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:
Prevention of access, i.e. where damage to buildings, roads, bridges etc (not the property of the Insured) prevents ingress and/or egress 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, e.g. the Longford Gas Crisis in Victoria, which cost industry, $1,300 million, the Mercury Power Crisis in Auckland and countless similar events across Australia and the world.. The failure of water, wastewater 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 the use of a competent insurance broker or adviser who can explain and quote on all the various covers available.
In the case under analysis, the loss occurred by fire (an insured peril), causing damage to a dryer, which was covered by Section 1 of an ISR policy. As such, all three requirements of the Material Damage Proviso are fulfilled, and a valid claim exists.
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 where there are funds in place to reinstate the damaged property. This is by way of the Material Damage policy.
STEP 2.1: CALCULATING 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.
For this reason, it would not be appropriate to simply take the last three months trading before the fire, i.e. the first quarter of the calendar year, and use this as the basis of calculating the loss in the second quarter. In the case under review, January and February are typically slow months for a drycleaner, being summer in the Southern Hemisphere. However, the second quarter picks up, particularly if there is a cool autumn.
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. In the case under review, this is 3 months.
By taking the figures straight from the financial accounts of Australasian Dry Cleaners, we can easily determine that the Standard Turnover for the three months of the loss (that is, the 3 months from the preceding year) is $110,978. A section of the accounts is set out below.
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 the Australian ISR Mark IV wording states:
“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 movement
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.
While Australasian Dry Cleaners is a fictitious company, the figures used in the example come from a real business not in the drycleaning industry. Their loss occurred in July 2005, and only the months during our imaginary period of disruption have been changed, so that our estimate can be compared to actual. This is aluxury neither the Insured nor the Insurer has in real life. Set out in Table 2 below, is the Turnover for Australasian Dry Cleaners from January 2004 to June 2007.
STEP 3.3: ANALYSIS OF MONTHLY TURNOVER
In Table 2, we have calculated the short and the longer-term trends of the business. The growth rate shown is always the growth in the Turnover for the corresponding period 12 months prior, e.g. March 2007 Turnover has grown by 17.6% over the $35,091 generated in March 2006. As can be seen from the Table, the loss has caused quite a drop in Turnover from the corresponding period in 2006. Overall, it is down 18.2%.
Of more interest to us at this stage is what the Turnover would have been but for the loss. Overall, the business has grown by 14.6% over the 12 months to 31 March 2007, compared to the 12 months to 31 March2006. However, the growth at 18.6% has been higher than the annual growth when comparing the 6 months immediately preceding the loss, to the same 6 months in the prior year.
As part of any such analysis, it is necessary to look at the monthly, quarterly, semi-annual and annual growth (both positive and negative) in the business. Other tools, such as moving average calculations, should be performed to really understand the growth of 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 labour strike in the industry or supply chain, a change of fashion, or other changes in consumer behaviour – these all need to be addressed. Absolutely anything and everything that may have altered the performance of the company, either positively or negatively, should be examined. Remember the Adjustments Clause states that the changes can be pre- or post-loss. In our case, there are no such special circumstances to influence the result.
STEP 3.4: GRAPHING THE RESULTS
From the graph, it is clear the business was performing well above the previous year, and had been growing year on year for the past 3 years. The impact of the loss in April 2007 is quite obvious.
Finally, to give some comfort that the growth rate is close to the mark, reasonableness tests are carried out. In this type of loss, reasonableness tests may include an analysis of stock levels (work in progress) and production movements. Each type of claim and business has its own such reasonableness tests. However, it must always be remembered that these are but tests. The insurance policy covers loss of gross profit from lost sales, or lost production.
Looking at numbers alone can be difficult. The use of charts is a great help as it often shows quite clearly the growth of the business leading up to the loss, and the impact of the disruption on the business. This current case is a good example.
STEP 3.5: AGREEING THE RESULTS
Armed with the graph and the spreadsheet calculations, and after carrying out the reasonableness tests, the percentage that will be used in the calculation will be agreed by the Insurer/Loss Adjuster and Insured/Loss Manager. It is not unreasonable to suggest that each party will take up a position that is in their best interests. This could range from 14.6% (the annual rate) to 18.6% (the rate of growth over the six months leading up to the loss). As the most recent growth rate is statistically the more accurate, the parties agree on the higher rate of 18.6%.
