Changes Cloud Insurance Issues

If you’re like many business owners, you embrace technology for the efficiencies it can bring to your operations--and you worry about keeping abreast of it.

Your insurance broker should worry, too, because if your business coverage lags behind the pace of technological change, it may cost you more than necessary, and in a worst-case scenario it could land you in a fight with your carrier.

Why? Because the advance of technology can turn an element of ordinary business property coverage into a source of contention between insured and insurer, and the more rapid the advance, the greater the likelihood of trouble.

The source of trouble lies in the language by which your insurer promises to make good a loss under a “replacement-cost” property insurance policy, the most common kind of property insurance sold to businesses in the U.S.

In essence, replacement-cost coverage obligates your insurer to replace your lost property with functionally equivalent--which is to say, not necessarily identical--material with no discount for depreciation. Thus if fire destroys 10 machines each capable of producing, say, 10 units of your product a day--that is, machinery capable of a total output of 100 units a day--your insurer may get you five newer, more efficient machines each capable of producing 20 units a day. Your insurer, in other words, restores your capacity to produce 100 units a day, whether that takes 10 machines or five.

Put another way, your insurer may make you whole without giving you exactly what you lost, and without considering the tax treatment of the lost property. And if five new machines do the work of your original 10, so much the better.

So what’s the catch?

The catch lies in what insurers call moral hazard. It is a well-established principle in the law that you may use insurance to restore a loss but not to better your position. Even so, insurance often does exactly that--because advances in technology make it impossible not to.

For example, if fire destroys your trusty old 386 megahertz computer, your insurer can’t replace it with an identical machine because nobody makes clunkers like that anymore. Instead, you get a modern machine far more powerful and robust--a better machine by any measure. The effect, of course, is that you improve your position.

The moral hazard arises when people see that insurance sometimes does better one’s position, and they come to expect it. They file a claim, end up no better off than they were, and feel cheated. Hence some feel tempted to cheat first. Insurers know this, and as they guard against it vigorously, they often make the claims process adversarial.

This may promote a kind of reluctant honesty, as it were, but it also eats away at the relationship between insurer and insured, and it does nothing to spread understanding of what insurance does and does not do in an orderly economy. You’re far better off knowing what to expect from your insurance before you make a claim--and that, of course, is the job of your broker.

“There is no functional equivalent for a 5-year-old computer,” says Robert E. Hayes, senior vice president of Aon Risk Services, a unit of the big insurance brokerage Aon Corp., with offices in downtown Los Angeles.

“Technological change confuses the picture because it brings the issue of betterment into the scene. You’re not going to get 10 new machines just because fire destroyed 10 old ones. You’re going to get enough machinery to restore your production capacity.”

Some business owners fall into another trap by increasing the insured values of their machinery and electronic equipment in accordance with inflation, Hayes says, and in doing so they may pay more for their coverage than necessary.

The smarter idea, Hayes says, is to gauge your risk and fashion your coverage accordingly. If you want to replace lost property with identical items, make sure you buy insurance that promises explicitly to do so--and prepare to pay a hefty premium too.

If you want your insurer only to restore your position in the event of a loss, insure the replacement cost of your property--that is, the cost of functionally equivalent property--and don’t expect to better your position when the time comes to file a claim.

“If you list equipment in accordance with what it cost you to buy it 10 years ago and then multiply it by an inflation factor, you may overstate your actual exposure and pay more premium than necessary,” Hayes says. “Instead, find out what it would really cost to replace your equipment with its functional equivalent--and insure that value.”

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Juan Hovey can be reached at (805) 492-7909 or at jhovey@gte.net.