2nd Source - C111 Chapter 8 Advanced Loss Adjusting

Chapter 8 – Business Interruption Claims

Introduction

-        The reason business interruption claims are subject to negotiation are:

·         Less tangible than direct physical damage claims

·         Subject to many variations

·         Need to understand the nature of the loss and specifics of the insured's business in order to assess coverages and adjust the claim

·         "Normal" is difficult to define as business activities are uncertain and financial flux is often experienced in today's business environment

·         Business interruption claims are a challenge to quantify

What is Business Interruption Insurance?

-        Extends coverage to insure the contribution that those assets make towards the profits of the business

-        An interruption in operation, due to a covered peril like fire, will typically result in a loss of sales

-        The two (2) types of losses that are covered by business interruption policies are:

                        I.          Loss of profit

                      II.          Loss of contribution towards necessary continuing charges for a specified period of time (aka the indemnity period)

-        Business interruption coverage will only apply to losses that are covered under the policy

-        Coverage is intended to return the business to the financial condition that would have existed had the incident not occurred, subject to policy limitations; i.e. return the business to "normal"

-        To determine the financial condition that would have existed during the period of loss requires:

·         Recreating the conditions that would have existed during the indemnity period

·         Projecting the operating results that could be expected under those conditions

-        "Normal" is difficult to define especially in the business world where there is a great deal of uncertainty and financial flux;  business rarely quantify their daily operations as "normal"

Forms of Coverage

-        The two (2) standard forms for business interruption coverage are:

                        I.          The Profits Form

                      II.          Gross Earnings Form

-        Both forms cover for the following losses:
"directly resulting from necessary interruption of business caused by destruction or damage by the perils insured against, to building(s), structure(s), machinery, equipment or stock on the described premises"

-        Both forms include coverage for the following:

·         Loss resulting from a reduction in sales (also called "turnover")

·         Loss resulting from an increase in costs, over and above what is normal, to avoid a reduction in sales

Profits Form

-        Gross Profit - net profit before taxes and all insured standing charges

-        Standing Charges - expenses that would continue in the event of an interruption;
e.g. Management salaries, mortgage interest, property taxes, property and plant depreciation

-        Variable Expenses - expenses that vary in direct proportion to sales.  If the sale is lost then the variable expense is not incurred and therefore not insurable;
e.g. Delivery of goods, materials expense and labour expense to produce the product

-        The three (3) categories NOT permitted to be classified as insured standing charges are:

·         Depreciation of stock

·         Bad debts

·         Ordinary payroll - wages and salaries other than salaries to permanent staff and wages to foremen and important employees whose services would NOT be dispensed, should the business be interrupted by a covered loss

-        Increase in Cost of Working

·         Gross profit may be reduced due to a loss of sales or additional costs incurred over and above what is normal

·         Additional expenditure necessarily and reasonably incurred for the sole purpose of avoiding or diminishing the reduction in "turnover" except for those expenditures that did not take place during the indemnity period

·         Economic Test must also be satisfied - the expenditure can NOT exceed the sum produced by applying the "rate of gross profit" to the amount of the reduction thereby avoided - e.g. If the insured spent $5000 to save $3000 worth of sales, then this would fail the Economic Test

-        The indemnity period extends until financial results are back to normal subject to a maximum period which is usually 12 months

-        Measure of Recovery clause - same as a Co-insurance clause, and often the Profits Form has a 100% coinsurance requirement;  if the insured is not adequately insured then this clause will penalize the settlement amount for any business interruption claim

-        An endorsement can be purchased to cover ordinary payroll for a specified period of time like 90 or 180 days

Gross Earnings (Mercantile or Non-Manufacturing) Form

-        Coverage is provided for "reduction in gross earnings directly resulting from (such) interruption of business less charges and expenses which do not necessarily continue during the interruption of business"

-        Gross Earnings is defined as follows:

+Total Net Sales
+Other Earnings (from operation of business)

-Merchandise Sold (including packaging)

-Materials & supplies consumed directly in supplying the service(s) sold

-Services purchased from outsiders (not employees of the insured) for resale which do not continue under contract

***NO other costs shall be deducted.  Therefore ordinary payroll is NOT listed in the above definition and is insured in the standard Gross Earnings Form***

-        Expenses to Reduce Loss
These are expenses that are necessarily incurred for the purpose of reducing loss under Gross Earnings Form, but this will NOT apply if the aggregate (total sum) of such expenses exceed the amount by which the loss under the Gross Earnings Forms is reduced

-        Indemnity period continues until the damaged property is restored/repaired;  there is no maximum indemnity period, however, compensation for losses will stop once the property is restored or could have been restored regardless if the operations continue to be affected by the damage to the property

-        Measure of Recovery

·         AKA Co-insurance clause

·         This clause will penalize any recovery amount that falls under coverages if the amount of insurance is not to value or to a certain %; normally minimum % is either 50% or 80%

·         If ordinary payroll is to be covered then usually 80% of the amount of insurance will be needed

