Machinery Loss of Profits Insurance

Münchener Rück Munich Re

This publication was conceived, written and realized in terms of both graphic design and typography exclusively by Munich Re staff. © 1997 Münchener Rückversicherungs-Gesellschaft Address for letters: D-80791 München Germany http://www.munichre.com Order number 0224-E-e/175.1 The paper used for this brochure was produced without chlorine bleaching.

Machinery Loss of Profits Insurance

A publication of the Munich Reinsurance Company 1

Increasing complexity and automation of industrial plants, e.g. in petrochemistry, have led to a higher claims potential in the event of business interruptions.

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Introduction Under both machinery and fire insurance, indemnity is provided, in respect of damaged or destroyed machinery, solely for the material loss sustained by the insured. These types of insurance do thus not protect the insured against all the losses which arise in connection with a fire or the breakdown of machinery, since in most cases a material loss also causes an interruption or interference of the insured’s business operations. The result is a financial loss in the form of lost profit and unearned standing charges. In many cases the loss sustained as a result of an interruption or interference of business operations by far exceeds the mere material loss. An awareness of the need for insurance protection against the financial consequences of material damage arose at the beginning of this century, and the result was the introduction of the two variants, loss of profits following fire insurance and loss of profits following machinery breakdown insurance – also called machinery loss of profits (MLOP) insurance. As the size of modern production facilities increases, MLOP insurance is becoming more and more important. The individual production stages in modern processes are often accomplished by just one machine, the failure of which leads to substantial interruption losses. Moreover, the new electronics LOP has been introduced. In principle, electronics LOP is the same as MLOP; but it offers the extended scope of cover of an electronic equipment policy. Munich Re will be glad to support clients in this difficult class of insurance by assisting in inspections, preparing quotations, settling claims and providing training courses. In the following, the basic features of MLOP insurance will be dealt with.

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1 Subject matter insured MLOP insurance provides cover for the actual loss of profits sustained as a result of a business interruption caused by material damage indemnifiable under machinery insurance. MLOP insurance provides indemnity also in cases where the material loss amount falls below the deductible to be borne by the insured under the machinery cover. Basically speaking, a loss due to an interruption or interference of business operations is made up of the following factors: a The reduction in operating profit, i.e. the profit from selling the goods produced and traded by the insured and from rendering services.

b The standing charges, i.e. the costs incurred entirely or in part if operations are interrupted or impaired. These comprise wages and salaries, including social security contributions if they continue to become due during the interruption; interest, economic depreciations, basic rates for third-party energy, expenses for the current upkeep of buildings and machines, rent, taxes and other non-specified working expenses, expenses for the preservation of vested rights, insurance premiums and other business expenses, e.g. guaranteed commissions.

Not included in standing charges, however, are turnover taxes and expenses for raw or auxiliary materials, fuels and goods purchased unless they serve to continue operations; excise taxes, freight charges, specified licence and inventor’s fees and similar expenses. Loss minimization costs are also covered if they lower the insurer’s obligation to indemnify. These include expenses that avoid, minimize or terminate an interruption loss soon after the occurrence of material damage.

In the event of damage to the company power plant, business interruption can often be avoided by buying third-party energy. Increased cost of working insurance covers such cases.

60 MW diesel aggregates in a diesel power station.

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Loss minimization is of great importance in MLOP insurance. The following are examples. – Purchase/sale of semi-finished goods – Provisional repairs – Early overhauls

– Overtime work, additional shifts, work on Sundays to accelerate repairs on undamaged machines to reduce the interruption loss – Rent of machinery (e.g. transformers, boilers, compressors) – Recommissioning of old machinery

If, in the course of arranging the insurance, it becomes evident that enterprises can continue to work after material damage, e.g. by – acquiring third-party electricity if the company power plant fails, – renting machinery, – applying alternative methods,

– Purchase of non-identical (but compatible) machinery – Express, airfreight

– Shifting of operations to alternative plants – Making up for the production loss after reopening

– purchasing semi-finished or finished goods, then increased cost of working insurance is recommended for the plants in question as an alternative to full MLOP cover.

Damage to a steam turbine generator in a paper mill.

2.2 MW back-pressure steam turbo-generator in a sugar factory.

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2 Indemnity period limit and time excess To make a risk assessable for the insurer, it is necessary to apply certain limits to the period for which indemnity is provided. This is done by specifying a period of indemnity.

