Common pitfalls in business interruption insurance.

COMMON PITFALLS IN BUSINESS INTERRUPTION INSURANCE

Tips on what to look for to ensure complete--not partial--recovery from a disaster.

Economic ruin from a business interruption may be averted through adequate insurance coverage. However, how to calculate such coverage is often misunderstood. A prospective insurance buyer should not attempt to make this determination; it should be left to CPAs and others with expertise in the field.

Business interruption insurance insures a business for earnings that would have been generated had no interruption occurred. This article discusses the common fallacies that arise in dealing with business interruption insurance. These may stem from the form of the policy--gross earnings or net income. They also may arise because insurance agents themselves are unfamiliar with how to calculate coverage properly or because the insured is inexperienced at filing a claim. Moreover, recoverability may be impaired when the due diligence and dispatch clause of the policy is not met.

THE GROSS EARNINGS FORM

Although insurance and accounting terms may sound similar, CPAs should be aware that definitions differ. For example, practitioners should not confuse "gross earnings" with "gross profit." Gross earnings is a technical insurance term with only limited similarity to the accounting concept of gross profit. It refers to a subtotal in the formula below:

        Gross sales
minus   Sales deductions

equals Net sales minus Gross earnings deductions equals Gross earnings minus Noncontinuing expenses equals Business interruption loss times

Co-insurance percentage equals Collectible business

        interruption loss
plus    Extra expenses

equals Total collectible business

interruption loss

The formula begins with "gross sales"--a term that's defined similarly by accountants and insurance companies. "Sales deductions," however, consist of discounts, commissions, bad debt and other items directly related to sales. "Gross earnings deductions" include only raw materials and consumable supplies. This insurance concept is not the same as the accounting concept of cost of goods manufactured, because gross earnings deductions don't include any other inventoriable manufacturing expenses--for example, direct labor and overhead. These expenses are considered elsewhere. Therefore, gross earnings is quite different from gross profit.

"Noncontinuing expenses" (also referred to as "discontinued expenses") represent the difference between projected normal expenses and the actual expenses that would have occurred during the loss period. By treating noncontinuing expenses as a reduction of gross earnings, the insurance company, in essence, takes a credit against the gross earings--which they insure--for expenses that have ceased. For example, if employees were laid off following a catastrophe, the difference between the anticipated normal labor expense and the actual expense incurred represents a noncontinuing expense. Similarly, if a production facility is partially or totally destroyed, less gas and electricity, for example, would be needed. Depending on the extent of the damage, utility consumption could cease altogether. Here again, the insurance company would take credit for the reduction in expense.

Noncontinuing expenses should not be confused with the accountant's "variable expenses" and continuing expenses should not be confused with "fixed expenses." Some variable expenses--such as direct labor--may continue during a period of business interruption if partial production continues. Conversely, some fixed expenses--such as rent--may not continue if production comes to a complete halt. Each operating expense needs to be analyzed to determine whether it's noncontinuing--not whether it's variable or fixed. After all operating expenses have been analyzed, the total noncontinuing expenses are deducted from gross earnings. The resulting amount is the business interruption loss.

Co-insurance clause. Many business interruption policies contain a co-insurace clause (also called a "contribution percentage"). The co-insurance clause of gross earnings forms must be understood. It says the insurer won't be liable for a greater proportion of any loss than the limit of liability (amount of insurance) bears to the amount produced by multiplying the contribution clause percentage (50%, 60%, 70% or 80%) by the gross earnings that would have been earned, had no loss occurred, during the 12 months immediately following the date of damage or destruction to the property.

Frequently, this clause is considered a penalty. Actually, co-insurance means the insured business has chosen to share in the total amount at risk--the gross earnings expected in the 12 months following the damage or destruction. How much the insured business can collect is calculated as Collectible percentage of loss = Insurance in force/Insurance required

This formula shows a loss is 100% collectible only if

1. The coverage is adequate--that is, the face value of the policy and the required amount of insurance are equal.

2. The loss is less than the face value of the policy.

"Extra expense" is added to the business interruption claim to arrive at "total collectible loss." These extra expenses are costs incurred above and beyond the normal operation of the business. Depending on the particular coverage in force, the extra expenses may or may not be collectible. Extra expenses incurred that reduce or mitigate the loss are insured to the extent they reduce the business interruption claim. Thus, the insurance company is willing to pay additional dollars to lessen their exposure. For example, the insurance company would cover expenses for a temporary facility to generate sales to reduce the loss.

