Large-Loss Forensic Investigation Techniques

One of the more challenging types of large losses to quantify is the potential loss of business income for a manufacturing facility that suffers an interruption in its production process. In these cases, it is not uncommon for the affected party to base its loss of business income claim solely on lost production, versus a loss of sales or orders. The following is a discussion of types of analyses performed by forensic accountants when calculating the loss of business income for a manufacturing facility.

Claims Settings

Claims for loss of business income stemming from production losses can arise in a number of settings. We often see these claims being submitted against a first-party property insurance policy in which covered property has suffered damage due to a covered peril. These same claims can also end up in a subrogation action against a third party with the first-party property carrier seeking recovery from the party alleged to have caused the loss. Finally, these claims can be found in lawsuits filed directly against a third party, and, in turn, as a claim against the third party’s commercial general liability (CGL) policy.

While the general economic theory and concepts are the same in each setting, the loss recovery will be different in the property setting as the insurance contract is the differentiating factor. These claims are subject to the conditions set forth within the property insurance contract. Some of these limitations and conditions include policy language regarding a covered peril, applicable waiting periods and or deductibles, coinsurance requirements, monetary limits for ordinary payroll, actual loss sustained requirements, and time limits for loss recovery. These contractual limitations will also be relevant in any subrogation action. However, when measuring the loss in either the direct litigation action or the CGL claim, no contractual limitations exist, and the damages will need to be based solely on sound economic damage theory and applicable case law. In this example, we will assume a claim is being presented in a first-party property setting.

Gaining an Understanding

Manufacturing processes are generally complex, so it is important for a forensic accountant to understand the production processes involved and how they have been impacted by the loss. One of the first steps in dealing with these types of losses is to gain an in-depth understanding of the policyholder’s operations. This can generally be accomplished by interviewing the policyholder and asking them to provide an overview of their operation, a tour of facilities, and a review of production flowcharts and diagrams. Areas of inquiry should include:

• What is the policyholder’s normal production cycle, how many days per week do they operate, and what is the number of labor shifts, hours per shift, production lines, etc.?
• Which products were affected, and has the product mix changed subsequent to the loss?
• Did the policyholder sustain any lost sales or order cancellations? If so, can this be documented?
• Are there any seasonality issues to production or sales?
• Does the loss facility produce finished salable product or is the facility considered a process center and production is subject to further processing at other locations?
• If the policyholder maintains more than one facility, are there any upstream/downstream impacts, or was production shifted between facilities?
• Was the loss facility operating at full capacity at the time of the loss, and are there any capacity constraints due to labor force availability and/or equipment?
• Are there any contractual obligations with customers or vendors? If so, will any of these obligations be impacted due to the loss?
• Identify any internal and external opportunities that may mitigate the loss, including retooling of other facilities to accommodate lost production.

The aforementioned areas of inquiry are not meant to be all-inclusive. Additional inquiries may be necessary based on the type of facility affected, industry in which the business operates, and length of time the business has been in operation.

Obtain and Review

In addition to complex operations, manufacturing businesses often have a comprehensive set of accounting and production records. Most large manufacturing businesses use standard cost reporting that includes variances to capture actual results. Since standard costing can vary widely from actual results, it is imperative to measure the policyholder’s loss using actual results. Understanding the policyholder’s reporting and accounting process should simplify requesting and obtaining relevant records. The following is a list of the types of documentation forensic accountants request during the course of their analysis:

• Pre- and post-loss profit and loss statements or plant cost statements
• Federal/state tax returns
• Budgets and forecasts
• Sales summaries by product and line of production indicating number of units and total sales amount
• Daily/weekly/monthly production reports
• Periodic inventory reports
• Sales and purchase commitment contracts
• Documentation supporting any specific loss of sales or orders
• External documentation regarding the industry and economy in which the business operates.

The example above is specific to a manufacturing facility. The types of documentation will vary for retail and service operations, as well as for other differing industries.

Quantifying the Loss

Ultimately, determining whether the policyholder sustained a loss will be dependent upon documenting a loss of sales. When the claimed-loss measure is based on a loss of production, various forensic accounting techniques will need to be employed to verify that the loss translated into a loss of sales. The policyholder’s operations should carefully be considered to properly quantify the loss. For example, if their downtime is limited to a short period and the facility has idle capacity for makeup, lost production may not translate to lost sales. Furthermore, there may be other actions available for the policyholder to mitigate the loss. Calculating the policyholder’s loss measure using a loss of production model without considering these mitigation possibilities would be ill advised and requires a thorough investigation by the forensic accountant.

