This is the one of the most frequently asked question of our team. It comes up without fail at every training session and seminar.
Anyone in business knows that it is much easier and less expensive to look after and service an existing customer than to lose the customer and have to replace them. The insurance industry accepts this notion, and realizes that in the event of an insured loss it is, on the face of it, better to incur some increased costs of working to minimize the period of disruption and/or the shortfall in Turnover during the period of disruption. In other words, they allow the business to claim some additional expenses not normally incurred to retain its market share.
To provide different levels of protection most policies offer two forms of cover. These are discussed below under two headings:
Expense to Reduce; and
- Extra Expense
Extra Expense coverage is often mistaken for “expense to reduce” coverage. These coverage are not the same and in actual fact “expense to reduce” is not generally even mentioned but is characteristically an attribute of all Business Income policies.
EXPENSE TO REDUCE
When you declare a sum insured under most commercial or business owner’s packs you are selecting cover for loss of insurable gross profit.
Sharing this same sum insured is a Loss of Gross Profit as a result of incurring expenses to reduce a potential business interruption loss.
What this means is that the insurer does not differentiate between a financial loss to the insured business as a result of a loss due to turnover having fallen due to an insured disruption or as a result of the business incurring expenses to reduce a potential loss. It will meet losses suffered by the business in either form or a combination of both up to the sum insured.
How the Policy does this is best explained by way of an example.
Let us assume that a business has sustained fire damage to a machine worth $150,000. It will take 6 weeks for the machine to be sent by sea from Italy, its place of manufacture. For every week that the insured business is without the machine it loses $10,000 in revenue. This reduction in turnover results in a loss of insured Gross Profit of $4,000. If the Insured were to airfreight the machine from Italy to the US it would cost an additional $25,000 but would reduce the disruption to the business by 5 weeks.
Under the terms of the Material Damage section of the Policy, the insurer will replace the machine, subject to a test for the adequacy of insurance. Replacement not only covers the cost of buying the machine in Italy but transporting to the Insured’s premises and installing it. This claim will be based on the cost of sea freight, the most economical form of transport.
The owner of the business decides to pay the difference of $25,000 and air freight the machine to the US and eliminate the 5 weeks time delay and thereby minimize the disruption to his customers.
The first issue to understand when considering whether an increased cost is recoverable under this section of the Policy is that the expense must be for the sole purpose of avoiding or diminishing the reduction in Turnover. In our case, the air freight was for the sole purpose of diminishing the reduction in Turnover as a result of the damage, and was successful in doing so.
Not all expenditure passes this test. 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 in the form of Additional Increased Cost of Working for this type of expense, and we address this later in this section. In our example case of the airfreight of the machine, the expenditure passes this 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 avoiding a claim for loss of insured Gross Profit.
We test this by comparing the expenditure incurred (here $25,000) to the loss of insured Gross Profit avoided. In this case it was $20,000 ($4,000 x 5 weeks).
This being the case the Insured is able to claim $20,000 as an Increase in Cost of Working. This test is based purely on a cost benefit analysis with the limit being the amount of insured Gross Profit saved.
Any amount not paid as an increased cost of working may be considered under the wider cover of Additional Increased Cost of Working, which we discuss later under the next sub-heading.
One final point needs to be made about Increased Cost of Working cover. Under the vast majority of ISR and business pack policies any amount payable as in Increase in Cost of Working claim is subject to the test for under insurance. If there is under insurance then the amount paid by the Insurer will be reduced in a proportion based on the terms of the under insurance clause.
What happens when loss mitigation efforts exceed the potential BI losses? This is where we bring in the concept of Extra Expense.
The cover provided by Extra Expense is much broader than that provided by
a. Extra Expense Coverage is provided at the premises described in the Declarations only if the Declarations show that Business Income Coverage applies at that premises.
b. Extra Expense means necessary expenses you incur during the “period of restoration” that you would not have incurred if there had been no direct physical loss or damage to property caused by or resulting from a Covered Cause of Loss.
We will pay Extra Expense (other than the expense to repair or replace property) to:(1) Avoid or minimize the “suspension” of business and to continue operations at the described premises or at replacement premises or temporary locations, including relocation expenses and costs to equip and operate the replacement location or temporary location.
(2) Minimize the “suspension” of business if you cannot continue “operations”.
We will also pay Extra Expense to repair or replace property, but only to the extent it reduces the amount of loss that otherwise would have been payable under this Coverage
This wider cover allows extra expenses that maintain the business or service, but which do not necessarily reduce or avoid a Loss of Turnover during the Period of Restoration. For example, with the example of an Insured employing additional accounting staff to ensure debt collection is maintained at the normal rate then this would now be covered under the Policy. In other words there is no “sole purpose” test.
Further, the Extra Expense 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 Period of Restoration. The costs, however, must be reasonable and incurred in consequence of the damage.
In the example of the Insured that air freighted the machine out from Italy, if this company demonstrated that it was a prudent course of action for the business to take and that they would have met the expenditure even if they were not insured, then the Insurer would meet the difference between the amount incurred of $25,000 and the amount paid as an Increase in Cost of Working Item. $20,000.
From experience we find this to be a very valuable cover. It allows an insured to make quicker decisions as they do not have to justify expenditure before incurring it. If it is prudent and reasonable then it should be covered by the Policy.
One final benefit is that the Extra Expense cover is not subject to any adjustment for under-insurance. In all policies where you can insure for it, the sub-limit or sum insured is a first loss limit.. 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.
Besides air freighting, Extra Expense has been used to fund:
- Additional rent for temporary premises
- Outsourcing of manufacture to a competitor or contract manufacturer
- An advertising campaign to win back lost or disgruntled customers
- The hire of temporary plant and or equipment
- Overtime payment to staff
- The temporary employment of additional staff
This is just a short list that immediately comes to mind. It is really an invaluable cover that every Insured should have.
This is one of those areas of the business interruption cover that is quite complex. The overview provided above has been given to give you a good grasp of the cover. The points to take away is that every policy should have some coverage for Extra Expense.