By Mike Edwards, CPCU, AAI
“I have an opportunity to quote on a nice commercial property account. In some initial conversations with the prospect, he mentioned that he was unhappy with his present agent, and made some reference to a claim involving a margin clause, where he wasn’t paid the full amount of the loss. He said he does not want a margin clause on his new policy. This is the first time I have run into this issue, and would appreciate a little information about exactly what a margin clause is and how it works, and also, what kind of claim problem it could have caused. In addition, if you can suggest any resources I could go to in order to get additional information, it would be a big help.”
A margin clause is used in blanket insurance as a tool to promote the accuracy of the limits of insurance of the property on the Statement of Values. The incentive for the insured is to avoid the penalty which is possible with a margin clause. It is roughly similar to how “guaranteed replacement cost” (GRC) coverage works in the Homeowners Policy. When GRC was first introduced, it provided great peace of mind to consumers, in situations where the replacement cost (RC) of their home exceeded the policy limit. If the insured agreed to insure the home for 100% RC value, and to notify the insurer of improvements of greater than 5% of the home’s value, then the insurer would pay the full RC, even where the limit of liability of the home was insufficient.
However, it wasn’t long before flaws in that strategy began to appear. One of the most startling events for the industry was the massive fire losses in Oakland, CA in 1991. Some industry research in the years immediately following the fire showed that insurers paid over $270,000,000 in claims in excess of policy limits. There were numerous factors in the huge overpayment, and GRC was just one. However, insurers soon filed amended versions of their GRC endorsement which capped the total amount payable at a percentage (usually 25% or 50%) of the stated limit of insurance.
The parallel for Commercial Property policies is best illustrated in a case I recently read about, which reveals the potential problem with blanket insurance and agreed value. The blanket limit on 8 buildings was $21,530,169 – with 100% coinsurance at RC, and Agreed Value. One building suffered a total loss in a tornado. The Statement of Values (SOV) form (CP 16 15) attached to the current policy indicated the value for that building was $1,247,625. However, during the claims process, it was discovered that the actual RC of the building was approximately $2,200,000. Nonetheless, the advantage for this insured to have Agreed Value on a blanket policy is that the full $2,200,000 is paid (less deductible), so long as the blanket limit is sufficient (which was $21,530,169). Note that the Agreed Value option suspends the coinsurance provision, which is why Agreed Value is so frequently used.
Understandably, insurers have a polar-opposite view. For one building to have an error of $952,375 (insured 56% to value) is hard to fathom, and suggests extreme carelessness by the insured, agent, and/or underwriter, or possibly fraud or material misrepresentation. For this reason, most insurers require that the insured sign the Statement of Values (SOV) endorsement, although under ISO rules – and the language on the form itself – make signing optional. That document might possibly end up as a Plaintiff’s Exhibit in court one day.
More broadly, separate from possible fraud or material misrepresentation, commercial insurers have begun incorporating provisions into their coverage forms which provide safeguards similar to that used by homeowners insurers in the GRC endorsement. The use of a margin clause places a cap on how much an Agreed Value option will pay on a blanket policy. In addition, a margin clause also functions with coinsurance, where applicable.
The specific cap on amounts payable under a margin clause with blanket coverage is incorporated into the commercial property policy either by endorsement, or additional language inserted into the coverage form itself. This presents a special challenge for agents. An endorsement is much easier to find than a few sentences added to the body of a coverage form. But either way, it is vitally important for the agent and insured to be aware when a policy contains a margin clause. Many agency quote forms include a notation that a margin clause applies.
By way of a general discussion of how a margin clause works, here are some excerpts and commentary on the ISO margin clause endorsement: CP 12 32 06 07 – Limitation on Loss Settlement – Blanket Insurance (Margin Clause), which was introduced in the 2007 ISO commercial property forms revisions. Keep in mind that many insurers might have their own proprietary version of a margin clause endorsement, or have modified their coverage form itself to incorporate essential margin clause language. A margin clause can be applied to buildings as well as business personal property.
The first section of the CP 12 32 is a Schedule which indicates which premises and type of property is subject to a margin clause, and what the margin clause percentage is. Under ISO Commercial Property Manual Rule 34.B.6., the margin clause percentages for which a rating factor is provided are 105%, 110%, 120%, and 130%. Proprietary forms and rules might be different.
Here are excerpts from the CP 12 32 which provide details on how the margin clause functions.
CP 12 32 06 07
B. Margin Clause
With respect to property that is subject to a Blanket Limit of Insurance, we will determine a maximum loss payable for each building and for the contents of each building or the contents at each premises. The maximum loss payable is determined by applying the applicable Margin Clause percentage indicated in the Schedule to the value of the property as shown in the latest statement of values reported to us.
Actual loss payment will be determined based on the amount of loss or damage subject to all applicable policy provisions including the Limits of Insurance Condition, Coinsurance, Deductible and Valuation Conditions. But the actual loss payment, for each building, for the contents of each building or for the contents at each premises, will not exceed the maximum loss payable as described above and will not exceed the Blanket Limit of Insurance.
The Margin Clause does not increase the Blanket Limit of Insurance.
