From time to time you will see headlines claiming that an alarming number of businesses fail after a catastrophic loss due to lack of planning or inadequate business insurance or business interruption insurance. Usually those numbers, 50% to 70%, are unsupported. I know of no reliable study that indicates an actual number.
After Tropical Storm/Hurricane Sandy I attended commercial seminars by both The Hartford and Travelers. They both indicated a Sandy-related percentage of business failures due to inadequate coverage at over 50%. Not specifically their insureds, but overall numbers.
After Hurricane Irene it was estimated that about 40% of the loss sustained was not covered. Much of this was due to the lack of Business Interruption Insurance for flood victims. Flood is not a normal covered peril on most Business Interruption Insurance policies.
Travelers Insurance indicated to us that they did a study after the tornado in Joplin, Missouri in May of 2011. According to them, the average commercial account was insured to about 60% of value. If a building had a replacement cost value of $1,000,000, on average the insured amount was $600,000.
Businesses don’t usually go broke because they don’t have adequate insurance on their building. Their biggest risk for being underinsured on the building is a coinsurance penalty on a partial loss. In the twenty “valued policy” states, the full amount of the policy is paid without regard to actual value of the building. Mortgagees and other lender/loss payees usually make sure that building and contents fire policies carry enough insurance to cover debts.
Rather, it has been our experience that businesses who have a catastrophic loss will go out of business if they don’t have adequate Business Interruption Insurance.
Business Interruption Insurance replaces business income lost as a result of an insured loss that interferes with, or stops, the operations of the business. The loss must have been caused by a covered peril, such as fire or a windstorm. This kind of coverage is not sold as a stand-alone policy, but can be added onto the business’ property insurance policy or comprehensive package policy. Since Business Interruption Insurance is included as part of the business’ primary policy, it normally only pays out if the cause of the loss is covered by the primary policy. Because coverage is limited to perils insured on your real property coverage part, you need to pay special attention to business interruption needs from flood or earthquake, which probably are not included.
Business Interruption Insurance is also known as Time Element Insurance. It provides vital protection when circumstances are beyond the control of the business owner.
Policies that include Business Interruption Insurance place a further degree of care on the insurance company to get the insured back in business as quickly as possible as a matter of preserving corporate insurance company assets.
Three Kinds of Business Interruption Insurance:
There are three kinds of Business Interruption Insurance normally involved in loss:
- Basic Business Interruption Insurance compensates the insured for the income lost or extra expense incurred during the time needed (and insured) to repair or replace the damage to the covered property.
- Extended Business Interruption Insurance provides coverage (sometimes limited by a period of time) for the income lost after the property is repaired or replaced, but before the income returns to its pre-loss level.
- Contingent Business Interruption Insurance provides coverage for the insured’s loss of income or extra expense incurred resulting from physical damage, not to its property, but to the property of providers, suppliers, or consumers of its product or services.
Losses Covered by Business Interruption Insurance
The following are typically covered under Business Interruption Insurance:
- Profits that would have been earned, and
- Operating expenses and other costs still being incurred, and
- Temporary Location Extra Expense, and
- Extra Expenses, and
- Rental Expense, and
- Civil Authority / Government mandated closure of business lost revenue.
1. Profits that would have been earned — typically reimburses the insured for the amount of gross earnings less the normal expenses that the insured would have earned, but for the interruption of the insured’s business. This coverage normally has a seventy-two hour waiting period, and will last a year.
2. Operating expenses and other costs still being incurred — this might include the salaries of key and/or skilled employees who the insured doesn’t want to lose. Unemployment insurance is inadequate for most employee’s needs. The penalties for your workers going on unemployment insurance can be substantial in increased payments. Your workers will be ready to go when you are, which will be less disruptive. This coverage normally has a seventy-two hour waiting period, and will last a year.
3. Temporary Location Extra Expense – the insured might find that it is best for his business to open as quickly as possible in a temporary location. The rent for that temporary location would be extra expense. This coverage normally has no waiting period, and will last a year.
4. Extra Expenses – this could include any extra expenses incurred due to the covered loss, including expenses that are incurred to minimalize the loss of profits. This coverage normally has no waiting period, and will last a year.
5. Civil Authority / Government mandated closure of business lost revenue. It is not uncommon for civil authorities to shutdown access to a business for safety reasons after a covered loss to the insured. This coverage normally has a twenty-four hour waiting period. The coverage has a thirty-day maximum on most policies.
The time to consider Business Interruption Insurance is when you purchase your insurance, not after a loss.
Business Interruption Insurance Review:
Many businesses close after a natural disaster because they didn’t have a contingency plan in place. A Business Interruption Review will help you a long way toward such a plan.
Review Your Current Policy
How does your policy define business interruption and what triggers the coverage? What time periods must pass before coverage takes effect? How long will the coverage stay in effect?
Develop a Loss Plan (What to Do in Case of Loss)
All carriers require prompt notice and that you act in good faith to limit the total loss. Know if there are maximum time limits within which you need to report. Make sure your insurance agent has access to copies of your policies in case yours are destroyed or unavailable. One officer in your company should have a list of policies and carriers at an off-premises location.
Know What Is Needed for Proof of Loss
Usually this will simply be a statement what happened, what property was involved, and documentation of loss.
What Needs to Be Done to Mitigate Loss or Recover Quickly
- Are alternative facilities available?
- Could you operate elsewhere?
- Can you rent equipment?
- Would it be efficient to add overtime?
- Will your current inventory satisfy your customers during loss period?
