In an interdependent economy, a loss such as a fire or flood can destroy businesses and livelihoods months or years after the event and far from the affected zone. Industry experts talk about the fine print in business interruption policies and what brokers and businesses get wrong.
by Steven Chong
Business interruption (BI) insurance is one of the most vital policies a broker can place for a business of any size – industry leader and LMI Group founder Professor Allan Manning puts it in the top three – yet it’s also one that is commonly overlooked or underinsured, particularly among smaller businesses.
“It’s like a personal accident policy in that it protects the company’s income stream, allowing owners and managers to continue to pay their expenses, repay debts and meet any new costs that arise as a result of the event that prompted the disruption, and maintain their normal net operating profit before tax,” Manning says.
CGU research of nearly 500 small businesses found that one in four would not survive if they had to close their doors for three months, and Vero’s Andrew Geldart reports that about half of businesses that suffer a total loss don’t resume trading, while about a third fail within three years without adequate BI cover.
“Business owners often underestimate the likely impact of an event,” says Philip Johnson, Zurich’s National Property Underwriter. “Most businesses that suffer a major fire but do not have BI insurance fail within a year or two. Following a catastrophe event such as a major storm, flood or earthquake, the incidence of businesses failing is even greater. It takes a while for the evidence of this to be fully apparent as uninsured businesses will strive to work through the problem.”
While property insurance may eventually repair or replace the building, plant and contents, the business meanwhile runs at a loss, so BI is usually offered in conjunction with cover for property damage.
CATEGORIES OF BI
Johnson and Geldart say that BI most commonly comes as Gross Profit because it suits any business with variable expenses that produces or sells merchandise, and typically covers two aspects:
- Reduction in turnover less the uninsured working expenses, and
- Expenses increased beyond normal levels to maintain business operations, generally limited to the amount of gross profit saved by incurring the additional expense.
“Gross Profit is effectively the turnover of the business minus the expenses deemed to vary in proportion with a reduction in turnover,” says Johnson, and to determine its insurable value, the business expenses need to be split into those that would:
- reduce in proportion to a reduction in turnover (such as purchases or freight),
- continue unchanged regardless of turnover (contractual obligations), or
- partially reduce if turnover reduced (eg salaries and payroll).
However, Prof Manning points out that some insurers call their traditional insurable gross profit ‘Gross Revenue’ to avoid confusion
between accounting gross profit and insurable gross profit.
2007 – Newcastle, NSWThe Hunter and Central Coast regions of NSW were lashed with torrential downpours and gale-force winds over the June long weekend, causing flash flooding, and a bulk carrier to spectacularly run aground on Nobby’s Beach.Thousands of residents were urged to abandon their homes ahead of a torrent of expected floodwater.The State Emergency Service issued an evacuation order for about 5000 residents in affected areas and about 75,000 homes experienced power cuts.The Premier said the damage in Newcastle was worse than that caused by the city’s 1989 earthquake, and its insurance cost was about $1.5bn – the fourth largest general insurance inflation-adjusted loss since records began in 1968.While the media focus was on the grounded Pasha Bulker and the Hunter floods, most insurance losses resulted from the Friday flash flooding in Newcastle CBD, as did five fatalities. Significant economic losses and social disruption occurred as knock-on effects of the loss of critical infrastructure – 300,000 people were without mains electricity for four days and some for up to a month, and the coal export chain halted for two weeks.The knock-on effects to local businesses were devastating economically and even those that weren’t damaged still lost revenue because they could not trade. Robust BI cover may have protected some businesses, but the insurance industry’s specificity around wording came under the spotlight in the aftermath, where property damage from ‘riverine’ or inland flooding from swollen rivers or dams was not covered by some insurers, while stormwater flooding was.Other businesses had their properties insured for damage that did not occur, but did not have cover for lost trade. Consumer and media backlash then and in the Queensland 2011 floods have led to pushes for a standardised national definition of flood.
Gross Revenue cover is appropriate where business expenses are fixed and don’t vary directly with sales, such as professional services like accountancy, architecture and financial planning firms, says Geldart. To calculate it, any expense normally paid out of the firm’s revenue that ceases or reduces due to the event are deducted, says Prof Manning.
Gross Rentals insurance is similar to Gross Revenue but the wording has been adapted to respond to a loss of rental income for a property owner or landlord. It should also include the outgoings paid by the tenant such as rates, water and insurance, adds Prof Manning.
