Sometimes, insureds choose a “path of least resistance” when deciding to save some premium dollars. That path can often take the form of eliminations of coverage or lowering of limits of insurance, which can lead to them being underinsured and the consequences of being underinsured.
It’s not automatically problematic to reduce your insurance costs by forfeiting some coverages. However, it is important to know what you are paying for so that you can determine if you actually need the coverage of if that line on your policy applies to something that is inapplicable to your situation or something that you can afford to self-insure (pay out of pocket) and personally assume the risk of loss.
The problem arises when insureds incorrectly evaluate their, or their business’s, financial ability to compensate for claims out of pocket, the amount of the maximum probable loss they may incur, or possible penalties that may affect claim payment amounts because they chose to insure at insufficient limits. Here are a few consequences of being underinsured:
Who Tends to End Up Underinsured?
Regarding businesses, including agricultural operations, two types of insureds often seem to be those most likely to look to manage insurance premiums via the reduction of their coverages or limits. They are, respectively, new business start-ups and business owners in the twilight of their career.
Relating to Personal Insurance, the same is true; young, single individuals and older retirees are those most likely to look at cutting back coverage to save some bucks. Whether it be business or personal, it is easy to follow the logic behind this observation.
Why Businesses May be Underinsured
75% of businesses in the United States are underinsured by 40% or more, and there can be many reasons for this. Businesses that are just starting out often have limited capital and may operate several years in the red before realizing a profit.
Businesses with more maturity may have accumulated significant cash reserves and have more established and reliable revenue streams to help weather financial storms and unexpected losses. Additionally, loans have often been paid off and so these businesses are not required by a lender to carry Business Property Insurance, if they don’t wish to do so.
Why People May be Underinsured
Young individuals who have few assets and lower income rates don’t have a lot for someone to take if they are sued, only to find out after the fact that they have insufficient insurance limits. Certainly, wage garnishment could occur, serving to financially compensate an injured party, but the potential of that seems to be largely off the radar of most insurance buyers.
Generally speaking, younger folks also tend to be more willing to assume risk before they get married and start a family. Older retirees who established a level of increased financial security or reserves, but are now operating on a fixed income, are often either better able to assume additional risk or are looking to find ways to minimize living expenses out of necessity.
How Businesses Can End Up Underinsured During a Generational Ownership Transition
The implications and repercussions of underinsuring can be especially damaging for family businesses when losses occur within the span of a generational ownership transition. Transitions, in general, are a time of vulnerability time for businesses. This can be attributed to multiple things, but one common reason can be the difference in the insurance needs for one generation versus those of the next.
A successful first-generation business owner who is getting ready to exit the family business may very well be enjoying the fruits of 30-plus years of labors and realizing the security of having significant financial reserves. In many cases, their assets are all owned free and clear from liens or mortgages.
If the unthinkable happened and the business suffered an insurmountable loss, they could retire and live off the savings they accumulated over the last couple of decades. Furthermore, a property loss that is limited to only one of the business owner’s buildings may result in the simple decision to discontinue that portion of the business’s operations. After all, if it is not the primary source of income vital to the business, it may not constitute a crucial revenue stream that is needed to make loan payments because there may not be a loan payment any longer.
3 Consequences of Being Underinsured During an Ownership Transfer
Although the daily operations are transferring to the next generation, it is common that the real property remains under the ownership of the retiring owner. A family corporation may rent facilities from a retired owner. This is a beneficial structuring of the business, as it provides some separation of assets in addition to some income for the former owner after they no longer are receiving wages.
The problem arises when the older generation property owner is the one who carries insurance on the buildings they own and seeks to lower their insurance premiums by reducing perils or limits. This can result in less coverage and also could put the business at risk for the consequences of being underinsured.
1. Reducing Perils Can Eliminate Protections
Insuring for fewer causes of loss is one way to lower your premium, but it can also end up in less coverage when you need it. Not having the protections you need is one of the consequences of being underinsured.
For example, reducing a building’s coverage from Broad Form to Basic Perils eliminates the ability to receive claim payments for things like water damage from pipe ruptures or damage caused to property by falling objects.
2. Reducing Limits Can Reduce Loss Settlements
Another common scenario is when the property owner reduces the insured limit of buildings that are vital to the business’s operations. If a Replacement Cost provision is placed on the policy, the insurance company will pay to replace the damaged property with materials and construction of “like kind and quality” up to the limit on the policy.
