After the initial chaos, confusion, and massive disruption typical of a catastrophic
loss, a company is faced with a myriad of decisions. Most of them ultimately
focus on the same issue: How can we mitigate the loss and resume operations
as quickly as possible? A major part of this process typically includes repairing
or rebuilding the damaged facility.
The basic intent of property damage and business interruption coverage is
to repair or replace damaged property and to reimburse the insured for lost
profits and continuing costs. However, the insured may find that it doesn't
want to—or can't—repair or replace the property "as was." Some reasons may include:
- Building codes have changed since original construction.
- It is impractical or inefficient to rebuild the previous design.
- Operations can be enhanced—changed, expanded, or minimized—by making
significant changes.
- The damaged location can more effectively be consolidated into or moved
to another location.
The basic property insurance policy allows the insured to be reimbursed for
costs to repair or replace the damaged assets and the business interruption
impact for the time required to repair or replace "with due diligence and dispatch."
Typical policy wording is as follows:
Property Damage
In the event of such damage or destruction, the Company shall pay
the actual expenditure incurred in repairing or replacing the damaged property.
The term "replacement cost" as used here means the cost to repair or replace
lost or damaged property with property of comparable value and quality on
the same or another site, and used for the same purpose, without deduction
for depreciation, deterioration, or obsolescence.
Business Interruption
In the event of such damage or destruction, the Company shall be
liable for the actual loss sustained by the Insured resulting directly from
such interruption of business, but not exceeding the reduction in Gross
Earnings … less charges and expenses which do not necessarily continue during
the interruption of the business, for only such length of time as would
be required with the exercise of due diligence and dispatch to rebuild,
repair, or replace such part of the property as has been damaged or destroyed.
Property Damage and Business Interruption Illustrations
Let's look at a hypothetical situation. Tylake Corporation owns a manufacturing
plant located in Des Moines, Iowa, that produces dizaphones. The plant suffers
a fire that destroys the entire plant.
Scenario 1: Rebuild the Property as It Was before the Incident
Tylake rebuilds the plant as it was before the incident a cost of $1 million.
The time to complete repairs is 6 months. What is Tylake entitled to under its
property policy?
Tylake is entitled to the $1 million that it incurred to complete repairs.
It is also entitled to the business interruption losses incurred during that
6-month period of time.
Scenario 2: Rebuild "As Was," but Comply with "Code Upgrades"
Although Tylake's management is willing to replace the plant as it was before
the incident, new building codes written after original construction must now
be adhered to, for an additional cost of $200,000. What is Tylake entitled to?
The insured's policy will dictate the amount of coverage that is provided.
While the standard ISO CP 00 10 "Building and Personal Property Coverage Form"
provides coverage for the increased costs incurred to comply with the enforcement
of new building codes, it also places a cap on the amount of such coverage.
Many companies craft customized (manuscript) policies which either expand or
do not limit the amount of such coverage. Typical wording for this type of policy
is as follows:
Increased Cost of Construction
In the event of physical loss or damage covered hereunder that causes
the enforcement of any law or ordinance in effect at the time of loss regulating
the construction, repair or use of property … this Company will be liable
for the increased cost of construction.
With this type of coverage, most policies typically require that the code
upgrade be in place before the incident
occurred. For example, after some of the recent hurricanes, local authorities
made changes to code requirements after
the incident. Costs incurred to meet such code upgrades may not be recoverable.
Assuming that Tylake's policy had code upgrade wording such as that shown
above, and that the new building codes were written prior to the incident, Tylake
should be entitled to recovery of the total cost incurred, including the costs
incurred to meet the new codes, or $1,200,000.
Scenario 3: Comply with "Code Upgrades" that Extend the Time To Complete
Repairs
When code upgrades are required, it often means that the time to complete
the repairs is longer. Tylake is happy to hear that the cost of the code upgrades
will be reimbursed under its property policy. But it also finds that the time
to rebuild the plant will take longer in order to adhere to the code upgrades.
Instead of completing the repairs in 6 months, it will take 8 months to complete
the repairs and meet the new code requirements. What is Tylake entitled to?
The standard ISO CP 00 30 "Business Income (and Extra Expense) Coverage Form"
states that ""period of restoration" does not include any increased period due
to the enforcement of any ordinance or law that regulates the construction,
use or repair, or requires the tearing down of any property." For this reason,
most companies that have manuscript policies which cover the increased costs
of construction due to code upgrades (as discussed in Scenario 2 above) typically
also have manuscript policies that provide for the period of interruption to
reflect the increased time to adhere to the code upgrades. Typical wording is
as follows:
Increased Cost of Construction
This policy also covers any increase in the Business Interruption
and extra expense loss arising out of the additional time required to comply
with state law or ordinance.
If Tylake's policy has code upgrade wording similar to the above, the additional
time required to comply with the code upgrades should be covered.
Scenario 4: Don't Rebuild
Tylake decides not to rebuild the damaged plant at all. What is Tylake entitled
to?
Most policies state that the insured must take a reduction for depreciation
if they decide not to rebuild and to "cash out" on the policy. Typical wording
is as follows:
Actual Cash Value
If within one year, the process of repairing, rebuilding, or replacing
the property has not begun, then the value of the property will be the Actual
Cash Value. The term "Actual Cash Value" as used here means the Replacement
Cost with deduction for depreciation, deterioration, or obsolescence.
If the insured's policy includes wording similar to that above, and it decides
not to complete the repairs, it would be entitled to the $1 million, less a
factor to reflect the physical deterioration or depreciation of the property.1
When the repairs are not made, the insured is typically entitled to business
interruption losses incurred for the estimated time that it would have taken
if repairs were indeed made.2
Scenario 5: Make Significant Enhancements
Tylake decides to make significant enhancements to the plant rather than
to rebuild it as it was before the incident. Instead of repairing the plant
for $1 million, it intends to spend $2 million to enhance the facility. The
time to complete repairs is expected to take 9 months rather than the 6 months
that was expected if the facility was repaired as it was. What is Tylake entitled
to?
When a significant loss occurs, the insured should determine if repairing
the damaged asset as it was before the incident makes good business sense—from
an operational and financial perspective. In this scenario, Tylake should be
entitled to the $1 million cost to rebuild the plant as it was
before the incident and should be entitled
to business interruption losses for the 6 months that that it would have taken
to rebuild the facility to as it was before
the incident.
Conclusion
When a significant property loss occurs, the insured should carefully review
all options regarding repair or replacement of the damaged facility. Should
the facility be repaired or rebuilt? Should it be relocated to a different location?
Should significant changes be made to the facility?
The insured should also carefully review its insurance policy to determine
what may be recoverable by insurance under each option. It is important to recognize
that the amounts recoverable under its property and the business interruption
policies may not be based not on the actual costs incurred—or the actual time
to complete the repairs—but rather on estimates of what it would have taken
to repair the asset as it was before the incident.
A thorough analysis of all the facts and various options, utilizing the services
of qualified forensic accountants, insurance professionals, and attorneys can
help point the way to an effective course of action and a beneficial recovery.
Michael C. Speer, CPA,
is an Expert Commentator for the IRMI.com
business
interruption series, which provides articles on practical and topical ideas
on how a risk manager or insurance professional can better understand the business
interruption claims process and the challenges faced with such claims. Mr. Speer
has over 30 years of experience in public accounting and consulting firms. He
is a member of the Disputes, Valuations, and Investigations practice of LECG
and on the leadership team of the firm's business interruption and fidelity
claims support group. He also provides general forensic accounting and litigation
support services. For contact information, see
Mr. Speer's full biography on IRMI.com.
He can be reached at