- If you use current inventory, how long will it take you to replenish inventories to the quantities before the loss?
- What is your economic advantage of having your current level of inventory?
- Do you have limited markets or suppliers?
- How much production can be deferred?
- Are long-term contracts at risk?
Interruption of Computer Operations
Do you have special circumstances or needs for a particular premises computing? This might be a trigger for need for Contingent Business Interruption Insurance.
What Will You Need for Bookkeeping
You have the burden of proof of loss. You will need to account for additional rent, relocation expense, IT additional expense, increased marketing and advertising to sustain business, and extra expense to do temporary repairs.
What Documentation Is Needed in Case of Loss
You can expect that the insurance company will need five years of tax returns, monthly sales tax returns for prior three years, W-2s and 1099s for five years, annual and monthly financial statements for five years, current aged accounts receivables, depreciation schedules, customer lists, and suppliers lists. In addition they will want articles of incorporation, by-laws and partnership agreements. They will also want board minutes, business leases, rental agreements, and all business contracts and agreements.
How Long Will You Likely Be out of Business
Under many Business Interruption Insurance policies, the period of loss will be determined by the time it should reasonably take to repair, rebuild or replace the property after the initial damage has been sustained. A lot of policies have language asserting that the period of loss does not included periods in when the business would have ceased operations for any other reason besides the insured coverage.
Do you have interdependency with other operations? If so, have you placed coverage for Contingent Business Interruption Insurance? Is a partial interruption a possibility? How long will you pay employees? Which employees? Can they help reduce the covered loss?
What is your likely exposure to shutdown by Civil Authority?
Possible Coverage Adjustments
A Business Interruption Insurance policy can be adjusted in many ways if the underwriter is willing.
The definition of suspension can be tailored to your needs, as can the definition of resumption of operations. The coinsurance provision can be adjusted. An agreed value can be set for maximum monthly coverage. Covered locations might be adjusted beyond listed and newly acquired.
Understanding Coinsurance as It Applies to Business Interruption Insurance
Calculating the amount of coverage you need might take some doing.
Business interruption policies have significant coinsurance penalties for under-insuring. A coinsurance penalty is a deduction applied by the insurance company to the claim amount. The penalty can range from 20% – 50% of a loss.
Insurance policies define the amount of insurance coverage required in terms of “gross earnings” and many policies define “gross earnings” by a different method than your business accountant might.
Assume, your business has “gross earnings” as defined by the policy of $100,000. Assume your policy has a 80% coinsurance clause. Your business must purchase at least $80,000 in coverage . . . 80% of $100,000. This requirement is meant to prevent businesses from purposefully understating their income to reduce their premiums. If the business does not insure to 80% of its “gross earnings” in coverage, a coinsurance penalty will be applied.
The penalty is derived by dividing the amount of coverage actually carried by the amount required to be carried, and then multiplied by the loss.
For example; your business (referenced above) had a Business Interruption Insurance loss of $50,000, but had only carried $50,000 in coverage.
The amount of coverage actually carried divided by the amount required ($50,000 / $80,000) = .625
Multiply that number times the loss (.625 x $50,000 = $31,250).
The Business Interruption Insurance carrier would only pay you $31,250 of your proven $50,000 loss, so your coinsurance penalty would be $18,750.
Insurers have become increasingly aware of the difficulty business-owners have with these policies. A number of years ago they combined several Time Element policies into one policy form and went to an Actual Loss Sustained form.
A large number of insurers now include in their policies what is called a Premium Adjustment Endorsement. If your policy does not have this, consider asking your underwriter or agent for the endorsement. The Premium Adjustment Endorsement helps eliminate the risk by allowing the business to insure for an outside loss possibility based on Gross Earnings. At the end of the policy period, the premiums are recalculated according to an audit, and any excess premiums are returned.
You need to make special considerations for seasonal businesses and a business that is rapidly growing.
Calculating Your Needed Coverage Amount for Business Interruption Insurance
The following is an extremely simplified methodology and if your business is larger or more complex, you need to involve an insurance agent and accountant.
Calculate the net sales of the business. This figure can be reached by subtracting several adjustments from gross sales. Adjustments might include, but not be limited to:
- discounts given, and
- returns and allowances, and
- bad debt, and
Calculate total revenues by adding net sales and other income that would be lost should your normal business operations be interrupted by a covered loss. Other income could include, but is not be limited to:
- rent, and
- interest, and
- service fees.
Calculate the gross earnings of your business. This figure is often the result of the total revenues less the merchandise or materials consumed. There are two factors that go into the merchandise and materials consumed:
- purchases during the year, and
- change in inventory (the beginning inventory minus the ending inventory).
Calculate your gross sales after discontinued expenses. Discontinued expenses are those expenses that will not be incurred during the time of the business interruption. These expenses could include:
- payroll that would not continue, and
- rent, and
- utilities, and
- delivery, and
- advertising, and
Subtract the total of the discontinued expenses from the gross earnings.
Determine the probable duration of your business interruption. There is no method to determine that duration. You need to guestimate how long you believe it would take you to rebuild or relocate your business in a worst-case scenario, given the advice of your insurance and accounting professional.
If you feel you require six months of Business Interruption Insurance, multiply the gross earnings after discontinued expenses by 50%. If you require nine months of Business Interruption Insurance, multiply the gross earnings after discontinued expenses by three quarters 75%.
Other Enhanced Insurance articles related to Business Insurance:
Business and Commercial Insurance (Includes Video)
Building Content & Glass Insurance
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