There are many problems and challenges encountered on a day-to-day basis in the settlement of business income claims. Our purpose here is not to cover the method of determining a business income claim, but primarily the challenges which are encountered in the settlement of such claims by adjusters and other involved parties.
Essentially, the principal problem exists in that most persons involved in a business income loss misconstrue the axiom that the policy will do for the insured what the business would have done had there been no insured peril which caused the business interruption. That principle is mistakenly interpreted that you take the profit you would have made during the time operations were interrupted, measure it against the profit (or operating loss) you did make, and you collect the difference. Not so. There are many instances in which this description of the coverage does not fit policy provisions.
In a business income loss involving a gross earnings policy, many uninitiated insureds fail to understand why they pay a premium on gross earnings, yet collect less than expected, i.e. less discontinuing insured expenses. The policy clearly defines gross earnings, but the phrase "discontinued expenses" is one which is all encompassing. Even though persons familiar with the insurance policy and the procedures normally utilized in considering discontinued expenses will understand this, the uninitiated person is often left to try to comprehend the phrase. The coverage is for the actual loss sustained; therefore expenses that are not actually incurred (although insured) are not recoverable. It is rare that the amount collectible is measured to be the same as gross earnings. This would happen when the period of interruption is very short and, as a result, no expenses would be abated.
Measuring the Loss: Interruption or Indemnity
To measure a business interruption loss, the primary need is to determine the period of indemnity. It is generally known that the cost of any improvements or modifications in repairing or replacing existing property at the time of the loss is not normally covered by the property insurance policy. The reference to improvements in repairing or replacing damage is distinguished here, from the improvements a tenant makes in occupying leased or rented property. It follows that if the period of time taken to repair or replace the improvement or betterment exceeds the time it would have taken with due diligence and dispatch to repair or replace the property to its "as was" condition, that additional time element is also not compensable under the normal business income policy, since it is then beyond the period of restoration as defined. To measure the period of indemnity, the "as was" due diligence repair period would be subject to credit for those times when operations would not have been carried on. Examples might be vacations, Sundays, holidays, employee strikes or time to repair uninsured damage events. No actual loss would be incurred on those days.
An example would be a case in which, after an explosion and fire, the insured changed all of the equipment involved in a manufacturing plant and made various improvements and betterments to such equipment in order to, among other things, reduce the risk of explosion. These changes were being contemplated and were in the planning stages at the time of the explosion. The loss merely accelerated those plans and caused a forced interruption of the operation, as opposed to a planned and orderly shutdown, which would have been incurred when the changeover was made. The insured required several months to design the necessary changes, manufacture and install the new equipment. A claim was submitted for the entire period of interruption; i.e. from the date of the explosion to the date that the insured commenced production with the new equipment. For this particular loss, the insured called the adjuster immediately after the loss and requested guidance as to how he would handle the business income adjustment. What the insured had in mind was more along the lines of which expenses would be treated as discontinued by the adjuster to arrive at the business income claim. The insured had a presentation drawn up whereby they listed various expense categories and sought guidance as to which would be covered and which would be discontinued. The adjuster wisely answered that normally the problems encountered in adjustments of a business income claim do not result from whether or not certain expenses are continued or discontinued, or whether the percentage of business interruption loss as related to total sales or revenues is, say 38.3% or 32.7%. Any such differences are usually resolvable between reasonable parties. The problem in loss adjustment is usually the period of indemnity (as opposed to the period of interruption) or in what might be termed the "multiplier," or projected rate of sales or production increase.
In the above cited case in which the company changed its equipment, the period of interruption was the basis for the claim by the insured, whereas the adjuster looked upon the period of indemnity as being somewhat shorter. Those two terms are quite often inappropriately used interchangeably, but actually have different meanings in the pure sense of the words. The period of interruption, or suspension, is that period of time in which the insured's operations have been interrupted or suspended. The period of indemnity is the time the insurance company will pay to repair, rebuild or replace the damaged property with reasonable speed and similar quality.
The problems relating to the multiplier are usually those revolving around either the rate of increase or decrease in production or sales projections for the period following the loss, which may or may not have any relationship to the prior experience and may reflect excessive optimism. Another multiplier problem is when the production per hour is calculated on the basis of operation hours, but multiplied by the total hours on the clock including those hours that the machinery is nonproductive. This is the proverbial "comparing apples and oranges."
For example, the insured normally produces 1,200 units per day in 10 operating hours, or 120 units per operating hour. However, 120 units (per hour) is applied to a full day (24 hours), instead of applying only to operations hours (10 hours) during the day. The miscalculation by the insured accounts for an additional 1,680 units per day-they more than double their claim with this calculation error (See Figure A).