Before looking at the effect of this rate, it was mentioned that these figures were taken from a real set of accounts. Only the figures for the second quarter of 2007 were altered to represent the disruption caused by the theoretical fire. It is convenient now to compare the estimated growth rate with that which the business actually did achieve. In the genuine case, the business grew by 21.1%.
This real life case has been included to show that the adjustment can only ever be just an estimate and that there is no correct answer. I have seen Insurers, Loss Adjusters and Insureds all be very dogmatic that their calculation of the trend of the business is correct, and are not prepared to move 0.01%. This example proves the folly of such intransigence.
STEP 3.6: HELP IN GETTING IT RIGHT
While it has been proven above that there is no perfect answer, there are statistical techniques that can be used to improve the chances of getting close to the correct answer. In statistics, we are taught that any variable that is measured over time in a sequential order, is called a “time series”. All time series contain at least one of the following four components: trend, seasonal variations, cyclical variations, and irregular or random variations. Although each component has been briefly touched on earlier, there are analytical models that have been devised to assist in the prediction of each. Just a few of the techniques available for each of the four components of time series analysis used by the Loss Management International are:
Seasonal Variation: Winters
Cyclical Variation: Kondratief
Irregular or Random Variation: ARIMA and Box-Jenkins
A detailed examination of each is outside the scope of this introductory guide. However, it is useful to keep in mind that a specialist Loss Manager can provide valuable assistance in the calculation of the trend and special circumstances of a business using such techniques.
STEP 4: CALCULATE THE SHORTFALL IN TURNOVER
Having established the Standard Turnover at $110,978, and agreeing the adjustment for the trend and special circumstances at 18.6%, we next need to do the simple tasks of calculating the Actual Turnover achieved during the period of disruption, and the shortfall between this actual figure and the Adjusted Standard Turnover.
We see that the Turnover achieved during the period of disruption was $90,810, as set out in Table 3 below.
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 2007. This is set out in Table 4 below:
At this point, we have calculated the Shortfall in Turnover sustained by Australasian Dry Cleaners as $40,810.
STEP 5: CALCULATE THE RATE OF GROSS PROFIT
Gross Profit, as defined under a Business Interruption policy, is not 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 ISR Mark IV 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 bearrived at in accordance with the Insured’s normal accountancy methods, due provision being made for depreciation.”
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 mentioned at the start of this chapter. 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, insurance proposal or the Broker’s placing slip. 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:
Direct Selling Costs
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 keep this example simple, the level of stock for Australasian Dry Cleaners is taken as being a constant $1,000.
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’.
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 May 2007 would have generated more Gross Profit for the insured business. The Insured may decide to postpone this as they feel that to increase prices, while they are not able to provide their normal level of service, is not prudent. If the Insured’s claim was only based on the historic Rate of Gross Profit without an adjustment from 1 May 2007, 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.
STEP 5.4: ADJUSTMENTS TAKE SKILL & TIME
Many accountants try to calculate a Business Interruption claim without spending sufficient time with the Insured to know what changes have and were to take place in their business. Similarly, some Loss Adjusters attempt to adjust the claim without going through the same process. This is particularly the case where one Loss Adjuster handles the Material Damage claim and another Loss Adjusters is introduced, well after the loss, to adjust the Business Interruption claim. Either the Insured or Insureris penalised, or a dispute arises between the parties over adjustments. This can be overcome by everyone involved in the preparation and adjustment process, taking the time to understand the Insured’s business, and that includes plans developed and approved but not implemented before the loss.
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, as has been done in Table 5 below.
Australasian Dry Cleaners
Calculation of Insured Rate of Gross Profit (April 2006 to March 2007)
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 93.7%. Wherever possible, reasonableness tests are made, and these are done by comparing this Rate of Gross Profit with that of similar businesses, where this information is available. A professional Loss Manager, Claims Preparer or Loss Adjuster will (or should) have handled claims for a wide range of businesses, and will therefore have statistics on each. Again, it must be stressed that these are only reasonableness tests, and every business is different. If the test suggests there may be an error, further enquiries with the Insured are necessary to ensure that the Insured Rate of Gross Profit is reasonable.
In our example, the calculated Rate of Gross Profit of 93.7% is considered reasonable to use as the Adjusted Rate of Gross Profit for Australasian Dry Cleaners’ claim.
STEP 6: CALCULATE THE LOSS OF GROSS PROFIT (ITEM 1A)
In this step, we simply apply the Adjusted Rate of Gross Profit (93.7%) to the Shortfall in Turnover of $40,810 to obtain the Loss of Insured Gross Profit of $38,239. Table 6 below shows the calculation on a month-by-month basis.
