Measuring Business Interruption Exposure: "Business Interruption Values" and "Maximum Probable Loss"
Christopher Brophy | October 1, 2012
Each year, corporations provide updated "business interruption values" to their insurers. This is important as it helps the insurer to understand the relative size of the risk. Surely, a $100 million company has more exposure than a $50 million company does. However, the worksheet can also be confusing and misleading. 1
Business interruption values are determined using a "BI worksheet," a relatively standard form that varies slightly by insurer. But the worksheet is really too basic; it doesn't give the insurer a true understanding of the risk exposure. The true risk would need to consider many factors, including the following.
- The number of locations, which spreads the risk. (Five locations with $20 million in sales have a lower risk of a large loss and higher probability of more frequent losses than one location with $100 million in sales.)
- The overlap and interdependency between locations. (A loss could be mitigated if the different locations do the same thing. A loss can be greater if one insured location receives work-in-process or components from another insured location.)
- A realistic assessment of the time to complete repairs at each location. (A location with complex construction and intricate machinery may take years to complete repairs and resume operations; a basic warehouse and assembly operation may resume operations in 3 months.)
To be sure, the insurer's underwriting department considers many factors to assess the risk and quote premiums. The BI worksheet is an important part of that equation but must be supplemented with other pertinent data.
Determining reasonable BI values is important. If an insured has insufficient values, it may find that it is underinsured when a loss occurs. This is especially important if the insured has a "coinsurance clause," which would effectively penalize the insured for not buying the proper amount of insurance. (Most corporate policies do not have a coinsurance clause. Instead, they have "agreed-upon values," which provide a certain amount of insurance and are not subject to a coinsurance penalty if underinsured. Nonetheless, it is important to provide proper information to ensure that values are reasonable.)
The Basics of the BI Worksheet
To complete the BI worksheet, the insured provides basic actual data for the prior year and projections for the upcoming year. Most forms request the following data.
- Total sales (or sales value of production)
- Less: cost of goods sold
- Less: utilities
- Less: services purchased from outsiders
- Less: other costs that would discontinue 2
Most insurers have two separate forms: one for manufacturers and one for mercantile operations. Most forms draw a distinction for "ordinary payroll." Ordinary payroll is generally defined with wording such as "the entire payroll expense for all employees of the insured, except professionals, officers, executives, department managers, and employees under contract." Insureds can usually purchase 30, 60, 90, or more days of ordinary payroll. If 30 days are purchased, the worksheet will show that all but 30 days of ordinary payroll is subtracted from revenue to arrive at the business interruption value.
Many insureds prepare the form themselves, often with the guidance of their insurance broker. The risk management group usually solicits the input of the finance team to obtain the proper data and complete the form. The finance team usually follows the same steps every year, so that the form is consistently prepared. Of course, if an error is made in one year and the approach is replicated, the error perpetuates. Only when a loss does occur and the declared values are more closely examined does the error become known. Many insureds with complex operations find it helpful to use a forensic claims accountant to help develop the BI value and to monitor the process annually. 3
Maximum Probable Loss (MPL)
An insured may also want to understand its own risk, partly to be able to manage its exposure to a catastrophic loss and partly to be able to meet the insurer head-on as they negotiate contract terms of its policy. A more appropriate assessment of an insured's risk is a comprehensive MPL assessment, which provides a more meaningful analysis of the insured's risk and considers what really might happen should a loss occur. An MPL assessment typically looks first to the locations of the insured that have the most exposure. Next, it asks whether other locations have the ability and capacity to make up a portion of that location's loss. Would outside service providers be able to offer capacity to mitigate the loss? Would customers be willing and able to wait to receive shipments, so that the insured could make up a portion of the loss after repairs are complete? Could a temporary facility be used to mitigate the loss?
A good MPL calculation will include a narrative explanation that details the exposure and identifies the realistic mitigation activities. To fully assess the MPL of an insured, one should consider numerous factors, including the sales at each location, the costs that would discontinue in the event of a loss, the ability to mitigate a loss, and the reasonable time to complete repairs. The MPL calculation is important to determine whether policy limits are reasonable, but not excessive, and to help the insurer decide whether an adjustment is appropriate. Whereas insufficient policy limits can be devastating if a loss occurs, excessive values may mean that annual premiums are higher than necessary.
A good MPL analysis will also consider the need for other insurances, such as contingent business interruption coverage. Contingent business interruption coverage pays for losses incurred as a result of damage to the insured's customers or suppliers. This can be important for insureds that have important dependencies within their supply chain. Some insurance provides coverage only for losses attributable to the insured's direct customers or suppliers; others provide coverage for losses to customers or suppliers of any tier, so that losses attributable to a customer's customer or supplier's supplier (of any level) should be covered.
An MPL analysis can help determine the appropriate amount of ordinary payroll coverage. For example, if 30 days would be sufficient, why buy 180 days of coverage?
An MPL analysis will also consider a reasonable amount of time for extended period of indemnity. This is important coverage as it pays for losses after repairs are or could be complete. In some cases, an insured may have ongoing losses even after repairs are complete. However, if the insured does not reasonably expect losses to persist after repairs are complete, it may buy only limited extended period of indemnity coverage.
Most worksheets calculate an "annual business interruption value." But, suppose the real assessment of risk is that the operations could be repaired or replaced in 6 months, even with the most devastating loss. Some insurers include an estimated time to complete repairs on their worksheet, which allows the insured to fine-tune its annual calculation to a more realistic time period.
Conclusion
The preparation of annual business interruption values is a tedious and often problematic task for many insureds. It is usually met with: "The Risk Management group needs us to fill out that form again." However, the values derived from that form are important. BI values help to establish the overall risk of an insured, factor into the policy limits, and are used to determine the premium. An insured should be careful to understand the details of its BI worksheet and should consider a more comprehensive MPL assessment to supplement the BI values. This is generally more meaningful as it more specifically addresses the risk of the insured and considers specific factors that could impact the loss.
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