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Tapping Business Interruption Insurance Coverage to Assist Small Business During the COVID-19 Pandemic: Benefits and Drawbacks

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by Lloyd Dixon and Bethany Saunders-Medina

April 10, 2020

Legislation has been introduced in several states that would require insurers to cover business interruption losses due to the COVID-19 outbreak even if the policies exclude losses due to viruses and communicable diseases. Such laws would undoubtedly encounter challenges under the Contract and Takings Clause of the federal constitution and similar provisions in state constitutions. But setting apart such challenges, what are the advantages and disadvantages of such a law? If policymakers were to proceed with such an approach what design considerations should they keep in mind?

Background

There are a number of potential sources of assistance for losses due to disaster. These include government programs, insurance payments, tort cases, and philanthropy. Insurance plays a major role after many disasters. For example, insurance payments accounted for roughly 50 percent of the benefits paid out to those killed in the 9/11 attacks and the businesses and individuals in New York City affected by the attack on the World Trade Center. In the face of large losses by businesses and their employees due to stay-at-home orders, some are advocating legislation that would increase insurance payouts for business interruption due to COVID-19-related losses.

Property policies for smaller business often include provisions aimed at excluding coverage for business interruption losses due to virus and bacteria. Legislation has been introduced in New Jersey, Ohio, and Massachusetts to nullify this potential exclusion. For example, Ohio's law would require that

Notwithstanding any other law or rule to the contrary, every policy of insurance insuring against loss or damage to property, which includes the loss of use and occupancy and business interruption, in force in this state on the effective date of this section, shall be construed to include among the covered perils under that policy, coverage for business interruption due to global virus transmission or pandemic during the state of emergency.

The law would apply to policies issued to businesses located in the state with 100 or fewer employees. Importantly, insurers who make payments to policyholders due to the legislation can apply to the state Superintendent of Insurance for reimbursement for such payments, and the superintendent will recover such outlays from insurers in the state. The bill is silent on whether insurers would then be able to pass on such assessments to future policyholders.

Benefits of Legislation to Require Insurers to Pay COVID-19-Related Business Interruption Losses

Retroactively requiring insurance policies with business interruption coverage to cover business interruption losses due to COVID-19 is attractive for a number of reasons.

Provides a Source for Badly Needed Assistance

The insurance payments would help firms that might be at risk of failing and workers who may have difficulty meeting their basic needs.

Takes Advantage of Insurance Claims Paying Machinery

There could be as many as 30 million claims from small business that suffered COVID-19-related losses

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Insurers have well developed mechanisms for valuing and paying claims. Insurers can pay claims relatively quickly and do not have to wait for the promulgation of regulations to distribute legislatively approved funding. However, the scale of the COVID-19 outbreak would create challenges for the industry. An industry trade group projected that there could be as many as 30 million claims from small business that suffered COVID-19-related losses—which is more than 10 times the number of claims that the industry has handled in any one year.

Rewards Firms That Plan Ahead for the Risks They Face

From a social perspective, there are many advantages to relying heavily on insurance to reimburse disaster losses. Properly priced insurance provides incentives to mitigate risk and insurance can make payments more quickly than government programs established post event. Providing payments for COVID-19 losses through the insurance mechanism can increase the visibility of insurance in our nations disaster compensation system.

Spreads Losses over All insurers, and Potentially All Commercial Policyholders in the State

The assessments of all insurers to pay for COVID-19-related business interruption payments would avoid potentially concentrating the costs on a small set of insurers that happen to write business interruption coverage in the industries most affected by the virus. If insurers can then recover the assessments from policyholders, the costs would then be distributed broadly across the businesses in the state.

Preempts Coverage Litigation over Business Interruption Coverage

There will undoubtedly be disputes and litigation between insurers and policyholders regarding whether the language in particular policies exclude COVID-19-related losses. Legislation mandating such coverage would presumably preempt such disputes, although litigation over the constitutionality of such legislation will undoubtedly arise.

