Fire Insurance Defined

Sound Management dictates that properties should be adequately covered by

insurance to enable the business to replace damaged properties at the current
market price. Calamities such as typhoon, earthquake, fire are difficult if not
impossible for accompany to avoid. The only recourse is to cover the property with
an insurance policy, the most popular of which is the fire insurance policy.
Fire insurance is a contract whereby the insurance company (insurer), for a
fixed consideration called insurance premium, guarantees to pay the policy holder
(insured) specified sum of money for loss or damage sustained on the insured
policy.
Important factors to be considered
1. The policyholder pays a fixed consideration periodically called insurance
premium. Usually payment is made in advance and this is accounted for
using the Asset Method.
2. The basis for insurance settlement is the sound value if damaged property is
a depreciable fixed asset or market value if damaged property is in the form
of merchandise.
3. Insurance settlement shall in no case exceed the face of the policy. The policy
amount represents the maximum amount recoverable from the insurance
company.
4. The percentage of loss may be total or partial and should also be considered
in determining fire loss and insurance settlement.
Accounting for Fire To facilitate accounting when fire occurs and destroys property, a
Fire Lossaccount is often used. This is a summary account where one records all
transactions related to the fire evenntA debit balance represents the loss from fire.
A credit balance should be reclassified as Gain on Fire Insurace Settelement
In T Account form, the following are the transactions posted to the fire loss account
account:

Fire Loss
1. Salvage proceeds
3. Book value of
of destroyed
property
property
destroyed by fire
2.
Insurance claim
4. Cancelled
premiums
5. Expenses incurred
to the fire
Illustration related
1
event
On October 1, 2010 fire gutted totally the building of Angie Trading. This was
constructed on July 1, 2006 at a cost of P5,000,000 with an estimated useful life of
25 years. Insurance premium is paid every March 1 starting March 2007 for

P150,000 to Masuwerte Insurance Company. Face Value of the policy was P2000,000
and expenses incurred when the fire occurred amount to P20,000. The property has
Fire Loss
a sound value of P2500,000 and salvage proceeds amounted to P75,000 The Fire
loss account would thus reflect the ff:
P 4 150 000 6. Salvage proceeds P 75 000
1. Book value of
2 000 000
62 500 7. Insurance claim
building
20 000
2. Cancelled
premiums
3. Fire Expenses

Fire Loss will be a debit balance of P2 157 500.

a. Book Value of building:
Cost
Accumulated Depreciation from 7/1/06 to 10/1/10
5000000/25 years = P200,000 x 4.25 years

P 5 000 000
850 000
P 4 150 000

b. Cancelled premium (unexpired premium)

From 10/1/10 ro 3/1/11 (P15000 x 5/12)

P 62, 500

c. Insurance Claim is the sound value of P2 500 000

Or face of policy of P2 000 000 whichever is lower

P 2000 000

Accounting for damaged or destroyed property

1. Update depreciation from the last accounting period to fire date
2. Close the cost and accumulated depreciation of the property and charge
the book value to the fire loss account
3. Update insurance expense from the last accounting period to fire date
4. Charge the balance of the unexpired premium to fire loss
5. Charge expenses to fire loss
6. Credit fire loss for salvage proceeds and insurance claim.
Following illustration 1 and assuming that the last accounting period was December
31, 2009 the entries on October 1 will appear as follow:
1. Depreciation Bldg
P15 000
Accumulated Bldg
P15
000
To update depreciation from1/1 to 10/1
(5000000/25= 200000x9/12)
2. Fire Loss
415 000
Accumulated Depreciation Bldg
85 000
Building
500 000

To close book value for fire loss

3. Insurance Expense
Prepaid Insurance
To adjust for expired insurance
(150000x9/12)
4. Fire Loss
Prepaid Insurance Expense
500
To close unexpired insurance
5. Fire Loss
Cash

112 500
112 500
62 500
62

20 000
20 000
To record expense incurred by the firm

6. Cash

75 000
Fire Loss
To record proceeds from salvaged materials

7. Cash/Claim from Insurance Company

Fire Loss
To record receipt of claim

75 000

2 000 000
2 000 000

8. Income and Expense Summary

2 415 000
Fire Loss
2 157 000
Depreciation Expense
150
000
Insurance Expense
112 500
To close all nominal account to income and expense summary
Partially Damaged property
If the property is partially damaged, then only the book value of the
destroyed portion should be closed tp the fire loss account. Following
illustration 1 but assuming that the building was on 40 % destroyed, then the
book value to be charged to fire loss would be:
Building Cost (5M x .40)
Accumulated Depreciation (850 000x.40)
Book Value

