Business Interruption risk was the top ranked risk for the sixth year in a row according to The Allianz Risk Barometer 2019. As business structures become more complex, companies often need more sophisticated insurance products to properly manage their business interruption risks.
Given the increasing complexity of business structures, in many cases, it is difficult to know the types of risks to which a business may be exposed and how the business interruption loss is calculated.
In this article, we will introduce the basic concept of a business interruption calculation along with potential issues that may arise from catastrophic events and how these can have an impact on business interruption losses.
Basic Understanding of Business Interruption Losses
Following an incident causing physical damage, a business' operations may be impaired or cease altogether, which can result in a loss of profits. In some cases, the amount of physical damage can be less than the amount of lost profits. This has given rise to Business Interruption loss insurance (BI), which has been developed to assist insureds to mitigate the risk of loss of profits.
Business interruption insurance is a contract of indemnifying the loss of profits. We know that the property insurance would return the Insured's property to the same position after fire or other insured damage, as if the loss had not occurred. In the same way, the business interruption loss cover puts the Insured's finances in the same trading position after the incident, as if the loss had not occurred.
The table below illustrates how business interruption insurance can help the Insured maintain the same net profit when impacted by an incident:
The business interruption insurance will cover loss of profits of the business as a result of the incident. After considering the insurance payment, the Insured will generate the same net profit had the loss not occurred (i.e. fixed costs and net profit).
Based on the Standard Policy Wordings, insurers pay the "loss resulting from interruption of or interference with the Business carried on by the Insured at the Premises consequent upon DAMAGE to Property used by the Insured at the Premises for the purpose of the Business."
Furthermore, this incident should be caused by the Insured Peril. This depends on the policy coverage.
After the damage to property is quantified, the physical damage may result in a reduction in turnover of the Insured's business. It is important to note that the loss sustained should be as a result of the physical damage from the Incident. If the reduction in turnover is not fully or partially attributable to the Incident, the loss may not be covered by the Policy or certain adjustments should be made to estimate the loss resulting solely from the incident.
"But for" analysis is a useful tool in estimating the business interruption losses. It should be asked but for the damage, what would have happened to the Business?
For example, what if a major customer left for another competitor just before the incident occurred?
In this case, the loss of a major customer is not related to the Incident. Since the business would have experienced the loss of a major customer regardless of the Incident, the Insurers are not liable for the loss of revenue from this situation. In order to reflect the loss solely as a result of the Incident, an appropriate adjustment should be made to the total loss figures. Otherwise, the Insured would be compensated for a loss that is not covered by the Policy.
Business Interruption Loss Calculation Formula
While we are not analyzing a business interruption loss calculation in detail, it is beneficial to understand the basic components of a business interruption loss calculation.
Determination of the reduction in turnover
From standard turnover, actual turnover will be deducted during the interruption period to calculate the reduction in turnover. Standard turnover is the turnover based on the corresponding period in the prior year with the interruption period. For example, if the interruption period is January 2018 to April 2018, the standard turnover is based on the period from January 2017 to April 2017.
However, businesses are constantly evolving due to various factors. It is unusual that the turnover of the business stays the same as the period in the previous year. Therefore, standard turnover will normally be adjusted. This adjustment to standard turnover is allowed per the other circumstance clause to reflect the business trend but for the incident.
"Such adjustment as may be necessary to provide for the trend of the Business and for variations in or other circumstances affecting the Business either before or after the Incident which would have affected the Business had the Incident not occurred, so that the figures thus adjusted shall represent as nearly as may be reasonably practicable, the results of which but for the Incident would have been obtained during the relative period after the Incident."
The adjustments can be made in different ways depending on the nature of the business and data available. Some examples of the application of the other circumstance clause include year to year trend adjustment, budget to actual achievement, market share analysis, etc.
Application of Rate of Gross Profit
Once reduction in turnover is determined, projected rate of gross profit is applied to the reduction in turnover to measure the loss of gross profit. The Policy defines the rate of gross profit as "the rate of gross profit earned on the Turnover during the financial year immediately before the date of the Incident". Please note, rate of gross profit is also subject to other circumstance clause. Therefore, a trend adjustment may be applied depending on the nature of the business to determine the appropriate rate of gross profit but for the incident.
Deduction of Fixed Costs Savings
If there is a reduction in fixed costs as a result of the incident, this should be deducted from the loss calculation. For example, if a warehouse of the Insured was destroyed and no alternative rent was incurred, rental charges would cease. Therefore, the saved rental charges should be deducted from the loss calculation in order to put the Insured in the same position had the incident not occurred.
Increase in Cost of Working (ICW)
The basic concept of ICW is the Insured incurred additional costs to mitigate or avoid the loss of gross profit. There are requirements that the additional cost needs to meet in order to be considered as an ICW. Per the Policy, "the additional expenditure necessarily and reasonable incurred for the sole purpose of avoiding or diminishing the reduction in turnover and ICW costs should be incurred during the indemnity period". Furthermore, the expenditure needs to meet the economic limit criteria. In order to save $1 of gross profit, the maximum additional expenditure is capped at $1. The Insured may purchase the additional increase in cost of working (AICW) extension to avoid the economic limit criteria. However, AICW usually has a sublimit.
Examples of ICW include:
i) The cost of temporary repair of the machinery to continue
production during the interruption period.
ii) Overtime costs to speed up the restoration of the damaged property.
iii) External purchases of materials or finished goods, as an alternative to in-house production.
Application of the Average Clause
It is important the Insured declares an adequate Sum Insured. If there is underinsurance, the Insured should bear a proportion of the loss.
A simple summary is illustrated below.