Drawbacks of Legislation to Require Insurers to Pay COVID-19-Related Business Interruption Losses

A key drawback of requiring payment of COVID-19-related business interruption losses is the potentially adverse effect on the price and availability of business interruption insurance in the future. Insurance priced at levels that accurately reflects underlying risk allows businesses to transfer risk and make investments that would otherwise be too risky to justify. A robust and well-functioning insurance market will be essential for economic recovery and growth after COVID-19 passes. Legislation that interferes in the insurance contract process can adversely affect price and availability in a number of ways.

Reduces Existing Surplus

Requiring coverage for risks for which premiums were not collected will result in large losses in insurer surplus (insurer assets net of liabilities). The surplus was not sized to take account of COVID-19-related losses with the result that existing insurers will not be well positioned to continue or expand coverage once the virus abates. New insurers may enter the market, but it may take time to replace insurance-writing capacity.

Magnifies Contract Uncertainty

The possibility that contract terms can be reinterpreted by legislators, regulators, or courts can increase insurance price and reduce the availability of coverage. For example, concerned with efforts by residential insurers to reduce their exposure to wind risk after Hurricane Andrew in 1992, the Florida legislation prohibited insurers from nonrenewing more than 5 percent of their book of property policies in any 12-month period. This change coupled with restrictions on increasing premiums prompted insurers to adopt strict underwriting standards to limit the type and amounts of new business and was one factor leading to a dramatic reduction of the market share of large, national insurance companies in the state. In the case of COVID-19, these state programs will likely magnify insurer concerns regarding contract uncertainty.

Enhances Assessment Uncertainty

The potential that an insurer can be assessed to cover losses of other insurers can also reduce the willingness of insurers to write coverage or increase the price at which the are willing to offer it. A case in point is the experience in Mississippi following Hurricane Katrina. Budget shortfalls by state residual insurance markets that provide coverage to homeowners that could not find coverage in the standard market resulted in substantial assessment on all insurers in the state. In one case, a residential insurer whose policies were all in the northern part of the state observed that despite this underwriting caution, the company was required to pay a loss assessment that exceeded the total direct premium it wrote in 2005. Such assessment reduced the incentive to write coverage in the state. A program to finance COVID-19 related business interruption payment through insurer assessments should be expected to enhance insurers concern about future assessments and increase the costs of coverage.

Litigation

While such a law may reduce insurance coverage litigation involving insureds suing insurers, such a law will likely prompt considerable constitutional litigation and controversy over the appropriateness of a government abrogating explicit contract terms.

Implications

Although the short-term benefits of legislation to require insurers to pay COVID-19-related business interruption losses are attractive, the long-term drawbacks of such legislation are real, although hard to quantify. Policymakers should compare the advantages of potentially quick infusions of resources to small business with the potential longer-term consequences of higher-priced and more limited coverage on economic recovery and growth once COVID-19 passes and protracted constitutional litigation. Policymakers should also compare the benefits and drawbacks of this source of assistance with other potential sources, such as state or federal aid.

If policymakers do decide to pursue such legislation, they could consider how to tailor it in ways that reduce potential adverse consequences. For example, claims payments to any insured could be capped to reduce overall costs. Or, the ability of insurers to recover assessments from future policyholders could be made explicit up front. To eliminate the need to take similar actions in future pandemics or relative large-scale disasters, policymakers might also consider setting up a government insurance backstop for losses due to pandemics. In return for dropping exclusions in insurance policies for pandemics and communicable diseases, state or federal governments might provide a backstop once insured losses reach a certain level. But such an approach would best be taken by agreement, rather than fiat.


Lloyd Dixon is director of the RAND Center for Catastrophic Risk Management and Compensation and a senior economist at the nonprofit, nonpartisan RAND Corporation. Bethany Saunders-Medina is a policy analyst and coordinator for the RAND Institute for Civil Justice.

Commentary gives RAND researchers a platform to convey insights based on their professional expertise and often on their peer-reviewed research and analysis.