STEP 1.1: DOES THE BI POLICY COVER THE LOSS?
The vast majority of Business Interruption policies will only respond to a loss that follows damage to the physical assets of the business that are covered by an insurance policy. This may be a Fire policy, a Business Pack or Section 1 of the Industrial Special Risks policy. In insurance terminology, the insurance of property is known as Material Damage cover. Hence, the section of the Business Interruption policy that deals with this area is known as the Material Damage Proviso.
A typical Material Damage Proviso states:
“A claim for business interruption can only be made for disruption to the business resulting from damage to insured property by an insured peril.”
STEP 1.2: NOT ALL DISRUPTIONS FOLLOW DAMAGE
Not all disruptions to a business are caused by damage to insured property. Examples of losses sustained through other causes include:
- Denial of access, i.e. where damage to buildings, roads, bridges etc (not the property of the Insured) prevents access to the Insured’s place of business.
- Major damage or destruction of property of a major supplier or major customer of the Insured.
- Loss of Public utilities, the failure of water, and telecommunications, including Internet access, have also resulted in business interruption losses
Cover is available for all of these possibilities and for others as well. We strongly recommend that all clients make use of a competent insurance Broker or adviser who can explain and quote on all aspects of the various covers available.
The important point to bear in mind is that the disruption must follow damage to insured property by an insured peril. The reason for this is many-fold, and includes the benefit to the Insurer that they do not have to repeat all the Exclusions under the Material Damage policy. Another benefit is that the Insurer only responds to claims to reinstate the damaged property. This is by way of the Material Damage policy.
STEP 2.1: CALCULATE THE STANDARD TURNOVER
Under the earlier heading of, The Underlying Principle, we explained that the underlying principle of the Business Interruption cover was to place the Insured in the same position they would have enjoyed but for the loss. This sounds good in theory, but just how do you determine what the Turnover would have been in our case for the three months of the disruption. Anyone in business knows that nothing stays the same. There are peak periods and quiet periods throughout the year. As an example, Christmas is typically a good selling period for retailers.
The Business Interruption policy overcomes such difficulties by providing a formula under which the claim is to be calculated. This formula is preceded by a series of definitions that explain which items are to be included in the claim calculation. The first definition of interest is the one for Standard Turnover. The typical definition for Standard Turnover is:
“Standard Turnover – The Turnover during that period in the 12 months immediately before the date of the damage which corresponds with the Indemnity Period.”
STEP 2.2: CALCULATE THE STANDARD TURNOVER – PART 2
To overcome the problem of seasonality, the policy uses as its starting point, the corresponding period 12 months before, as the period of the current disruption. This is not necessarily for the full 12 months, but for the same period as the period of the current disruption.
By taking the figures straight from the financial records, we can easily determine that the Standard Turnover for the 12 months of the loss . A section of the accounts is set out below.
Table 1 – Standard Turnover (July 2008 to June 2009)
STEP 3.1: CALCULATE THE ADJUSTED STANDARD TURNOVER
We have already discussed that businesses are rarely, if ever, static and they grow or decline over time. To use figures from 12 months earlier to calculate a claim may well disadvantage an Insured. To maintain the underlying principle of the policy, the extremely important Adjustments Clause is included in the policy. For example:
“Adjustments shall be made to the Rate of Gross Profit, Annual Turnover, Standard Turnover and Rate of payroll as may be necessary to provide for the trend of the business and for the variations in or other circumstances affecting the business either before or after the damage or which would have affected the business had the damage not occurred, so that the figures thus adjusted shall represent as nearly as may be reasonably practicable the results which, but for the damage, would have been obtained during the relative period after the damage.”
This simply means that adjustments should be made to the Standard Turnover (and three other areas that we will discuss later) to arrive at what would have been achieved but for the loss. The adjustments can be for:
- Seasonal Variation: Cycles that occur over short periods of time (less than 1 year). As the policy has already addressed trend in the use of Standard Turnover, only changes in trend would typically be addressed under the Adjustments Clause. This may be caused by the change in date of a religious festival such as Easter.