Issues in Catastrophe Events and Business Interruption Losses
In general, losses are usually related to one specific property or location of the Insured. However, in the event of catastrophic events, such as an earthquake, typhoon and flood, these natural disasters give rise to damage of other parties surrounding the Insured.
It is critical to understand the difference when dealing with natural catastrophes as opposed to a normal property damage claim.
Impact of Catastrophic Events
Natural catastrophes include earthquakes, typhoon or floods. They are unpredictable and the impact varies depending on the situation. However, their threats can lead to loss of human life, extensive damage to property and financial loss.
The approach to estimating losses from natural catastrophes can be different from normal property damage claims, since the Insured's operation can be impacted by other factors besides its individual physical damage.
The individual physical damage to an Insured's premises may be relatively minimal when compared to the financial impact that the natural catastrophes may have on the insured's business. For example, infrastructure throughout the surrounding area is often severely damaged. Delivery of supplies can be interrupted, and the customers may not be able to purchase the goods or services from the Insured due to the suspension of their operation.
The economic loss of any catastrophe can be more complex than what the physical damage indicates at first. Economic losses due to shortage in turnover from suspension of production, additional costs incurred for loss mitigation, and additional costs for restoring financial data and other important records can affect a business' operations for months. In the absence of a detailed immediate recovery plan and appropriate business interruption loss insurance, the interruption period can be quite substantial.
Contingent Business Interruption Loss Arising from Catastrophic Event
Usual business interruption insurance policies cover the Insured for losses arising from the interruption of their own operations as a result of physical damage to the Insured's property. These normal business interruption Insurance policies do not usually provide sufficient coverage in the event of catastrophic events. Therefore, it is beneficial for the Insured to obtain business interruption coverage that includes policy extensions such as Service Interruption (interruption of utility services), Denial of Access, Loss of Attraction and Contingent Business Interruption ("CBI") (i.e. loss arising from damage to suppliers or customers). Different sub limits, indemnity periods and deductibles can be applied to these coverage extensions.
An important extension for catastrophic events is CBI, which extends the cover for financial loss as a result of interruptions to suppliers' or customers' operation/production. There are no conceptual differences between business interruption and contingent business interruption loss calculations. However, the type of peril and property damaged at the supplier or customer must be insured and listed by the Policy. Difficulties could arise in correlating the business interruption losses to specific suppliers and customers when multiple parties are impacted.
Catastrophes can affect a whole industry including its suppliers and customers, as increased integration in manufacturing processes results in greater interdependencies among upstream and downstream business partners.
The development of global supply chains management creates challenges. Businesses now tend to have minimal inventories to reduce inventory costs. As a result, this may create vulnerability, as no spare inventories are maintained to mitigate a disruption in operation. Furthermore, over reliance on automation can create a susceptibility to disruption if the automation failure causes difficulties to achieve production through alternative methods.
Other Circumstance Clause in Wide Area Damage
Catastrophic events, such as earthquakes, typhoons and floods, can not only lead to damage to the Insured's property, but also give rise to wide area damage. In the case of wide area damage, it is important for us to understand how the Policy is triggered by the incident.
We acknowledge business interruption insurance covers "the loss resulting from interruption of or interference with the Business carried on by the Insured at the Premises consequent upon DAMAGE to Property used by the Insured at the Premises for the purpose of the Business".
Therefore, it is quite clear that the coverage does not include other damage within the surrounding areas. In other words, the business interruption policy is triggered by the damage to the property operated by the Insured not by a specific peril or damage to surrounding areas.
For example, let's assume there are two restaurants located in an area that suffered massive devastation due to an earthquake. Restaurant A sustained physical damage following the catastrophe, which resulted in a reduction in turnover for 6 months. Restaurant B sustained no physical damage to the property. However, Restaurant B experienced a similar level of reduction in turnover for 6 months after the catastrophe due to the downturn in local economy. Please note that both restaurants do not have any coverage extensions such as loss of attraction or denial of access.
In this example, Restaurant B is not eligible to make a business interruption loss claim for a reduction in turnover, as there is no physical damage to the Restaurant B's property although they suffered a loss from reduction in turnover after the earthquake.
Restaurant A, however, sustained a loss due to physical damage, and therefore, it seems that they are eligible for a business interruption loss claim. In this case, it is important to segregate the loss that is due to the physical damage of Restaurant A as Restaurant B's income after the incident suggests that the losses of Restaurant A are not solely due to physical damage of Restaurant A. In other words, but for the physical damage, Restaurant A would have sustained a decrease in income resulting from the fact that the local economy has declined due to the earthquake. It can be said that this part of the loss stems from a loss of attraction.
In this case, the other circumstance clause plays a key role for the "but for" analysis in the projection of standard turnover. In order to properly estimate the loss of Restaurant A above, certain adjustments should be made to the standard turnover of Restaurant A.
We have witnessed shortages in human resources and material resources in relation to recent catastrophic weather events. This can extend the restoration periods due to the scarcity of resources. Therefore, comprehensive business recovery plans are extremely important.
The recovery plans should include ensuring the safety of staff and customers along with the restoration of properties such as buildings and plant. To mitigate the loss during the restoration period, the business may find alternative means of production by incurring additional costs. The preservation of documentation and restoring of financial data are also important, as these will be required to estimate the losses after the incident.
Moreover, businesses need to have proper coverage in their policy, particularly when operating in vulnerable areas impacted by catastrophes. Businesses need to consider the consequences of the natural catastrophe event and purchase the appropriate insurance policy with the proper extensions.
The survival of a business may ultimately depend on the recovery plan in place and the purchase of the appropriate insurance policy when the catastrophe strikes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.