2.1 Indemnity period limit In contrast to a material loss, the loss of profits following a business interruption depends on the time factor involved. In other words, the longer the period for which operation is interrupted or impaired, the greater the loss of profits. For this reason it is essential to set a certain limit for the period during which the insurer is obliged to provide indemnity for an interruption loss. This is done by the insured specifying an indemnity period limit which represents the maximum time for which an insurer is liable for loss of profits. The period of indemnity begins on the date on which material damage could first be said to have occurred, as

judged according to the recognized principles of engineering, at the latest, however, on the date when the loss of profits commenced. Generally the indemnity period limit is three, six, nine or twelve months; a period of more than twelve months can be agreed on request. The basic rule is that the indemnity period limit should relate to the amount of time required for removing the interruption loss, i.e. for repairing the machinery damaged or for the delivery of new machinery in cases of a total loss, assembly and trial run. Higher premiums are, of course, charged for long indemnity period limits.

Damage to a piston compressor.

Broken calender of the coating unit in a paper mill.

Even a short circuit in coils of a large electric motor driving an important machine may lead to major LOP damage.

Destruction of the gearing of an offset printing press due to the failure of control systems.

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2.2 Time excess Under normal circumstances, losses due to interruption lasting for a short period of, say, up to seven days can be borne by the insured company itself. It is, therefore, advisable to exclude such minor losses from the cover provided. This is done by specifying a time excess of a number of days during which any loss of profits arising is borne by the insured. This is arrived at by multiplying the average indemnifiable daily loss by the number of days of the time excess agreed (proportional time excess).

The minimum time excess is two days, but normally it should not be less than seven days. The time excess to be applied depends on the quantity of finished products stored, the possibilities of catching up with lost output, and the financial burden which can be accepted by the insured company itself. If a long time excess is agreed, the premium may be reduced considerably.

Failure of the public power supply and deterioration of the material processed can be covered under an MLOP policy. This feature is of importance for an aluminium smeltery, for example.

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3 Sum insured, value insured, valuation period The following terms are also of great importance in MLOP insurance: 3.1 Sum insured The sum insured is made up of the operating profit and the standing charges in the course of twelve successive calendar months (i.e. normally the business year). 3.2 Value insured The value insured is made up of the operating profit and the standing charges which the insured would have earned without taking any indemnifiable interruptions in the valuation period into consideration.

3.3 Valuation period The valuation period comprises twelve months and ends at the point in time at which interruption lossses no longer occur (lost operating profit and standing charges), at the latest, however, at the end of the indemnity period limit.

DM/Time

Damage

Material damage

Interruption Indemnity period Indemnity period limit
The indemnity period ends at the point in time at which interruption losses no longer occur.

Time

Operating profit

Operating profit

Wages, salaries, pensions Interest, depreciations Non-specified taxes Fixed costs (e.g. licence fees) Basic power rates Insurance premiums

Fixed costs

Sum insured

Turnover

Raw, auxiliary materials; fuels VAT, turnover tax Energy consumption Postage and freight charges Licence fees (non-specified) Contract penalties

Variable costs

Determination of the sum insured.

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4 Underinsurance On the basis of the sum insured and the value insured, it is possible to check whether underinsurance is involved when a loss of profits claim arises: This is the case whenever the sum insured is lower than the value insured. Underinsurance can be avoided by making allowance, when calculating the sum insured, for the probable trend of the insured’s business in the financial year following the current period of insurance.

If the trend of the current period of insurance alone were considered, losses occurring towards the end of the year might cause substantial underinsurance. On the other hand, a special premium refund system is provided by MLOP insurance in the form of a premium adjustment clause to avoid the insured having to pay an excessive premium due to a very conservative fixing of the sum insured. According to this clause, a pro rata return of premium is made in respect of that share of the sum insured which exceeds the actual value insured for that period of insurance.

Electronics LOP insurance covers electronic medical equipment for which no alternative exists.

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5 Determination of premiums To make MLOP insurance successful, it must not only cater for the specific needs of the market but also charge premium rates which are commensurate with the risks involved. Due allowance must therefore be made for the following factors when determining premiums: – The general and the specific technical risk of the machinery to be insured – The “moral” and technical hazard relating to the user

– The effect of machinery breakdowns on the operating profit and standing charges (factor of relative importance) – The reserve facilities and spare parts available – The possibilities of loss minimization – The general economic and political conditions

Red-hot shell of the rotary kiln of a wood pulp works after destruction of the lining.

Wood pulp and paper industry plants are very exposed and therefore often protected by MLOP insurance, such as this paper machine for newspaper.

