Adjustment of Fire Losses
The Insurance Contract
A fire insurance policy is a contractual engagement, modified by the conditions stated, to pay or replace, in part or in whole, any loss through fire, covering the property specified for a definite period. The amount to be paid cannot exceed the face value of the policy. The main points covered in the policy are the parties, the property, the risk, the amount, the term, the premium, and the conditions governing. There are three ways in which the contract may be terminated, namely: by expiration, cancellation, or forfeiture. Generally the contract holds good until noon of the day named as the date of expiration. Therefore, if a fire should break out in the forenoon on that day but the greater part of the damage were caused after the noon hour, the whole loss would be covered according to the terms of the policy. The policy can be canceled immediately by the insured by giving notice to the insurance company. The latter, however, must give notice and wait five days before the cancellation will be effective.
In case of cancellation, the premium cost for the expired term is usually higher proportionately than for the whole term; what is known as the “short rate” becoming effective. The causes for the forfeiture of the policy are many and various. Among the reasons are concealment or misrepresentation, or fraud in connection with taking out the policy or in substantiation of claims for losses incurred. Some of the parts of the agreement relative to occupancy, vacancy, change in title, use or allowance of dangerous substances may be the cause. Then again, neglect of the clauses as to the maintenance of an adequate sprinkler system, making provisions for watching the building, etc., may lead to forfeiture.
Requirements in Case of Loss
When a loss occurs the first thing necessary is to give at once a written notice to the insurance company and to endeavor to protect the property from further damage. The next step is to separate the damaged and the undamaged movable property, and to put these two classes in order so as to facilitate checking up. Then follows the making out of an inventory giving accurate details concerning the kind, the amount, the cost, and the damage claimed in respect to the goods. Upon the arrival of the adjuster of the insurance company, adjustment may be made immediately, or it may be a protracted affair, depending on conditions. The insured is required by the terms of the policy to submit a sworn proof of loss within 60 days. This proof must enumerate the facts and beliefs of the insured regarding the origin and time of the fire, the interest the insured has in the property, together with the interest, if any, held by others, the cash value of each item, the sum total of the loss sustained, the encumbrances on the property, other insurance, whether valid or not, a copy of all descriptions and schedules of all the policies, any change in title, use, occupation, location, possession, or exposure of the property since the issuance of the policy. It is also required to state by whom and how the insured building was occupied at the time of the fire. Sometimes the insurance company may require that this proof be verified by plans or specifications of the building, machinery, or fixtures that have been destroyed or damaged. At its option, it may request a certificate from an impartial magistrate or notary public substantiating the correctness and honesty of the claims presented. It is further required that the insured keep himself ready to exhibit any remains of the property in question. He may also be required to submit to an examination under oath and produce at the option of the insurance company any books of account, bills and other vouchers, and permit copies or extracts to be made from them.
Determination of Value of Loss
The insurance policy gives no hard and fast rule regarding the determination of value. The usual phraseology is: “This Company shall not be liable beyond the actual cash value of the property at the time any loss or damage occurs and the loss or damage shall be ascertained or estimated according to such actual cost value, with the proper deduction for depreciation, however caused, and shall in no event exceed what it would then cost the insured to repair or replace the same with material of like kind and quality.”
The insurance company has accordingly the option of using the lower of two bases of settlement, viz.: (1) actual cash value at the time of the fire; or (2) what it would cost the insured party to replace the property lost. The price which governs, cost or selling, will depend upon the nature of the property. As a general rule, it is the cost price. For goods which cannot be readily or advantageously reproduced, like cereals and cotton, the adjustment basis is the local open market price prevailing immediately before the fire. In adjusting values, adequate depreciation allowance is made not only for ordinary wear and tear, but also for losses incidental to changes of fashion, demand, etc.
Adjustment of Differences
Whenever there is a dispute regarding the standards applicable in the adjustment or a disagreement regarding the method by which the standards are applied, one or the other of the parties generally invokes the provisions of the policy for an appraisal. In accordance with the terms of the policy, the insurer and insured may each appoint an appraiser who in turn selects an umpire. This official does not act except when called on for a decision if the appraisers disagree on some point. The appraisers proceed to make a joint appraisement of the damage caused and the value of the loss. If this appraisal is incorporated in a written award and signed by the appraisers, it is binding on both parties, and will be upheld by the courts. This provision is applicable to total and partial losses, but is limited to questions of value and damage. The appraisers are generally experts, but may call in any other person to give testimony. They are not bound by any legal rules of evidence, but may determine their own procedure.