- Trend: Long-term, relatively smooth pattern of the business (longer than 1 year).
- Economic Cycles: A wave-like pattern, which varies about the long-term trend (boom and recessions).
- Irregular Fluctuations: Any random movements after trend, cycles and seasonal variations are removed.
STEP 3.2: GROUPED AS TREND AND SPECIAL CIRCUMSTANCES
These are often grouped together and called Trend & Special Circumstances. In theory, this sounds quite easy, but in reality this is quite often the most difficult part of the whole calculation. Business owners are typically optimists and, in just about every case we have been involved in, the business owner has argued that “but for the fire, this would have been our best year yet”. On the other hand, Insurers and their Agents (i.e. Loss Adjusters) have handled many claims for all types of businesses. They require substantial proof of any adjustment to the Standard Turnover. The best place to start is to look at the performance of the affected business over a reasonable period. The use of computer spreadsheets has made this task much easier.
STEP 3.3: ANALYSIS OF MONTHLY TURNOVER
STEP 3.3: ANALYSIS CONTINUES
As part of any such analysis, it is necessary to look at the monthly, quarterly, six monthly and annual growth (both positive and negative) in the business. Finally, and this is often overlooked, is the need to examine if any special circumstances have arisen, which may have affected a business. These may have been the opening or closing of a nearby competitor, a change of opening times, or other changes in customer behaviour – these all need to be addressed. Absolutely anything and everything that may have altered the performance of the business, either positively or negatively, should be examined. Remember the Adjustments Clause states that the changes can be pre- or post-loss. In our case despite the obvious downward trend. Both annually and in the months imeediately before the loss a new set of menus had been prepared to take advantage of an increase in interest in the lunchtime trade and a new market for the restaurant by catering for Pre Theatre Dinner Customers. The effect of this change in trading was discussed with the Loss Adjuster as being a Special Circumstance and it was agreed that the downward trend would have been arrested by the changes and a nil trend was applied to arrive at the calculation of Standard Turnover for calculation of the Shortfall in Turnover for the Indemnity Period.
STEP 4.1: TURNOVER ELSEWHERE
When considering the Turnover achieved by the insured business, we again refer to the policy wording. Most policies clearly define this. Using the ISR Mark IV wording as an example, this policy states:
“Turnover Elsewhere After Damage:
“If during the Indemnity Period goods shall be sold or services shall be rendered elsewhere than at the Premises for the benefit of the Business either by the Insured or by others on his behalf, the money paid or payable in respect of such sales or services shall be brought into account in arriving at the Turnover during the Indemnity Period.”
This is self-explanatory and follows the underlying principle of putting the Insured in the same position as if the loss had not occurred.
STEP 4.2: SHORTFALL CALCULATED
We now bring all this together to calculate the Shortfall in Turnover caused by the disruption as a result of the fire on 1 April 2009. This is set out in Table 4 below
At this point, we have calculated the Shortfall in Turnover.
STEP 5.1: CALCULATE THE RATE OF GROSS PROFIT
Gross Profit, as defined under a Business Interruption policy, is not necessarily the same as accounting gross profit. This is something that is often misunderstood by an Insured or their accountant, with adverse effects to the settlement. The policy once again provides a definition.
The definition for the Rate of Gross Profit as stated in the policy wording is:
“GROSS PROFIT: the amount by which:
1. the sum of the Turnover and the amount of the Closing Stock and Work in Progress shall exceed
2. the sum of the amount of the Opening Stock and Work in Progress and the amount of the Uninsured Working Expenses as set out in the Schedule.
Note: The amounts of the Opening and Closing Stocks and Work in Progress shall be arrived at in accordance with the Insured’s normal accountancy methods.”
The actual loss sustained by a business is not the Loss of Turnover, as there are variable costs that are not incurred which normally would be. To be compensated for such costs would mean that the Insured profits from the event, which goes against the underlying principle of insurance. The policy bases the amount paid on the Loss of Gross Profit, which is a percentage of the Shortfall in Turnover.
