The most fundamental elements in resolving business interruption claims are a
correct application of the BI formula and the integrity of the calculations
behind it. Examples help illustrate this point.
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.