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1 Feb 2018

Business Interruption – What Is It and How Does It Work?

If your business suffered damage from an unexpected weather event, fire or a key supplier suffered the same, have you ever considered the impact this may have to your revenue.

According to The Insurance Council of Australia, an examination of small to medium-sized businesses found that 26% have no form of general insurance with sole traders among the most uninsured, with 40% operating with no coverage. Even more alarming was the discovery that only 27% operate with some form of business interruption coverage.

The statistics speak for themselves. A reported 80% of businesses who suffer a severe disruption to revenue without business interruption insurance enter administration or are liquidated within 12 months of a major loss.

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 it work? At McKenzie Ross, we call it “life insurance for your business” and in this article, we attempt to answer both questions and provide 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 revenue, cash flow and/or profitability, BI steps in to protect the organisation by continuing to pay the net profit, plus all on-going fixed expenses which can include the following:

  • Operating costs such as lease payments, hire purchase and mortgage repayments
  • Relocation and retraining costs
  • 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 the balance sheet of all businesses. Far too often, clients only think of Business Interruption if the business ceases to trade. What happens if you can continue to trade from the premises albeit at reduced revenue or increased cost?

 

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, as 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, $500,000, would be:

Reduction in Turnover       x Rate of Gross Profit          = Loss of Gross Profit
($500,000) 30% $150,000

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.

 

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. Turnover can still be severely reduced by damage to racking or machinery with no damage to the building, which means no rent abatement clause.

Reduction in Turnover $500,000
Less Savings

Purchases

Freight

 

$325,000

$  25,000

 

65%

5%

Loss of Gross Profit $150,000

In this calculation, if a business loses $500,000 in sales and it does not save $350,000 of purchases plus $25,000 in freight, the BI policy will not respond adequately.

This example highlights the importance of accurately listing uninsured working expenses as those that, in your own unique cost structure are totally and directly variable to your 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.

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
($500,000) 20% $100,000

Whilst the actual loss of Gross Profit was $150,000, we have taken rent out as an uninsured working expense which was not saved in direct proportion to turnover. The business however is still liable to pay it to the property owner leaving an out of pocket cost of $50,000.

 

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.

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