It is a mistake to jump to the conclusion that the occurrence of increased production or revenues following the restoration of operations is makeup. Each situation must be carefully examined to determine the nature of the increased production and revenue and how it relates to the losses claimed.
The calculation of business interruption losses following a covered cause of loss involves an analysis of not only what would have happened had the loss not occurred but also a calculation of actual revenues realized and expenses incurred during the period of indemnity (also referred to as "period of loss" or "period of restoration"). Further, during the period of indemnity, the insured is typically expected to reduce the amount of lost revenues, where possible, by continuing operations and utilizing undamaged and damaged property to the extent possible. The concept of "makeup" takes this a step further by adding an additional, and frequently misunderstood, element to the loss calculation.
"Makeup" generally refers to a reduction in the amount claimed for production and related revenues that are realized after the period of indemnity if such production and related revenues are deemed to directly make up for revenues claimed as lost during the period of indemnity. A simple example of this concept is a manufacturer that, shortly following restoration of its factory, produces and sells a custom order that was previously claimed as lost during the period of indemnity. An illustrative clause from an actual insurance policy states that the insured is responsible for "making up lost production within a reasonable period of time not limited to the period of restoration."
Determining When Makeup Applies
Revenues cannot always be made up following restoration of operations. It depends on the type of business, the nature of the loss, available capacity, seasonality, changes in demand, and a variety of other factors. Even a sharp increase in production and revenues following restoration of operations versus normal historic trends may not necessarily indicate the existence of makeup. An example is a surge in production in September at a manufacturer of gift items following restoration of its operations at the end of August. The surge in production may, in fact, be the result of new orders for the holiday season and have nothing to do with orders and production lost prior to September.
Each situation must be individually explored and analyzed to understand the potential for makeup and the nature of post-restoration production and/or sales. The following are examples for a variety of scenarios and businesses:
- A manufacturer of specialty food products experienced a loss from wind damage in September, shutting down two of its manufacturing lines that normally produced items that realized their highest sales during the holiday season. By the time operations returned to normal capacity in late November, it was too late to produce the inventory required by the insured's customers (retailers) for that year's holiday season. Accordingly, makeup was not possible.
- A professional services firm had its operations interrupted due to a tornado that prevented its professionals from working on projects for 2 weeks, resulting in a large loss of chargeable hours. Based on a review of the types of projects and available capacity following the restoration of operations, it was determined that the insured could make up only a portion of the lost charge hours. Since some of the projects were time sensitive, they could not be made up and were considered completely lost revenues.
- A downtown hotel that does primarily commercial transient business and averages 70 percent occupancy during October was closed for a month due to a fire in its lobby. The transient business was considered completely lost and could not be made up (nightly room rentals are essentially "perishable inventory"). The same was true for most of the limited group business, because the groups did not rebook their events following the loss. However, two groups did reschedule their events and related rooms for the following month, during a time when the hotel had sufficient capacity. Thus, that specific group business was considered makeup and reduced the amount of the total loss claimed.
- A local single-operation car rental agency was closed for 2 months due to a tornado that damaged its facilities and much of its inventory of vehicles. There was no makeup since the daily rental of vehicles (also considered a "perishable inventory") could not be made up. Once those rental days were gone, so were the revenues.
- A local 24-hour diner was closed for 3 months due to a fire. It did not do any banquet or group business, and, as a result, there was no opportunity for makeup—all revenues were completely lost.
- A toy manufacturer had two of its production lines shut down for 3 months due to a product recall. There was a surge in production and sales following the restoration of operations that exceeded historic trend and, at first glance, appeared to be makeup. However, upon further examination, it turned out that there was a significant increase in market demand for certain toys at that specific time due to the appearance of the toys in a movie that just opened in theaters. Accordingly, the surge in production and sales was based on new demand rather than makeup of previously lost production.
- A manufacturer of custom-order machine parts was closed for a month due to an explosion. One customer, which accounted for 25 percent of the lost revenue during the period of loss, agreed to extend the order due date on its products until after the insured resumed operations. The insured had sufficient capacity to complete the order after it resumed operations but also realized contractual penalties for late delivery of the order. Thus, while the belated production was considered makeup, there was still a loss of revenue resulting from the decreased net sales price for the order.
Conclusion
It is a mistake to jump to the conclusion that the occurrence of increased production and/or revenues following the restoration of operations is makeup. In many situations, makeup is not feasible or even possible. Enhanced production and revenues may be completely unrelated to losses incurred during the period of indemnity. Accordingly, each situation must be carefully examined to determine the nature of any increased production and/or revenue and how it relates to the losses claimed.
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