P 2 000 000
340 000
1660 000

The insurance claim will also change. Where the loss is 40%, then insurance
claim will be 40% of the sound value of P 2 500 000 or the policy amount
which is P 2 000 000 whichever is lower. This time the insurance claim will
only be P 1000 000.
If the property is only partially destroyed, the agreement may call for the
policy to be in effect for the undestroyed portion. Then cancelled premiums
will be based on the following formula:
(Insurance Claim/ Policy Amount) x Unexpired Insurance

P1000 000/ 2000 000 or 50% * 62 500 = P31 250

The prepaid insurance account will still have a balance of 31 250 representing
premium for the undestroyed portion of the building from the date of the fire
up to the next premium date which is 5 months. This will be adjusted for the
expired portion on December 31, 2010 which is P 18 750 (P 31 250 * 3/5) with
the remainder to be expired on December 31, 2011.
TYPES OF INSURANCE POLICIES
Open Policy is an insurance policy where the value of the property insurance
is not agreed by the parties until date of loss or fire, hence the maximum
indemnity may not be provided for in the face of the policy. Amount of loss to
be compensated for is % of loss * agreed value of property which is usually
the sound value at date of fire.
Valued Policy is one where the value of the property is agreed upon at the
time the policy is made. Hence the maximum indemnity is stated on the face
of the policy and is the basis for claim. However, if it is a partial loss, then the
recoverable amount is agreed upon by the parties at fire date but in no case
should it exceed the face of the policy.
To illustrate:
Open policy: Sound Value of property at fire date, P750,000.

Agreed Value
% of Loss
Amount of
Loss
Insurance
Claim

Case 1
P1,000,000
100
P750,000

Case 2
P600,000
100
P750,000

Case 3
P1,000,000
80
P600,000

Case 4
P400,000
60
P450,000

P750,000

P600,000

P600,000

P400,000

In cases 1 and 3 the amount of loss is lower than the face of the policy, hence
insurance claim is based on amount of loss. In cases 2 and 4, the face of the
policy is lower than the amount of loss, hence insurance claim is based on the
face of the policy.
Valued Policy: Face of policy, P1,000,000
Case 1
Agreed value
Agreed loss
% of loss
Insurance

100
P1,000,000

Case 2
P750,000
P750,000
60
P750,000

Case 3
P1,500,000
80
P1,000,000

Case 4
P1,200,000
100
P1,000,000

claim
With a valued policy, as long as it is a total loss, the face of the
policy is the basis of the claim, as in cases 1 and 4, regardless of the percent
of loss on date of fire. However, if it is a partial loss then the agreed loss will
be determined at the date of fire but again in no case should claim exceed
the face of the policy.
POLICY WITH A CO-INSURANCE CLAUSE
A co-insurance clause provides that if property is insured at less than
its full value, then the company becomes a co-insurer thereof. It means that
the insurance company will not indemnify the policy holder for the full
amount of the loss because part of the loss should be shouldered by the
latter. The following formula is used:
Face of policy/Sound Value of property x Agreed Loss = Claim
To illustrate, assume that the face of the policy is P1,500,000 and the value of
the property is P1,750,000. There is a co-insurance clause and the property
was 75% destroyed by fire. The co-insurance clause was not complied with
since the value of the property is P1,750,000 but was insured only for
P1,500,000, then insurance claim will be:
Agreed Loss (75% x 1,750,000)

P1,312500

Claim: 1,500,000/1,750,000 x 1,312,500

P1,125,000

The policy holder is a co-insurer for 250,000/1,750,000 or 14.2857%.

POLICY WITH A CO-INSURANCE REQUIREMENT
If a policy provides for a co-insurance requirement in percentage and
the insured fails to comply with this, again the insured becomes a co-insurer
and the insurance company pays only a proportionate amount of the loss
based on the following formula:
Face of policy

Agreed Loss = Claim

Required co-insurance

In both cases, if the co-insurance clause or the co-insurance

requirement is complied with, then the general rule in determining insurance claim
should prevail.
To illustrate, assume face of policy is P1,500,000 and the value of the
property is P1,750,000:

Case 1)
There is an 80% co-insurance requirement and the property is 75%
destroyed by fire: The coo-insurance requirement is complied with since 80% of
P1,750,000 is P1,400,000 and the face of policy is P1,500,000. Thus the insurance
claim is based on the general rule which is agreed loss P1,312,500 (75% of
P1,750,000) or face of the policy P1,500,000, whichever is lower. Insurance claim is
P1,312,500.

