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Insurance Law and Business Interruption Insurance

Date: December 05, 2007

Authors: Frank Egan B.A., LL.B., A.C.L.A., F.T.I.A. (Notary)

People in business insure their premises, contents and stock against the material damage risks of fire, explosion and other perils, but have they given the same thought to the other problems which would arise following any of these events, the problems which manifest themselves when the fire engines have driven away.

THE PROBLEMS

What usually happens to a business following a serious fire, explosion or other catastrophe -

  • Production is disorganized.  Possibly stops altogether.
  • Income falls drastically.
  • Redundancy and other payments must be made to employees who lose their jobs.
  • Emergency measures, like hire of other premises and plant, must be paid for.
  • Delays in rebuilding and replacement of plant will drain capital.
  • Lost orders and customers may never be recouped.
  • Recruiting and training new staff can delay recovery.
  • Net profit becomes net loss.

There is just as great a need to insure the loss of cash flow as there is to provide material damage cover for buildings, plant and stock.  The interruption to trading may last for a few months, a year or even longer.  There are also the immediate extra expenses to get the business going again, and as quickly as possible, so that customers are not lost.

Insurance can be arranged to provide the necessary cover for these business risks under a Business Interruption Policy.

Basically a Business Interruption Policy provides cover against a loss of "gross profit" which in insurance terms means simply, net profit and overheads.

The question most people in business ask is how can they ascertain, for the purposes of insurance protection the intangible loss - the loss of future earnings?

EXPERIENCE

Experience shows that the proportionate effects of a fire upon the earning capacity of a business can be readily and accurately measured, on most cases by comparing the turnover (income, takings) in the months following the damage with that in the corresponding period in the 12 months preceding it, subject to appropriate adjustments for special circumstances or trends of the business.  For example, if a fire causes interruption of business throughout October, November and December, the loss of turnover during these months can be found by means of a comparison with the turnover for October, November and December in the preceding year.

In general, the loss of turnover during any period, of whatever length, can be used as a yardstick for measuring the interruption of trading, provided that provision is made for any necessary adjustments.

As loss of turnover is not synonymous with loss of gross profit, how can the yardstick of turnover be used to assess the net effect of a fire upon the earnings of a business?

In this way: each dollar of turnover may be assumed to bear an equal share of:

  1. prime costs, which are conventionally entered in the first section of a trading account, such as purchases, whether for resale or for use in manufacture, productive wages, consumable stores, fuel for trade purposes, power, and other process charges.  These may be described as variable or working expenses, that is, they vary proportionately with the rise or fall of turnover;
  2. overhead expenses, such as administration, selling and distributive costs, which generally appear in the second section of a trading account or in the profit and loss account.  Because they are not controllable as are prime costs, they are for insurance purposes referred to as "standing charges", a term which aptly describes their nature;
  3. the residual net profit.

TURNOVER

Should turnover fall in consequence of damage by fire, the prime costs will be reduced proportionately and, therefore, no loss will be sustained by the business under this section.  Standing charges, however, as they do not vary directly with turnover, will not fall proportionately therefore, in the event of a reduction in turnover, these will bear an increased incidence beyond its normal ratio.  This relative increase in the amount of the standing charges will have a corresponding inverse effect by reducing the residual net profit.

At the same time there will be concurrent loss of net profit taking place due to there being a smaller volume of turnover on which it can be earned.

However, if compensation is provided by insurance on every dollar of turnover lost during a period of interruption for the amount of standing charges and residual net profit normally borne by each dollar of turnover, the revenue of a business will be restored to the extent necessary to cover these two items.

This simple principle that reduction in turnover after a fire is a reliable guide to and a suitable index for measuring the proportionate effect of the fire upon the earnings of a business, and that the actual loss can be ascertained by applying to this reduction the ratio which standing charges and net profit together normally bear to turnover, should be the basis of most of the Business Interruption Insurance transacted in Australia.  Unfortunately this is not always the case and sometimes creates unnecessary hardship for insured's.  Be careful as Business Interruption Insurance is the least understood business insurance product sold in Australia today.  Both brokers and insurers display a level of ignorance which is astounding.  Be careful and make sure you secure the correct product for your business and are adequately insured.

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