Business Interruption Loss Claims
Business interruption losses are some of the most complex and challenging claims an analyst will face. Typically, they take a long time to resolve because the full extent of the loss is normally not realized for some period of time.
The goal is for the insurer to pay the policyholder’s lost profits and all continuing expenses so that, financially speaking, it will be as though the policyholder had not suffered a loss.
Generally, there are three types of business interruption insurance:
- “Business interruption” insurance is intended to compensate the insured for the income lost during the period of restoration or the time necessary to repair or restore the physical damage to the covered property.
- “Extended business interruption” provides coverage, typically limited by a period of time, for the income lost after the property is repaired, but before the income returns to its pre-loss level.
- “Contingent business interruption” provides coverage for the insured’s loss of income resulting from physical damage, not to its property, but to the property of providers or suppliers on the one hand or consumers of its product or services on the other.
Gross Earnings Insurance
With Gross Earnings Insurance, it is assumed that the loss ends once the company is in a position to restart its operations. Specifically, the period of indemnity is essentially the period of time required, with “due diligence” to “rebuild, repair or replace” the damaged property. The indemnity period may extend beyond the term of the policy, but it will end, at the very latest, at the end of a period specified in the policy, which is normally twelve months after the date of the interruption. Any loss which occurs after operations have recommenced is not insured.
There are two general forms of Gross Earnings insurance for: 1) mercantile or non-manufacturing companies, and 2) manufacturing companies. The differences between the two forms relate primarily to the definition of insured earnings. The mercantile form defines insured earnings as sales foregone, less the direct cost of goods sold and other direct material costs. The manufacturing form defines insured earnings as the sales value of production foregone, less certain costs and expenses.
The definition of earnings under either Gross Earnings Form does not include a deduction for payroll expenses. Therefore, “ordinary payroll,” which generally is the expense related to non-essential employees, is insured. If desired, ordinary payroll may be excluded from coverage by choosing the appropriate policy exclusion. Under this coverage, the insured is usually required to select either a 50% or 80% co-insurance factor.
A definition for the Gross Earnings Form follows:
Insurance coverage for loss in the gross earnings of the business (minus expenses that cease while the business is inoperative) as a result of the interruption of normal business activities caused by damage to the premises by an insured peril. Non-continuing expenses include light, gas, and advertising for which there is no contractual obligation.
Proof of Loss
Most policies require the insured to file a detailed “proof of loss” within a short period (30 days, for example) after a loss occurs. Then, after a preliminary review, the insurance carrier makes an initial estimate of the loss and establishes a loss reserve. Once this reserve is set, it may be difficult to convince the carrier to accept a larger claim, so make sure you document your losses as accurately and as soon as possible.
Estimating damages with a reasonable degree of accuracy in the early stages demonstrates to the carrier that you’re acting in good faith and supports requests for advance payments.
Determining your continuing and non-continuing costs is another critical issue. Most business interruption policies compensate the insured only for the former. In other words, to calculate recoverable lost income, you take lost sales and then subtract non-continuing costs. Continuing costs are not subtracted because they’re incurred despite the business interruption.
Mitigation
The insured’s duty to mitigate its loss is an area that’s ripe for controversy. Although there are many actions a company can take to limit its damages, not all of them are reasonable. For example, you might be able to reduce your company’s loss by laying off salespeople or other staff. But that may not be a smart move if the business interruption is relatively short, the cost of hiring replacements when normal operations resume is high, and the loss of experienced staff would hurt your company in the long term.
Establishing the Loss Period
The period of time that the operations of your business are interrupted is also critical to measure, as you are entitled to recover business income you would have earned during that period, but for the interruption.
Indemnity
As is true with other forms of coverage, business interruption coverage is based on the principle of indemnity, which provides that insurance should put the injured or damaged party in the same position as they were prior to the loss – no better and no worse. Business interruption claims are very difficult to quantify as they rely on projections of future income streams and expenses. As is the case with other forms of property coverage, the insured has the burden of substantiating its losses to the insurance carrier.