“It is called Gross Rentals because insurable Gross Profit insures the revenue of the business less any expenses that are either defined in the policy or listed on the policy schedule. Such expenses should always be expenses that are truly variable to sales with the variation occurring in direct proportion to sales,” Prof Manning told IRP.
“For Gross Rentals or Gross Revenue, there is no need to consider the cost of goods sold or uninsured expenses – the full rental or revenue value is insurable,” says Johnson. He adds that when calculating values or sums insured, the possibility of a loss on the last day of the policy should be considered, which will usually be at least 12 months later. The required sum insured should include allowances for business trends for the full indemnity period starting from that day.”
DETERMINING GROSS PROFIT
Insurable Gross Profit should not be mistaken for the accounting Gross Profit, but Dr Manning says it often occurs because the difference is not taught in university. The confusion commonly arises in manufacturing, where the cost the accountant is trying to determine is the exact cost of goods sold, such as direct materials and labour, and factory overheads are captured and deducted from sales turnover to arrive at the accounting Gross Profit.
1998 – Longford, VictoriaEsso’s natural gas plant at Longford in Gippsland exploded in September 1998, killing two workers and injuring eight. The 30-year-old plant was operated by Esso, then a subsidiary of Exxon, but was also part-owned by BHP and was the primary provider of natural gas to Victoria.Extremes of operating temperature created a brittle fracture in a plant heat exchanger, which releases 10 tonnes of hydrocarbon gas that ignited into a fierce jet that burned intensely for two days. The plant was shut down immediately and within days Victoria was left without gas. This shortage devastated Victoria’s economy, crippling its commercial sector and costing industry about $1.3 billion. For up to 20 days, many Victorians – particularly the hospitality industry – were without gas for cooking, hot water or heating; they were then enraged to be compensated an average $10 on their next gas bill.Technically, there was no Longford ‘explosion’ but a blaze of continuously burning vapour, with other gas releases and minor fires. However, there was no blast wave and a control room nearby was unscathed and damage localised to the immediate vicinity.“The interruption of a public utility may not cause any damage to property, but could still result in a significant loss of insurable Gross Income,” Prof Allan Manning says. Many businesses without BI insurance suffered. Those financially affected by the gas shortage pursued a class action in the Supreme Court, which settled in 2004 when Esso was ordered to pay $32.5 million to businesses that suffered a financial loss as a result of the accident.
However, insurable Gross Profit typically includes fixed expenses and overheads, payroll and net profit, says Johnson. “Basically it is the difference between the business’s fixed and variable costs of producing the goods or services – rent, raw materials, freight, commissions, electricity, etc – and the revenue they provide.
“For more complex businesses, payroll deserves a separate review because some costs can be treated as variable expenses. Payroll for key personnel should be considered in Gross Profit calculations, while it may be appropriate to consider wages of casuals, for instance, as variable expenses that do not need to be insured.”
To be fully insured under a BI policy, only those expenses that are truly variable in direct proportion to sales should be listed as an Uninsured Working Expense and not insured. Geldart says that in the case of setting Gross Profit figures, it is always better to overestimate because the Declared Values under an ISR policy are declarations and as such are adjustable.
“Purchases are a typical example of a variable expense,” says Prof Manning. “However, many other expenses may not slow at the same rate as sales revenue in the event of a disruption. When you are considering any uninsuring any expense, it is important to
consider what would happen to the expense in the event of a partial loss, not just a total loss.”
To clear up misunderstandings, a BI Cover Calculator was developed at BIcalculator.com.
The selection of an indemnity period is another critical step in arranging a BI policy, says Johnson. “The worst possible scenario should be considered. For a manufacturer reliant on specialised machinery, it may be well over 12 months before replacement machinery can be sourced, then it may still have to be shipped in, installed and commissioned. It could be 24 months before the business regains full operating capacity. In the meantime, major customers may have found other suppliers. The indemnity period should include some allowance for ramping up production and regaining market share.