STEP 5.2: UNINSURED WORKING EXPENSES
At the beginning of this case study, details were provided on what constitutes uninsured working expenses. These are usually taken from the policy schedule.. In reality the expenses listed should only be those that are truly variable to sales.
Far too often, the Uninsured Working Expenses are not recorded anywhere, and the only uninsured expense that is taken into consideration is direct purchases. This is fine, as long as the Sum Insured or Declared Value (we will discuss each of these terms shortly) is adequate. Otherwise, the claim will be proportionally reduced by the amount of under-insurance. The reality is that the cover may not have been purposely uninsured, and the problem has come about by not recording as Uninsured Working Expenses, those expenses which are 100% variable to Turnover. We discuss this further in the Business Interruption Calculator section of this website. The point that is being stressed here is that it is imperative that the Insured, Broker and Insurer all know in advance which items in the accounts have been chosen by the Insured as Uninsured Working Expenses.
The Uninsured Working Expenses chosen in this example are:
- Purchases adjusted for opening and closing stocks
- Bad Debts
Even purchases are sometimes not variable with turnover. For example, a business that forward purchases raw materials may find that, following some catastrophic event in which their production capacity has been destroyed, they are still obliged to continue to take in raw materials that have been purchased and which will have to be paid for. In those circumstances it will be preferable to insure turnover rather than gross profit as none of the costs of running a business are actually variable with turnover.
STEP 5.3: ADJUSTING THE RATE OF GROSS PROFIT
The policy definition of the Rate of Gross Profit also brings in changes to stock levels. Again, this is discussed in detail in the section titled Calculating the Sum Insured. To level of stock taken in this example, takes opening stock as £19,065 and Closing Stock as £22,977. There we no adjustments made for Discounts and Bad Debts.
The Rate of Gross Profit in a business can and does vary. This can be due to a myriad of reasons. For example, a business may have increased its selling price, but been able to keep costs steady. Improvements in efficiency may have been achieved by the introduction of a new machine or process. It is therefore necessary to not only look at the Rate of Gross Profit as defined in the policy for just one period, but to look at it over time to ascertain if there has been any movement. If so, the question needs to be asked, “Why?”
Finally, it is necessary to look at whether any changes were planned in the business, either by way of pricing, improvements in efficiency or increases in production costs, that may have or will affect the Rate of Gross Profit sometime during the period of disruption. For example, a planned price increase from 1 August 2009 would have generated more Gross Profit for the insured business. If the Insured’s claim was only based on the historic Rate of Gross Profit without an adjustment from 1 August 2009, they would not be compensated fully.
An adjustment may also be warranted if the Rate of Gross Profit changes due to seasonality. For example, a toy store may have a higher Rate of Gross Profit during the months leading up to Christmas, particularly when compared to January when they may have an annual clearance sale in which the price of all toys is reduced.Referring back to the definition of the Adjustments Clause, you will note that adjustments are not only possible to Standard Turnover, but also to three other calculations including the Rate of Gross Profit. Remember the underlying principle of ‘returning the Insured to the position, as near as money will allow, to where they would have been but for the loss’.
STEP 5.4: ADJUSTMENTS TAKE SKILL & TIME
As with the Standard Turnover, the following expenses are taken from an actual business to lend some authenticity to the study. A spreadsheet is once again utilised to examine not only the current Rate of Gross Profit, but also any changes in the Rate of Gross Profit. To highlight any changes that may be occurring and to ascertain why, particularly if they are only short-term changes that may cause a one-off effect, it is recommended that each of the uninsured working expenses are looked at separately.
STEP 5.5: AGREEING THE RATE OF GROSS PROFIT
In our example, the Insured did not have any plans which would have altered the Insured Rate of Gross Profit. The Rate of Gross Profit for this business has in fact remained fairly constant at around 71.55%. A professional Loss Adjuster will (or should) have handled claims for a wide range of businesses, may therefore have statistics on each. Again, it must be stressed that these are only reasonableness tests, and every business is different.