Gross Earnings Manufacturing Form

-        The chief differences between the terms and conditions of the Gross Earnings Manufacturing form and Gross Earnings (non-manufacturing) Form are:

·         The Manufacturing form defines "gross earnings" based on the sales value of production rather than that of sales

·         Manufacturer's profit is considered "earned" when production is complete; i.e. Finished Stock is excluded because it represents past production, and earnings are considered complete

·         Finished stock may be covered under another section of the CGL policy

·         Gross Earnings (non-manufacturing) Form includes coverage for merchandise that is sold (including packaging material), which under the Manufacturing form is excluded

Other Income Forms

-        These forms combine several of the concepts from the traditional Profit forms and Gross Earnings forms which ends up providing the similar options

-        These forms are not use much and often sold as packages with other types of coverages

-        These forms are also found with manuscript wordings which add even more variations and the adjuster must review the wordings carefully to understand what coverages are available to the insured when a claim is presented

Ten (10) Steps to Settlement (AAIIEEEHGCS)

        I.            Analyze & understand Coverages

     II.            Analyze & understand the Business

   III.            Identify the cause of damage
Identify Impact on Business

  IV.            Help insured to Recover Quickly

     V.            Estimate Reserve

  VI.            Gather insured's Financial Information

VII.            Examine insured's Business Outlook

VIII.            Calculate the loss

  IX.            Examine Related Coverages

     X.            Settle the Claim

I.  Analyze & Understand Coverages

-        Determine the following:

·         Indemnity period

·         Charges and expenses that are covered or excluded or limited

·         How payroll is covered and for how long

·         Co-insurance clause is to be applied or not

II.  Analyze & Understand the Business

-        Learn the product or services being provided by the insured

-        Visit the site with the insured shortly after the incident in order to gather info about what the insured is selling and the impact of the loss on the business

-        For business interruption losses it is necessary to calculate the projection of sales (turnover or revenue) that would have been possible if the damage had not occurred

-        Determine the following information:

·         Legal form of the operation? (sole proprietorship, partnership, joint venture, or corporation)

·         How is the business organized? (several locations, segmented depts, interdependencies between divisions)

·         What are the key operational factors? (dependency on suppliers, customers, and important staff members)

·         How does the business environment affect the operation? (economic trends, and competitor activities)

-        The insured is the best person to educate the adjuster on the above

-        Members of the insured staff which may be valuable sources of information for the adjuster to ascertain the insured's business are:

·         General manager

·         Production team

·         Finance dept staff

·         Marketing dept staff

·         Human resources staff

-        By taking the information provided by the insured and researching the business environment, the loss adjuster can verify and criticize the information obtained and better position him/herself to evaluate the claim in an objective and fair manner

III.  Identify the Cause of Damage and Identify Expected Impact on Business

-        Loss must be covered under direct damage section of the property policy to qualify for coverage under business interruption section of the policy

-        Gather details about the damage and the expected repair, rebuild, or replacement plans to determine the expected duration (indemnity period) of the business interruption loss

-        If the operation continues to be affected after the restoration period and the insured has a Profits Form, then the indemnity period will be extended until the operation is back to where it was prior to the loss or the maximum limitation period under the policy which is usually 12 months

-        The insured is still entitled to business interruption benefits even if s/he is not going to undertake the repairs to the building.  However, business interruption coverage will be limited as per the conditions under the policy.  The adjuster must take into consideration the savings the insured will receive for the complete shutdown of operations.  These savings will come from standing charges or non-continuing costs, and will likely be substantial

IV. Help Insured to Recover Quickly

-        Business interruption coverage = Time element coverage

-        Time element coverage highlights that there is a link between time and coverage

-        An efficient and timely return to pre-incident operating conditions will minimize the loss sustained

-        The loss adjuster can take the appropriate measures to ensure quick recovery by the insured:

·         Consider requests for interim payments against covered losses to assist in the financing of restoration

·         Offer advice to help the insured consider options for an effective recovery plan (e.g. rent generators, find a temporary location, rent equipment, etc.)

·         Keep on top of the contractors repairing/rebuilding the insured's property;  the loss adjuster can follow up with the supervisor of the repair/rebuild operations to ensure timely actions are taken to minimize the downtime or delays in construction

V.  Estimate Required Reserves

-        Complex business interruption claims may require forensic accountant to help calculate the loss

-        The loss adjuster must gather as much information as possible from the insured to accurately estimate the reserve

-        The reserve is a reference point which the adjuster will review throughout the claim

-        The insured will be in a position to estimate the loss of gross sales

-        All expenses will not be readily available; the adjuster and the insured must wait for the indemnity period to end and determine the total cost incurred to get an accurate value of the business interruption claim

VI.  Gather Financial Information and Records

-        The forensic accountant services will gather required documents and will assist in calculating the loss

-        Recent historical operating statements are needed and should be obtained for the last two (2) to three (3) years; these documents may also be called:

