STEPS 1 – 11
STEP 1.1: DOES THE BI POLICY COVER THE LOSS?
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
“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
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
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
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
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:
- Trend: Holt/Brown
- 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
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
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.
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:
- Agents’ Fees
- Direct Freight
- 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 Insurer is 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.
STEP 5.5: AGREEING THE RATE OF GROSS PROFIT
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.
STEP 7: INCREASED COST OF WORKING
Loss of Gross Profit & Increased Cost of Working
STEP 8: 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.
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.
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
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
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.