Interruption Insurance, also known as BI is one of the most important classes of insurance any business can buy. The most common queries we get from our clients in relation to BI are, what exactly is it; and in practice how does a claim get calculated and settled? We call it “life insurance for your business” and in this article we will attempt to answer both questions and provide a greater insight into a lesser understood area of insurance.
In practice, if a business or organisation suffers disruption caused by an insured event, that affects cash flow and/or profitability, BI steps in to protect the organisation by continuing to pay the net profit, plus all the on-going fixed expenses which can include but are not limited to the following:
- Financial costs such as lease payments, hire purchase and mortgage repayments
- Pay-Roll costs including on costs such as WorkCover, PAYE, payroll tax and superannuation contributions
- Rent and other fixed outgoings
- Insurance – keyman, income protection, life insurance and general insurance policies like this one
- Utilities such as gas, electricity, communications and water charges
- All other expenses of the business that will continue during the period of disruption
Fundamentally, the principle behind BI is to put the business back into the position (or as near as will allow) that would have been enjoyed had the loss or disruption not occurred. The policy responds by covering the cost of outgoing expenses to the business, plus any “increased costs” the business incurs as a direct result of the disruption.
At McKenzie Ross, we consider BI cover a vital class necessary to protect all businesses. The statistics for businesses who do not buy BI speak for themselves, as a reported 80% enter into administration within 12 months of a major loss.
Uninsured Working Expenses
Insurable Gross Profit is the key component of most traditional BI policies and is your sum insured. To determine this figure, there are generally two main considerations:
(i) How long do I need the Indemnity Period?
(ii) Which expenses should be listed as “Uninsured (Working) Expenses”?
The Gross Profit Sum Insured or Declared Value insures the financial loss resulting from reduced turnover and / or increased costs. Since uninsured working expenses are deducted from turnover to calculate the applicable Rate of Gross Profit, uninsured expenses reduce the claim in proportion to the reduction in turnover.
Usually, the insuring clause is defined as follows:
In respect of reduction in turnover, the sum produced by applying the Rate of Gross Profit to the reduction in turnover during the Indemnity Period, resulting from the Damage.
Modern BI policies usually pre-print “Purchases” as the first in a list of uninsured expenses and allow additional expenses to be added as uninsured expenses. Only expenses that are directly variable with turnover or output should ever be on this list (i.e. uninsured). We are frequently asked whether certain other expenses should be insured or uninsured and some may appear to be totally variable when in fact they are not.
In summary, a claims settlement works as follows:
Purchases and other uninsured expenses are deducted from the turnover to calculate the Rate of Gross Profit. The effect of this is the assumption that uninsured expenses have been saved due to the reduction in turnover. For example, if the uninsured expenses are purchases and outwards freight and these comprise, say, 70% of the sales value, then the Rate of Gross Profit is 30%.
A BI claim for lost turnover of, say, $360,000, would be:
Reduction in Turnover x Rate of Gross Profit = Loss of Gross Profit
($360,000) x 30% = $108,000
As you can see, a Business Interruption policy will only cover 100% of the loss if the rate of Gross profit is accurate and the uninsured working expenses have actually been saved.
Reduction in Turnover $360,000
Purchases $248,400 69%
Freight $3,600 1%
Loss of Gross Profit $108,000
In this calculation, if a business loses $360,000 in sales and it does not save $248,400 of purchases plus $3,600 of freight, the BI policy will not respond adequately.
This example highlights the importance of listing uninsured working expenses as those that, in your own unique cost structure are totally and directly variable to revenue. That is they will always be saved in direct proportion to any lost sales.
The safest and simplest option, which suits most small to medium enterprises, is to list only purchases as uninsured. When you calculate the Gross Profit as its sum insured (as distinct from the Rate of Gross Profit for a claim), it might slightly overstate the amount, however doing this will ensure there is no uninsured loss.
The mistake most Accountants and Financial Controllers generally make when left to determine the Gross Profit Sum Insured is to nominate expenses as uninsured because they will be saved if the business is completely closed. Rent is a good example of this. Yes, rent will be saved if the business is shut because the premises are so badly damaged that they cannot be occupied. However turnover can still be severely reduced by damage to racking or machinery with no damage to the building, which means no rent abatement clause.
Using the same data as above but assuming rent is 10% of overall turnover and we have taken it out as an uninsured working expense, the rate of Insured Gross Profit is reduced to 20%. The BI claim would now be adjusted as follows:
Reduction in Turnover x Rate of Gross Profit = Loss of Gross Profit
($360,000) x 20% = $72,000
Whilst the actual loss of Gross Profit was $108,000 as above, as rent was taken out as an uninsured working expense and not saved in direct proportion to turnover, the business is still liable to pay it to the property owner leaving an out of pocket cost of $36,000.
