Understanding Business Interruption Insurance

Business Interruption Insurance, also known as BI, Consequential Loss or Loss of Profit insurance, is one of the most complicated areas of insurance and partly because of this, is an aspect of cover that is most likely to cause a problem in the event of a claim. Here we explain what it is, how it works, the potential pitfalls to avoid when arranging it, and how to approach Business Interruption Insurance for your own business needs.

Even some insurance professionals struggle to obtain a real understanding of Business Interruption cover and what it involves, so what chance do commerce and industry leaders have?

The annual Allianz Risk Barometer report was published earlier this year and showed us that the top 4 causes of business interruption that participating companies fear most were Cyber incidents, Natural catastrophes, Pandemic outbreak, and Major transportation/shipping disruptions*.

Last year (2021), Cheshire Fire and Rescue Service reported that almost 1 in 5 businesses suffer some sort of disruption every year, be it fire, flood or other emergency, and that following a disaster, 25% of businesses never re-open, 80% of companies who don’t recover in a month are likely to go out of business, and 75% of businesses without Business Continuity plans fail within 3 years.

These industry statistics highlight just how important Business Interruption insurance can be and why it needs to be understood and arranged correctly.

Definitive data varies but Business Continuity experts consistently opine that the majority of businesses fail within 18 months of a major loss, such as a fire. It is not the insurance of property, stock or machinery that causes the demise; it is the inadequacy of the business interruption cover.

Although it is not possible for us to cover business interruption insurance cover in this one article, we hope to alert you to some of the key pitfalls or errors that can occur in the arranging of this cover, and encourage you to speak to your contact at McClarrons for a more in-depth discussion about Business Interruption Insurance and how it can protect your business, should the worst happen.

It is easy to think of publicly reported fires, storms, explosions and tsunamis, and the devastating damage caused by these events. The impact on company profits, due to being unable to operate, can last for years after the event itself.

History of Business Interruption Insurance

Fire insurance has a history going back to just after the Great Fire of London, and although Britain may claim ownership, Business Interruption Insurance is a mere 150 years old and the French lay claim to the first forms of such policies. Companies were already being indemnified for damage caused to assets but there was a need to also insure the resultant impact on earnings. This market development also coincided with the need for companies to adopt common accounting standards and report financial results, thereby giving insurers a basis on which to settle claims.

Approach to Insuring Business Interruption

Firstly, consider what would be the immediate, mid-term and long-term effects on your business in the event of a major loss. Then, think about what the worst-case scenario would be as this will be a basis for establishing what form and what amount of Business Interruption cover is required. This is also the starting point for building a Business Continuity/Crisis Containment Plan, which is recommended to help your business recover in the event of a significant loss. Take into consideration some concerns you may have, for example:

• If my business premises is destroyed, where would I operate from the next day?
• How long will it take to rebuild the premises (taking into account debris removal, planning permission, and availability of builders and materials)?
• Am I likely to lose customers in the period during which I am unable to operate?
• What is the potential lead time for replacement machinery or equipment?

For most businesses, Gross Profit is insured, but it is possible to insure on Gross Revenue, especially for those in the service sector. It is important to make sure that the sum insured is correct, and that the indemnity period suitably reflects the time it will take for the business to entirely return to the trading position it was in before the loss.

What Are Common Mistakes to Avoid When Buying Business Interruption Insurance?

Below is a list of 5 of the more common areas where problems can occur in arranging cover:

Definition of Gross Profit

The insurance definition is different to that used in accounting; wages are the principal difference. For the insurance calculation of Gross Profit, we want to only deduct from turnover those working expenses which will reduce in direct proportion to a reduction in turnover. Since you will likely want to continue paying your workers after a major loss, wages do not get excluded from the Gross Profit sum insured.

Equally, it is important to deduct the right expenses; if the item of expense reduces proportionately as turnover reduces, this can be removed in the sum insured calculation, which could positively affect the premium. Accuracy and precision are key here.

Indemnity Period

As already alluded to, this is a very common reason why businesses fail, as they underestimate the time it will take to completely recover. For a manufacturing company, anything less than a 24-month indemnity period is unlikely to be sufficient, especially if it is a single-site operation. Remember, it is the time taken to fully recover that needs to be considered, not just the time to recommence trading.

Non-Damage Business Interruption

Businesses need to consider the potential loss of profits which are not a result of destruction or damage to their own property. This could include:

• A problem with the supply chain
• A product recall issue
• Terrorism incidents leading to a denial of access
• Disease (such as recently experienced Covid-19)
• Weather (for example, where business is affected due to extended weather conditions)

Suppliers and Customers

Loss or damage at the customer’s or supplier’s premises can have a knock-on effect on your business, causing loss of profit; therefore, the level of exposure must be assessed and insured properly. In most cases, this is a very inexpensive issue to cover, but beware of policies which have “built-in” standard limits, as these may be insufficient for your business needs.

Additional Increased Cost of Working

This is an area where mistakes are commonly made. Most Gross Profit wordings incorporate the Increased Cost of Working cover automatically. This allows the business to incur an additional cost with the aim of mitigating any loss of Gross Profit. Importantly, this expenditure needs to be economic; in other words, the loss of profit needs to exceed the increased cost incurred. Additional Increased Cost of Working allows for an uneconomic expenditure, which is important to avoid losing a customer to a competitor, for example.

Calculating Business Interruption Insurance

To help calculate your potential financial losses and leverage your business interruption insurance, specific methods can be employed. First, project what the business results would have been if the triggering event hadn’t occurred. Then, determine the actual business results during the loss period. Finally, subtract the actual results from the projected ones to ascertain the loss value. This process entails analysing trends like sales growth over the years and accounting for seasonal variations.

Documents such as tax returns or net income statements form the foundation of this calculation. With these in hand, there are two formulas to help determine the loss: the top-down and bottom-up approaches. The former subtracts the expenses saved from the projected sales, while the latter adds up the projected net income and compares it to the actual income, including all incurred expenses.

For instance, consider a restaurant impacted by COVID-19. Under the top-down approach, it calculates the total sales it would have had, subtracting saved expenses. Conversely, the bottom-up approach determines the projected net income, adding back all incurred expenses, including those resulting from the crisis.

Summary of Solutions

Cover must be scoped specifically for each business, but making the cover bespoke for your business does not necessarily mean it is more expensive. Often, the solution is a different type of policy structure. Here are some alternative/additional solutions to consider when designing Business Interruption Insurance cover:

• Loss Limit Basis of Cover (of particular relevance where a total loss of Gross Profit is impossible or improbable)
• Declaration-Linked Policies – to mitigate the possibility of under-insurance
• Parametric insurance Policies – a relatively new innovation and useful for weather-type risks, especially

We hope this article has gone some way to provide insight into some of the areas of Business Interruption Insurance that can cause confusion.

If you would like more information on the solutions above or a thorough review of your business insurance, please contact our Business Insurance Team on 01653 609151 or at commercial@mcclarroninsurance.com. If you’d prefer, you can fill out the form below.

Business Interruption Insurance FAQ’s