Coinsurance Requirements for Property Insurance and the Fire, Lightning, Explosion, and Windstorm Causes of Loss

This section of the study guide is intended to provide practice problems and solutions to accompany the pages of Insurance Operations, Regulation, and Statutory Accounting, cited below. Students are encouraged to read these pages before attempting the problems. This study guide is entirely an independent effort by Mr. Stolyarov and is not affiliated with any organization(s) to whose textbooks it refers, nor does it represent such organization(s).

Some of the questions here ask for short written answers based on the reading. This is meant to give the student practice in answering questions of the format that will appear on Exam 5. Students are encouraged to type their own answers first and then to compare these answers with the solutions given here. Please note that the solutions provided here are not necessarily the only possible ones.

Source:

Myhr, A.E.; and Markham, J.J. Insurance Operations, Regulation, and Statutory Accounting (Second Edition). American Institute for Chartered Property Casualty Underwriters. 2004. Chapter 5, pp. 5.24-5.30.

Original Problems and Solutions from The Actuary's Free Study Guide

Problem S5-56-1. A property insurer has a coinsurance clause, which requires the insured to purchase insurance of at least 80% of the property's insurance value in order to avoid a penalty. If the insurer does not insure up to the required amount, then the insurer only pays the fraction of any loss that is equal to the fraction of the required amount of insurance that the policyholder owns. Assume that the policyholder has purchased insurance with a limit of $460,000 and has suffered a loss of $100,000. At the time of loss, the value of the insured property was ascertained as being $800,000. How much will the insurance company pay the policyholder?

Solution S5-56-1. This question is based on the discussion in Myhr and Markham, pp. 5.24-5.25.

The amount of insurance the insured needed to have purchased to avoid the coinsurance penalty is 80% of $800,000, or $640,000. The insured only purchased $460,000 of insurance, or 460000/640000 = 0.71875 of the required amount. Thus, he will only get 0.71875*100000 = $71,875 of his loss paid for by the insurer.

Problem S5-56-2.
(a) In evaluating the risk of fire, underwriters use the COPE model. What does the COPE acronym stand for?
(b) With regard to a cause of loss, what is the amount subject?
(c) With regard to a cause of loss, what is the probable maximum loss (PML)?
(d) Which of these is always greater than or equal to the other: the amount subject or the PML?

Solution S5-56-2. This question is based on the discussion in Myhr and Markham, p. 5.26.

(a) COPE stands for Construction, Occupancy, Protection, and Exposure -- the four factors used to analyze the fire cause of loss.

(b) The amount subject is the "total value exposed to loss at any one location from any one event" (Myhr and Markham, p. 5.26).

(c) The probable maximum loss (PML) is "an estimate of the largest likely loss" (Myhr and Markham, p. 5.26).

(d) The amount subject is always greater than or equal to the PML. The amount subject is the total value exposed to loss, whereas the PML is an estimate of what the greatest loss is likely to be. Sometimes, actual losses can exceed the PML, as when a building that was not expected to ever suffer a total loss actually suffers such a loss. But the total value of the building - the amount subject - would not be exceeded even if a total loss occurred.

Problem S5-56-3. Which of the following statements about lightning damage are true? More than one answer may be correct.

(a) Insurance policies that cover property on land and in a fixed location have in virtually all cases paired coverage for lightning with coverage for fire.
(b) Lightning damage can only accompany fire damage; this is why the two coverages have historically been paired together.
(c) The insured property's plumbing system is particularly vulnerable to lightning.
(d) The insured property's electrical system is particularly vulnerable to lightning.
(e) With current technology, it is possible to completely prevent lightning damage.
(f) If the power lines entering a building have an external surge protector, it would be redundant to employ interior surge protectors on such equipment as computers within the building.
(g) The probability of lightning damage can be reduced by lightning rods.

Solution S5-56-3. This question is based on the discussion in Myhr and Markham, pp. 5.26-5.27. The following answers are correct:
(a) Insurance policies that cover property on land and in a fixed location have in virtually all cases paired coverage for lightning with coverage for fire.
(d) The insured property's electrical system is particularly vulnerable to lightning.
(g) The probability of lightning damage can be reduced by lightning rods.