Australasian Dry Cleaners
Calculation of Loss of Gross Profit (April 2007 to June 2007)
STEP 7: 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 Australasian Dry Cleaners spent $5,000 extra to air freight the industrial clothes drying machine to Australia, so that it could be brought back on line several months earlier than if it was sea freighted. This is estimated to have reduced the Turnover that would have been lost, by $30,000.
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 ISR Mark IV wording. 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 purposeof avoiding or diminishing the reduction in Turnover. In our case, the airfreight 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 airfreight 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. We test this by applying the Rate of Gross Profit to the Loss of Turnover avoided by the expenditure, and compare the result against the expenditure. In our example, the Loss of Turnover avoided by bringing the dryer in early, was $30,000. We have already calculated the Rate of Gross Profit as 93.7%. By applying this rate to the amount of lost Turnover avoided, we ascertain that the saving in Gross Profit was $28,110 (93.7% of $30,000). Clearly, the expenditure of $5,000 was economic as it is well below the Loss of Gross Profit avoided. Therefore, the Increased Cost of Working item is claimable in full.
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 Australasian Dry Cleaners now stands at $43,239 as calculated in Table 7 below.
Australasian Dry Cleaners Loss of Gross Profit & Increased Cost of Working
STEP 8: SAVINGS
So far in our examination of the claim by our imaginary company, Australasian Dry Cleaners, 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 an abatement 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 actual words of the ISR Mark IV wording policy state:
“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, we assume that the Insured has stood-down one part-time employee for the period that the dryer was out of commission, at a saving (including all on-costs) of $555. The claim thus far is set out in Table 8 below.
Australasian Dry Cleaners Loss of Gross Profit & Increased Cost of Working less Savings
STEP 9.1: CHECK FOR ADEQUACY OF INSURANCE
It is extremely important to make sure that insurance is adequate in the event of a loss. In small and medium enterprises, the problem of under-insurance is at its worst.
In my own experience from over 35 years in handling claims, I have found that over 85% of Business Interruption claims for small and medium-sized enterprises are reduced by not being fully insured. The worst case was where the Insured only received 6.13% of their loss. This was an extreme case, but it is not uncommon to see the claim cut down by over half due to an inadequate Sum Insured or Declared Value.
The Insurance Council of Australia report that non-insurance and under-insurance is at its worst on Business Interruption policies.
The way the policy operates is that not only are you penalised if the loss exceeds the amount of cover selected, but in each and every case where there is under-insurance, the Insured is said to be their own insurer for the pro rata proportion of under-insurance. The actual wording of the ISR Mark IV 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 Australasian Dry Cleaners had declared Gross Profit for their business at $450,000. During the course of our claim calculations, we have determined that the Rate of Gross Profit for this business is 93.7%.
Again, we need to refer to the policy to understand the definition of Annual Turnover. The ISR Mark IV 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 April 2007 is $465,935. The figures in Table 9 are taken from the schedule in Table 2 set out earlier in this chapter.
Australasian Dry Cleaners Annual Turnover (April 2006 to March 2007
STEP 9.2: CHECK FOR ADEQUACY OF INSURANCE CONTINUES
We turn now to the Adjustments Clause, which was discussed under Step 1. This clause stated that adjustments could and should be made to four calculations 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 to be the same.
Using the growth rate of 18.6%, we can easily calculate the Adjusted Annual Turnover. This is done in Table 10 below.
Australasian Dry Cleaners Adjusted Annual Turnover (April 2006 to March 2007)
The next task in this Step is to apply the Rate of Gross Profit (calculated earlier at 93.7%) to the Adjusted Annual Turnover, to ascertain what level of cover was necessary to be fully insured, and compare this to the Declared Value/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.
Australasian Dry Cleaners Calculation of required Declared Value
STEP 9.3: THE COST OF UNDER INSURANCE
Unfortunately for the owners of Australasian Dry Cleaners, their claim will be reduced by the application of Average. The adjustment of the claim is made using the following formula.
In this case, the claim would be adjusted as follows.
The claim calculation process is not quite over yet. There are at least two, sometimes three, other sections to consider. If Wages are insured separately, then they need to be addressed as well. This is a complicated area, deserving a section of its own, and is covered in detail later in this site. Ignoring Wages for the moment, two areas still need to be addressed. These are Additional Increased Cost of Working (the wider cover for Increased Cost of Working) and Claims Preparation Fees. These are looked at after the Application of Average as neither section is subject to Average.
