In uncertain times, many businesses are shut down, but will their business interruption policy kick in?
Business interruption or BI losses are less tangible than direct physical losses. The insured needs to un understand the wording of the policy and how it affects the loss calculation. Both the nature of the loss and the specifics of the business must be understood before determining how to document the loss. This article provides practical tips for examining a business interruption loss and seeking an equitable settlement.
Step 1: Understand the coverage
A lot of current insurance policies in effect for business interruption coverage may have a provision that pandemics are excluded from the loss. This type of provision will almost certainly be challenged in court in a class action, so may, in the future, be open to the court’s interpretation. In addition, business interruption coverage is normally preceded by an event that has occurred, such as a building fire or a critical piece of equipment failing. The current pandemic shutdown has none of these items, and yet sales, and profitability of companies are almost certain to be affected
Marsh, a leading insurance broker, said it is experiencing a surge in inquiries for PathogenRX, a product launched in 2018 to provide financial protection to companies hit by an infectious disease outbreak in the United States and Asia. The product includes a policy underwritten by Munich Re, one of the world’s biggest providers of cover to protect insurers against big losses. Insurance policies with this provision would certainly respond to the current outbreak
Where the business interruption policy may well respond is where key suppliers that have been named in the insurance policy are unable to deliver a product, resulting in the company losing profitability as it is no longer able to manufacture due to a shortage of raw materials.
A solid understanding of the business interruption coverage is needed to determine the indemnity period (compensable period of loss from the event), the insured charges and expenses, the appropriate treatment of payroll costs, and the application of any coinsurance provisions. (The insured’s part of the loss)
Two forms of business interruption coverage are widely used in Canada, both as endorsements to the property policy: the Gross Profits form and the Gross Earnings form.
\Gross Profits form is based on the UK Insurance model, with Gross Earnings based on the USA Insurance model.
|Gross Profit||Gross Earnings|
|Period of cover||The predetermined maximum period of cover as a result of the event. The time period will be from 6 to 36 months set in six months increments||No predetermined period. The cover finishes when the last nail is inserted in the construction. There is no cover for losses sustained after the construction or repairs are complete|
|Formula to compare turnover in the 12 months preceding the incident to turnover in the period of cover. Uninsured working expenses are true variable costs. Gross profit is defined as turnover less purchases stock movement and uninsured expenses||Actual losses sustained during the time it would take to rebuild the insured’s property with “due diligence and dispatch” (If it takes to long to rebuild in the insurance companies’ view, it can limit payment to a “reasonable time”).
The calculation is normally a bottom-up calculation (net profit plus normal operational expenses, including payroll)
|Proximate cause||Indemnity to a business is qualified by the words “in consequence of the incident.”||Indemnity in business is qualified as “the actual loss sustained due to the suspension of the operations of the insured during the period of restoration.|
|The increased cost of working (ICOW)
Extra Expense (EE)
|ICOW is an additional expenditure incurred by the insured to minimize the loss of gross profit (hiring of a generator when there is an electrical failure)||EE is similar to ICOW but will cease when construction completes|
|Finished stock||Loss or damage to finished stock covered||Loss or damage to finished stock is not covered|
Based on the type of coverage will affect if the policy will respond to the latest pandemic. The Gross Profit BI Coverage may well respond to the pandemic, while the Gross Earnings BI Coverage is less likely to respond
Both provide coverage for loss resulting from a reduction in sales and loss resulting from an increase in costs (to avoid a reduction in sales).
Step 2: Understand the business
Business interruption loss calculations require a projection of the sales (the turnover or revenue) that would have been possible if the damage had not occurred. Questions to consider include:
- What is the legal form of the operation -sole proprietorship, partnership, joint venture, corporation?
- How is the business organized? One location or many? Segregated departments or linked? This is vital, as one area may be on shutdown, but production could be moved to another part of the country where there is not a lockdown in effect
- Are there key success factors, limitations, production bottlenecks, essential personnel or suppliers?
- What’s the impact of the overall business environment -regulation, competitors, other external events?
The insured is in the best position to educate the person completing the claim about both the business and the industry in general. At the same time, independent research can uncover information that will help you put the claim into context and evaluate representations made by the insured.
Step 3: Identify the cause of damage and expected impact
Business interruption coverage compensates the insured for business losses resulting from insured direct damage to property. To pinpoint which losses flow from the damage, you may need to call on independent experts to help review the cause of loss, estimate repair costs or estimate the restoration period.
