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Business interruption coverage from startup to finished product.

Business Interruption Coverage From Startup to Finished Product

Business interruption insurance is vital because it permits a company to continue its daily operations in the midst of a loss occurrence. By allowing earnings and expenses to continue, it can mean the difference between the survival or demise of a business.

The coverage is based on an analysis of what the business would have produced and sold had no loss occurred. Because it is difficult to determine the "use value" of business property, especially after loss or damage occurs, the risk manager must consider the intent of the coverage and what goes into adjusting a business interruption loss before it actually occurs. He or she should also realistically forecast sales or production, expenses and the time involved in a shutdown.

Standard business interruption policies cover loss resulting from the total or partial interruption of business caused by damage to or destruction of real or personal property on premises occupied by the insured. An underwriter's liability is limited to the actual loss sustained or loss of net profit plus out-of-pocket expenses to be met while the business is suspended, less any expenses saved. In the case of the manufacturer, it is the margin over the cost of materials and supplies used to produce a finished product; for the merchant, it is the margin over the cost of merchandise. Because the intent of coverage is to cover these margins, the amount of insurance will depend on the dollar volume of sales lost less any reduction made in expense to produce sales.

How Much Insurance?

As with any exposure, the risk manager must identify and analyze potential loss exposures in order to know how much business interruption coverage to purchase. Start by reviewing the financial statement and underlying records, specifically the profit and loss statement and the sales record for the past two years. The gross profit on the financial statement is not necessarily synonymous with gross earnings. There is a significant difference between the amount of insurance for business interruption coverage and the figures on the profit and loss statement. Therefore, the profit and loss figures must be rearranged to conform with the insurable value under the policy to properly collect lost earnings.

In evaluating the business interruption value of manufacturing risks, remember that because finished stock has built-in profit it does not become part of lost earnings. Income is derived from the increased value of the materials when the manufacturer converts them into product; that is, the difference between the value of raw materials and the value of the finished product. The loss to the finished product is covered by the direct loss or damage policy for selling price as is raw stock for replacement cost. Again, the manufacturer is insuring the margin over the cost of materials and supplies used in production of the finished product.

The amount of gross earnings for insurance recovery in manufacturing is the sum of total net sales value of production, total net sales of merchandise and other earnings derived from business operation. Subtracted from this figure are the cost of raw stock from which production is derived; materials and supplies directly consumed in the manufacturing process or in supplying the service sold; merchandise sold, including packaging materials; and services purchased from outsiders for resale which do not continue under contract.

Raw stock consists of materials the insured receives for conversion into finished stock. Recovering income for loss or damage to raw stock is limited to the length of time during which raw stock would have made operations possible or to the time needed to replace or restore the raw stock, whichever is less. Stock in process is raw stock that has undergone aging, seasoning, mechanical or other manufacturing processes but has not become finished stock at the insured location. Additionally, stock in process would consist of inventory of material and manufacturing cost of work in process. It does not include the finished product. (See sample manufacturer's profit and loss statement, inventory calculation for cost of goods sold and business interruption value statement.)

Table: Profit and Loss Jan. 1 to Dec. 31, 1977
Sales (less returns and allowances) $650,000
 Less cash discounts 5,000
 Net sales $645,000
Cost of goods sold 425,000
 Gross profit on sales $220,000

Selling Expenses:
 Salespersons' salaries $52,000
 Payroll taxes 2,150
 Sales office rent 5,000
 Depreciation, furniture and fixtures 350
 Advertising 9,500
 Miscellaneous expense 11,000 $80,000

Administrative Expenses:
 Office rent $6,500
 Office salaries 30,000
 Payroll taxes (general) 1,100
 Bad debts 500
 Telephone and telegraph 3,500
 Interest expense 500
 Heat and light 800
 Depreciation, furniture and fixtures 200
 Taxes 4,200
 Insurance 800
 Miscellaneous expense 16,900 $65,000
 Net income for the year 75,000

[Tabular Data Omitted]

For mercantile risks, gross earnings is the sum of total net sales and other earnings derived from operations of the business, less the cost of merchandise sold, including packaging material, materials and supplies consumed directly in supplying service(s) sold by the insured and service(s) purchased from outsiders - not employees of the insured - for resale which do not continue under contract. Net sales is gross sales less returns and allowances, discounts, bad debts and freight out. Additional earnings include revenue from rent earned from other portions of the insured premise, interest on charge accounts and leased departments. Cost of merchandise sold is derived from inventory at the beginning of the accounting period plus merchandise purchased - less discounts plus freight in - minus merchandise inventory at the end of the accounting period.

