Business Interruption

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INTRODUCTION

Understanding the insurance concepts applying to financiallosses, due to an accident or an incident, can be one of themost difficult areas of property and casualty insurance.Unless you have had the opportunity to take advancedinsurance studies on the subject or have an accounting background, you may be like many others who struggle tounderstand how this type of coverage actually works. This paper is intended as a primer to understanding insurance for business interruption losses, often referred toas time element losses.

THE PURPOSE OF A BUSINESS

All businesses, from large corporations to the corner store,have the same business objectives: to earn sufficient revenueto cover the necessary fixed expenses of the business and toearn a profit. Proceeds from the sale of goods and servicesare used to pay for the cost of goods to be sold, servicesprovided or raw materials used in manufacturing theproduct, as well as all other expenses of the business. With alittle luck, there may be some money left over – the profit.If for some reason a business cannot sell its services orproducts due to a catastrophe and income revenues cease,there willbe no proceeds available to contribute to theongoing costs and there will certainly be no opportunity tomake a profit. Therefore the business owner is forced tocontinue paying expenses that cannot be reduced oreliminated during the period of interruption of business.

March 2004

© 2004 Crawford Adjusters Canada

BUSINESS INTERRUPTION INSURANCE

By Lorne Montgomery,

CIP

BUSINESS INTERRUPTION INSURANCE – AN INTRODUCTIONMARCH 2004

2

THE OBJECTIVE OF BUSINESS INTERRUPTION INSURANCE

Loss of income or revenue for any length of time could result in total failure of the business.Business interruption insurance products are designed for this exact purpose, and serve to indemnify the business policyholder for the expenses that cannot be eliminated, along with any profit that mighthave otherwise been made, had it not been for the incident causing the loss. The underlying purpose of the insurance is to specifically provide coverage for

loss of profit

and

necessary continuing expenses

in consequence of an insured event resulting in physical damage toinsured property. There are various types of policies, ranging from those which measure only the lossof sales, or loss of production, and some which provide indemnity for an agreed amount prior to any business interruption, subject to various pre-conditions. We deal with the two most commoncoverage forms in this discussion.

TYPES OF COSTS OR EXPENSES OF A BUSINESS1. Discontinuing Expenses (Variable & Semi-variable Costs)

If the sales of the business are interrupted due to damaged buildings or equipment, some costs canbe immediately suspended. In the case of a manufacturer, costs such as the raw materials used tomake the product ultimately available for sale automatically cease because the raw materials will notbe required until production resumes. This may be the case for certain other expenses of the businessas well, such as advertising expenses. There is no point in advertising if no products or services willbe available for sale. Expenses that can be reduced, suspended, avoided

, or discontinued (allinterchangeable terms meaning the same thing), are the

variable costs.

The expenses that can only partially be reduced are

semi-variable

.Imagine a company loses a valuable piece of equipment and cannot operate until it is repaired orreplaced. Hourly workers who normally operate the machine or who are employed to handle theproduction from the machine can be sent home and payroll can be reduced (variable labourexpense). Important employees, or key employees

, such as specially trained operators, supervisors,department heads or administrators are essential personnel of the business and without them, no one would be available to organize the restoration and restart the business. These individuals continue tobe paid even though no production occurs.Electricity consumption might be reduced because less is required if damaged equipment is shutdown. However, certain electrical needs may continue, such as plant lighting and heating. This may also be the case for certain maintenance costs, especially any maintenance that had beenused in keeping the damaged or destroyed equipment in good working order during manufacturing.If the loss applies to only one piece of a collection of similar production or equipment, themaintenance costs may not be able to be reduced at all because the same maintenance personnel haveother machines to care for. Any expense that is seen to have been reduced, totally or partially, will not be included whencalculating any claim payable under most business interruption forms.

BUSINESS INTERRUPTION INSURANCE – AN INTRODUCTIONMARCH 2004

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2. Continuing Expenses (Fixed Costs)

The two primary business objectives,

fixed costs and profit,

obviously require protection

.

The documents which reveal the overall performance of a business are summarized in the

Income & Expense Statement

. The following illustration is a simple financial statement of a newsprint producer,and shows how each bale of newsprint manufactured is assigned a share of all the manufacturing andoperating costs.

QUALITY PAPER MILLS

1

Revenue10,000,000$

100%2Cost of Sales3Raw Materials (Wood Fibre)3,500,000-$ 35%4Manufacturing Supplies 1,000,000-$ 10%5Outside Services (Freight)500,000-$ 5%6Total Cost of Sales5,000,000-$ 50%

7Gross Earnings5,000,000$

8

Expenses

9Production Labour3,000,000-$ 33%10Heat & Light25,000-$ 0.0025%11Production Electricity75,000-$ 0.0075%12Rents100,000-$ 0.01%13Banking & Finance200,000-$ 0.02%14Insurance25,000-$ 0.0025%15Administration 1,000,000-$ 10%16Depreciation of Assets75,000-$ 0.0075%17Total Expenses4,500,000-$

18Net Profit500,000$

5%

COST OF SALESPRODUCTION LABOUR

1 TON OF NEWSPRINT

Each ton of newsprint represents 100% of the

net sales value of production

(Line 1 in the illustration). If each ton is sold at $500, then the business will have sold 20,000 tons per year to make the $10 millionshown on the revenue line.Fully half the value of each ton sold covers the cost of raw materials (wood fibre), manufacturing supplies (process chemicals) and any outside services (freight and packaging) used to make thenewsprint. The

cost of sales

is $5 million for a year’s worth of production (Line 6). If the mill is shutdown, that cost can be fully eliminated or avoided, so it need not be insured.Some of the expenses, which account for 44.5% of each ton sold, might be avoided or reduced in theevent of a shutdown, such as the hourly labour (ordinary payroll - 33%). In most conditions,production labour is a variable expense. There is no point in paying workers who cannot work.Sometimes, however, the employer will not want to risk losing any of the labour force and has theoption to include the value of labour as a fixed cost, so an Ordinary Payroll Endorsement can bepurchased. It usually covers the cost of the payroll for a fixed number of days, 90 days for example.Otherwise, ordinary production labour is regarded as a variable cost, except for the key employees.Heat, light and electricity are generally semi-variable, depending on how much the usage variesrelative to production. The illustration shows production electricity as a separate line, so if there is noproduction, there can be no expense incurred for production electricity and it will become a fully avoided cost. On the other hand, the plant and office will still need heat and lights, so for thisexercise, we assume such costs are fixed and the utility bills will need to be paid in full, thus the costsare fixed – 1% of the total sale in the example.

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