When confronted with a business interruption claim, either from the perspective of a first-party property loss or third-party liability claim, a claims evaluator must be aware of a multitude of elements when considering the claim.
These challenges may result from external conditions—such as insufficient historical data, the length of the indemnity period, multiple losses—or from a theoretical misunderstanding as to what the business interruption coverage provides to an insured. These factors must be considered and be fully understood to provide a quick and accurate settlement of the claim.
The following will address some of the challenges encountered while reviewing a business interruption claim. However, before we proceed any further, here are a few operational definitions for the uninitiated.
What Is Business Interruption?
Business interruption, as the term would imply, is the temporary cessation of business operations on either a partial or complete basis, as the result of a specific and sometimes catastrophic event. In terms of insurance coverage, the loss event is the result of a covered peril, i.e., fire, hurricane, or tornado.
Falling under business interruption coverage often are separate components, for, among others things, the insured's business income loss as well as coverage for extra expenses incurred to mitigate the loss. The business income loss, which at times is used interchangeably with business interruption, is the portion of the coverage that indemnifies the insured for the loss business income which the insured would have earned but for the loss. The term "but for the loss" is an important concept to consider for a moment, as it is at times misunderstood and becomes a point of contention.
The insurance contract between the insured and the insurer is designed to make the insured whole, and to not unduly enrich the insured through an insurance recovery. Often, an insured operates under a faulty assumption that the insurer will pay them for the lost profits during the period of interruption, less any actual profit or loss, the difference being the recoverable loss. This is incorrect as the coverage is for actual loss sustained; accordingly, deductions must be taken for certain expenses that were not incurred during the loss period. The concept of discontinued expenses is sometimes an area that is difficult for some to fully wrap their arms around.
Key Term to Remember—Actual Loss Sustained
In a somewhat simplified example, the claims evaluator should examine the insured's profit and loss (P&L) statement for a period of time ending prior to the date of loss. The closer the period end date of the P&L statement is to the date of the loss, the more timely the information will be and a better metric to help in the determination of the loss. A determination between whether the expenses are fixed or variable is made, and the variable expenses, i.e., those that vary directly with sales, are segregated from fixed expenses to begin the determination of the noncontinued expenses. These expenses are typically expressed as a percentage of sales, although in some instances, averages are also used.
The variable expenses attributed to the lost sales during the loss period become the basis for the discontinued expenses that are deducted to calculate the business income loss, cost of sales being one of the best examples of such an expense. Further, in some situations, the line between a fixed or variable expense is not as cut and dry, as these expenses have both fixed and variable components. These semi-variable expenses, depending on their materiality to the insured's operations as well as the claim, often require additional analysis. An insured's payroll is an example of one such item that requires further scrutiny, specifically to determine the divide between hourly and salaried employees.
Indemnity versus Loss Period
Another area which, at times, can be a point of contention is the issue of indemnity period versus loss period. Specifically, if there is a divergence between the length of time taken or should have been taken to repair the damaged property with due diligence and dispatch to pre-loss condition, or the condition of the property, but for the loss. Careful consideration should be taken in regard to any potential improvements and betterments to the damaged location during the restoration period. If in this instance the length of time to complete the repairs exceeds the period of time it should have taken, either because of the improvements or because the insured has not taken measures to mitigate the loss, the indemnity period would be shorter than the actual loss period, and the insured's recovery would be based on the shorter time element.
In furtherance of our discussion of the measurement of the insured's actual loss sustained, the claims evaluator should be cognizant of the insured's ability to mitigate their loss either during the loss period of shortly thereafter. Specifically, the insured may be able to mitigate the lost sales either through a resumption of partial operations at the damaged location or temporary location. The insured may also shift production to an undamaged portion of a manufacturing facility, add additional shifts, or temporarily outsource a production to a competitor. The insured may be able to make up a portion its lost sales for the rescheduling of appointments, such as would be the case for a professional service provider.
Extra Expenses Incurred to Mitigate the Loss
Often, an insured has additional coverage for the reimbursement of certain expenses that are incurred as a direct result of the loss. Common examples of such an expense are the additional rent incurred to shift production or sales to a temporary location and the rental of equipment, such as portable generators, to continue partial operations at the insured's loss affected location. However, in all cases it is important to remember that the total of the extra expense that the insured is reimbursed is limited to the amount of the business income loss had the extra expenses not been incurred.
A hypothetical example would be a claim involving both a business income loss and a claim for extra expenses. For this example we'll assume a short-term loss, ignoring wait periods or deductibles, caused by interruption of power resulting in the suspension of business for a short period of time. Accordingly, a claim for a business income loss was submitted for the suspension of the operations during the loss period. Further, a claim for extra expenses was submitted by the insured for the rental of portable generators to supply power to the insured's business.
During the examination of the sales documentation provided in support of the claim, it was determined that the insured was not able to generate sales during the loss period. As a result of the insured's inability to generate sales during the loss period, there were no actual sales to offset against projected sales during the loss period. Accordingly, a business income loss was calculated based on a complete suspension of operations for the loss period.
In this example, the expenses incurred for the rental of the generators were not able to help the insured to mitigate the claim through the resumption of partial operations during the loss period. As such, the additional expenses incurred would not be reimbursable to the insured since the insured's recovery for the business income loss was based on a complete suspension of operations. The theory in play here is that the insured's recovery should not exceed the amount of the loss that otherwise would have been payable had no action been taken. This principle would also hold true in the event that this insured is able to generate actual sales during the loss period resulting in a minor reduction in the business income loss. If, as in this case, the reduced business income loss in combination with the extra expenses incurred still exceeds the amount of the loss as originally calculated, the insured's recovery for the extra expense would be prorated to equal the value of the loss as originally calculated.
The Proof Is in the Numbers
The scenarios touched on above give some of the more common examples of how the insured may be able to mitigate the loss. If such is the case, the extra-expense coverage would kick in. Simply stated, the extra-expense coverage reimburses the insured for the expenses incurred during the loss period which exceed normal operating costs. Consideration should be given to the extent and type of expenses for which the insured is reimbursed. Essentially, a determination must be made to ensure that the expenses are actually "extra" and are not ordinary to everyday operations of the business. An example of this would be the differential between employee overtime that exceeds normal per-loss overtime or the payroll of salaried employees incorrectly included in extra expenses. The insurer's reimbursement to the insured for the extra expense incurred, however, would be limited to the amount of the loss that would have otherwise been recoverable had the extra expense not been incurred.
Although the examples illustrated above only provide a few of the myriad of challenges one might confront in the evaluation of a claim, they do provide sound fundamentals. These fundamentals, when explained properly and applied consistently, will go a long way toward reducing the potential points of contention that may arise between the insured and the insurer.
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