Surviving A Loss – Business Interruption Insurance
When considering our risk exposures personally and for our company, our minds generally tend to gravitate towards our physical assets and their protection. Hence, there is a general understanding and acceptance of most of the major forms of property insurances, while high profile litigation has produced a similar top of mind response to our acceptance of liability insurance and its necessity. Post loss recovery, however, receives far less prominence than it should in most cases, and the result of this is seen in not enough attention being paid to risk management and disaster mitigation, along with the risk transfer tools such as Business Interruption Insurance which is the subject of this article. In fact, even though not an inexact science, many studies have produced statistics showing up to 80% of companies without business continuity plans going out of business within 5 years of a major loss.
In the Caribbean, we are faced with many risks, and none more so than the added hazard of catastrophic weather systems such as Hurricanes, and volcano and earthquakes in some islands. These risks naturally result in extensive property damage which is commonly catered to in varying degrees by companies, but far too little attention is paid to the financial impact of the post loss recovery period. In the Caribbean, this is compounded by the fact that even in the case where a company has its asset base spread over different locations, the catastrophe nature of the Hurricane risk is such that often times the company faces destruction across all of their properties. Hence, with no income coming in, a company will have the added burden of struggling to refinance with the bulk of the company’s collateral gone or severely compromised. Companies thus find themselves undercapitalized and unable to service their debts and expenses following a loss. It is for this reason that securing the pre-loss income stream is often vital to the company’s survival, and Business Interruption Insurance, also known as Consequential Loss or Loss of Profits Insurance, is the preferred tool for achieving the same.
What this cover provides is an indemnity to the insured for financial losses arising as a consequence of an insured peril causing insured damage to an insured property. These losses are defined on the basis of the cover which defines what is insured (eg. Gross Profit, Revenue, Wages etc.). Losses do not need to be total, as cover responds to any drop in turnover following insured damage to insured property, and an indemnity period is selected by the insured which determines the maximum period for which a claim can be made.
Because the cover is related to losses flowing from the operation of an insured peril on insured property, premiums are calculated using derivatives of the property insurance rate for the insured property. Rates, having already been set based on the various attendant risks associated with your operation (location, construction, type of business etc.), are then adjusted again for the period of indemnity selected. Periods of cover (called the indemnity period) are generally set in blocks such as 3 months, 6 months, 9 months and 12 months with longer periods possible. The longer the period of cover, the higher the premium, but it is not proportionate since the frequency is high for small claims and reduces the severity (which produces longer rebuilding phases) increases.
Note as well that cover is operative for the period (subject to being within the covered indemnity period) starting immediately following the insured loss and ending when the insured item (Gross Profit, Rent, Revenue etc.) achieves it’s former levels and is adjusted for trends. Hence, cover regularly extends past the point when the insured property is repaired as business generally takes a while to pick back up, and the main reason why annual figures are used for setting sums insured and then the rate is used to adjust premium is to allow for trends in business such as for example a toy store who would suffer a disproportionate monthly lost Gross Profit in December.
The most common types of cover are as follows:
A. Gross Profit - Difference Basis
This is the most common form of cover whereby the insured ensures their Gross Profit on the expectation that it will be reduced following insured damage (eg. Fire in a manufacturing plant). Gross Profit is insured as opposed to revenue on the expectation that the expenses forming Cost of Goods Sold will vary 100% with Turnover and therefore cease to be incurred in the same proportion that Turnover is reduced. For this form of cover the sum insured is calculated as follows:
Gross Profit = The sum to be insured represents the amount of which:
- the sum of the turnover and the amount of the closing stock shall exceed
- the sum of the opening stock and work in progress and the amount of the *specified (or uninsured) working expenses.
Specified working expenses or uninsured working expenses are the charges that vary proportionately with the rise or fall in turnover. The insured can eliminate these expenses by name specifically, and sometimes additional expenses are included by the insured where they feel that they can either bear that expense themselves or have an alternative mitigation plan that will eliminate that cost if needed.
Examples of Specified (Uninsured) Working Expenses are:
- Purchases
- Carriage
- Packing Materials
- Freight
- Wages (if to be insured by a separate item)
B. Gross Revenue
This form of cover is easy to understand since it covers, as the name implies, loss of Gross Revenue following an insured loss the property. This, however, is expensive insurance due to the high sum insured. Hence the Gross Profit cover in A. above is often more attractive.
C. Gross Rental
In this cover insurance is taken out to cover loss of gross Rental Income only. This form of cover is very similar to Gross Revenue cover in B. above, especially if Rental income is the only source of revenue. This can be different, however, where a company has other revenue streams and only seeks to insure the Rental Income which they deem vulnerable to insured perils (eg. A property owner who has rental income as well as investment income that is not subject to insured perils).
D. Standing Charges only
This form of cover operates in the opposite fashion to the Difference Basis described in A. above. Rather than insure Gross Profit and provide for an insurance indemnity that covers all operational expenses, cover is approached from the opposite direction whereby only the specific expenses for which the insured desires cover are insured. These expenses are called standing charges and from an insurance perspective, an insurable standing charge might best be defined as an expense that might not diminish proportionately with a reduction in turnover following loss due to an insured peril or any other variable charge which you may deem desirable to continue in the best interest of the business. Common examples are directors fees, rent payable, advertising, bank charges, motor vehicles expenses, communications cost etc.. Standing charges can be insured either wholly or as a percentage of turnover.