Choice (b) is not correct; lightning damage can and does occur independently of fire damage.

Choice (c) is not correct; there is no reason for why plumbing systems would be more vulnerable to lightning than most other building components.

Choice (e) is not correct; lightning damage cannot (yet) be completely prevented, but there are many effective ways of reducing loss frequency and loss severity.

Choice (f) is not correct; some particularly intricate types of equipment, such as computers, should have their own interior surge protectors, even if an exterior surge protector is present.

Problem S5-56-4.
(a) What is a combustion explosion?
(b) What are two effective methods for preventing combustion explosions?
(c) What are two effective methods of minimizing damage from combustion explosions that occur?
(d) What is a pressure explosion?
(e) Give three examples of pressure vessels that are vulnerable to pressure explosion.

Solution S5-56-4. This question is based on the discussion of explosions in Myhr and Markham, pp. 5.27-5.28.

(a) A combustion explosion is an "explosion caused by a fire that develops so rapidly that gases expand violently and explode. Combustion explosions occur when a flammable cloud of dust, vapor, mist, or gas encounters an ignition source" (Myhr and Markham, p. 5.27).

(b) The following two effective methods for preventing combustion explosions are discussed by Myhr and Markham, p. 5.27:
1. Limiting the amount of fuel in the atmosphere;
2. Restricting the supply of oxygen that reaches the fuel.

(c) The following two effective methods of minimizing damage from combustion explosions that occur are discussed by Myhr and Markham, p. 5.27:
1. Venting, which relieves pressure on the building itself and directs the force of the explosion away from susceptible property;
2. "Isolating the potential source of an explosion by placing spaces or barriers between the source and the property that might be damaged".

(d) A pressure explosion "occurs when a container burses because it cannot contain internal pressure" (Myhr and Markham, pp. 5.27-5.28).

(e) Some examples of pressure vessels that are vulnerable to pressure explosion, discussed by Myhr and Markham, p. 5.28, are as follows:
1. Water heaters;
2. Tanks;
3. Boilers;
4. Process equipment in manufacturing occupancies;
5. Fired kettles.
Any three of the above answers would suffice.

Problem S5-56-5. Which of the following statements about the windstorm cause of loss are true? More than one answer may be correct.

(a) Windstorm is a greater potential cause of loss for commercial properties than for personal properties.
(b) Windstorm is a greater potential cause of loss for personal properties than for commercial properties.
(c) The outer walls and roof of a building are the key determinants of whether that building withstands windstorm damage.
(d) Most windstorm damage actually results from wind-driven rain.
(e) Windstorm losses typically simultaneously affect large numbers of insureds.
(f) One way for an insurer to restrict its windstorm loss exposures is to focus only on one area or a few proximate areas where the insurer has thoroughly studied the history of wind damage - and to restrict the writing of coverage to that area.
(g) It is possible to take routine measures to largely immunize property against tornado damage; this includes lowering awnings and making sure that any patio furniture is securely protected.

Solution S5-56-5. Myhr and Markham, pp. 5.28-5.30. The following answers are correct:
(b) Windstorm is a greater potential cause of loss for personal properties than for commercial properties.
(c) The outer walls and roof of a building are the key determinants of whether that building withstands windstorm damage.
(e) Windstorm losses typically simultaneously affect large numbers of insureds.

Choice (a) cannot be correct if choice (b) is correct.

Choice (d) is not correct; most windstorm damage results from the effects of high wind on exposed property.

Choice (f) is not correct; the best way to minimize the impact of windstorm losses on an insurer's book of business is for the insurer to diversify geographically, so that a windstorm in one location would not be as damaging to the insurer's book of business overall. Concentrating business in a single area is probably the worst possible course of action.

Choice (g) is not correct; while the measures suggested can reduce some tornado damage, they are by no means guarantees that no damage will occur. Typically, there is little that property owners can do to be absolutely sure that a tornado will not devastate their property.

See other sections of The Actuary's Free Study Guide for Exam 5.