While crossing the Atlantic in 1921, Albert Einstein discussed his famous equation E=MC² with another passenger, Chaim Weizmann, who said:

Einstein explained his theory to me every day. And soon I was fully convinced that he understood it.

Some of the most important ideas in business are expressed in simple relationships: "Buy low, sell high." "The devil is in the details." "Time is money." But behind these familiar phrases are complex thought processes: calculations, assumptions, expertise, and creativity.

Similarly, when a business is interrupted, the owner makes a seemingly simple request of an insurance provider: Pay me for the sales I would have had. Yet, behind this request is a complex reality. When the owner has to prove the sales that they would have had, the projected or estimated amount is many times a challenge to prove. And, since insurers often hear "We were having our best year yet …" from claimants, it's no surprise that business interruption claims are looked on with a measure of skepticism.

A policyholder's success depends on understanding the "business interruption (BI) formula of insurance." The term business interruption usually describes the disruption of typical operations as a result of a definable event that is beyond the entity's control. In legal contracts and insurance policies, business interruption means the financial impact of such a disruption over a period of time.

Business interruption insurance is typically purchased as an endorsement to property insurance. Under most policies, actual physical damage or loss resulting in business interruption meets the requirement for coverage. Many policies use "business income insurance" as an alternative term. The basic concept of both phrases is simple: Pay to make me whole—as if no loss had incurred.

But this simplicity is deceptive. Business interruption claims can become more difficult and even contentious in circumstances where differences of interpretation emerge about the reliability of projections or the meaning of policy provisions. A successful claim entails maneuvering through the gray areas inherent in business interruption, including financial projections, consumer demand, and policy interpretation, to reach a number that's reasonable, credible, defensible, and well-supported.

Understanding BI Claims

The business interruption formula can be summarized as follows.

BI = T x Q x V
where:
BI = business interruption
and:
T = the number of time units (hours, days) operations are shut down
Q = the quantity of goods normally produced, or sold, per unit of time used in T
V = the value of each unit of production, usually expressed in profit

Let's walk through an explanation of this formula and explore its possibilities.

Quantity

At lunchtime, he takes large quantities of illicit gin.

Determining quantity, or a specific number or amount, can be one of the most challenging components of a BI claim. Where specific production is lost, the numbers can be more straightforward. But where production varies with unpredictable demand, the claim becomes more complex. When a manufacturing plant's production becomes limited or ceases as a result of an insured loss, predicting what production levels would have been can become speculative. How much would we have made?

Traditionally, a claim preparer analyzes the planned, budgeted, or anticipated production against historical output and trends. This approach becomes more complex when the loss period is particularly long or when the business lacks historical data (e.g., start-ups or new product introductions). Also open to interpretation are the time, effort, and documentation required to calculate quantity, since these often vary with the comfort level and expertise of the insurance company's adjusters and accountants.

It is the policyholder's obligation to prove the loss. Proof usually comes in the form of documentation, but meetings and policyholder's statements also play a role in the claim process. As noted earlier, one of the most common statements that adjusters hear from policyholders is "This was the worst possible time for us to have a loss. We were going to have our best year ever." While such a comment neither helps nor hurts a claim, it certainly contributes to the audit skepticism of the adjuster and consultants.

Efforts to document and corroborate claims occur on both sides of the table. Naturally, misunderstandings can result. Consider this example of extenuating circumstances in determining quantity. Several years ago in the South, a flood engulfed a food packaging plant whose main products were frozen vegetables. In evaluating the claim, the insurance company's New York-based accountants eliminated one of the company's product lines in their calculation of lost sales, because their analysis suggested that sales in okra (a Southern vegetable used in gumbo or as a side dish) were drastically depressed.

On hearing this, the company's chief financial officer (CFO) jumped to offense, "Those Yankees are trying to take the okra off our plates!" Rather than starting the second Civil War, however, the food packager showed the insurance company the real reason for the prior year's drop in okra production and sales: a drought that had decimated the crop. During the year of the loss, however, forecasts clearly showed that there would have been a bumper crop; therefore, the packaging company's loss was significant.

Time

Time is the longest distance between two places.

Time is one valuable that cannot be replaced. While in the BI formula, time means the length of the loss period in the BI formula, this is where many of the most challenging claim arguments occur. For example, in the United States, the Loss of Earnings forms typically define the end of the indemnity or loss period as "the period of time until physical repairs are complete" or "often until business returns to normal." But in the United Kingdom, the Lost Profits Form often defines a fixed period of loss.

Variability in time occurs when the adjuster and policyholder do not agree on scope. The adjuster might think physical repairs should take 8 months, but the policyholder is convinced they will take 10 months. Who pays for the extra 2 months—the insurer or the insured? Is the difference split and/or negotiated? Here, the BI formula is important for several reasons: (1) an exact amount for the 2 months under dispute can be calculated; and (2) if time is the issue, either party can hire an engineer or a consultant to prepare a critical path analysis, or apply other techniques to resolve uncertainty.

The following example suggests how difficult it can be to put a specific number on the time variable in our business interruption formula. Facing a decision whether to rebuild a plant after a fire, a company struggled with how to rebuild and where. The delay was so extensive that the company agreed that a credit of time to the insurance company could be applied to its business interruption claim. That, of course, raised two big questions about time: how much and which months?

Complicating matters were three additional variables: first, losses varied by month because of product and production seasonality; second, during the business interruption period, some production would be outsourced to another plant; and third, some production would come on line slowly in the new plant. In long and arduous discussions, the accountants, engineers, and adjusters struggled to decide: "If we eliminate a month's worth of value from the claim, which month should it be—a month of "average value," a middle month, the "best" month, the last month, or some "hybrid?" The policyholder had a team of claim preparation accountants work with engineering efficiency experts to develop financial models of where the extra time was spent and how it should be deducted from the claim. In the end, in this case it was evident that one of the "tail end" months should be considered as a possible credit or reduction to the claim.