In our example, the calculated Rate of Gross Profit of 71.55% is considered reasonable to use as the Adjusted Rate of Gross Profit?
STEP 6.1: CALCULATE THE LOSS OF GROSS PROFIT (ITEM 1A)
In this step, we simply apply the Adjusted Rate of Gross Profit (71.55%) to the Shortfall in Turnover of £979,245 to obtain the Loss of Insured Gross Profit of £700,649. Table 6 below shows the calculation on a month-by-month basis.
Table 6 – Calculation of Loss of Gross Profit (July 2009 to June 2010)
STEP 7.1: INCREASED COST OF WORKING
What we have covered so far in this section is known as Item 1(a) of a typical Business Interruption policy, i.e. Loss of Gross Profit. As every businessperson knows, it is much easier to retain a customer than to find a new one. The insurance policy accepts this notion, and realises that in the event of an insured loss, it is often better to incur some increased costs to minimise the period of disruption and/or the shortfall in Turnover during the period of disruption. This is addressed in Item 1(b) of the policy, titled “Increase in Cost of Working”.
In our example, the owners of the restaurant had the Gratuities or Tronc to be dealt with as an Increased Cost of Working. together with the costs of accelerated working to allow reopening for Christmas 2009 and costs incurred in promoting the reopening of the premises.
The Material Damage section of the policy would only have met the cost of the replacement machine. This would have allowed for sea freight, but not the more expensive airfreight. There has been a significant saving under the Business Interruption section of the policy as a result of the increased expenditure and, to determine what, if any, is recoverable under the policy, we once again refer to the standard. Item 1(b) – Increase in Cost of Working states:
“The additional expenditure necessarily and reasonably incurred for the sole purpose of avoiding or diminishing the reduction in Turnover which, but for that expenditure, would have taken place during the Indemnity Period in consequence of the damage, but not exceeding the sum produced by applying the rate of gross profit to the amount of the reduction thereby avoided.”
The first issue to understand when considering whether an increased cost is recoverable, is that the expense must be for the sole purpose of avoiding or diminishing the reduction in Turnover. In our case, the payment of the Tronc, the payment of the accelerated costs for reinstating the premises and general contents and the costs involved in the reopening of the premises was for the sole purpose of diminishing the reduction in Turnover as a result of the damage, and was successful in doing so – some expenditure is not. An example that often arises is the employment of additional staff in the accounts department to catch up on issuing invoices and statements, and the collection from debtors. This may reduce the delay in the collection of revenue, but does nothing to reduce or avoid a reduction in Turnover. As such, the additional wages would not be covered under this wording. There is a wider cover readily available for this type of expense, and we address this later in this section. In our example case, the expenditure on paying the Tronc and the accelerated costs passes the first test.
The second test is known as the Economic Limit Test. In simple terms, it means that you cannot claim more as an Increased Cost of Working item than was saved by way of reduction in loss of insured gross profit. In this case it is not possible to specifically identify the reduction in loss of insured gross profit. However the Loss Adjuster accepted that were the Chefs and Staff to have left this would have had a disastrous effect on the ability of the restaurant to operate fully once reopened. It was for this reason that the payment of the Tronc was accepted as an Increased Cost of Working The payment of the costs incurred in accelerating the reinstatment work reduced the period that the restaurant was closed thus reducing the shortfall in turnover. The Increased Costs of Working incurred totalled £302,790.
Any amount not paid here, may be claimable under the wider cover of Additional Increased Cost of Working.With the Increased Cost of Working expenditure passing both tests, the claim for now stands at £1,003,439 as calculated in Table 7.