Creating a Flow Chart

The next stage in determining business interruption value is to evaluate all organizational operations and how they contribute to earnings. This is an ongoing process and requires input from others in the organization. An organization's operations can best be depicted using a flow chart. It will pinpoint bottlenecks in critical areas in the production process. Interdependent locations and contingent operations that could affect earnings will also come to light.

Interdependent locations include two or more locations that are dependent on one another when a loss at one curtails business at all locations. Blanketing business interruption coverage usually takes care of this exposure. Contingent locations, on the other hand, can be contributing properties that supply great quantities of product for sale or manufacture, recipient properties that purchase completed product in large quantities or properties that draw customers to the insured business from other properties.

Bottlenecks are created when a key building or machine is destroyed, forcing the entire production process to shut down. For example, a bottleneck could occur if the manufacturer of a machine that has broken takes a year to replace it or the sole supplier of an ingredient needed in the production process sustains a total loss and is unable to meet the manufacturer's supply needs. Remember too that damage to a seemingly insignificant building or machine could also cause a business interruption loss.

Figuring in Time

In considering organizational operations and their potential business interruption exposures, the risk manager must determine the amount of time needed to restore total or partial operations if a loss occurs. The contemplated degree of interruption or shutdown will determine the severity of loss exposure.

Considerable analysis is required to develop a maximum time period for a total loss. This analysis includes consideration of secondary space, setup time for replacement operations, availability of new equipment and possible subcontracting of certain processes. Realistic monthly business interruption values must be worked out showing historical and projected values, seasonal fluctuations, length of time for anticipated recovery in the event of a partial or total loss and the amount of business interruption insurance needed to cover the loss.

Policy terms refer to what the business would have earned during the time required, "with due diligence and dispatch, to repair or replace damaged property." To collect under the policy, it is not required to actually repair or replace damaged property. Loss is payable on the actual loss sustained during the period the business could have repaired or replaced damaged property with the exercise of due diligence and dispatch. Therefore, partial resumption of operations, if possible, is required to reduce the loss.

Manufacturing risks must use raw stock at the insured location or elsewhere to reduce the covered loss. Mercantile risks must completely or partially resume operations whether or not property is damaged or use merchandise or other property at insured locations. In both cases any expense incurred to reduce the loss is covered as long as the expense does not exceed the amount by which the loss is reduced.

Calculating Co-Insurance

Another factor that determines the amount of insurance is co-insurance. Co-insurance is related to earnings during the year following damage to insured property. The selected percentage can be equated to the time needed to repair or replace the property.

Since co-insurance percentages range from 50 percent to 100 percent, it is important to estimate the length of downtime in months as a percentage. For example, if an organization's operations will be interrupted for six months, the insurable value would be 50 percent of the business interruption value; therefore, a 50 percent co-insurance clause could be selected. Conversely, if the interruption period is 18 months, the insured should select an amount equal to 150 percent of the business interruption value subject to the highest co-insurance percentage available within a 180-day extended period of indemnity endorsement. It is important to consider the interruption period in selecting the amount of insurance because it may take longer than 12 months to restore the business' operations to their original conditions.

Extending the Indemnity Period

Because business interruption insurance covers loss of net income or profit before taxes plus continuing expenses on an actual loss sustained basis, the time it takes for the damaged or destroyed location to be repaired, replaced or rebuilt ends the interruption period. Often the business continues to lose earnings beyond the complete restoration of the insured property. The actual loss sustained period of restoration limitation in the basic form can be expanded through an endorsement to the policy. It insures continued lost earnings in units of 30-day periods beyond the time required by due diligence and dispatch to restore the business. Coverage begins when the basic form requirement is completed and continues until business is back to normal. Seasonal businesses have a real need occurs before or during the main earning season.

