How Much Business Income Coverage Do You Need?

Beware Coinsurance Penalties

Calculator with pen sitting on a computer printout
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What limit should you choose when purchasing business income coverage? This question can be difficult to answer. For one thing, business income losses are calculated based on your actual loss of income. To ensure your limit will be adequate, you need to accurately project your revenue twelve months in advance. Moreover, business income coverage pays for income you lose during a shutdown of your operations.

Thus, you must also estimate how much time you will need to repair your property and get your business running again after a physical loss.

Definition of Business Income

The first challenge in choosing a business income limit is understanding the meaning of business income. Under many business income forms (including the ISO forms), this term means the sum of the following:

  1. Net income, meaning net profit or loss before income taxes
  2. Normal operating expenses that continue after a loss. This includes payroll.

If your business earns income by renting property to others, you can include, or exclude, your rental income in your calculation of business income. If your company generates all of its income from rental properties, your business income will consist of rental income only.

Calculating Business Income

The most accurate way to calculate your business income is to use a business income worksheet.

You can use the standard ISO worksheet or one prepared by your insurer. If you need a worksheet, your agent or broker can obtain one for you.

The worksheet outlines a step-by-step process for calculating your business income exposure. This process involves two steps. The first step is to determine how much income your business generated in the previous twelve-month period.

Secondly, you will need to project your income for the future twelve months. You can make your projection by adjusting your 12-month historical figures. Your calculations should reflect any changes you expect over the coming year, such as an increase or decrease in sales.

 For many business owners, a business income worksheet can be bewildering.  If you find the worksheet confusing, ask your accountant to complete it for you.

Coinsurance Penalty

Many business income forms include a coinsurance clause. This clause imposes a penalty if the limit on your policy is less than the requirement amount. If coinsurance applies to your policy, a coinsurance percentage will be listed in the declarations. This percentage may be anywhere between 50% and 125%. Here's how the clause applies:

Suppose that you have purchased business income coverage based on projected income of $1 million. Your policy includes a coinsurance requirement of 80%. To avoid a coinsurance penalty, you must purchase a limit of at least $800,000 (.80 X $1 million). You decide to purchase only $700,000 as a cost-saving measure.

Three months into your policy period a fire breaks out in your warehouse. The fire damages the building, forcing you to shut down your business for several weeks.

You suffer a $175,000 income loss due to the shutdown. You have under-insured your business income exposure by $100,000. Here's how your insurer calculates your loss payment. 

Maximum loss payment = loss amount X (limit purchased/ the limit required) 

Amount paid by your insurer pays = $175,000 X (700,000 / 800,000) or $153,125

You must pay the remaining $21,875, which represents the coinsurance penalty. You can avoid such a penalty by purchasing an adequate limit for business income coverage. Alternatively, you can avoid coinsurance by purchasing business income coverage that applies on an agreed value basis.

Premium Adjustment Endorsement

As noted above, it is important to purchase enough business income coverage to avoid a coinsurance penalty. Yet, it is also possible to purchase too much insurance.

If the limit you purchase exceeds the amount required by the coinsurance clause, you will have wasted money on unused insurance. The Premium Adjustment Endorsement will allow you to avoid this situation.

This endorsement provides a refund if your business income limit exceeds the amount required by the coinsurance clause. You must submit two reports of your business income values to your insurer. One must be filed when your policy begins (or when the endorsement is attached). The second must be submitted within 120 days of the date your policy ends. Your insurer will compare the limit you purchased to your required limit based on your actual values. If the limit you purchased exceeds the required limit, your insurer will return the excess premium.