2011 – Tully, Northern QueenslandFebruary 3 marks the fourth anniversary of category five tropical cyclone Yasi making landfall at Mission Beach, before sweeping through the townships of Tully, Cardwall and Innisfail.A large proportion of homes were damaged but Yasi’s major impact on the area was the damage to Tully Sugar Mill. According to Matt Pearson, Executive General Manager – Claims for Suncorp, Yasi “not only badly damaged the mill – it nearly destroyed a community. Many of the locals worked at the mill and it was the lifeblood of the surrounding sugar cane farms.“It was crucial to have the mill operating four months after the disaster in time to crush the next sugar harvest.”Queensland was still struggling with widespread flooding at the end of 2010 and the inundation of Brisbane in January 2011, so insurers had to bring in overseas loss-adjusting teams to help the already overloaded local teams. Vero had its Events Response Team in place within five days of the cyclone striking. Using its special relationship with building management multinational Lend Lease, the insurer was able to ensure the mill was operational in time to meet the needs of the harvest.
“Businesses without complex requirements may be able to use alternative premises and start to trade sooner, but if they rely on passing
traffic, finding a suitable location may take time. For a landlord, the time to obtain development and building approvals should be added to the likely construction period.”
Businesses tend to be too ‘light on’ when setting indemnity periods and underestimate how long their business will be interrupted, says Andrew Geldart. Citing recent natural catastrophic events such as Christchurch earthquakes and Queensland floods and cyclones as examples, he suggests adding 25–30% to the times that clients estimate. In case it gets overestimated, the period for Vero’s policy is adjustable.
Want help explaining the basics of business interruption insurance to clients? NIBA has created an animated video designed to be shared with clients.
Johnson says that catastrophe events are a special case because there is likely to be delays in gaining access to the affected area and then having damage assessed and repairs quoted. “There may be hundreds or even thousands of properties with damage, all competing for the time of a limited pool of loss assessors, builders, repairers, reconstruction materials, etc.”
- Not allowing for escalation costs – revenue, payroll, CPI and wage increases may end up higher than initially thought for say, a three-year indemnity period. “Insured values should include allowances for forecast trends in the business and the possibility that a loss may occur on the last day of the policy,” advises Johnson.
- Too short an indemnity period – the selected period should allow for obtaining development and building approvals, time for rebuilding or repairs, allowance for the purchase, installation and commissioning of replacement machinery, operational restart and some time for regaining market share or shelf space.
- Inadequate cover for dependencies on important suppliers or customers – can any actions be taken to minimise the risk to the business if a main supplier can no longer provide supply? It may be necessary to purchase specific cover extensions for key dependencies.
- No contingency planning – preparing a plan not only helps the business evaluate the BI cover they need but it can be used as a blueprint for recovery in the event of an interruption. It may also highlight issues unrelated to insurance, allowing the business to avoid future problems.
- Not listing the Uninsured Working expenses on the policy schedule – ensure they are deducted from insured values, and that Gross Profit values are higher than necessary or the customer may be underinsured.
OTHER BI POLICIES
A simplified BI form that provides a regular fixed payment; effectively, cover for cash flow. “It is typically limited to a percentage of historical income values depending on the occupation,” says Johnson. “Coverage percentages are fixed by occupation and may not be equivalent to the actual Gross Profit of the particular business. Instant Profits cover may be okay for simple businesses but these policies do not include flexible options. In addition, Instant Profits cover may not be available for some occupations.”
Prof Manning says that a weekly stand-alone policy would have both a weekly sum insured/limit and an overall limit.
Increased Cost of Working, Additional Increased Cost of Working and Claims Preparation, all of which must be pre-approved by the insurer, are purchased as a lumped extension.
Introduced by mainstream insurers to counter the increasing popularity of the stand-alone covers. They are not widely used and typically regarded for use by smaller businesses only.
Coverage is triggered by weekly income falling below specific levels, explains Johnson. “Coverage ceases when weekly income reaches the percentage of historical average weekly income set out in the particular policy wording. Insured values do not need to be calculated to obtain cover but the historical results of the business may still limit payouts.
“The maximum percentage of coverage available will often be higher than is available under Instant Profits covers. However benefits will cease before the business income has been fully restored. They often do not provide options for insuring payroll or wages flexibly, and the extensions for contingency covers may also be quite basic,” Johnson says.
BI as part of business package policy
The policy wordings related to the extra covers or contingencies and limits they include vary between insurers but they generally follow the same principles. They usually offer a broad general cover suitable for most small to medium-sized businesses but more specific extensions, such as overseas or specified suppliers’ premises, may not always be available.
Prof Manning says that this increasingly popular form requires the insured to declare the current turnover and the underwriter uses a database to provide an insurable rate of Gross Profit. “This is used to rate the insurance and takes away the complexity of arriving at a sum insured,” he says.