The CP 12 32 also includes three examples (see below) which present different scenarios that show how blanket insurance interacts with coinsurance and/or a margin clause. “Example 1” shows how a margin clause works, where there is coinsurance, but no coinsurance penalty. “Example 2” illustrates how a margin clause applies with no coinsurance – which usually indicates the Agreed Value option was selected (suspending coinsurance). “Example 3” shows how the margin clause works if there is coinsurance, and a coinsurance penalty applies. The bold language below appears in the CP 12 32 endorsement.
EXAMPLE #1
Buildings #1 through #3 are covered under a Blanket Limit of Insurance of $4,500,000. The combined value of these three buildings at the time of loss is $5,000,000. There is a Coinsurance requirement of 90% (.90 x $5,000,000 = $4,500,000); therefore no Coinsurance penalty.
The value stated for Building #1 is $1,000,000. The Margin Clause percentage is 120%. The maximum loss payable for Building #1 is $1,200,000 ($1,000,000 x 1.20).
Building #1 sustains a loss of $1,200,000.
The Deductible is $10,000.
Step 1: Amount of loss minus Deductible
($1,200,000 - $10,000 = $1,190,000)
Step 2: Since $1,190,000 is not more than the maximum loss payable, we will pay $1,190,000.
In this example, the insured’s payment is reduced only by the deductible ($1,200,000 - $10,000 = $1,190,000 paid). This amount is less than the maximum loss payable (scheduled value x margin clause = $1,200,000), so in this loss, the margin clause did not result in any penalty for the insured. However, had the margin clause been 105%, the maximum loss payable would have been $1,050,000.
EXAMPLE #2
Buildings #1 through #3 are covered under a Blanket Limit of Insurance of $4,500,000. The coverage in this example is written without a Coinsurance requirement.
The value stated for Building #1 is $1,000,000. The Margin Clause percentage is 115%. The maximum loss payable for Building #1 is $1,150,000 ($1,000,000 x 1.15).
Building #1 sustains a loss of $1,300,000.
The Deductible is $10,000.
Step 1: Amount of loss minus Deductible
($1,300,000 - $10,000 = $1,290,000)
Step 2: The result in Step 1 exceeds the maximum loss payable. We will pay $1,150,000, the maximum loss payable in accordance with the Margin Clause.
It is very important to note that the margin clause is applicable even where the Agreed Value option is selected by the insured. In this example, absent the margin clause, the building, which was listed on the Statement of Values (SOV) form at $1,000,000 – but sustains $1,300,000 damage – would be covered for $1,290,000 (amount of los minus deductible). However, the margin clause x the SOV limit for this building produces a maximum loss payable of $1,150,000. This example clearly illustrates the potentially severe effect a margin clause can have on the amount payable for an insured’s claim, even when the Agreed Value option is selected. But from the insurer’s point of view, since the SOV limit for this building is off by 30%, there is little appetite to pony up the full amount. With the increasing use of margin clauses, some experts have concluded that “the Agreed Amount option is dead.” Solution: accurate SOV limits.
EXAMPLE #3
Buildings #1 through #3 are covered under a Blanket Limit of Insurance of $4,000,000. The combined value of these three buildings at the time of loss is $5,000,000. There is a Coinsurance requirement of 90% (.90 x $5,000,000 = $4,500,000); therefore the Blanket is underinsured and there will be a Coinsurance penalty.
The value stated for Building #1 is $1,000,000. The Margin Clause percentage is 120%. The maximum loss payable for Building #1 is $1,200,000 ($1,000,000 x 1.20).
Building #1 sustains a loss of $1,200,000.
The Deductible is $10,000.
Step 1: Amount of Blanket Limit divided by Coinsurance Requirement
($4,000,000 ÷ $4,500,000 = .889)
Step 2: Amount of loss times Coinsurance penalty factor
($1,200,000 x .889 = $1,066,800) (the adjusted amount of loss)
Step 3: Adjusted amount of loss minus Deductible
($1,066,800 - $10,000 = ($1,056,800)
Step 4: We will pay $1,056,800 (less than the maximum loss payable). The remainder of the loss ($143,200) is not covered, due to the application of the Coinsurance penalty and Deductible.
In this example, the insured will face a coinsurance penalty. However, the resulting payable amount of $1,056,800 (Step 4) is less than the margin clause maximum loss payable, so the insured is not penalized by the margin clause. But, had the margin clause been 105%, the maximum loss payable would have been $1,050,000 (SOV x 105%) vs. $1,056,800.
I think you can see now that it is quite plausible your prospect could have had a very unpleasant claims experience due to the margin clause. And it is certainly understandable that he would want to avoid one in his next policy. If you have markets that do not insert a margin clause, all the better. But the best solution is always to have accurate values on the SOV, with annual reviews.
As to resource materials for you to review, here are some suggestions. The IIABA’s Virtual University has three other excellent articles on the margin clause. Use the Search function near the top of this page and search for “margin clause.” In addition, an often overlooked source for useful insurance information is through a general Internet search (Google, etc.). Among the articles I found on the Internet, here is the best one on margin clauses from VU faculty member and industry legend, Don Malecki:
