STEPS 1 – 11
STEP 1.1: DOES THE BI POLICY COVER THE LOSS?
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
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
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
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
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
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 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
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 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
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.
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 :
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.
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:
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.
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.
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.