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22 Mar 2018

Insurable Gross Profit & Uninsured Working Expenses

“The sum of Turnover and Closing Stock, less the sum of Specified Working Expenses and Opening Stock”.

Following on from last month’s article in relation to how a Business Interruption claim gets adjusted, we thought it appropriate to outline how to come up with a company’s Insurable Gross Profit sum insured. Arguably the best way to do this (and to reduce the risk of being underinsured) is to take the turnover of the business, add the closing stock and then deduct the value of the opening stock and purchases during the last financial year. This ensures every other expense of the business, other than purchases, are insured.

Some policies (Typically ISR) also allow other expenses of the business, which vary in direct proportion of sales, to also be deducted.

We provide our commentary below on our opinion of their variability to turnover.

Advertising is variable in that it is a discretionary expense. During a significant business interruption in which you have no goods to sell you would typically stop advertising. Why would you create demand that you cannot satisfy? However, any savings during the initial months of an interruption will probably be eroded by additional advertising later when production has resumed, and the business wants to regain 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 Advertising Expenses should be insured.

Bad Debts are a normal cost 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 bad debts are 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 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? Whatever the complications in BI claims, one thing is clear, depreciation does not vary directly with turnover or output. Depreciation should never be listed on 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 uncommon, however illustrates the selection of insured/uninsured expenses is unique to each business’ own 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. If the business is not making sales it will not be incurring this type of 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. Power and gas therefore should never be listed as an uninsured working expense.

Repairs & Maintenance. If a major interruption occurs and the factory’s plant is damaged or just idle for a significant period there will be savings in repairs and maintenance. However most claims are for “non-major” interruptions in which repairs and maintenance are not saved.

If you decide to reduce your sum insured by designating repairs and maintenance as an uninsured expense it should be done so with the knowledge that it will be under-insured in a “non-major” interruptions. Sales can be lost without savings in repairs and maintenance.

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 a sales person achieving budgets and earning the commissions they have come to rely on, they may resign. In most business interruptions sales reps are paid compensation in lieu of commissions and no savings result. Therefore 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 must 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% as part of Gross Profit for the duration of the indemnity period. 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.

If you are concerned about how to correctly calculate your Insurable Gross Profit and what Uninsured Working Expenses to include, contact your Account Manager today.


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