After the value of the loss has been arrived at, by agreement or appraisal, the liability as modified by the conditions or limitations comes up for consideration. There are generally a number of these clauses present in every policy although they are not always in force. One of these is the pro rata or the contributing clause. In the standard policy this clause reads as follows: “This Company shall not be liable under this policy for a greater proportion of any loss ... than the amount hereby insured shall bear to the whole insurance, whether valid or not, or by solvent or insolvent insurers covering such property.” The apportionment of the loss on this basis is often a complicated affair.
Effect of Coinsurance Clause
Another limitation clause is the “coinsurance,” sometimes called the “average clause” or “reduced rate” clause. The object of this clause is to make the relation between value and insurance somewhat more stable and to adjust the rates in accordance with the ascertained probability of big and small losses. The assumption is that partial losses to the property will also be partial losses to the insurance company. Rates can be adjusted in the light of the ascertained probability of the respective occurrence of slight and serious losses, and on the assumption that partial losses to the property will also be only partial losses to the insurance company. This clause does not operate to reduce the insured’s recovery if either the loss or insurance equals or exceeds the named percentage of value. Where applied, it does so only after any apportionment under the contribution clause has been determined.
The effect of the coinsurance clause is usually to make the insured a coinsurer with the company for the difference between an amount limited in the policy and the face of the policy. The limiting amount is usually 80%, though it may be any other agreed per cent. The clause in the policy may read somewhat as follows:
“In consideration of the premium for which this policy is issued, it is expressly stipulated that in event of loss this company shall be liable for no greater proportion thereof than the sum hereby insured bears to eighty per cent of the cash value of the property described herein at the time when such loss shall happen, nor more than the proportion which this policy bears to the total insurance.”
Thus, in order to make the insured a coinsurer, in the event of loss the company’s liability is limited to that proportion which the sum insured bears to 80% of the cash value of the property described in the policy at the time of loss. Where the loss or the insurance equals or exceeds 80% of the value, the clause has no effect; when both are less, the insured and the insurer bear the loss in certain proportions. A few illustrations will show the way in which the liability of the company is determined. In the case of an 80% coinsurance clause, the formula by which the liability can be determined is derived as follows:
- A = the sum insured, i.e., the face of the policy
- B = the amount of the loss
- C = the cash value of the property at the time of the loss
- L = the liability of the company
Then, in accordance with the provisions of the coinsurance clause,
| L = | A | × B or | AB |
| .8C | .8C |
Three applications of the formula will be illustrated. In the first, both the face of the policy and the amount of loss are less than 80% of the cash value of the property. In the second, the policy carries 80% of the value of the property but the loss is less than 80% of the property value. In the third, while the face of the policy is less than 80%, the loss is more than 80% of the property value. From the formula, it is evident that where A is 80% of C, the formula reduces to B; and where B is 80% of C, it reduces to A. It must be borne in mind, however, that the insurance company is never liable for more than the amount insured, i.e., the face of the policy, nor for more than the amount of the loss.
| Face of Policy “A” | Cash Value of Property “C” | Amount of Loss “B” | Liability of Insurance Company “L” | |
|---|---|---|---|---|
| (1) | $3,000 | $5,000 | $2,500 | $1,875 |
| (2) | 4,000 | 5,000 | 2,500 | 2,500 |
| (3) | 3,000 | 5,000 | 5,000 | 3,000 |
Applying the formula in:
| (1) | AB | = | 3,000 × 2,500 | = 1,875 |
| .8C | .8 of 5,000 | |||
| (2) | AB | = | 4,000 × 2,500 | = 2,500 |
| .8C | .8 of 5,000 | |||
| (3) | AB | = | 3,000 × 5,000 | = 3,750 |
| .8C | .8 of 5,000 | |||
It will be noted in (3) that, inasmuch as the policy is $3,000, only $3,000 can be collected.
When the amount of the liability has been determined, the insurance company has three options:
1. Payment may be made in cash within 60 days after the completion of the proof of loss.
2. It may rebuild or replace the property. Notice of such intention must be given within 30 days from the filing of proof.
3. It may pay the “sound” value, i.e., the actual cash value of the property and dispose of what remains of it for its own account.
In most cases the first method is followed.
