Business interruption (BI) insurance provides a lifeline following a loss, supporting organisations financially until they make a full recovery. However, inaccurate sums insured and inadequate indemnity periods are a major source of underinsurance, jeopardising the chances of recovery for many businesses. The following tips will enable you to arrange the correct level of BI insurance.
1. Have a plan
Planning how to respond to potentially harmful events is vital for any business, and an essential first step in choosing the correct Business Interruption cover. Business continuity planning is a valuable exercise that helps increase an organisation’s resilience through anticipating potential losses and planning how best to respond. It is advisable to record key findings in a formal business continuity plan (BCP), which should remain under regular review and testing, and serve as a core risk management tool. For example, should a key supplier suffer a major loss, a good BCP might detail arrangements with alternative suppliers that could quickly meet urgent customer orders. In addition to boosting resilience, considering potential loss scenarios is the best way of identifying much of the information needed to set suitable Business Interruption cover levels. For example, without fully understanding how an organisation’s variable costs will change following a loss, it will not be possible to set an accurate gross profit sum insured (see tips 3 & 4 below). Equally, without contemplating potential worst-case scenarios, it will not be possible to choose a suitable maximum indemnity period (see tip 5 below).
2. Choose the cover that is right for you
There are three main types of Business Interruption cover:
• Loss of gross profit
• Loss of gross revenue
• Increased cost of working
Loss of gross profit is the most common form of Business Interruption cover, but does feature certain complexities that commonly lead to underinsurance if approached incorrectly. It is therefore important to fully understand how each type of cover operates and carefully assess which is best suited to an organisation’s particular needs. For example, loss of gross profit is specifically designed for manufacturing-type risks and recognises that a downturn in production will actually lead to some cost savings as well. These savings are known as ‘uninsured working expenses’, and form an important part of the gross profit sum insured calculation (see tip 4 below). For organisations with few, or no, uninsured working expenses, a gross revenue basis is likely to be the more suitable basis of cover. Business continuity planning will enable you to understand how resilient an organisation’s operations are, and the likely impacts following a loss.
3. Approach calculations properly
Business Interruption claims are settled by reference to specific formulas listed in the policy wording. As with all sums insured, it is essential to approach BI calculations correctly in order to avoid underinsurance. Calculating loss of gross profit sums insured is where many experience difficulties, and where underinsurance frequently originates. A leading reason is that an accountant’s definition of ‘gross profit’ differs considerably from the figure required for insurance purposes. The former deducts all production costs, whereas the latter recognises that some costs will continue following a loss and therefore need to remain in the sum insured. Not recognising this important distinction frequently leads to figures being provided that do not follow the calculation stipulated in policy wordings, resulting in significant levels of underinsurance.
Common pitfall – ‘Gross Profit’ definition
4. Take care with ‘uninsured working expenses’
Uninsured working expenses (UWEs) form a vital part of the insurable gross profit calculation. If insuring on a loss of gross profit basis, it is important to fully understand the meaning of UWEs and only specify costs that truly fit. UWEs are costs that vary in direct proportion to a reduction in turnover (i.e. if turnover reduces by 30% then that cost will also reduce by 30%). UWEs can often include items such as raw materials, production wages and freight. However, it should never be assumed that these costs are always UWEs. This is something that can vary between organisations, and needs to be identified via business continuity planning. Routinely subtracting certain items during the gross profit calculation is a common source of underinsurance. Another common error is to only think in terms of total losses, whereas the majority of losses are likely to be partial. For example, consider a factory that sends shipments via weekly containers. In the event of a total loss, where production stops completely, this cost should cease, as there are no products to ship. However, following a partial loss, it is likely that this cost will actually remain the same, as weekly shipments will still need to be made. Freight is therefore not a UWE for this organisation, as the cost will not vary in direct proportion to any reduction in turnover.
5. Maximum indemnity periods - be conservative
A maximum indemnity period (MIP) is the time following a loss during which Business Interruption claims can be made. If the MIP expires then claim payments will cease, even if the sum insured has not yet been exhausted. Setting an adequate MIP is therefore just as important as calculating an accurate sum insured. BI insurance is designed to support policyholders until they recover to the position they were in prior to a loss – i.e. return to their former profitability. A common source of underinsurance is to think that this is simply the time taken to reinstate damaged property. However, once an organisation’s property is reinstated, an equal or greater amount of time is often needed for activities such as recruiting staff, commissioning equipment and, vitally, winning back lost business. Additionally, there is a vast range of circumstances that can delay an organisation’s recovery. Not contemplating worst-case scenarios, either by not using proper business continuity planning or being too optimistic about recovery times, is a frequent source of underinsurance. MIPs should reflect the maximum time it could take a business to return to its former level of profitability based on worst-case scenarios.
6. Adjust sums insured in line with MIPs
A simple, yet common mistake, is to not alter sums insured in line with any changes to the MIP. For example, if changing from a 12 month to a 24-month MIP, then the underlying sum insured may need to at least double, as it is now applied to double the length of time. However, this is only a basic calculation, with further consideration needed to ensure sums insured remain adequate for the full length of the MIP (see tip 7).
7. Account for future trends
While cover may be adequate at inception, organisations do not remain static, with revenue and profitability changing over time. BI insurance is designed to put the policyholder back in the position they would have been had they not suffered a loss, and sums insured need to take account of future business trends in order to avoid underinsurance. For example, should an organisation suffer a loss towards the end of a 12 month policy period, and it then takes 24 months before they fully recover, that is 36 months after which the BI cover levels were initially set. If that business was growing at a constant rate of 20% per year, then it would have grown significantly by the end of those 36 months had it not suffered the loss. To ensure cover is adequate for the duration of the MIP, the sum insured needs to reflect both current and future circumstances, accounting for any anticipated business trends.