Business InterruptedUnderstanding How Business Interruption is Measured and Coverage is Applied

January 2014 • Lockton Companies

L O C K T O N C O M P A N I E S

SHERI WILSONSenior Vice President

National Property Claims214.969.6721

swilson@lockton.com

Business Interruption (BI) insurance has often been seen

by risk managers as a “smoke and mirrors” portion of an

insurance contract. Terms such as “necessary suspension

of operations,” “period of restoration,” “continuing normal

operations incurred,” and “extra expenses” have companies

with a business loss looking for their broker, forensic

accountant, or even public adjuster to assist them in

preparing the documents to quantify the loss.

As the landscape for policy language is vast and dynamic, this paper will focus on the Lockton form language for a BI loss.

The Lockton policy form defines Business Interruption as: “Loss due to necessary interruption of business conducted by the Insured, including all interdependencies between or among companies owned or operated by the insured resulting from loss of damage insured herein and occurring during the term of this policy to real and/or personal property described. Such loss shall be adjusted on the basis of actual loss sustained by the insured, consisting of the net profit which is prevented from being earned including ordinary payroll; and all charges and other expenses (including soft costs) to the extent that these must necessarily continue during the interruption of business, but only to the extent to which such charges and expenses would have been incurred had no loss occurred.”

WHAT THIS MEANS

Business interruption occurs when an insured

suffers a loss or damage to physical property (real

and/or personal) by a covered cause of loss, and a

loss of earnings or suspension of operations ensues.

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First-party policies can have a variety of ways to define the business loss that companies may suffer. There are business interruption forms, gross earnings forms, gross profits forms, and extra expense forms to name the four primary types. Each form in its development was aimed at capturing the story of the business loss that might happen if an insured experienced a loss of property. Each of these time-element exposures are distinct and have unique characteristics taken into account when a loss occurs. Here we focus on the business interruption form and its practical and basic application.

BI occurs when an insured suffers loss or damage to physical property (real or personal) by a covered cause of loss, and a loss of earnings or suspension of operations ensues. For example, a fire damages an insured’s building and equipment, and the business is suspended for six months.

The Business Interruption policy is a first-party property policy, which has the following components:

Policy Declarations

Contains a description of the insured’s business and provides the outline for the contract.

Limits of Insurance

Defines the corners of the contract and each party’s risk.

Coverages

Defines real and personal property as well as your business interruption.

Conditions, Exclusions, and Definitions

Used to develop a story about the risk and place guidelines on the policy response to loss.

First-party policies can have a variety of ways to

define the business loss that companies may suffer.

January 2014 • Lockton Companies

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STEPS FOR BUSINESS INTERRUPTION INSURANCEExample: A fire damages an insured’s building and equipment and the business is suspended for six months.

step Review the insurance policy for covered causes.

A logical first step it to look at the insurance policy and note that “fire” is an insured peril and, thus, coverage under this policy has been triggered by direct damage resulting from a covered cause of loss. While a fire loss might seem intuitive—“covered”—keep in mind that the policy has to be triggered by a covered peril in order to allow the policyholder to recover any loss of income.

step Confirm the potential for makeup is included in the policy.

In our example, we stated that a suspension of operation resulted from the fire. We have to assume that the insured was losing not only gross revenue but profits from net income and fixed costs that cannot be recovered. Consideration must also be given during this six-month reported suspension that the business cannot make up the lost business by using any other means and methods. The potential for makeup is viewed as an obligation of the insured under the “Conditions” of the policy and forms part of the basis for the contract. To keep it simple, let’s assume that the business suffering the fire does not have potential for makeup of lost income and, therefore, we need to measure a BI loss.

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step Determine the period of restoration.

Our next element to consider is the “Period of Restoration.” Loosely defined, this is the time in which the damage to real and personal property can be repaired or replaced and/or the insured’s business is restored. What makes the BI measurement unique is that rarely does a business suffer a loss of real and/or personal property that when restored, the business immediately returns to preloss revenues. Many variables come in to play when measurement of the BI loss actually occurs.

step Measure the business interruption loss.

