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1 September, 2016
Contingency insurance, such as event cancellation cover, is commonly underwritten on the basis that premium is paid on a minimum and deposit basis (M&D premium). However in our experience insureds misunderstand the operation and effect of M&D premium in contingency policies.
M&D premium provides flexibility in pricing contingency risks by requiring a minimum deposit to be paid by the insured at the time of taking out the cover based on projected revenue (typically 75% of the total premium), which is then adjusted at the end of the policy period once actual revenue is known.
With M&D premium the insured has the peace of mind knowing that if it does not achieve its anticipated projections it will not be obliged to pay the full premium. It will only have to pay some lesser amount calculated according to actual revenue and down to the minimum premium, which is typically set at 75% of the original calculated premium. Conversely, the insured would only ever be required to pay the full premium if it meets or exceeds its projected revenue for which it took out cover.
We can illustrate how M&D premium is intended to operate by using an event cancellation policy as an example:
An event organiser seeks cover for a set of three concerts it is planning to hold;
The event organiser submits a projected estimate of all anticipated revenue (e.g. ticket sales, food sales, merchandise sales) it expects to receive from each of the three concerts, being $1,000,000 per concert and totalling the sum of $3,000,000;
The insurer calculates a $30,000 premium payable based on the event revenue estimates, but only requires the insured to pay 75% of this upfront on a minimum and deposit basis, being $22,500;
The insured event holder declares final revenue of $2,500,000, meaning the final premium payable is $25,000 (less than the original $30,000 premium that was calculated) and subsequently requiring only an additional $2,500 to be paid to the insurer.
When issuing cover with M&D premium, an insurer calculates the premium payable having regard to the projected revenue. Normally that same projected revenue is also adopted as the limit of liability.
An emerging trend from claims submitted by insureds illustrates that they misunderstand the intended operation of M&D premium and the limits of liability under the policy. Insureds sometimes assume that the limit of liability is, like the payment of premium, flexible and subject to both upwards and downwards adjustment.
In the event of a claim, an insured cannot obtain indemnity for a sum in excess of the limit of liability (which was based upon the projected revenues provided by the insured). This often arises where an insured was conservative in its projected revenue or, for whatever reason, it is having a more successful year than anticipated.
To illustrate this misunderstanding using our example from above, if the insured's first two concerts exceed forecasted revenue by $200,000 each and the third event has to be cancelled due to a weather event, the insured cannot simply pay a greater premium to increase the cover and limit of liability from the $1,000,000 provided for the third concert in the schedule of cover. The insurer's liability will always be capped by the limits of liability agreed to and provided for in the schedule of cover.
If policies with M&D premium were to operate in accordance with this misunderstanding, the result would be that an underwriter could theoretically be writing lines of business with an uncertain limit of liability that could potentially be in excess of their individual authorities and lead to unsustainable exposures.
Further, it would lead to (and likely provide incentive for) underinsurance on contingency risks as an insured could project lower forecasted revenue to obtain a lower premium and simply pay a greater premium in the event that any claim on the policy needed to be made. Of course if an insured intentionally projects lower forecasted revenue then that may also give rise to issues of non-disclosure and misrepresentation.
It is important that all insureds properly understand how their contingency policies operate and have realistic expectations for what to expect if a claim arises. Brokers can assist insureds by explaining the operation of M&D premium prior to policy inception as well as the consequences of failing to provide accurate project revenues, namely that they will not be covered for any loss in excess of their projected revenues.
For further information, please contact:
Edward Burrell, Clyde & Co
edward.burrell@clydeco.com