STEP 10.1: ADDITIONAL INCREASE IN COST OF WORKING
As 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 ISR Mark IV wording.
“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 assist 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 10.2: A LITTLE KNOWN BENEFIT OF ACIOW
In our example case, all the increased costs of working incurred by the business (that is, the air freighting of the replacement machine at a cost of $5,000) 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 $5,000 which has not been met due to under-insurance is, in fact, claimable under the Additional Increased Cost of Workingcover.
The claim for air freighting was $5,000, but was reduced by 13.09% due to under-insurance (as shown in Step 9). This equates to $655. After the inclusion of this item, the Adjusted Loss for Australasian Dry Cleaners calculates to $37,751 as set out in Table 12 below.
Australasian Dry Cleaners – 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.
STEP 11: CLAIMS PREPARATION FEES
The reader is asked to refer to the case study of Bancrofts Dry Cleaners,and to recall all the extra duties the management team and staff were required to deal with as a result of the loss. This was at a time when everyone, particularly the owners, were under great psychological stress.
As can be seen from this section, the calculation of the insured loss is typically not straightforward. It is clear the Insured needs assistance in first understanding how the policy works and then in gathering the data, calculating the loss and then presenting it in a suitable form to the Insurer and/or Loss Adjuster. More importantly, the Insured who has suffered the loss needs the assistance of someone who has attended a great many loss situations and can bring with them experience on loss mitigation strategies that have worked in the past. This is a time when decisions taken will not only affect the business in the short-term, but also for many years to come. While the crisis is a threat to the business, it also opens up legitimate opportunities that need to be considered.
The Insurers themselves employ experts, as many within the industry acknowledge that they do not have the expertise themselves to calculate a claim under this type of policy. Having seen the simple example of Australasian Dry Cleaners, would you have had the time or experience to prepare your own, or your client’s, claim?
The insurance industry also accepts that a business needs assistance at this time, and a wide variety of cover is available for professional fees. This can range from the services of a Public Accountant to wider covers that provide full claims preparation costs including assisting in disputes over policy liability and coverage.
The reality is that this is a complicated area, with each claim having its own nuances. It is more than an accounting exercise where an Insured is asked to ‘lend the accountant their watch to let them know the time’. As a result, many accounting practices refer their clients to a specialist Loss Manager/Claims Preparer when they are faced with an insured loss. The benefits of using a specialist Loss Manager are addressed further, under the heading “Need Help With a Claim”
As with the majority of areas covered in this website, it is necessary to read the actual insurance policy contract to ascertain the cover provided. A sample definition taken from theISR Mark IV is set out below.
“The insurance under this item is to cover such reasonable professional fees as may be payable by the Insured and such other reasonable expenses necessarily incurred by the Insured and not otherwise recoverable, for preparation of claims under the Insured’s material damage and consequential loss insurance policies, and the Insurers shall indemnify the Insured for such reasonable fees and expenses.”
This wording does not limit the fees to those of a Public Accountant as does some of the business packs. It accepts that management and preparation of the claim is not just an accounting exercise, but also requires other specialist skills.
It should be noted that this wording does not typically cover the time of the Insured’s own staff in preparing the claim. Considering that the Insured’s Accountant or Finance Director are typically salaried employees, the claim is prepared without any additional direct costs to the insured business. As such, the notional value in preparing the claim by such an employee is not covered. If overtime or some other payment to the employee is made, then the amount is recoverable but only to the value of the additional expenditure.
Finally, the cover is for claims preparation only and does not strictly cover negotiations after the claim has been submitted, to reach a final settlement. This is often quite difficult to differentiate, and the majority of Insurers allow some reasonable latitude in the definition.
Much of our work as Loss Managers arises in cases where there is a dispute between the Insured and the Insurer on policy liability. The expenses incurred in investigating the cause, which can include the appointment of an engineer or other specialist, are again not covered by the standard wording quoted previously in this Step. Similarly, the costs of dispute resolution are not covered, although wider cover is available.
In our hypothetical case of Australasian Dry Cleaners, they incurred costs of $13,400 while the policy had $20,000 coverage. As the claim was accepted as presented, the full $13,400 was claimable. In summary, the Insured’s adjusted loss (including Claims Preparation Fees incurred) totals $42,203 as set out in Table 13 below.