Extra Expense
The insured has a duty to minimize the business interruption exposure and resume all operations possible under the circumstances. However, the insurer does not have a right to force the insured to operate the business or deal with competitors in ways the insured feels do not reflect wise business decisions. The insured must remember that the insurance company is primarily concerned with the business during the interrupted period, whereas the insured must consider the livelihood of the business for years to come. As a result, the insured must make prudent decisions that are best for the business. Expediting an extra expense coverage can provide the insured with the latitude to make those decisions.
Expenses to reduce a loss – also known as “expediting expenses” – will have a substantial effect on a business interruption claim. For example, if the insured were to have parts flown in rather than delivered by truck, in order to reduce the business interruption loss, the increased loss would be covered under expediting expenses. They are covered only to the extent that they actually reduce the loss. For example, if it costs $1,200 to save $1,000 of business interruption, the insurer would pay only $1,000 as an expediting expense. However, if the $1,200 is spent reasonably in an effort to resume operations, the $200 difference would be covered under “extra expenses.” The prudent business person might actually spend $1,200 to save $1,000 when the long-term benefits in protecting market share justify the additional expense.
Extra expense coverage which expands the basic business interruption coverage can provide benefits, especially to those that can ill afford to be closed for any amount of time. Other businesses must resort to subcontracting work to maintain their market position and reduce their loss of earnings.
Executive Overtime
Another point to be considered with business income claims is the time spent by staff trying to resume operations under adverse conditions. This often involves not only hourly employee, but salaried personnel and officers as well. If part of an officer’s time is needed to plan strategies for operating under the interrupted conditions, additional time should be calculated in the claim. If after a loss officers must concentrate on minimizing the business income claim instead of handling their normal tasks, such loss of expertise needs to be addressed in the calculation of the claim. It should be noted that carriers normally resist this type of claim by maintaining that unless additional compensation is actually paid, there is no actual loss.
Extra Expense
- Extra Expense insurance reimburses a company for what it spends, over and above normal operating expenses following a loss
- Extra expense may include those necessary to continue operating the business at its original location, or at a temporary replacement location until the original location is repaired.
- Extra expense may include the costs necessary to continue operating the business at its original location, or at a temporary replacement location until the original location is repaired, and it may also include the costs to source replacement product.
- Unlike mitigating or expediting expenses, extra expenses do not necessarily have to reduce the loss. However, they may be capped by policy endorsements.
Period of Interruption
The period of interruption is defined as the “reasonable amount of time necessary for the insured to resume business.” Obviously, the time required will vary not only by the amount of damage suffered, but also by the nature of the company’s operations. Most policies will not cover the entire period needed to rebuild the business to the level that would have been enjoyed had the loss not occurred, but only to the point where goods or services are being produced again – presuming the markets are still there.
Discontinuing Expenses
An important calculation in a business income claim, is subtracting expenses which “necessarily” discontinue. The word “necessarily” appears in most policies and its importance can hardly be overstated.
Consider the case in which an insured is forced to shut down permanently as the result of a devastating loss. Many insurers would attempt to stop (or discontinue) most expenses. However, the insured would need to calculate expenses that would have occurred if the company had returned to business. For example, it the company had been operating from a leased location, rental payments might actually cease for only nine months out of twelve. The insured would need to continue to lease the property while renovations were made and the merchandise restocked. Therefore, in making these calculations, only nine out of twelve months rent would be saved.
Depreciation is another factor that can often be used to the disadvantage of the claimant because many insurers prefer to use the insured’s income tax return for the depreciated value of property or equipment it reflects. Values on a tax return are often highly overstated. The IRS policy of allowing an asset to be depreciated over an accelerated period of time does not reflect the actual life span or economic value of that asset.
Net Profit or Gross Profit
A mistake often made in evaluating a potential business income claim is considering only the net profit. This approach is incorrect. For example, let’s say a business had $7 million in sales per year, a gross margin of $5 million, and a net profit of a respectable $500,000; and management expected that six months is as long as the company would be out of business. It would be foolish for the firm to buy $250,000 of coverage at 100% co-insurance since it would collect only five cents on the dollar! A quick look at the formula by which such a business interruption claim is calculated shows why:
Amount of insurance x loss = claim
Co-insurance % x Gross earnings
-or-
$250,000 x $250,000 = $12,500<
100% x $5,000,000
Business income insurance is generally sold on a “gross profit” (or “earnings”) basis rather than “net profit” basis. The industry recently changed the general definition of coverage from “gross profit less discontinuing expenses” to “net profit plus continuing expenses.” Since the policy form writers insist there is no intended diminution in coverage, the calculations should have the same result.