However, it's sometimes possible to add an extra expense clause to the business interruption policy that covers expenses over and above those that reduce or mitigate the loss.

MISCALCULATING ADEQUATE COVERAGE

Obviously, the key to full and fair recovery from a business interruption is to avoid becoming a co-insurer; that means having adequate insurance coverage. Surprisingly, insurance agents themselves commonly miscalculate what's adequate. Exhibit 1 on page 54 illustrates the reasoning of such an insurance agent. The agent asks, "What's the profit you want to insure?" The income statement shows net income of $1,000. The agent next asks, "How many expenses do you expect will continue if business is interrupted?" The answer is $2,000 ($1,000 for rent plus $1,000 for salaries). The agent then inquires, "Under a worst-case scenario, what's the maximum amount of time you expect to be out of business?" If XYZ's owner replies six months, the agent multiplies the $3,000 subtotal ($1,000 net income plus $2,000 continuing expense) by 50% (one-half year) and recommends the purchase of $1,500 of insurance. Method A in exhibit 2 on page 57 shows the agent's calculations.

Although this recommendation may seem reasonable enough, the agent's two mistaken assumptions are that only collectible amounts are insurable and the percentage of downtime is the same as the co-insurance percentage. All expenses, other than those included in gross earnings deductions and net sales deductions, are insurable whether or not they continue. However, expenses only will be paid if they continue in a business interruption. Therefore, if the agent had included the $1,000 of noncontinuing expenses for supplies, he would have arrived at the correct recommendation to purchase $2,000 of insurance [($1,000 net income plus $1,000 rent plus $1,000 salaries plus $1,000 supplies) times 50%]. Although the co-insurance percentage doesn't have to equal the percent of downtime, this example considered the two equivalent.

HOW TO DO IT RIGHT

The correct amount of insurance is determined by this formula:

Gross earnings times Co-insurance percentage

Insurance required

Method B in exhibit 2 applies this formula. Assuming XYZ wants to purchase a 50% co-insurance policy, method B shows the insurance required is $2,000. If XYZ fulfills the 50% co-insurance provision of the policy, it will be paid its loss in full up to the face value of the policy. If XYZ fails to do so, then it shares in the loss and must go partially uncompensated. Exhibit 3 at left shows method B fulfills the 50% co-insurance requirement and method A does not. Should XYZ suffer a loss carrying the $1,500 recommended by the insurance agent, it would have to absorb $500 or 25% of the loss: Collectible percentage of loss = Insurance in force/Insurance required

75% = $1,500/$2,000

Much too often this less-than-100% payout becomes a reality to the surprise of XYZ's management and its owners/stockholders.

Reviewing policy calculations. Growing companies must reassess their coverage at least quarterly. Failing to keep earnings forecasts up to date is another pitfall for an insured business. For example, operating assets may be damaged or destroyed on December 31 under a policy that expires on January 1. In such a case, the gross earnings the business would lose in the second year, not the first year, would be used to determine the business interruption loss. Thus, the company could inadvertently become a co-insurer.

THE NET INCOME FORM

The second type of business interruption insurance contract is the net income plus continuing expense form. Continuing expenses are the inverse of noncontinuing expenses: A normal expense that does not discontinue obviously continues. Therefore, net income plus continuing expenses is the same as gross earnings less noncontinuing expenses. The amount collectible under either type of policy is the same.

Exhibit 4(A) below shows the amount XYZ can collect under the net income method is $3,000 ($1,000 net income plus $2,000 of continuing rent and salaries expense), Exhibit 4(B) shows the amount collectible under the gross earnings less noncontinuing expenses also is $3,000 ($4,000 gross earnings minus $1,000 noncontinuing supplies expense).

Co-insurance can be written in the policy regardless of which method is used; the results are the same. However, the calculations are easier using the gross earnings expense method.

A recommendation. One of the easiest ways to avoid the entire problem of co-insurance is to boy an agreed-amount endorsement. This eliminates the co-insurance clause within the policy and the insured won't get caught in an underinsured position. When considering an agreed-amount endorsement, the cost/benefit tradeoff must be evaluated. The insurance company generally will request the insured fill out a complete business interruption worksheet before it's willing to provide the agreed-amount endorsement.

