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Hostile la Vista

From burned panoramas in New Mexico and Colorado to sludge-filled canals in New York, businesses are being bankrupted by hostile environments created by someone else's actions.

January 11, 2011 Photo
Lost earnings from calamitous events are one thing. They can largely be recouped through a claim on a business income policy. But what about the long-term loss of business value because of the destruction of venue? The collapse of tourism on the Gulf Coast. The gutting of retirement resort sales because of a landscape-razing forest fire. The destruction of value in high-rent apartments because of smelly, polluted canals in New York or dubious gas pipelines in California.

What happens when the surrounding vistas or the attraction of a community is destroyed? Certain businesses in small mountain towns, such as hotels, wedding venues and restaurants, rely on the community and the scenery that surrounds them. From the woodlands in Colorado to the shores of the Gulf Coast, we have seen unprecedented business losses that were exacerbated by the damage to their nearby communities. Even where there is no direct damage to the insured property, potential or scheduled customers stay away because of the destruction to the surrounding area.

When someone else—be it a commercial enterprise, an organization, or a private individual—destroys the surroundings that underpin the value of a business's attraction, it's time to turn to liability claims against the offending party. The complication may seem to be rooted in establishing culpability. That could be true, but once liability is established, the key to recompense is proving how much value—not just income—was actually lost as a result of the responsible party's actions.

Accounting for Value
The measurement of damages against a third responsible party may be substantially different than that of a traditional first-party business income loss. First, there is no requirement that there be physical damage to the insured property, only that the event caused a drop in earnings. Also, there is no limit on the period of time for which damages can be claimed. If a business fails or sustains a permanent decline in customers, then the measurement of damages would begin with quantifying the value of that business before the event and comparing that to the value of the business following the event.
There are three methods for measuring the value of a business: income, market and cost (asset) methods.

The income method measures the future cash flow of the business and discounts that amount to present value using a discount rate. The projection of cash flow is usually calculated for up to five years. The discount rates are usually much higher than discounts rates used in personal injury claims and are based on the opportunity costs of investing in other types of investments.

The market method is based on the sales price of similar businesses. Databases exist for thousands of merges, sales and acquisitions that are available to the business valuation practitioner. These can be used to gather information on the sales price of comparable companies. The sales prices are compared to revenues or some other basis such as EBITDA (earnings before interest, taxes, depreciation and amortization) to determine a ratio. That ratio is then applied to the revenues or other basis to determine the value of the affected business.

The asset method is based on the cost to reconstruct the physical assets of the business. Included in the costs is a premium for having the assets fully constructed. It takes time to assemble assets into a moneymaking operation. That time has value, which must be included in the calculation. This method is more appropriate for businesses that have a significant amount of tangible assets. For a business that did not suffer physical damage, or had net profits, the asset method most likely is not a proper method to measure the value of a business. The asset method would be used to measure the liquidation value of the assets, which is often much less than the cost to reconstruct the assets.

The specialized nature of such calculations may be outside the training or knowledge base of an insurer's claims department, but that doesn't mean that inferior evaluations are inevitable. Forensic accountants with special training in business valuations can be a valuable aid in determining damages.
Paul Cadorette is a partner in the Denver office of RGL Forensics and has extensive experience measuring economic damages as a forensic accountant, focusing on investigative auditing and litigation support.
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