The form covers the projected earnings for one year following loss or damage to insured property. An extension beyond this period is required to fully indemnify the insured. This extension provides additional time to return business to normal and is subject to all terms and conditions of the basic form, including the co-insurance provisions.

Considering Payroll

Another important consideration is the amount of insurance in ordinary payroll. This payroll excludes management, supervisory and key employee payroll. It can be scrutinized in adjusting a loss, so handle the matter carefully. Take into account job functions, labor markets and job skills when excluding ordinary payroll from coverage. In many instances insureds may want to exclude ordinary payroll entirely, but to do so they will have to take a higher co-insurance percentage.

In any case, it may be best to insure all ordinary payroll or limit it to 90, 120 or 180 days to assure efficient resumption of operations, protection against increased state unemployment compensation taxes and satisfaction of certain moral obligations in economically depressed areas. Finally, whatever payroll is excluded from coverage, all ordinary payroll, including social security taxes, unemployment tax, compensation insurance and other variable charges related to payroll, is deducted from gross earnings as defined in the contract.

Is Extra Expense Coverage Necessary?

There is a great distinction between expenses to reduce a loss and extra expense to avoid temporary suspension of operations. Organizations such as dairies, newspapers, retail establishments and hospitals cannot afford to be out of business and can incur extraordinary expenses by continuing to provide goods and services. These organizations may need to rent temporary or substitute facilities, pay additional freight charges to expedite shipping, spend more to maintain market share or pay a premium to purchase raw materials.

Extra expense insurance covers the need to continue operations no matter how serious the damage to insured property. The coverage pays incurred expenses in order to continue nearly normal operations during restoration. Determining extra expense requires a concrete plan for business continuation after a loss. The plan should indicate what has to be done to continue operating after a loss has been sustained and establish the cost of renting substitute facilities, extra freight charges, transportation for employees and extra advertising.

Adjusting a Loss

Adjusting a business interruption loss requires using the forecast or the workout method. The business interruption value and the amount of loss will be determined from the probable earnings for the subsequent 12-month period after the loss. Therein lies the difficulty in adjusting the loss because agreement regarding sales or production lost during the interruption period, increased cost of producing or selling and expenses incurred to reduce loss come under close scrutiny. Invariably, the insured and adjuster will disagree on the figures.

In most instances the adjuster will use the forecast method. It is employed when repair work is necessary to resume full operation. It is also used when the insured wants to delay the repairs to suit his or her convenience or make them in such a way that the time taken will exceed the time required to complete them with the exercise of due diligence and dispatch.

The workout method is based on the adjuster's authorization to replace, repair or recondition the property as soon as possible and resume operation. When restoration is complete, the business interruption claim is presented for the difference between the gross earnings that would have been earned if no business interruption had occurred and the actual gross earnings resulting from operations during the restoration period. The adjuster is also authorized to make payments needed to reduce loss and contract the amount spent with the sum for which the insurer would have been liable if the amount had not been spent.

In the final analysis the coverage objective is to arrive at a satisfactory agreement based on four criteria. The first is the year's probable earnings determining whether or not operation of the co-insurance or contribution clause will reduce the insured liability. The second is the actual sustained loss which may be the margin between selling prices and direct costs of the sales lost, less any charges and expenses that do not continue, or the increased cost of producing or selling. The next is the expense, if any, needed to reduce loss under the policy. The final criterion is the amount by which the loss under the insurance policy will be or was reduced by the incurred expense.

The Internal Revenue Service uses the term "involuntary conversion" for lost or damaged property. It has ruled that proceeds from insurance covering earnings and continuing expenses on involuntarily converted property will be taxed as ordinary income. Because the business interruption policy covers unrealized profit and continuing expenses, proceeds from recovery under the policy contribute to taxable income and are taxed at that rate.

Understandably, when one considers the many factors that go into a business interruption loss adjustment, the concept of making money on the loss fades rapidly. Business interruption coverage was never intended to do more than the business would have done had no loss occurred, thus preserving the principal of indemnity.

Peter T. Clark, ARM, is an account executive at John L. Wortham & Son, a privately owned insurance brokerage in Houston.
COPYRIGHT 1990 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Author:Clark, Peter T.
Publication:Risk Management
Date:Oct 1, 1990
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