Throughout the course of my career in evaluating business income losses, I have fielded numerous questions from clients and insureds alike, as to what goes into the calculation of a business interruption claim. Often enough, after I've given what I consider the standard explanation, I get the feeling that a few, maybe more, are left with more questions than answers.
This observation could possibly stem from either the complex nature of business interruption theory or the fact that not all of these individuals are accountants. Further, most of the articles that I've read on this topic touch on some theory, however, they shy away from a discussion related to sales projections, income statements, and tax returns, possibly due to the fear that they might lose their audience.
For the most part, I understand this omission. A detailed discussion related to debits and credits, heavy on "accountant speak," would risk losing the reader's attention. However, based on the number of times I've had one-on-one discussions related to the topic, I feel it is an important subject and worthy of additional consideration.
Two Methods to Achieve an End
As I've discussed in other articles on the subject, the process of evaluating claims involves an estimation of an insured's or claimant's business results, as they would have likely occurred had the loss event not happened. The approaches utilized to achieve this end fall into two methodologies: the gross receipts method and the net income method.
The gross receipts method, also referred to as the "top-down" method, is the difference between lost sales and the expenses saved as a result of not earning the lost sales. Conversely, the net income method, or "bottom-up" method starts with an insured's or claimant's loss period net income and adds back the expenses that continued during the loss period. This can be achieved through a projection of a business's sales and expenses for the loss period, from which a line-by-line determination is made as to whether an expense is continuing or noncontinuing, or a combination of both.
From a practical standpoint, each method has its merits as well as its drawbacks. The gross receipts method yields a simpler calculation, which in turn means it is more easily understood by all parties involved. Its main drawback is that it ignores historical net losses the insured/claimant may have experienced prior to the loss. Conversely, the net income method provides a somewhat more conceptually complex calculation. However, I believe it provides a superior calculation, especially when considering an extended period of indemnity, as it does not treat losses as though they occurred in vacuum.
The Trinity of Business Interruption
We've discussed the applicable methods of analyzing business interruption claims, so now what's the next step? This brings us to the three types of source documentation that are essential for the evaluation of any business interruption loss. The first and most obvious piece of information is the sales data before, during, and after the loss period. The next is the historical operating information of the insured/claimant, whether it is an internally prepared income statement or a recently filed tax return. The final piece of information is the historical payroll of the insured/claimant for a defined period of time prior to, as well as during the period of restoration.
A fair degree of skepticism should be applied when reviewing sales, operating, or payroll information, especially those that are internally prepared. Further, efforts should be taken to reconcile internally prepared information to tax returns (income or payroll) filed with the Internal Revenue Service or state departments of revenue.
The fundamental first building block of nearly all business interruption claims are the historical sales of the insured/claimant. Using the historical sales, loss period sales are projected, typically by applying a period-to-period trend analysis, to ascertain any inherent growth or decline immediately prior to the loss. In all but very short loss periods, the trend can be applied to an average sales amount for the period of time prior to the loss, or the historical sales of the prior year to the corresponding months in the loss period. This is typically the case for retail businesses that have a seasonal element to their sales. It is important to have an open dialogue between the claims evaluator and the insured/claimant in order to get a solid understanding of the revenue generating cycle.
Once the loss period sales have been projected, the next step is to determine what expenses have continued or discontinued as a result of the cessation of business. The underlying theory is to determine all of the expenses incurred by the business that vary relative to changes in revenue and those which do not vary or vary very little. An example to illustrate this point is the cost of food sold in a restaurant, which increases with every additional dollar of sales, as opposed to the rent expense of a restaurant, which is usually a fixed amount and does not fluctuate as a result of an increase or decrease in revenue.
Payroll is unique in that it can at times be purely variable, as in the case of hourly workers, or completely fixed, in the case of a salaried workforce. As a practical matter however, it usually falls somewhere in-between and is why it is often evaluated separately.
In the "bottom up" method, I like to use a three column reproduction of the insured's or claimant's income statement, in which the likely operating results are projected assuming that no loss occurred in the far left column. The projected expense amounts are derived either by a percentage of historical sales or as an average amount where the denominator is determined by length of the loss period. This gives an indication of how the business would have fared had the loss occurred, including whether the business was profitable or operated at a loss.
The middle column represents the estimated or actual results of the business during the loss period, including any actual sales or revenue received as a result of the resumption of partial operations. Because a detailed review of actual loss period expenses is not undertaken due to time and cost considerations, sound judgment must be applied to determine which expenses continued either to generate sales during the loss period, if applicable, or were fixed in nature regardless of sales volume.
The remaining column on the far right is the difference between the projected amounts and the estimated actual amounts, resulting in the business income loss for the loss period.
As previously stated, I prefer the bottom-up method as it takes into consideration any net losses that the insured/claimant may have experienced prior to the loss, which, if ignored, could result in an overstated reimbursement. This clarity does come at price, as it is a more complex calculation than the top-down method, where lost sales less saved expenses equals the business income loss.
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