DUE DILIGENCE

The due diligence and dispatch clause of the insurance policy requires the insured to work with utmost efficiency to recover from the damage. The insured company will not receive full recovery if it takes more time than the insurance company believes is necessary to restore the operating assets to the condition they were in before the damage occurred. The due diligence and dispatch clause implies the business interruption may not be the actual time it takes for the insured to get back in business. Many times the insurance company doesn't allow full indemnification because the recovery time seemed excessive.

The best way to meet the due diligence and dispatch requirement is to develop a plan before disaster strikes and to review the plan periodically as conditions change.

SELECTING AN EXPERT

A key reason adequate coverage may not translate into a full or fair recovery is that the insured lacks expertise. The insurance company's specialists tend to work out loss claims in a way that benefits the insurance company. The insured business can work through this difficult situation by itself or consult a professional. Many CPAs and public insurance adjusters have this expertise. These professionals exclusively represent the insured in recovering the loss.

EXHIBIT 1 Projected operating losses from business interruption Assumptions: * Year 2 is the next year. * No sales deductions are expected. * Cost of goods sold consist only of raw materials. * Continuing expenses consist of rent and salaries. * Noncontinuing expenses consist only of supplies. * For simplicity, taxes are ignored. * The iincurrence of extra expenses is not expected to reduce

operating losses from business interruption

                     XYZ Company
             Pro forma income statement

for the 12-month period ended December 31, year 2

Sales                                                $10,000
Cost of sales                                          6,000
Gross profit                                         $ 4,000

Operating expenses:

  Rent                          $ 1,000
  Salaries                       1,000
  Supplies                       1,000                 3,000
Net income                                           $ 1,000

EXHIBIT 2 Two methods of calculating the required amount of coverage Method A: Calculation based on collectible expenses and period of interruption

XYZ Company

Calculation of required business interruption coverage

for the 12-month period ended December 31, year 2

Net income $1,000

Continuing expenses:

  Rent                            $1,000
  Salaries                         1,000                2,000
Total                                                  $3,000
Period of interruption                                   x.50
Required coverage                                      $1,500

Notes: 6 months/12 months Method B: Calculation based on gross earnings and the co-insurance percentage

XYZ Company

Calculation of required business interruption coverage

for the 12-month period ended December 31, year 2

Sales                                                 $10,000
Cost of sales                                           6,000
Gross earnings                                          4,000
Co-insurance percentage                                 x .50
Insurance required                                     $2,000

EXHIBIT 3 Calculation of the amount collectible under the two methods

                                  Based on      Based on
                                  Method A      Method B
Gross earnings in year 2            $4,000        $4,000
Business interruption loss           2,000         2,000
Period of loss                         .50

Co-insurance percentage Amount recoverable based on co-insurance equation

1,500(b) 2,000(c)

Amount collectible from insurance

company(d) 1,500 2,000

Notes: (a)Face value of policy/Gross earnings x co-insurance % x loss (b)$1,500/$4,00 x .50 x $2,000 (c)$2,000/$4,000 x .50 x $2,000 (d)The amount collectible from the insurance company is the lower of the businesss interruption loss, face value or the results of the co-insurance equation.

EXHIBIT 4 Comparison of the gross profit and net income methods A. Collectible loss under the net income plus continuing expenses method:

                      XYZ Company
          Calculation of collectible loss for year 2
                    net income method
Profit                          $1,000

Continuing expenses:

  Rent                 $1,000
 Salaries               1,000    2,000
Collectible loss                $3,000

B. Collectible loss under the gross profit less noncontinuing expenses method:

                      XYZ Company
          Calculation of collectible loss for year 2
                    gross profit method
Sales                     $10,000
Cost of sales               6,000
Gross earnings             $4,000

Noncontinuing expenses:

 Supplies                   1,000
Collectible losss          $3,000

DONALD J. DRAGONY, CPA, is corporate controller of the Alex N. Sill Company, a public adjusting firm, and manager of the business interruption accounting department. He's a member of the American Institute of CPAs, the Ohio Society of CPAs, the National Association of Accountants and the National Association of Public Insurance Adjusters. HANS SPROHGE, CPA, PhD, is an assistant professor of accountancy at Wright State University, Dayton, Ohio. A member of the tax policy subcommittee of the AICPA federal taxation division, he serves on the tax legislation committee of the Ohio state society and is a member of the American Accounting Association and the NAA.