Business Interruption Insurance
By Jeffrey W. Cavignac, CPCU, RPLU, CRIS © 2007 Cavignac & Associates — All Rights Reserved
Direct property insurance is pretty easy to understand. It covers the cost to repair or replace property which is damaged or destroyed by a covered peril such as fire, windstorm, vandalism or theft. Indirect property coverages, however, are a little more confusing but equally important. Indirect exposures include business income, extra expense, and rental income coverages.
One way to look at direct property coverage is that it protects a company’s balance sheet; whereas indirect property coverage protects a company’s income statement.
For the sake of brevity, I’ll refer to indirect property exposures as business interruption coverage (BI). BI coverage can be confusing, is commonly misunderstood, and is probably the toughest coverage to set a limit for. It also creates the biggest opportunity for inadequate values and coinsurance penalties. Many businesses that suffer major damage to their facilities never recover. If BI limits are not adequate the odds of recovery are even more remote. Before you invest any more time in this article, I encourage you to review your current BI coverage.
Many service-type industries, such as architects, engineers, attorneys, and retailers, have their property and liability coverages written on a Business Owners Policy (BOP). Most BOP policies automatically include BI coverage for up to a year on an “Actual Loss Sustained” basis. In other words, you don’t have to go through the process of setting a separate limit because there is no maximum. You will have coverage for your actual loss of business income for up to 12 months. So as long as you can resume operations within a year, your coverage is adequate.
For the vast majority of businesses, however, the amount of BI exposure needs to be determined. This valuation is critical. As mentioned earlier, inadequate or lack of BI coverage can doom a company that suffers a major loss.
What Does Business Interruption Cover?
In the event an insured location is damaged by a covered peril, a business may suffer a loss of income, a loss of rental income and/or incur extraordinary operating expenses to get back into business. These are the subjects of BI insurance.
1. Business Income is defined as “net income that would have been earned, plus continuing normal operating expenses, including payroll,” in other words, loss of profit plus continuing expenses.
2. Rental Value equals the rents you would have received during the period of restoration.
3. Extra Expense is defined as“necessary expenses you incur during the Period of Restoration’ (how long it should take to restore your premises to its pre-loss condition) that you would not have incurred if there had been no damage to your property.”
How to Calculate Your Exposure
The insurance industry is big on worksheets. The worksheet developed to calculate Business Income values (Form CP 15 15) is about as complicated and convoluted as they come. Most accountants – let alone insureds – don’t understand the massive form. With this in mind, we developed a much simpler form that will help you arrive at an appropriate limit. A copy of the form is included on page 6.
1. Determine How Long You Will Be Out of Business
The first thing you need to figure out is exactly what you would do if your facility were damaged or destroyed. Would you retire? If so, you might not want to buy BI coverage.
However, if you want to remain in business, then you need to decide how long it would take you to get up and running again (the Period of Restoration). Would you suspend operations until you could reoccupy your current location?
Would you search for an alternative permanent location? Could you use other premises to partially resume operations until your new permanent location is available?
All of these options need to be given consideration. A well written Disaster Recovery Program (see our Commercial Update Newsletter of August 2006 ) is crucial to successfully resuming operations after a major loss and can also substantially reduce your exposure to loss.
2. Determine Your Loss of Profits
The second step is to determine what your loss of profits would be during the Period of Restoration.
3. Determine Your Continuing Operating Expenses
Third, what would your continuing operating expenses be? Note that non continuing expenses are not covered. For example, if you are a manufacturer and your operations are suspended, you would not have to purchase stock and some of your utility expenses would disappear as well.
A major category of continuing operating expenses is payroll. You have the option of including or excluding “Ordinary Payroll.” Ordinary payroll is defined as “payroll expense of employees other than executives, department managers, employees under contract and other important employees.”
If your “ordinary” employees are important to your operation, you may want to keep them on your payroll until you are ready to reopen. Additionally, you can specify how long you might want to include them (i.e., 30, 60, 90 or 180 days).