Value

At two for a penny, licorice bootlaces were the best value in the shop!

R. Dahl

Value adds additional complexity to the business interruption formula because it introduces the worth of each unit of production. Assessing value brings into play questions such as: What price per unit would have been charged? What gross margin or profitability was expected? And what expenses would have been saved, or were noncontinuing? While "saved expenses" would seem fairly straightforward, there is room even here for disagreement between the policyholder and the insurer.

Forecasting sales or production involves several steps. The key variable is documentation to construct the type and amount of business that would have been conducted during the claim period. For example, if the business were seasonal, several years of experience might be needed to establish a production and sales profile. Forecasts and budgets can establish what management anticipated for the period in question, especially if past forecasts proved accurate. External economic predictors—such as trade association data, industry information, or Department of Commerce statistics—should also be considered and factored into the model when appropriate.

With all the variables introduced by the question of value, it's no surprise how complex the calculation can be. Most business interruption claims are not limited to only one issue or item to resolve, but rather include a mosaic of challenges to resolve, including each of the issues of time, quantity, and value. A perfect example would be that of the real estate company which specialized in converting distressed properties into successful timeshare properties—a claim further complicated by some policy questions. This real estate company purchased three resorts in the Caribbean, from a company on the verge of bankruptcy. Three months after the sale, the new owner had achieved a 30 percent increase in sales over the prior-year period—a success even more remarkable given that those 3 months were also the slowest time of the year for resort properties.

Unfortunately, immediately after this increase in sales volume, Hurricanes Luis and Marilyn slammed into the Caribbean, severely damaging the resort. After assessing all the damage, it was clear that repairs would take months. The real estate company presented a claim in excess of $25 million, to which the insurance adjuster responded "There's not much of a business interruption claim here because your loss is simply a delay in sales." Then, the adjuster pointed out that his own brother-in-law, who owned one of the units, had advised him that the prior owner had struggled to sell the units anyway.

Depending on one's point of view, the "delay in sales" concept was either nifty or shifty. In effect, the insurer was saying that because the number of units to sell was limited, and because the company would always have the ability to sell them, there was no "business interruption" loss. Yet, the actual insurance policy covered "loss of sales" for a 2-year period. To further complicate matters, the selling price of timeshares began to decrease after the storm, to induce consumer interest and increase sales volume.

Through extensive analysis, including educating the insurance adjuster to better understand the typical sales life of a timeshare property and considering the inherent business risk in maintaining such property, the claim preparer established a mechanism to consider the adjuster's concept of deferred or delayed realization of sales, while still reimbursing the policyholder for the loss. A "present value" method of future sales, along with the use of a "diminution in value" approach, demonstrated one of several methods to value the claim. Both incorporated the mechanics of the BI formula. By presenting several calculations, along with other horse-trading in the property claim, the claim preparer made enough options available for both policyholder and insurer to work toward a reasonable loss valuation.

Making a Claim

While all three areas (time, quantity, and value) contain an element of subjectivity, their importance in claim development is complementary. Consider the following illustrations.

• If a company's sales forecast is solid and reliable, but the downtime may vary, management should probably focus on the policy's indemnity period. A good strategy would be to hire an engineering consultant to help with critical path analysis.
• During times of economic swings or the introduction of new products or services, historical data is typically either limited or irrelevant. Reaching agreement with the adjuster's accountant can require many exchanges of data and lengthy follow-up discussions. Rather than rushing the process during a time of crisis and becoming frustrated by the need to develop corroborating arguments, a better strategy is usually to identify potential challenges at the outset as much as possible, then dedicate the time and resources to supporting assumptions. More up-front work can increase credibility and reduce the review period.
• Should coverage and policy interpretation appear to be at issue early on, it will be wise to engage the use of outside counsel that specializes in insurance coverage. Adding an attorney to the team does not mean litigation is at hand, but can protect an owner's interest and avoid unfounded disputes.

Ironically, insurance policies define coverage, but they never show how to put a claim together (see Beyond the Policy: Documenting a Business Interruption Claim, February 2001). Certainly the formula BI = T x Q x V is never found in any policy. What is also ironic, despite the fact that business interruption is a "gray area" within the insurance industry, is the dearth of court cases and verdicts. Perhaps the ability to resolve claims without the courthouse comes from accepting ambiguity in the process; either party would find it difficult to present its case in court. The end result is that claims tend to be resolved in a traditional claim adjustment process, and not necessarily in the courtroom.

In addition, policyholders have at their disposal the ability to hire independent accounting and claims experts that match those of the insurance company to help formulate the claim and manage the process. Having "expert to expert" meetings, with the two sides working hand-in-hand throughout the process, may also avoid protracted disagreements which may lead to a third party.

Know the Formula

Clearly, many variables contribute to a smooth process in managing business interruption claims. Properly documenting the claim is important, as is having an effective claims team and leadership (see The Shackleton Approach: Effective Leadership Throughout the Claims Process, August 2002). Yet, the quality of these variables also centers on an understanding of business interruption. The most fundamental elements in resolving claims of business interruption are a correct application of the BI formula and the integrity of the calculations behind it. Using the formula does not cause claims to be protracted; nor does it increase the differences between insurers and insureds. Rather, the formula is a reasonable ground on which the two parties can work out their subjectivity and come to a mutually satisfying agreement.

All examples in this article are based on actual claim settlement concepts, but names are withheld and circumstances altered to protect confidentiality.

This article was originally published in July 2004 and has been verified by the author as current.