Table 7 – Loss of Gross Profit & Increased Cost of Working
STEP 8.1: SAVINGS
So far in our examination of the claim by our imaginary company we have concentrated on the losses. These have been the Loss of Gross Profit and Increased Cost of Working. However, with a loss, there may be savings in normal expenses to the business. The Insured may have to abandon premises while repairs to the building are carried out. Most leases have a cessor of rent clause that allows the tenant to cease paying rent if the premises are not available for use. Wages of employees stood-down during the time they cannot be productively utilised, is another example.
If such savings to the business were not taken into consideration, then the underlying principle of returning the Insured to the same financial position, would not be met. The Insured would in fact be profiting from the loss. How can this be? If the Insured obtains the expected Gross Profit for the period of the disruption by way of actual Turnover achieved and the operation of the policy, and is paid any Increased Costs of Working, they will have a sum of money sufficient to meet all their normal business expenses (Standing Charges) and retain their normal level of net profit before tax. If, however, there is any saving in Insured Standing Charges, then the level of net profit before tax, increases. The underlying principle we have constantly referred to suggests that any saving in an Insured Standing Charge must be deducted from the claim settlement so that the Insured will, indeed, be in the same financial position had the loss not occurred.
The policy wording states :
“Any sum saved during the Indemnity Period in respect of such of the charges and expenses of the business payable out of gross profit as may cease or be reduced in consequence of the damage.”
To ascertain what savings, if any, have been made, an analysis of each expense normally met by the Insured is compiled. This is compared to the level of that expense during the Indemnity Period. In our example the Insured retained all staff and that total savings amount to £286,696. The claim thus far is set out in Table 8 below.
Table 8 – Loss of Gross Profit & Increased Cost of Working less Savings
STEP 9.1: CHECK FOR ADEQUACY OF INSURANCE
The restaurant had insured on an Estimated Gross Profit and no underinsurance applied. However to reflect how underinsurance operates the calculation below is being used to show how the level of underinsurance, if applicable would affect the amount payable by insurers. It is extremely important to make sure that insurance if not on an Estimated Gross Profit basis is adequate in the event of a loss. In small and medium enterprises, the problem of under-insurance is at its worst.
It is generally accepted that non-insurance and under-insurance is at its worst in Business Interruption policies.
The way the policy operates is that the Insured is penalised if the loss exceeds the amount of cover selected, resulting in under-insurance, the Insured is said to be their own insurer for the pro rata proportion of under-insurance. The actual wording of the policy states:
“If the declared value of Gross Profit at the commencement of each period of insurance is less than the sum provided by applying the Rate of Gross Profit to the Annual Turnover (or its proportionately increased multiple thereof, where the Indemnity Period exceeds 12 months), the amount payable hereunder shall be proportionately reduced.”
Again, the easiest way to understand the application of the adequacy check is by way of example. At the start of this section, we were advised that the restaurant had declared Estimated Gross Profit for their business at £750,000. During the course of our claim calculations, we have determined that the Rate of Gross Profit for this business is 71.55%.
Again, we need to refer to the policy to understand the definition of Annual Turnover. The policy provides the following definition:
“The Turnover during the twelve months immediately before the date of the damage.”
In our example, the Annual Turnover of the business for the 12 months prior to the date of the damage, which was given as £1,515,141. The figures in Table 9 are taken from the schedule in Table 2 set out earlier in this chapter.
Table 9 – Annual Turnover (July 2008 to June 2009
STEP 9.2 CHECK FOR ADEQUACY OF INSURANCE CONTINUES
Table 10 – Adjusted Annual Turnover (July 2009 to June 2010)
The next task in this Step is to apply the Rate of Gross Profit (calculated earlier at 71.55%) to the Adjusted Annual Turnover, to ascertain what level of cover was necessary to be fully insured, and compare this to the Sum Insured selected. It should be noted that again the Rate of Gross Profit may be different for this calculation to the one used in calculating the claim. This is rare and, in our case, no adjustment is necessary. This is shown in Table 11 below.
