Getting Business Interruption Insurance Right – Essential Insights

Business interruption insurance is designed to cover the loss of income a business suffers after a disaster. This type of insurance differs significantly from many forms of insurance because it is not only about covering physical damage but also about the financial impact of business interruption.

Companies can often run into problems with their business interruption claims after an incident due to misunderstandings regarding their cover. Policy wordings should clearly set out calculation methods for sums insured and exclusions to avoid issues. Yet, these explanations might not have finer points and considerations.

In this article we explore some of the details that prudent companies will consider when arranging their business interruption protection.

Business interruption insurance cover and contingent business interruption cover (or dependent business interruption cover) are both designed to protect businesses from financial losses due to interruptions. However, they differ in the source of the interruption they cover:

What Is Business Interruption Insurance

• Coverage Scope: Covers losses resulting directly from damage to the insured’s own property.
• Trigger Events: The interruption must result from an insured peril that causes physical damage to the insured property, such as fire, natural disasters, or vandalism.
• Purpose: Aims to compensate the insured for lost income and operating expenses during the period required to restore the damaged property and resume normal operations.
• Typical Inclusions:
  • Lost revenue
  • Fixed costs (e.g., rent, utilities)
  • Extra expenses incurred to continue operations (e.g., renting temporary premises)

What Is Contingent Business Interruption Insurance (Dependent Business Interruption Cover)

• Coverage Scope: Covers losses resulting from an interruption caused by damage to the property of a third party on whom the insured business depends.
• Trigger Events: The interruption must result from an insured peril causing physical damage to the property of a supplier, customer, or other key business partner.
• Purpose: Aims to compensate the insured for lost income and additional expenses incurred due to the disruption in the supply chain or customer operations that affect the insured business.
• Typical Inclusions:
  • Lost revenue due to supplier or customer disruptions
  • Extra costs incurred to find alternative suppliers or customers
  • Additional expenses to mitigate the impact of the disruption

Key Differences

Source of Interruption:

• Business Interruption Insurance: Direct damage to the insured’s property.
• Contingent Business Interruption Insurance: Damage to the property of a third party (e.g., suppliers or customers).

Dependence:

• Business Interruption Insurance: The insured business is affected by an internal incident.
• Contingent Business Interruption Insurance: The insured business is affected by an external incident impacting a dependent party.

Risk Management Focus:

• Business Interruption Insurance: Focuses on the insured’s own property and operations.
• Contingent Business Interruption Insurance: Focuses on the broader supply chain and the relationships with key external parties.

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1. Accounting vs. Insured Gross Profit

It’s vitally important that firms avoid underinsurance. Should a severe unforeseen event occur, it could have a devastating impact.  Key differences arise in the calculation methods used in business interruption policies. Your preference may depend on the nature of your business and your firm’s appetite for risk.

Here’s a detailed explanation of the two options.

Accounting Gross Profit:

• Definition: It is the profit that a company reports in its financial statements, calculated as sales revenue minus the cost of goods sold (COGS).
• Formula:

Accounting Gross Profit =  Sales Revenue – Cost of Goods Sold

•  Purpose: Reflects the company’s profitability before deducting operating expenses, taxes, interest, etc.
• Application: Used in financial accounting to show the financial performance of a business over a period.

Insured Gross Profit:

• Definition: A specific measure used for business interruption insurance designed to reflect the actual loss of profit due to a covered event.
• Formula:

Insured Gross Profit = Turnover – Uninsured Working Expenses

Where turnover is the total revenue, and uninsured working expenses are those variable costs that are directly proportional to the level of business activity (like raw materials).

• Purpose: To accurately compensate the insured for loss of profit by considering only those expenses that cease when the business is interrupted.
• Application: Used in insurance to calculate the sum insured and the potential payout in case of a claim.

A company might opt for insured gross profit over accounting gross profit in their business interruption cover because insured gross profit more accurately reflects the actual loss by excluding variable costs that cease during the interruption, ensuring appropriate compensation. This method aligns the insurance payout with the real financial impact of the interruption.

2. Benefits of Revenue Cover

Revenue Cover:

•  Definition: Insurance that covers the entire revenue generated by the business, as opposed to just the gross profit.

Benefits:

• Comprehensive Protection: Covers the total income, offering broader protection than gross profit cover.
• Simplified Claims Process: Easier to determine the loss since it considers total revenue, avoiding complex calculations involving costs.
• Supports Business Continuity: Ensures that the business can cover all expenses, including those that do not reduce proportionally with revenue loss.

Opting for revenue cover on business interruption insurance offers comprehensive protection by covering total income, simplifying the claims process, and supporting full operational continuity. However, it may result in higher premiums and can be less precise for businesses with significant variable costs, as it doesn’t differentiate between costs that continue and those that cease during the interruption.

3. Declaration Linked Policies

Definition: A type of policy where the sum insured is declared periodically (potentially quarterly if you’re a firm forecasting fast growth or are subject to difficulty in predicting seasonality) by the insured, and premiums are adjusted accordingly.

Benefits:

• Flexibility: Adjusts to the actual turnover, ensuring the business is neither over-insured nor under-insured.
• Cost Efficiency: Premiums are based on actual performance rather than estimates, potentially lowering costs.
• Accuracy: Regular declarations ensure the coverage remains aligned with the business’s current financial status.

A Declaration Linked Policy offers flexibility and cost efficiency by adjusting coverage and premiums based on actual turnover, ensuring accurate alignment with the business’s financial status. However, it requires regular, accurate declarations, which can be administratively demanding, and there is a risk of underinsurance if turnover is underestimated.

4. Appropriate Extensions and Clauses

Extensions and Clauses:

• Additional Increased Cost of Working (AICOW): Covers extra costs incurred to maintain operations after a loss.
• Denial of Access: Provides coverage if the business is unable to access its premises due to damage to nearby properties.
• Contingent Business Interruption: Covers losses resulting from interruptions at the premises of suppliers or customers.
• Utilities Extension: Covers losses due to the interruption of utility services (like power & water).

Clauses:

• Alternative Premises Clause: Allows for the use of alternative locations to mitigate the impact of a business interruption.
• Professional Accountants Clause: Covers the costs of hiring accountants to assist in preparing claims.
• Departmental Clause: Applies when the business has multiple departments, ensuring that unaffected departments do not impact the claim for the affected department.
• Salvage Sales Clause: Adjusts the gross profit calculation to account for any salvage sales made during the interruption period, reducing the claim amount accordingly.

Conclusion

Understanding business interruption insurance is crucial for firms. The pandemic demonstrated the importance of fully considering the impact of all potential eventualities. Clarity on policy terms, exclusions, and extensions can aid in effective risk management, prompt claims processing, and financial stability during unforeseen global crises. Appropriate coverage for revenue losses and operational disruptions should be arranged.

In summary, business interruption insurance involves distinct calculations for accounting and insured gross profit to reflect actual losses more accurately. Revenue cover offers broad protection, while declaration linked policies provide flexibility and cost efficiency. Appropriate extensions and clauses enhance the coverage, ensuring comprehensive protection against various risks associated with business interruptions. Understanding these elements helps businesses tailor their insurance policies to their specific needs, ensuring robust financial protection in the face of unforeseen events.