If a policyholder’s operation is at full capacity and they maintain little to no inventory, then typically a model using lost production may be appropriate. In this situation, any interruption in the production process will likely result in a lost sale at some point in the future. However, if the policyholder does maintain inventory and mitigates loss through utilizing on-hand inventory to maintain sales, then the change in inventory should be considered when calculating the potential loss. Safety stock replenishment may not be recoverable if the mitigation occurs during the normal course of business. As will be discussed in a following section, the policyholder may incur additional out-of-pocket costs to replenish inventory.

An Actual Loss?

As with most indemnification contracts, insurance policies normally provide loss-of-business-income coverage on an actual loss sustained basis. This means that a policyholder will need to demonstrate that there was an actual insurable loss suffered. As is the case with most lost-production claims involving a short interruption period, it is common for the policyholder to base their claim purely on lost production versus the identification of specific lost sales or orders. By using this methodology, they may fail to consider the following:

• There was sufficient existing inventory to satisfy orders.
• They were able to make up production in the immediate post-loss period to avoid sales losses.
• Production shortfalls at the loss location were covered using extra capacity at other insured locations or idle equipment; thus, sales losses were avoided.
• There was no loss of sales because additional out-of-pocket costs were incurred to outsource production or inventory needs.

If any of these issues are ignored, the loss model may be flawed and fail to demonstrate an actual loss sustained consistent with the terms of the conditions and provisions set forth in the indemnification agreement.

Makeup and Cost Inefficiencies

Policyholders that have idle production time can generally make up their production loss and in turn avoid actual sales losses in part or in whole through adding additional shifts, adding production days, retooling other production lines, or other mitigation means. However, there is often an increase in manufacturing and other costs caused by these mitigating actions that should be considered in the loss model. For example, if the policyholder adds an additional shift to a five-day workweek or has staff work during a weekend, then the additional labor would likely generate some level of overtime premium costs and associated fringe benefits. In this situation, the policyholder would have incurred labor costs at regular rates had no loss occurred, but now they will incur those same costs plus a premium for the overtime. In this example, the policyholder’s loss would be measured as the per unit incremental cost to make up the lost production.

Extra Expenses

In general terms, extra expense coverage is intended to provide the policyholder with a recovery of costs that they incur to mitigate the loss of business income. These costs are expenses that the policyholder would not have incurred had no loss occurred. If the policyholder has extra expense coverage, they may have to comply with certain conditions for reimbursement for these costs, depending upon policy provisions. In some cases, to recover such costs the policyholder has to demonstrate that the extra expenses incurred actually mitigated their potential loss of business income or shortened the period of restoration. However, this is subject to policy provisions and may differ per policyholder.

With most losses, the policyholder’s primary goal is to minimize the long-term impact on the business and expedite a return to normal operations with as little disruption as possible. This goal is consistent with policy provisions that require the policyholder to perform reasonable mitigation efforts. Depending on the policyholder’s operations, possible areas of mitigation to explore include the following:

• Securing alternate operating space and incurring additional rent and other facility costs.
• Outsourcing partial or entire operations to an external third party. If the policyholder utilizes raw materials in their production process that are produced internally for other finished goods production, consider obtaining those raw materials from other sources. These costs would likely include the incremental increase in normal manufacturing costs versus actual costs of external purchases.
• Incurring additional labor costs to make up lost production.
• Incurring additional shipping and transportation costs to obtain goods from an alternate source.
• Incurring temporary setup and tooling at an alternate internal location. These costs would likely include establishing operations at an existing location that was not previously set up to accommodate the production that may have been lost.

Some policies that provide extra expense coverage require the policyholder to demonstrate that those expenses were incurred to reduce their loss of business income exposure dollar for dollar, but others do not. It is not unusual for a carrier to limit the policyholder’s extra expense recovery to the potential loss of business income that was averted.

For example, consider a loss involving a production process where a policyholder produces raw materials for downstream finished-goods production. As a result of the loss, the policyholder is unable to produce the raw materials internally and decides to purchase the raw materials on the open market to avoid a sales interruption and resulting business income loss. The policyholder’s extra expense would be the difference between the normal processing costs that were avoided or saved versus the cost of the external purchases.

If, however, the policy also requires that the extra expense serve to limit the business income loss otherwise payable, the policyholder would also have to demonstrate that incurring these costs was less than the business income loss it would have suffered if the extra expenses had not been incurred. In these cases, it is important for the affected business to demonstrate that these costs represent an additional out-of-pocket cost versus an allocation of normal ongoing manufacturing costs.

Attempting to quantify a large loss may seem daunting, but understanding the impacted business operations, the availability of accounting records, and the contractual limits and terms in the insuring property policy will help ensure a successful resolution.   

Derek Royster is a certified public accountant and partner, and Eric Sherman is a director in the Charlotte, North Carolina, office of RGL Forensics. Both have been CLM Fellows since 2012 and can be reached at www.rgl.com.