Table 11 – Calculation of required
We turn now to the Adjustments Clause, which was discussed under Step 1. This clause stated that adjustments could and should be made to to reflect the trend and special circumstances of the business. We have already discussed adjustments to Standard Turnover and the Rate of Gross Profit. Annual Turnover is another of the calculations that should be adjusted.
The same process as was adopted for the calculation of the Adjusted Standard Turnover, should be utilised. In many cases, but not all, the same growth rate may be applicable for both the Annual Turnover and Standard Turnover. However, it should be borne in mind that this is not always the case. It is, of course, much easier to estimate the growth factor for Annual Turnover if the loss occurs quite late in the period of insurance, i.e. near the anniversary of the date of inception of the policy, as the actual growth that was achieved can be calculated. It is emphasised that the growth rate for Standard Turnover and Annual Turnover need not be the same. For the sake of this example, however, the growth rate is taken as a Nil trend.
Using the Nil growth rate we can easily calculate the Adjusted Annual Turnover.
STEP 9.3: THE COST OF UNDER INSURANCE
This is done in Table 10 below. Unfortunately for the owners their claim will be reduced by the application of Average. The adjustment of the claim is made using the following formula.
(Payable Claim) £716,743 / (Value at Risk) £1,084,083 x (Sum Insured) £750,000 = (Claim after average) £495,863
STEP 10: ADDITIONAL INCREASE IN COST OF WORKINGAs we saw at Step 7, Item 1B – Increase in Cost of Working has two limitations; expenditure must be for the sole purpose of reducing Turnover, and it is subject to an economic limit test. The cover provided by Additional Increase in Cost of Working is broader, as is clear from the following definition, which again has been taken from the policy.
“The insurance under this item is limited to increase in cost of working (not otherwise recoverable hereunder) necessarily and reasonably incurred during the Indemnity Period in consequence of the damage for the purpose of avoiding or diminishing reduction in Turnover and/or resuming and/or maintaining normal business operations and/or services.”
This wider cover allows increased costs that maintain the business or service, but which do not necessarily reduce or avoid a Loss of Turnover. For example, the Insured may employ additional accounting staff to ensure debt collection is maintained at the normal rate while their normal staff assists in other areas. As mentioned above, this cover is not subject to the economic limit test, which can be a great advantage, particularly if the expenditure ensures the retention of customers well after the expiration of the Indemnity Period. The costs, however, must be reasonable and incurred in consequence of the damage.
Finally, the cover is not subject to any adjustment for under-insurance. However, it is important that the cover is adequate to allow the businessperson to take all reasonable steps to protect their business during the period of the crisis.
STEP 11: WHAT ARE DECLARATION LINKED POLICIES
In our example case, all the increased costs of working incurred by the business amounted to £302,790 and appears to have been met as an Increased Cost of Working item. However, this section of the claim was reduced due to under-insurance. Under many Additional Increase in Cost of Working covers, the shortfall caused by under-insurance on Item 1(b) – Increase in Cost of Working (ICOW) items is claimable as an Additional Increase in Cost of Working item. This is because the Additional Increase in Cost of Working cover is not subject to average and is by its very definition designed to cover increases in a business’s cost of working that are not recoverable elsewhere under the Policy. Under the definition provided above, that portion of the £302,790 which has not been met due to under-insurance is, in fact, claimable under the Additional Increased Cost of Working cover.
The claim for Increased Costs of Working was reduced by 30.82% due to under-insurance (as shown in Step 9). This equates to £93,320. After the inclusion of this item, the Adjusted Loss calculates to £589,183 as set out in Table 12 below.
Table 12 – Insured Loss
The inclusion of Additional Increased Cost of Working cover can, in some policies, assist in recovering a portion of the under-insured loss. However, this is limited only to the Increased Cost of Working items and not for Loss of Gross Profit. The primary purpose of Additional Increased Cost of Working cover is not as a backstop for under-insurance, but rather as an extra cover in its own right for the reasons discussed earlier in this section. Adequate insurance on both Gross Profit and Additional Increased Cost of Working is strongly recommended.