Below I have provided commentary on several expenses that can cause problems.
Advertising is variable in that it can usually be incurred or not at the client’s option. It is a discretionary expense. During a significant business interruption in which you have no goods to sell you will probably stop advertising. Why create demand that you cannot satisfy? However, any savings during the initial months of the interruption will probably be eroded by additional advertising later when production has resumed and the business wants to regain its market share after the temporary absence.
The possibility of savings, even the probability of savings in a major interruption does not imply that an expense should be uninsured. Advertising is in this category. It is not directly variable with sales or production and although it might be saved in a major interruption it should be insured.
Bad Debts are normal costs of doing business they should be uninsured because they will vary directly with sales. Suppliers and building-related trades would be in this category with lots of small customers and typically a percentage of them not paying their accounts. However, if the bad debts shown in your P&L, they can be viewed as a “one off” reduction in Net Profit, which is insured, rather than typical of your variable cost structure.
Depreciation, is it an expense (non-cash) or is it a tax deduction? Does it vary with production or over time? Will a saving in non-cash depreciation reduce the cash settlement of a BI claim? But whatever the complications in BI claims, one thing is clear, depreciation does not vary directly with turnover or output and it should never be listed in a BI policy as an uninsured expense.
Inwards Freight and Duty (i.e. on Imports). These are expenses associated with purchases and can therefore be listed as uninsured.
Outwards Freight might not be as variable as it appears. e.g. A bakery has two ovens, one baking buns and another baking bread. After a fire in the bun oven it still bakes bread and its contractor or its own delivery truck still makes the regular daily delivery trips to all the customers but with only partly full loads. There is a loss of sales (no bun sales) but no savings in delivery costs. Therefore, for this cost structure outwards freight should be insured.
This is unusual and illustrates that the selection of insured/uninsured expenses is unique
to each business’ cost structure.
Outwork is the cost of sub-contracting part of a process, usually to a specialist such as printing companies sub-contracting or “outsourcing” plate-making or a garment manufacturer outsourcing “cut, make and trim functions”. It is the purchase of a service directly related to production (and sales) and like the purchase of materials it should normally be an uninsured expense because if the business is not making sales it will not be incurring these variable expenses.
Packaging is usually directly variable with sales and therefore can be uninsured.
Power (& Gas) always has a fixed cost element (fixed reticulation charges and maximum demand charges in larger users), which should be insured. Factory heating and lighting is fixed and even boiler fuel is not completely variable in many industrial plants (the boiler has to operate at similar rates of fuel usage whether the factory is running at capacity or, say, 50% of capacity) therefore should never be listed as an uninsured working expense.
Repairs & Maintenance (R&M). If there is a major interruption and the factory’s plant is damaged or just idle for a significant period there will be savings in R&M. But most claims are for “non-major” interruptions in which R&M is not saved.
If you decide to reduce your sum insured by designating R&M as an uninsured expense it should be done with the knowledge that it will be under-indemnified in a “non-major” interruptions because sales can be lost without savings in R&M.
Royalties are usually directly variable with turnover (therefore uninsured) but sometimes there is a fixed annual minimum that should be insured.
Sales Commissions are, in normal circumstances, variable with sales levels however if a business interruption prevents the sales persons achieving budgets and earning the commissions they have come to rely on, they may resign. In most business interruptions they are paid compensation in lieu of commissions and no savings result. Sales commissions should be insured.
Tool Replacements, Indirect Materials, Crockery, Cutlery & Linen Replacement – Tool replacements and indirect material costs in a factory are usually variable with activity levels and we would consider them to be candidates as uninsured expenses. The same applies to crockery, cutlery and linen in a restaurant.
Wages and how to insure them is a topic for discussion on its own. It is the most difficult decision any business has to make, and wages are rarely variable with turnover unless they are paid as “piece rates” for throughput or output. McKenzie Ross recommends insuring wages 100% for the duration of the indemnity period as part of the Gross Profit item. Wages should not be an uninsured expense or split.
If taken out as an uninsured expense, always be mindful of what your leave liability is on your balance sheet plus also what your severance obligations are. Quite often insuring this obligation can cost the same as insuring wages 100% where you get ultimate flexibility.
We hope this article provides a broader understanding of how a business interruption claim is settled, and the importance of getting the Insurable Gross Profit figure correct. If there is any aspect of this article you would like further details on, please contact your account manager for further explanation.
Content provided by Dave Hendry