Indirect Losses to Property, Verification of Property Losses, Intentional Property Losses, Replacement Cost, and Actual Cash Value: Practice Questions and Solutions

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 9, pp. 9.9-9.19.

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

Problem S5-64-1.

(a) What is the most important type of indirect loss to property?

(b) Which kinds of insurance policies typically cover the type of indirect loss in part (a), and which kinds of insurance policies sometimes do not cover this loss?

(c) What needs to happen to trigger coverage for the indirect loss in part (a), when such coverage exists?

(d) Give three examples of nonphysical losses to property. Are these losses covered by most insurance policies?

Solution S5-64-1. This question is based on the discussion by Myhr and Markham, p. 9.9, of covered causes of loss for property insurance.

(a) The most important type of indirect loss to property is loss of use of the property.

(b) A typical homeowners' insurance policy typically covers loss of use; on the other hand, commercial property insurance policies sometimes do not cover loss of use, unless such coverage is explicitly purchased by the insured.

(c) A direct physical loss to property needs to occur in order to trigger coverage for loss of use.

(d) The following examples of nonphysical losses to property are mentioned by Myhr and Markham, p. 9.9:
1. Obsolescence;

2. Loss of market;

3. Investment loss;

4. Financial fraud.

Any three of the above suffice as answers. Other valid answers may be possible. Most insurance policies do not cover nonphysical losses.

Problem S5-64-2.

(a) Name two causes of loss to property which are typically easy to verify.

(b) Name two causes of loss to property which are often difficult to verify.

(c) Name three exclusions for which it is often difficult to separate excluded losses from non-excluded losses.

Solution S5-64-2.

(a) Fire and windstorm losses to property are typically easy to verify (Myhr and Markham, p. 9.9). Other valid answers may be possible.

(b) The following causes of loss to property, which are often difficult to verify, are mentioned by Myhr and Markham, p. 9.10:
1. Water damage;

2. Collapse;

3. Theft;

4. Vandalism.

Any two of the above suffice as an answer. Other valid answers may be possible.

(c) The following four difficult exclusions are mentioned by Myhr and Markham, p. 9.10:

1. Gradual causes of loss;

2. Ordinance or law;

3. Faulty design, construction, or material;

4. Intentional acts of the insured.

Any three of the above suffice as an answer. Other valid answers may be possible.

Problem S5-64-3.

(a) What is the most common type of intentionally caused loss?

(b) To prove that the type of loss in part (a) actually occurred and was caused by the insured, what three facts must a claim adjuster demonstrate?

(c) What are two possible motives for this type of intentionally caused loss?

Solution S5-64-3. This question is based on the discussion of intentional acts of the insured in Myhr and Markham, p. 9.13.

(a) The most common type of intentionally caused loss is loss due to fire, i.e., arson.

(b) To prove that the insured committed arson, the claim adjuster must demonstrate the following, according to Myhr and Markham, p. 9.13:

1. "An incendiary fire (one that has been set intentionally";

2. "A motive on the insured's part";

3. "Opportunity on the insured's part".

(c) The following possible motives for arson caused by the insured are discussed by Myhr and Markham, p. 9.13:

1. Financial motives: The insured might be better off with vacant land and the insurance money than with an intact building.
2. Irrational motives: Anger toward a business partner, spouse, or other individual who would be worse off if the building were destroyed.

Other valid answers may be possible.

Problem S5-64-4. Mr. Ξ has purchased an insurance policy on his Superwidget, Mark X, which he purchased in the year 2310 for 6000 Golden Hexagons (GH). In the year 2315, a total loss to the superwidget occurs. Since that time, Superwidget, Mark X, has been discontinued and replaced by Superwidget, Mark Y, which has similar functionality. The market price of Superwidget, Mark Y, in 2315 is 7800 GH. The insurance company also calculates that, because of obsolescence and wear and tear, Mr. Ξ's former superwidget experienced 2300 GH of depreciation. How much will Mr. Ξ receive from the insurer if:

(a) The insurance is provided on a replacement cost basis?

(b) The insurance is provided on an actual cash value basis?

Solution S5-64-4. This question is based on the discussion of replacement cost and actual cash value in Myhr and Markham, pp. 9.15-9.19.

(a) Replacement cost is the cost to replace a destroyed item with either another instance of that item or an item of like kind and quality. Here, Superwidget, Mark Y, appears to be of similar kind and quality to Superwidget, Mark X. Moreover, replacement cost is the cost to replace at the time of loss, and, in most cases, does not take into account the item's original purchase price. Thus, the replacement cost in this case is the market price of Superwidget, Mark Y, in 2315: 7800 GH.

(b) In most cases, (Actual Cash Value) = (Replacement Cost) - (Depreciation). Here, replacement cost is 7800 GH, and depreciation is estimated at 2300 GH. Thus, compensation provided on an actual cash value basis would be 7800 - 2300 = 5500 GH.

Problem S5-64-5. Give three examples of considerations that a thorough estimate of replacement cost for damaged or destroyed property should take into account. Briefly describe what these considerations are and what aspects of them should be taken into account.

Solution S5-64-5. The following five considerations with regard to replacement cost are discussed by Myhr and Markham, p. 9.16:

1. Specifications: "What must be done, including whether to repair or replace the property, the exact type of materials, and the quantity of materials in exact dimensions or count."

2. Materials: "Material prices are based on prevailing material costs for projects similar to what is required by the policyholder's loss."

3. Labor: How much time is required to complete the project that would replace the damaged/destroyed property. It is generally considered fair to determine the cost of labor by multiplying the time required by published "standard" work rates.

4. Overhead: "The contractor's fixed costs of doing business or fixed specific costs attributable to the job. Examples include office space, telephones, permits, and job site offices."

5. Profit: Profit is typically calculated as a percentage of total other costs, as virtually every contractor will include some provision for profit in the price it charges to repair/replace the damaged/destroyed property.

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