The mechanism of calculating the loss includes examining what revenues the policyholder would have earned had the loss not occurred. One must deduct the actual revenues earned during the repair period, and from this revenue figure, the business interruption value can be obtained by subtracting the expenses that did not continue during that repair period.
Co-Insurance
Business interruption policies have significant co-insurance penalties for under insuring. A coinsurance penalty is a deduction applied by the insurer to the amount paid. Depending on the type of policy, the penalty can range from 20-50% of a claimed loss.
Insurance policies define the amount of insurance coverage required in terms of “gross earnings” and most policies define “gross earnings” in a substantially different method than your financial accountant would.
Insurers are becoming increasingly aware of the difficulty business owners have with these policies. A large number of insurers now include in the policies the Premium Adjustment Endorsement. If your policy does not, consider asking for the endorsement. The Premium Adjustment Endorsement helps eliminate the co-insurance risk by allowing the business to over insure. At the end of the policy period, the premiums are recalculated and any excess premiums are returned. Thus, the business owner can purchase a higher limit of policy without wasting premium dollars.
Co-Insurance and Adequacy of Coverage
In an Earnings policy, there will be either a 50% or 80% co-insurance requirement. Gross Proftis policies do not specifically state the amount of required co-insurance, however the policy implies 100% co-insurance. After determining the amount of required coinsurance, the adequacy of the coverage should be evaluated to determine the portion of the total loss which is actually insured.
If a coinsurance percentage is shown in the Declarations, the following condition applies in addition to the Common Policy Conditions and the Commercial Property Conditions. An excerpt from an actual policy follows:
"We will not pay the full amount of any Business Income loss if the Limit of insurance for Business Income is less than:
- The Coinsurance percentage shown for Business Income in the Declarations; times
- The sum of:
- The Net Income (Net Profit or Loss before income taxes); and
- Operating expenses, including payroll expenses;
that would have been earned or incurred (had no loss occurred) by your “operations” at the described premises for the 12 months following the inception, or last previous anniversary date, of this policy (whichever is later)."
Instead, we will determine the most we will pay using the following steps:
- Multiply the Net Income and operating expenses for the 12 months following the inception, or last previous anniversary date, of this policy by the Coinsurance percentage;
- Divide the Limit of Insurance for the described premises by the figure determined in step 1; and
- Multiply the total amount of loss by the figure determined in step 2.
We will pay the amount determined in step 3, or the limit of insurance, whichever is less. For the remainder, you will either have to rely on the other insurance or absorb the loss yourself.
Example:
When: The Limit of Insurance is $100,000.
The Agreed Value is $200,000
The Amount of Loss is $80,000 $100,000 ÷ $200,000 = .50
.50 x $80,000 = $40,000
We will pay $40,000. The remaining $40,000 is not covered.
In determining operating expenses for the purpose of applying the Coinsurance condition, the following expenses, if applicable, shall be deducted from the total of all operating expenses:
- Prepaid freight – outgoing;
- Returns and allowances;
- Discounts;
- Bad debts;
- Collections expenses;
- Cost of raw stock and factory supplies consumed (including transportation charges);
- Cost of merchandise sold (including transportation charges);
- Cost of other supplies consumed (including transportation charges);
- Cost of services purchased from outsiders (not employees) to resell, that do not continue under contract;
- Power, heat and refrigeration expenses that do not continue under contract;
- All ordinary payroll expenses or the amount of payroll expense excluded; and
- Special deductions for mining properties (royalties unless specifically included in coverage; actual depletion commonly known as unit or cost depletion – not percentage depletion; welfare and retirement fund charges based on tonnage; hired trucks).
Example No. 1 (Underinsurance):
The Net Income and operating expenses for the 12 months following the inception, or last previous anniversary date, of this policy at the described premises would have been:
$400,000
The Coinsurance percentage is 50%
The Limit of Insurance is $150,000
The amount of loss is $80,000
Step 1: $400,000 x 50% = $200,000
(the minimum amount of insurance to meet your Co-insurance requirements)Step 2: $150,000 e $200,000 = .75
Step 3: $80,000 x .75 = $60,000
We will pay no more than $60,000. The remaining $20,000 is not covered.