Determine the Revenue Stream

We want to measure the BI loss that the business suffers, so, we will look at a relative, representative period of time and see what revenues the business was producing. If there is no seasonality in the revenue stream and we have a consistent monthly earning income stream, it may only be necessary to look at a representative six months. But in most cases, we would likely want to look at least 12 months, and perhaps 18 months, to develop a monthly value for the BI loss.

Determine the Loss Profit

As the BI loss is the loss of profit and fixed costs that necessarily continue during the period of interruption, we also would look at the Profit and Loss Statements (P&Ls) and identify the profit and operating cost components for the business. Many insureds believe that BI is the loss of gross revenues, but for the purposes of insurance, BI is defined as

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Many insured believe that BI is the loss of gross revenues, but for the purposes of

insurance, BI is defined as the loss of profit and fixed charges that continue.

January 2014 • Lockton Companies

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the loss of profit and fixed charges that continue. It makes perfect sense if you think about it in a practical way. When the business operations are closed, the variable cost components of the operation discontinue, e.g., raw materials used in production are not used, and therefore raw material costs are suspended. As the insured is not incurring or paying those variable costs, the insurance company does not want to reimburse the variable costs.

In our example, our 18-month analysis of P&Ls will show that the company had an 18 percent profit margin. So for purpose of our BI measurement, we will use this 18 percent as our profit component.

Measure the Fixed Cost, Continued and Incurred

Next, we turn our attention to measuring the fixed costs that continue and are incurred. Both continuing costs and incurred costs are needed for calculating recovery. Insurers want to reimburse insureds for costs they suffer during the period of interruption. Looking back at P&L’s for the 18-month period we previously chose, begin to look at all expenses and decide if they are fixed (continuing) or are variable (discontinued). We want to be consistent in the approach and select the same period of time for the profit component and the fixed cost component of our claim. We may need further financial information to determine the fixed costs, as the P&L can have larger categories of expense items that aggregate expenses. Depending on the complexities of the business, insureds should not be surprised if the insurance company requests additional financial documents to demonstrate whether a cost is variable or fixed. For our purpose, let’s assume that all the information we need for fixed cost definition is contained in the P&L and we determine that fixed costs make up 25 percent of the costs incurred.

Put It All Together

Putting it all together, we estimate the revenue stream that was lost or impacted by the event. Taking this monthly revenue stream, multiply the profit and fixed components to identify the gross BI loss.

Example 1: Monthly Revenue is $250,000

Loss of revenue for 6 months = $1,500,000

Loss of profit (0.18 x $1,500,000) = $270,000

Fixed costs – (0.25 x $1,500,000) = $375,000

Gross BI Loss

$270,000 + $375,000 = $645,000

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Example 2: Monthly Revenue is $250,000

Loss of revenue for 6 months = $1,500,000

Loss of profit (0.18 x $1,500,000) = $270,000

Fixed costs – (0.25 x $1,500,000) = $375,000

Gross BI Loss

$270,000 + $375,000 = $645,000

Less Deductible - $250,000

Net BI Loss Recoverable = $395,000

The final step is a review of the policy to determine the applicable BI deductible. This deductible can be a dollar amount or a time-period deductible. To keep it simple, let’s say we have a $250,000 BI deductible. The net BI recovery under our loss scenario is $645,000 – $250,000 or $395,000.

The first thing you may notice is that the insured has suffered a loss of gross revenue of $1,500,000 and will recover only $395,000 from insurers. Recall earlier statements that gross revenue is not insured. Variable costs are not incurred and, therefore, not recoverable. In our example, fixed costs of 25 percent of revenue and profit of 18 percent of revenue are recoverable. This revenue stream is, therefore, insured at 43 percent.

step Apply policy deductible.

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January 2014 • Lockton Companies

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We have not attempted to touch on a limitless number of other circumstances but have kept this straightforward and succinct. The insured can have seasonality, net losses, and inventories to make up loss, other avenues to make up loss of revenue using other facilities and resources, additional expenses, and extreme variability in the gross revenue stream. Measuring the BI loss a company can suffer is an art, not a science. All aspects of the insured’s business, variables, anomalies not related to the loss, timing of the loss period, and many others have to be considered to develop a BI value that is recoverable.

Reach out to Lockton property claims advocates for assistance as soon after the loss as possible. Lockton

can assist in getting the right resources to bear on the measurement and recovery of your BI loss.

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