Some insureds have removed the days they felt were not "good" production days, and the resulting good days were used to calculate the daily production experience. (This is akin to a Chamber of Commerce for a resort excluding the rainy and cold days from its calculation for the average daily weather or rainfall). In these cases, it is the insured's contention that the interrupted days of production would all have been "good." It is those types of situations that cause the road to settlement to be a rocky one.
The key phrase in the business interruption insurance policy is ACTUAL LOSS SUSTAINED-set forth either in bold print or capitalized in most policies for emphasis. It is intended to indemnify the insured for actual losses within the policy provisions. The indemnification principle is one on which the entire insurance concept is predicated, in that the insured should not profit from a loss. There are situations, however, where the insurance contract permits a so-called profit, but this is usually in a manuscript-type policy where both parties (the insured and the insurer) have negotiated such terms.
In line with the indemnification principle, the usual business income insurance policy requires the insured to reduce the loss resulting from the interruption of business by:
1. Complete or partial resumption of operation of the insured's property, whether damaged or not.
2. Making use of merchandise, materials, or other property or production facilities at the loss or elsewhere.
In this connection, it is expected that, in the event of a loss, the insured would utilize the other plants owned or controlled by it, facilities of a competitor, subcontracting part of the production process, use of temporary facilities, existing inventory and any other feasible means to reduce its loss. By doing so, the carrier agrees to reimburse the insured for such expenses in excess of normal operating expenses, which are necessarily incurred for the purpose of reducing the business income loss.
It should be noted that the additional expenses incurred would be limited to the amount of the loss that would otherwise have been payable by the insurer, had the additional expenses not been incurred. It is assumed, for purposes of this discussion, that there is no extra expense coverage under which there is no such limitation. The theory involved here is that the insurer is not obliged to pay any more than would have been payable had no action been taken by the insured; i.e., the insured cannot be paid $1.50 if their recovery would have otherwise been $1.00.
In this connection, adjusters and claims professionals inquire as to whether or not the insured has other plants or other machinery, which could make up for lost production. Inquiries are also made with respect to gaining lost production through use of overtime, Saturday or Sunday work, additional shifts, recalling laid-off personnel, utilizing periods that would otherwise be idle, such as vacations or holidays, or switching around periods of shut-down for such things as boiler maintenance or turnaround. Adjusters also look to make up lost production through the use of existing inventories or the possibility of stockpiling partially completed production during the period of interruption, once operations are resumed.
In one case involving a multi-million dollar loss this procedure was used very successfully to minimize production of the final product (for resale to the customer). There was a vast differential in the capacity of two departments of the manufacturing facilities. Because the department that had been interrupted had approximately twice the capacity of the department which preceded it in the manufacturing operation (the affected department normally operated at 50% capacity because of the bottleneck in the preceding department), the insured was able to drastically minimize its loss through use of existing finished goods, inventories and stockpiling work-in-process inventories. There were additional expenses involved, which were, obviously, reimbursed to the insured. The insured maintained their sales and avoided the consequence of losing customers, which is not covered under the normal U.S. business interruption policy.
The concept regarding business income policies referred to above is not unique to any particular company. It is universal among standard, normal business income policies found in the United States. Exceptions to these policies are the Gross Profit, British LOP (Loss of Profit) or consequential profit forms, manuscript policies, or in recent years a provision has been added to the normal United States business income policy to cover an extended period of indemnity. That period is usually for a specific period of 30 days. A longer period may be purchased.
Apart from those policies, most business income policies cover only the actual loss sustained by an insured from physical damage to the described property which results in loss of revenues. The period of time covered is only until the damaged property is or could be restored, repaired or replaced with like kinds of property, exercising due diligence and dispatch. If, as a result of the loss, the insured suffers a loss of customers or a loss of sales after its operations are resumed, such loss is not usually covered unless other types of policies or extensions, referred to above, are in force.
Under the misconception that business interruption reimburses the insured for all the profit lost as a result of the insured peril, many insured and insurers become at odds over this issue. This is much more easily explained before a loss. When an economic loss, which is not covered under the policy, is suffered by the insured, difficulties often arise in settling the loss. Whatever can be accomplished to prevent misconceptions either before or shortly after the loss will make the road to settlement less rocky.
Chris Campos, CPA, is a senior partner with Campos & Stratis, a multi-national certified public accounting firm which focuses exclusively on forensic accounting. He has over forty years of diversified international business and accounting experience, and has given expert testimony in legal proceedings involving loss claims and lawsuits. Mr. Campos can be reached at email@example.com.