Example No. 2 (Adequate Insurance):
The Net Income and operating expenses for the 12 months following the inception, or last previous anniversary date, of this policy at the described premises would have been:
$400,000
The Coinsurance percentage is 50%
The Limit of Insurance is $200,000
The amount of loss is $80,000
The minimum amount of insurance to meet your Coinsurance requirement is $200,000 ($400,000 x 50%). Therefore, the Limit of Insurance in this example is adequate and no penalty applies. We will pay no more than $80,000 (amount of loss).
This condition does not apply to Extra Expense.
Policy Exclusions
Some of the more common exclusions follow:
- Since there typically must be a covered loss to covered property for business income coverage to apply, all of the exclusions in the property section of the policy are generally relevant.
- Coverage is generally excluded for periods when operations would normally have been idle.
- Additional cost with rebuilding due to labour unrest may be excluded.
- Income loss on long-term contracts may be limited to period ending with completion of repair or replacement.
- Coverage for consequential losses is generally excluded, unless the policy contains an extension of coverage for such losses.
- Coverage generally does not extend to utility service interruption.
- For manufacturing operations, recovery for lost profits on finished stock may be covered under physical damage to property, rather than under business interruption.
Property exclusions:
Idle periods:
Interference:
Loss of contracts:
Consequential losses:
Utility service interruption:
Finished stock:
As always, the policy wording must be examined critically in order to determine whether there will be coverage in any give situation.
Legal Issues
There will be a duty on the insurance broker, in certain situations, to provide business interruption insurance (or at least to explain its use) to their client: Pan Oston Ltd. v. Bowes & Cocks Insurance Brokers Ltd. [1998] I/L.R. para1-3590 (Ont. Gen Div.), aff’d 95 A.C.W.S (3d) 213 (C.A.)
Consequential Damages
Policyholders can now recover for damages beyond policy limits caused by the insurance company’s breach of policy, as a result of a pair of landmark 2008 decisions by the New York Court of Appeals (NY’s highest court).
According to the Court of Appeals, included in all insurance contracts is a promise by the insurer to act in good faith and deal fairly with the policyholder, which necessarily includes timely investigation and payment of covered claims.
The court, therefore, held that limiting the policyholder’s damage to the policy proceeds plus interest “does not place the insured in the position it would have been in had the contract been performed.”
Therefore, the Court held it is only fair for the insurer to be liable for not only what which should have been paid under the policy, but also for additional damages to compensate the policyholder for the resultant loss of the business.
The significance of the Court’s decision to award such consequential damages cannot be overlooked.
More importantly, the Court’s express recognition that the demise of the policyholder’s business is a probable and foreseeable consequence of an insurer’s failure to promptly pay a claim under a business interruption policy, thereby warranting consequential damages, can have far reaching effects beyond cases of bad faith on property damage and business interruption claims.
A sample summary loss claim follows:
| Insurance Claim Date of Loss: May 21, 2010 |
Remarks | |
|---|---|---|
| Direct Loss | ||
| Labor for Cleanup | $ 25,000 | |
| Property Damage Repairs | 16,000 | |
| Inventory Lost | 125,000 | Per Endowment |
| CPAs & Experts | 21,000 | |
| Management Salary - Devoted to Disruption | 65,000 | |
| Other Expenses | 2,500 | |
Total Direct Loss |
$254,500 |
|
Business Income Loss |
||
Lost Revenues |
$1,200,000 |
|
| Business Gross Profit | 42.00% | |
| Business Margin Loss | 504,000 | |
| Lost Customers (Book of Business) | 162,000 | Per Endorsement |
Total Business Income Loss |
$ 666,000 |
|
| Collectible Percentage (Co-Insurance) | 68.72% | |
Collectible Business Income Loss |
$ 457,676 |
|
Total Loss |
$ 712,176 |
Conclusion
In lieu of the current environment with respect to business interruptions to include the BP Oil Spill, I hope this information is timely and useful.