That means if a building is lost that costs $100,000 to replace and the limit that was purchased on the policy is $80,000, the insurance company will only provide $80,000 toward the reconstruction of the property. Even more problematic is when the limit of insurance dips below 80% of the replacement cost of the structure. In these cases, the loss settlement may be reverted to Actual Cash Value, which accounts for the depreciation of the damaged property.
Or, a Co-insurance Penalty may be applied and the claim payment will be made at a percentage of the limit on the policy, proportional to the amount of insurance the insured should have carried on the structure. This is another one of the consequences of being underinsured and is also one of the risks of having the wrong commercial property coverage.
3. Gaps in Coverage Often Result in Significant Loss
In any of the scenarios outlined, the gaps in coverage can be huge, and costly. The decisions of the former business owner who is no longer operationally involved in the business, but still owns the property that is consequential to the business, can have a huge impact on the business’s cash flow for the next generation. The impacts of underinsurance can be long-lasting and the consequences of being underinsured can damage your credit and make it difficult to get loans or to meet other financial needs for the business.
Damage to Credit
The family’s next generation may have taken out a large loan in order to purchase the business. They may have liens on vehicles, or other outstanding lines of credit, all of which generate monthly payments that still come due after a loss is suffered.
Although the younger generation of owner(s) may have wisely purchased Loss of Business Income within their own insurance policy, the retired, underinsured property owner may not have the financial means to cover a significant, albeit self-imposed, gap in insurance.
After all, if they received an Actual Cash Value claim settlement in the amount of $60,000 for a building that would cost $100,000 to replace, they likely decided that they would be fine with this payment as they evaluated that the building wasn’t critical to replace.
Difficulty in Securing New Business Loans
However, that same building that wasn’t absolutely critical to the debt-free 1st generation owner could contain a necessary revenue stream for the new business owners.
Now, the next generation is faced with the task of borrowing more money from lenders to reconstruct a building they weren’t contractually responsible for ensuring but, nevertheless, need for their business to survive.
Depending on how heavily leveraged the new owners already are, securing a loan may be a difficult thing to accomplish or may involve a payment that they cannot fit into an already strained budget.
How to Avoid Being Underinsured During an Ownership Transfer
Unfortunately, these scenarios happen to family businesses more frequently than you might expect. Differences in mindset, available financial resources and life stage all play significant roles in creating situations that leave the generation taking over the family business exposed to uninsured or underinsured losses, often through no fault of their own.
If the older generation is maintaining the insurance on their own property assets, which are leased to the next generation, in the absence of a contract that dictates differently, the younger generation is likely not privy to the amount of insurance being purchased on buildings that are pertinent to their business operations.
Assume Contractual Responsibility for Business Insurance
As such, a good practice is to discuss insurance options with an independent insurance agent and legal/contractual options with a lawyer. For example, the new owners may decide to assume contractual responsibility for maintaining property insurance for the consideration of a reduction in rental cost.
This allows them to be sure that the correct coverage and limits are being maintained and eliminates situations where the business is adversely affected by the insurance buying decisions of the property owner, which may have been made in their interest of saving a few premium dollars each year.
When you know the amount of insurance being purchased, you can work with an independent agent to determine if a potential reduction in premium is actual savings or less insurance.
Properly Evaluate Business Risks and Potential Losses
Failing to insure and underinsuring can have devastating financial impacts and sometimes they are felt by more people than just the policyholder. It’s important to properly evaluate the risks and potential losses your business could incur. Without a discussion with your independent insurance agent, it can be difficult to navigate.
You need to consider your maximum possible loss and your maximum probable loss, and then evaluate how much risk you can feasibly sustain and self-insure. This requires you to know and understand the coverages, limitations, and potential penalties that are written into your business insurance contract, as well as knowing how and where all of your business’s exposures are covered.
While business succession planning and insurance may sound like a bit of a process, the time to have these discussions is not after a loss occurs! If your business is about to go through an ownership transfer or you are about to inherit a family business, contact Ruhl Insurance at 717-665-2283 or 1-800-537-6880 to make sure you are properly covered!
Disclaimer: Information and claims presented in this content are meant for informative, illustrative purposes and should not be considered legally binding.