Once you have determined your monthly exposure and how long it would take to get back in business, you multiply your monthly exposure by the number of months it will take to get back in business, which produces your Business Income Valuation for the period of restoration.
4. Extended Period of Indemnity
Some businesses might complete repairs and be ready to go. However, it may take additional time to get sales ramped up to what they were prior to the loss. The standard Insurance Services Office (ISO) Business Income Coverage Form (CP 0030 0402) provides an additional 30 days of coverage after the period of restoration. This is known as an “Extended Period of Indemnity.”
This may not be enough, and a longer time frame may need to be endorsed onto your policy.
5. Extra Expense
The calculation of extra expense coverage can also be a challenge. Extra expense coverage reimburses you for expenses you incur during the“period of restoration” that you would not have incurred if there had been no direct physical loss. It includes expenses that help you avoid or minimize the suspension of your business, as well as expenses to continue operations at your original or replacement location. It also includes costs incurred to minimize the suspension of your business if you cannot continue your operations.
We have included our simplified Extra Expense Worksheet on page 7 to assist in this calculation.
6. Rental Value
Rental value not only includes the loss of rental income during the period of restoration, but it also includes any continuing operating expenses (including payroll) as well as the amount of charges that are the legal obligation of the tenant(s) but would otherwise be your obligation.
If the building is owned by you or the other members of your company, but held under a separate legal entity, you need to make certain to include the rental value in your business income calculation.
Alternatively, if the building is owned by the same entity that occupies the facility, then there is no rental exposure.
7. Your Business Income Limit of Coverage
Once you have figured out an appropriate Period of Restoration and the monthly exposures for Business Income, Extra Expense and Rental Value, you can then calculate your total exposure.
It is important to know that the BI value sets a maximum limit of coverage. In the event of a loss, you will be compensated on an “actual loss sustained” basis up to your limit of coverage. Another point to remember is that if you elect not to go back into business, you will still recover the loss of business income that you would have earned during the period of restoration.
Most underwriters want to see Business Income coverage written with coinsurance.
Coinsurance is designed to encourage insurance to value. Be wary of coinsurance — it can only penalize you! If you are underinsured at the time of a loss the coinsurance penalty will kick in and reduce your recovery, even for a partial loss. If you complete a worksheet to substantiate your valuation, most underwriters will agree to write coverage on an “Agreed Amount” basis. We strongly recommend that your coverage be endorsed accordingly.
The ISO BI form includes a 72-hour deductible. In other words, there is no coverage during the first 72 hours following the loss. Companies who do not use ISO forms may have a different deductible but you should be aware that you can generally negotiate it. If you want to retain more risk, you may elect to lengthen the deductible period.
Contingent Business Interruption
Some businesses are dependent on other companies for a significant part of their production or possibly a large percentage of their sales. A golf club manufacturer, for example, sourced their club heads from a facility in Australia. The Australian plant had a unique process to create the club head. If the facility in Australia were destroyed, the golf club manufacturer would suffer a major loss of income.
The basic BI policy is triggered only if there is direct damage to a covered facility. In this case, the Australian facility is not a covered location. A separate coverage known as “Contingent Business Interruption” is available for this kind of exposure.
The ISO Business Income form includes three weeks of coverage (beginning 72 hours after loss is suffered) if a civil authority prohibits access to your premises due to direct physical loss of or damage to property other than yours. Note that this damage must be caused by a covered peril. Civil authority coverage can be endorsed to last a longer period if necessary.
1. Make certain you have an effective Disaster Recovery Program. This should include the specific steps you will need to take to get back into business and how you will accomplish them.
2. Take the time to complete both a Business Income and Extra Expense Worksheet. Recognize that most people tend to underinsure, but this is one coverage you want to be sure you have adequate limits for.
Although business interruption is one of the most crucial coverages in your insurance portfolio, it is one of the least understood. In the event of major damage to your facility, appropriate business interruption coverage can make the difference between getting back in business or folding your tent.