·         Profit and Loss

·         Statements of Operation

·         Income Statements

-        The loss adjuster should determine the variable, semi-variable or fixed expenses

-        The financial information and records needed to evaluate a business interruption claim are:

·         Quarterly or monthly financial statements

·         Annual financial statements

·         Internally prepared statements

·         External Chartered Accountant assurance opinion

·         Notes related to financial statements that suggest projections of future revenues may be affected due to external factors

·         Forecast (or budgets) for future operating expenses (comparing past forecasts with actual results)

·         Sales records and significant contracts with customers and/or suppliers

·         Production records; using past and future forecast production records to estimate the results that would have been received if not for the loss

·         Equipment maintenance program; advise the insured to undertake these activities to non-damaged equipment and take advantage of the unexpected downtime

·         Payroll records; determine management and key employees from ordinary payroll

·         Determine savings due to staff layoffs and/or non-continuing labour costs due to the damage

·         Review and verify the invoices and/or general ledger for additional expenses and determine if they qualify for coverage under Increase in Cost of Working (Profits Form) or Expenses to Reduce Loss (Gross Earnings Form)

VII.  Examine Business Outlook

-        Assess the business environment, paying particular attention to competitors activities, regulatory bodies, supplier contracts and activities, and customer contracts and activities

-        Questions that can be asked by the loss adjuster are:

·         Is there a new competitor in the market place eroding the insured's market share?

·         Have regulations passed by legislation reduced productivity?

·         Have major suppliers, vendors or customers of the insured declared bankruptcy?

·         Have major suppliers and vendors of the insured signed contracts with competitors that cause a shortage of raw materials that will negatively impact the insured's business outlook?

·         Have customers of the insured steadily decreasing their orders in favor of internal production or an alternative product line?

VIII.  Calculate the Loss

-        This step may require the assistance of a forensic accountant

-        The loss calculation frame work would be:

·         Calculate the Insurable values;  i.e. defined gross profit or gross earnings

·         Determine Rate of Contribution; i.e. rate of gross profit/gross profit % or rate of gross earnings/gross earnings %

·         Determine Rate of Recovery;
-compare the insurance in force with the minimum coverage required
-apply the co-insurance clause if applicable (Profits Form usually require 100% and Gross Earnings Form usually require 50% to 80% depending on coverage)

·         Determine Net Sales Loss during the indemnity period as a result of the covered loss resulting in the direct damage
-calculate the difference between the projected sales (if the loss hadn't occurred) and actual sales 

·         Loss Calculation by applying the rate of contribution to the sales loss

·         Determine the Additional Expenses that were necessarily incurred to mitigate the sales loss; i.e.  Increase in Cost of Working - Profits Form and Expenses to Reduce Loss in the Gross Earnings Form;  the economic test must still be applied to verify that the expenses incurred don't supersede the actual sales lost - e.g. spending $5000 in equipment to save $3000 in sales

·         Deduct the savings in insured standing charges (Profits Form) or non-continuing expenses (Gross Earnings Form) - e.g. layoff of workers due to the damages caused by the covered loss

·         Calculate the ordinary payroll if it applies (Gross Earnings Form)

·         Apply the Rate of Recovery; i.e. co-insurance clause

·         Compare the limits of insurance to the amount calculated and see which is less;  apply deductibles as stated in the policy

IX.  Examine Related Coverages

-        Claims for business interruption should be reviewed for related coverages to ensure that items are not claimed twice
Example - A claim is submitted for business interruption under the Gross Earning Form for ordinary payroll.  Upon review the claim the adjuster found that equipment repairs and maintenance under the property damage section of the policy were claimed again under ordinary payroll.  The adjuster explained the principle of indemnity to the insured and advised that since this expense was paid under the property damage section of the policy it will be denied coverage under ordinary payroll of the business interruption section of the policy

-        Extra expense coverage may be available for expenses that don't meet the economic test
Example - Business interruption claim is presented under a Profits Form by the insured who runs a poultry processing plant.  As a result of the fire (covered peril) equipment breaks down and the insured uses an outside processor to ensure operations continue to meet the needs of customers.  The cost of transportation and the small margins in order to operate the insured's business, result in the outsourcing of the work costing more than the gross profit that were saved.  It made more arithmetic sense to just lose the sales.  However, by taking this necessary action, the insured was able to keep the customers, instead of losing them to a competitor and save future sales.  The adjuster took this into account and was able to find in the favor of the insured and convince the insure to pay the extra cost for outsourcing the work under the Increase in Cost of Working  under the Profits Form

X.  Settle the Claim

-        Keep in mind the business interruption claims are based on a "What if the damages hadn't occurred?" scenario, and often in "What if" scenarios, it is very difficult to determine the precise value of the settlement amount

-        Commercial insureds are often savvy about insurance law and also are in a better position to justify any value as they understand their business better than the loss adjuster; this consideration on the part of the loss adjuster must be looked into when dealing with insured during settlement negotiations

***Refer to Austin Corporation Business Interruption Case Study - pg 18 to 25***