Step 4: The insured has an obligation to act as if not insured
The insured should minimize business interruption losses by utilizing the following how:
- Request interim payments against covered losses, to help finance restoration and encourage the speedy recovery of operations. BI is one of the few losses where insurance companies are willing to make interim payments to minimize future damages.
- Generate a recovery plan for the organization (consider the rental of generators, a source of equipment, a temporary location, etc.).
- Keep track of contractors’ progress to prevent undue delays.
Step 5: Estimate the required reserve
At the outset, the insurer would like to know what the total amount of damages may be. In a fluid situation such as the pandemic, the only thing that will be established is that the reserve will need to change, making it critically important to record all of the assumptions made when advising the insurer of the required reserve
The insured or the insurer may engage an investigative or forensic accountant to help calculate losses, but may also require a preliminary estimate of the losses in advance of the detailed work, in order to set an appropriate reserve.
Before establishing a reserve, gather as much information as possible from the insured to document the basis for the estimate. If the reserve needs to be increased later, it will be easier to justify the change if your notes and reports concerning the preliminary estimate are clear. In some cases, losses may not be evident until they are incurred and you may have to wait until the indemnity period has ended before accurate numbers are available.
Step 6: Gather financial records
Even if a forensic accountant is involved in dealing with the claim, you’ll need to understand the evidence gathered.
Basic documentation generally includes the following:
- Recent financial statements, both audited and management accounts
- Forecasts (budgets) for future operating results
- Sales records and significant contracts with customers or suppliers
- Production records
- Details of equipment maintenance programs
- Payroll records
- Invoices for additional expenses
All parties in the claims process will need to cooperate to identify the most appropriate records in support of each item claimed.
Step 7: Examine the business outlook
The insured’s business outlook and environment also affect the operating results that would have been achieved. Assessing the business environment includes investigating the activities of competitors, regulatory bodies, suppliers, and customers. For example:
- Has a new competitor been eroding the insured’s market share?
- Have regulations been tightened or eased in ways that hamper or enhance productivity?
- Has a major supplier gone out of business, causing a shortage of raw materials?
- Have the insured’s customers been decreasing their orders in favour of internal production?
Step 8: Calculate the loss
The most important part of a claim is the formulation of the claim. This can be done by the company. The company may use an assistant such as a forensic accountant to formulate the claim. The cost of the forensic accountant will often be covered by the insurance company, in part or in full, if the insured has claims preparation costs as part of their policy. A basic framework for calculating losses under the standard Profits and Gross Earnings wordings.
- Calculate the insurable values using the profit and loss statement for the most recent financial year, adjusted to reflect the results that would have been obtained without the insured incident.
- Determine the rate of contribution using the insurable values as a percentage of sales.
- Calculate the rate of recovery by comparing the insurance in force with the minimum coverage required (determined by applying the specified coinsurance percentage to the insurable values).
- Determine the loss of sales during the indemnity period as a direct result of the damage. The sales loss is the difference between projected sales and actual sales.
- Calculate the lost contribution by applying the rate of contribution to the sales loss.
- Accumulate the additional expenses necessarily incurred to mitigate the sales loss. Compare these expenses to the avoided loss by applying the rate of contribution to the avoided sales loss (economic test).
- Deduct the savings in insured standing charges or non-continuing expenses.
- Calculate the loss related to ordinary payroll if separate coverage applies.
- Apply the rate of recovery to losses where a coinsurance clause applies.
- Determine the amount recoverable subject to the policy limits and not in excess of the actual loss sustained. Consider any waiting periods and deductibles that may apply.
Step 9: Examine related coverage
Since business interruption coverage is typically an endorsement to property coverage, the entire policy should be reviewed for related coverage to ensure the appropriate classification of losses. The insured cannot make a claim for the same item under two separate parts of the policy.
Extra expense coverage may be available for expenses incurred that do not meet the economic test associated with the additional expense coverage in the business interruption policy.
Step 10: Settle the claim
Business interruption loss calculations are estimated based on projected results in response to the question, “What if the damage had not occurred?” It is not possible to determine such losses with precision; they will almost always be subject to a negotiated settlement. There will always be competing interests during these negotiations and make every effort to ensure a timely and equitable settlement
No two claims are alike, and business interruption losses are no exception. However, these 10 steps can provide a framework for approaching the settlement process.
10 Steps to Settlement
- Understand the coverage.
- Understand the business.
- Identify the cause of damage and the expected impact on business.
- Help the insured recover quickly.
- Estimate the required reserve.
- Gather financial records.
- Examine the business outlook.
- Calculate the loss.
- Examine related coverage.
- Settle the claim.