Method of Record-Keeping to Facilitate Ready Adjustment
Under the standard contract the insurance company must make adjustment within 60 days after the report of the loss. Where no differences exist or only such differences as are capable of easy adjustment between the company and the insured, payment of the loss is usually made without any delay because of the advertising value in the community of a quick adjustment of fire losses. Most of the differences which cause delay in the making of adjustments result from the inability of the insured to prove satisfactorily the amount of his loss. Failure to prove loss usually results from a slipshod manner of keeping the records and a loss of the supporting vouchers. The standard policy provides that the insurance company may require the production of original bills and vouchers to establish the cost of the property destroyed. Where these are not obtainable the process of adjustment may be delayed until data on which to figure the original cost can be secured which is satisfactory both to the insurance company and the insured. Accordingly, in order to secure adjustment of fire losses without delay, the record of all assets should be supported by original vouchers. Where the asset account is a group account, i.e., one composed of numerous pieces of property, a subsidiary ledger or register, or inventory record as it is sometimes called, should be carried, in which appear the details of the group account. If, then, the assets covered by the group account are only partially destroyed, it is then possible readily to determine the cost value of the portion destroyed by comparison with the portion left. In the case of machinery and tools, furniture and fixtures, delivery equipment, etc., the use of such a register is particularly advantageous. If the voucher system of account-keeping is in use, there will be supporting data for all charges to asset accounts and an examination of these will make it possible to determine the legitimacy of all such charges.
Another point to be kept in mind if ready adjustment is desired is to make sure that the policy covering particular property makes a sufficiently definite statement of the property covered so as to indicate clearly the exact property to which the policy applies. Oftentimes policies are taken out on buildings with the description so indefinitely worded that it becomes very difficult, where there are many buildings, to know just what is covered by any particular policy. Where policies are taken out covering new equipment as it is purchased, and at some future time the equipment is moved from building to building, the problem of allocating the policy with the property covered by it becomes particularly difficult. To surmount these difficulties it may be wise even to draw up charts and maps of all buildings and their equipment, indicating on the insurance policies the particular pieces of property covered by them as shown on the map. As mentioned above, clear, businesslike records kept by the insured and properly supported by original data will always make for speedy adjustment of fire losses.
Adjusting Entries for Fire Losses
To make the books record properly the loss suffered by fire, it is necessary to set up a special account called “Fire Loss.” To that account will be charged the full amount of the loss, including any expenses incurred in connection therewith and also the portion of the unexpired insurance premium which is canceled by the fire. This account will be credited with the amount of insurance received or allowed by the insurance company. Stated otherwise, to the account will be transferred the book value of all property destroyed and all expenses in connection with the fire. After the account is credited with the amount of insurance received, the balance shows the net loss suffered by the fire and will be closed directly into surplus so as not to affect the results of the current period’s operations. As a rule, at the time of the loss of a fixed asset, depreciation has accrued from the close of the last fiscal period and this must be taken into consideration in making the adjustments on the books. The amount of such accrued depreciation must be charged to the current period’s Depreciation account because the period must bear its proper proportion of the expense. The offsetting credit to such charge will be made directly to the asset account rather than to its Depreciation Reserve account. The depreciation applicable to the asset destroyed which has accumulated in the past must now be transferred as a credit to the asset account. After such transfer and entry in the asset account of the accrued depreciation, the balance of the asset account shows the appraised value of the asset as at the time of the fire. If this appraised value is accepted as the true value by the insurance company, no further adjustment is needed and this becomes the figure or amount which is transferred to the Fire Loss account. If, however, settlement is made on a lesser valuation, in strict theory, the difference between the book value of the asset and the value accepted as the basis for settlement should be charged to surplus as an adjustment item occasioned by insufficient depreciation charges in former periods. Usually, however, no cognizance is taken of such adjustment and the total book value of the destroyed asset is charged to Fire Loss account.
If the loss is complete or the insurance company makes a settlement of the total amount of the policy, the policy is canceled and all unexpired premiums applicable to it are used up and constitute an additional loss occasioned by fire. The amount of such unexpired premiums is therefore charged to Fire Loss account. If settlement is not made for the total amount of the policy, the amount of the settlement is indorsed on the policy in order to show the amount of insurance still in force for which the company is liable. The due proportion of the unexpired premium will be charged off to Fire Loss account. This proportion will be represented by the ratio of the amount of the settlement to the face of the policy.
In the case of loss of stock-in-trade by fire it is very necessary to have available as the basis for determining the value of the merchandise destroyed the inventory record as at the close of the previous fiscal period. The record of all purchases, purchase returns, sales, and sales returns from then until the time of the fire, and the records of previous years, should also be available in order to determine the average rate of gross profit. If such rate of gross profit is not available, there must be a rate agreed upon by the insured and the company as the basis for settlement. The method of determining the value of the goods on hand at the time of the fire by means of the data just mentioned is explained in full in Volume I, page 506, under the head of “Book or Estimated Inventories.” Here also, as in the case of fixed assets, clear, businesslike records lead to a speedy adjustment of the loss.