Assets, Casual Losses and Insurance
Insurance policies covering losses of property are an integral part of most firm’s risk management. Some understanding of the basic features of insurance is thus essential to the accountant’s education. This article focuses on the effect of minimum coverage clauses of casualty insurance.
Generally, policies insuring against losses caused by such things as fire, theft, vandalism, storms, and earthquakes carry a minimum coverage requirement, such that the insured must obtain an adequate level of insurance or share in the loss with the insurance company. These requirements are known as coinsurance clauses.
At Least Minimum Coverage Held
If the insured company acquires sufficient coverage of its assets, the insurance company will pay the smaller of (1) the actual loss or (2) the face value of the policy. It is only logical that there would be no payment in excess of the loss or the coverage paid for by the insured.
For example, if a firm owns inventory costing $110,000 and carries a $100,000 fire insurance policy (which exceeds the minimum), it will receive up to $100,000 in payment of its damage claims. If $60,000 damage is incurred and the claim paid, this journal entry would be recorded:
If $110,000 damage is incurred and the maximum amount paid, this entry would be recorded:
If a depreciated asset is damaged and cash received in excess of its book value, the firm would report a gain from the fire.
Insufficient Coverage Held
The amount of minimum coverage is determined by applying a coinsurance rate to the full value of the covered property. Thus, inventory costing $110,000 covered by a 90 percent coinsurance policy must be protected with at least $99,000 of insurance or any partial losses will not be fully paid.
If the face value of the policy falls below the minimum amount, the insurance company will pay the smaller of (1) an adjusted loss amount or (2) the face value of the policy. The adjusted loss amount is found by multiplying the actual loss by the ratio of the actual coverage divided by the minimum coverage.
Thus, For example, if the actual coverage is only 70 percent of minimum, an adjusted loss equal to 70 percent of the actual loss is compared with the face value of the policy in order to determine the amount of the settlement. For the inventory situation described above, with $99,000 minimum coverage, a policy with a face of only $75,000 would achieve only 75.76 percent coverage ($75,000 / $99,000). If a loss of $49,500 occurred, it would be adjusted to $37,501 for determining the amount to be paid ($49,500 X .7576). This journal entry would be made:
Following example represents a flowchart analysis of the computation of the amount of proceeds from insurance settlements. If adequate coverage is held, the choice is between the face of the policy or the actual loss, whichever is lower. If inadequate coverage is held, the choice is between the face of the policy or the adjusted loss.
(a) Computing the insurance proceeds for a casualty loss
(b). Computation of insurance proceeds for a $100,000 casualty loss
Below example presents five examples that demonstrate how the procedures work. A uniform 90 percent minimum (coinsurance) rate and an actual loss of $100,000 are assumed.
Pro Rate Clauses
If more than one policy is carried on the same property, a loss (computed as illustrated above) is shared by the insurance companies in the relative proportion of policy face values. For example, assume that $110,000 of coverage in Case A of above example is carried with three insurance companies, as follows:
The $100,000 loss would be shared according to these percentages. Thus, policy 1 would pay $40,000, policy 2 would pay $50,000, and policy 3 would pay $10,000. If the value of the property at the date of loss had been larger such that $110,000 is not sufficient to meet the coinsurance requirements, the amount of loss to be paid would be computed according to the method described earlier and illustrated in example (a), but the percentages payable by the separate policies would not be affected. Policy 1 would still pay 40 percent of the adjusted loss, policy 2 would pay 50 percent, and policy 3 would pay 10 percent.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.