Case 2) There is a 90% co-insurance requirement and the property is 75%

destroyed by fire: The co-insurance requirement is not complied with since 90% of
P1,750,000 is P1,575,000 which is higher than the face of policy. Insurance claim is
therefore:

(1,500,000/1,575,000) x P1,312,500 = P 1,250,000

POLICY WITH CONTRIBUTION CLAUSE

An insured, with the consent of the insurance, may insure his property with
different insurance companies. With a contribution clause, the loss is to be shared
pro rata by the
(Face of Policy Total policies) x Agreed Loss = claim from each insurer
To illustrate, assume that Money Company insured his property with three insurance
companies:
Loyalty Insurance Company

P1,000,000

Fidelity Assurance Company

1,250,000

Honesty Insurance Company

750,000
P3,000,000

If the building is 60% destroyed by fire and the sound value of the building was
P4,000,000, then the insurance claim will be:

Loyalty (1,000,000/3,000,000 x P2,400,000) P800,000

Fidelity (1,250,000/3,000,000 x P2,400,000) 1,000,000
Honesty (750,000/3,000,000 x P2,400,000)

600,000

P2,400,000

Suppose the property was 100% destroyed by fire? The insurance claims will
be the face of the policies since the total amount of P3,000,000 is lower than the
agreed loss which is P4,000,000.

CONTRIBUTION CLAUSE WITH CO INSURANCE CLAUSE

If the above policies contain co-insurance clauses (which are not complied
with since total amount of policies is lesser than the value of the property) then the
insurance claims are computed as follows:
Face of policy

agreed loss:

Sound value
Loyalty (1,000,000/4,000,000 x P2,400,000)

P600,000

Fidelity (1,250,000/4,000,000 x P2,240,000)

750,000

Honesty (750,000/4,000,000 x P2,400,00)

450,000

CONTRIBUTION CLAUSE WITH CO INSURANCE REQUIREMENT

Suppose the above policies contain co-insurance requirements of 70%, 80%
and 90% respectively? The formula will be:

Face of policy
Total policies or co insurance requirement whichever is higher
Agreed Loss

Loyalty (1,000,000/3,000,000* x P2,400,000) P800,000

Fidelity (1,250,000/3,200,000 x P2,400,000) 937,500
Honesty (750,000/3,600,00 x P2,400,000)

500,000

P2,237,500

*Loyalty

4,000,000 X 70% = 2,800,000 vs 3,000,000

Fidelity
Honesty

4,000,000 X 80% = 3,200,000 vs 3,000,000

4,000,000 X 90% = 3,600,000 vs 3,000,000

MERCHANDISE DESTROYED BY FIRE

If what is insured and destroyed by fire is the merchandise in the stockroom,
the agreed loss will be based on its fair market value estimated using the gross
profit method (a topic in financial accounting) less the salvaged merchandise or the
percentage of loss whichever is given.
To illustrate, assume that on March 17, 2010 a fire destroyed 80% of the
stock in the warehouse of Ana Company. This was insured for P50,000. The following
data were given to you:

Sales (Jan. 1 to March 16)

P180,000

Merchandise inventory, Jan. 1

60,000

Purchases from Jan. 1 to March 16

(including goods in transit of p10,000)
Mark-up cost

210,000
20%

To solve:

Merchandise Inventory, Jan. 1

P60,000

Purchases (exclusive of in transit)

200,000

Total

P260,000

Less Cost of Sales (180,000/1.2)

150,000

Merchandise in the bodega

P110,000

Percentage of loss
Merchandise destroyed by fire

80%
P88,000

Charge to Fire Loss P88,000 and credit income and Expense Summary
(periodic method) or Merchandise Inventory (perpetual method). Insurance claim
will be P50,000 which is debited to cash or a receivable to cash or a receivable
account and credited to Fire Loss.

Suppose percentage of loss is not given and merchandise not destroyed by

fire has a sales value of P10,000, then how much will be recoverable from the
inventory?

Merchandise in the bodega

P110,00

Less Unsold Merchandise (10,000/1.2) 8,333

Merchandise destroyed by fire

P101,667