E. Wages & Salaries
This is similar to the Standing Charges Basis whereby Wages &/or Salaries are insured specifically on either a 100% or Dual Basis. The basic cover sees Wages & Salaries being treated much like a Standing Charge in D. above and provides for cover for 100% of the insured payroll. Cover will respond to payments made in this regard throughout the indemnity period.
The “Dual Basis” however is a means of reducing cover where a reduced exposure is anticipated after an initial period of 100% cover due to opportunities to reduce the payroll following an extended loss as provided by legislation. In this case the cover will have a “Dual” basis whereby there will be an initial period of cover where the sum insured is operative at 100%, and then a second period that follows thereafter for the remainder of the indemnity period at a percentage determined by the insured that represents their expected payroll after reductions due to things like statutory layoffs.
- In all cases, a savings clause is an operative where reductions in payroll are excluded from the claim on the basis that an insurance policy would only indemnify you for an actual loss otherwise you would be profiting from the policy which is deemed to be akin to gambling.
Additional Insured Items:
Increased Cost of Working – Following a loss an insured may experience increased costs of working in order to mitigate the loss as best as possible. Standard policy conditions provide cover for this on the basis that this reduces the loss payable by insurers in respect of Gross profit etc. There are cases, however, where these increased costs exceed the savings on the claim and thus this difference would not normally be covered. Cover can therefore be arranged for this as a separate item, and a premium assessed. An example of a situation where you may incur increased costs of working could be the cost of relocating guests to another hotel if you suffered a loss in order to maintain goodwill and/or keep alive a contract with a tour company with whom you have a long-term contract that you do not want to lose.
Professional Accountants Charges - In addition, you may insure the Professional Accountants Charges required of your accountants to investigate and verify amounts claimed by you as an additional item under any of the above policies.
Additional covers (that can be sourced but are difficult to place and often expensive):
Environmental Damage
Cover is based on losses suffered by the insured following damage to the insured’s environment. A good example would be a fire at the airport and guests were not able to reach your hotel which had suffered no damage but was empty as a result.
Supply Chain Insurance
Cover is based on consequential losses suffered by the insured following a disruption in the supply chain. Most commonly used with manufacturers or providers of goods and materials but could be modified to suit tourism.
Understanding your Exposure:
Typically, a company should review its exposures and tailor-make the policy to provide cover for the key areas of risk. Especially important is the period of cover or indemnity period, since not only is the cover limited to the period following the loss that has been bound, but the premium is also based on this. A brief example of some of the considerations would be:
- Does your company have any special requirements and could it easily find alternative accommodation?
- How long will your current stock last after a disaster and how vulnerable is it?
- Will staff be displaced and do they pose any special challenges in retaining or rehiring?
- Will your current inventory satisfy your customers during loss period?
- What are the vulnerabilities of your customers and suppliers?
- How leveraged are you by fixed costs that can’t be mitigated if turnover declines or disappears?
- How vulnerable are your computer systems and how easily can your data and systems needs be recovered and operational?
- How vulnerable are you to acts of civil authority such as denial of access to your premises following a hurricane?
Setting your sum insured:
Your sum insured needs to be carefully considered depending on the type and scope of cover being considered. There are too many possibilities to allow for this to be adequately addressed herein, but suffice to say that care needs to be taken to ensure that the sum insured accurately reflects the value at risk as much as possible. In the event of a loss, your claim will be paid in the same proportion that your sum insured bears to the actual value at risk. Hence, if your sum insured is found to represent only 60% of the value at risk based on the calculation of your insured items, then any claim will be paid at 60% of the amount claimed. Coverage can sometimes be extended upwards by 20% through an “upward adjustment clause”, and if this is offered (at terms that are agreed) then annually you will be billed for any excess of value at risk over sum insured up to 20%, and in the event of a claim your cover can be increased by up to 20% once proven that the actual did so exceed the sum insured.
Claims Requirements:
As with any insurance policy, it is only as good as the claim settlement. In any insurance claim, the burden of proof lies with the insured to prove their loss. As a result, you would be charged with proving your financial loss resulting from the operation of the insured peril. This can often be a complex procedure, especially in large claims where for example additional increased costs of working are involved and you have to show how incurring these mitigated the lost insured gross profit as adjusted for trends. In addition, audited (or unaudited) financial records going back 3 – 5 years are commonly required along with other financial documents such as asset registers, stock reports, VAT accounts and expense reports to name a few. It is for this reason that Claims Preparation Expenses are commonly insured as an additional item to aid in the cost associated in the preparation of the claim. This can be further expanded to include cover for services such as Claims Advocacy or even Forensic Accounting Claims Consulting from Marsh if the nature or scope of your business suggests a need for such.
This is just an overview of this type of cover, and we welcome your queries since this is a complex type of insurance and there are many other exclusions and provisions not mentioned herein that form part of a standard policy.