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5.1 The general and the specific technical risk of the machinery to be insured The general technical risk of a machine is dependent on its average claims frequency and the average interruption period. These two fundamental values must be calculated on the basis of statistics. Provided that maintenance of the machinery is first class, these values depend primarily on the type of machine involved and its capacity. This basic premium rate resulting from these criteria applies to machinery of proven design which is in good condition. However, it must be noted that these preconditions are often not met. Then the specific technical risk must be considered in the basic premium rate by applying a loading.
Company “infrastructure” is an object for MLOP insurance, e.g. boilers for the generation of process steam.

The protection of MLOP insurance also applies to small machines, e.g. rotary offset printing presses.

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5.2 The “moral” and technical hazard relating to the user The moral hazard depends on how qualified the management and the staff of a plant are, and is also influenced by the standing of the firm in the view of manufacturers and service organizations. The following figures show to what extent the moral hazard is influenced by the quality of staff. Of 1,740 claims involving the most varied types of machinery, it was found in a study that 62% were caused by faulty operation. Statistics compiled in the United Kingdom show that of 500 losses involving ammonia compressors, approximately 53% were due to human error. It is therefore quite obvious that when a risk is assessed, considerable importance must be attached to the training of the operating personnel by the insured.

The technical hazard of the risk depends on the plant organization, the loss prevention measures taken (regular maintenance, systematic supervision by means of indicating and measuring instruments, provision of safety devices and carrying out of non-destructive tests), and the possibility of repairing damage either at the plant itself or at least in the same country. Should the inspection of a plant to be insured reveal that standard loss prevention measures have not been taken or that repair work must nearly always be done abroad, insurance coverage can only be provided if a corresponding loading is charged on the premium.
Compressors are often the reason for bottlenecks; their failure may lead to the standstill of the entire enterprise.

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5.3 The effect of machinery breakdowns on the gross profit (factor of relative importance) Allowance is made for the effect of the breakdown of machinery by means of the so-called factor of relative importance. This factor corresponds to the percentage effect which a complete standstill of a machine during the entire period of insurance would have on the operating profit and the standing charges. When determining the factor of relative importance, allowance should not be made for the production. It should not be fixed according to possibilities of loss minimization. Ideally, factors of relative importance should be fixed on the basis of a flow chart which shows, in addition to these factors, the capacities of the machines and any reserve machinery.

It is very important for the insured to determine and indicate the factor of relative importance himself, as he is the only one who has the necessary detailed knowledge. If the factor indicated is too low, underinsurance will be claimed.

5.4 The reserve facilities and spare parts available The reserve factor is determined on the basis of the information provided regarding the reserve facilities available, and directly influences the premium calculation. The reserve factor is always less than 1, as any reserve facilities available will reduce the risk borne by the insurer. It is mainly dependent on the type and number of machines available, the number of failures if one machine stands still, and the ratio between the total capacity available and the load requirement. The availability of spare parts is taken into account when calculating the premium by a corresponding spare parts factor, also less than 1.

Machine tools installed in series: 100% 100% 100% 100%

1

2

3

4

in parallel: 60% 100% 100%

1 2
40%

3 4

100%

100% stand-by

Factors of relative importance depend on the operating configuration.

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5.5 The possibilities of loss minimization The results of MLOP insurance depend to a great extent on the loss minimization measures taken. It is therefore quite obvious that this topic deserves special attention. Such measures for loss minimization are, for example, the hiring of substitute motors, generators, transformers, boilers, small turbines, etc. or the speeding up of repair work by carrying out complex welding operations even on high-alloy materials or using metalock and other special repair methods on the damaged components.

Tube mill of a cement factory.

Discussion of loss minimization possibilities at the damaged front wall of a cement tube mill ...

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Airfreight, if necessary with chartered wide-bodied aircraft, shortens interruption periods considerably.

... and the front wall after provisional repair using the so-called metalock method.

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5.6 The general economic and political conditions Apart from delays in the repair of damaged machinery due to the location of an insured plant, it is also quite possible that the general economic and political conditions prevailing in a country will result in an extension of the normal repair period. Such extensions may, for example, be caused by the time required for procurement of import and export licences, by a shortage of foreign exchange, or by provisions or restrictions imposed by governmental authorities or other public institutions. In many countries it is often not possible, when concluding a policy, to anticipate all of these possibilities, so the risk involved for the insurer must be limited by applying a so-called “delay in repairs clause”.

Conclusion Modern machinery loss of profits insurance is a suitable means of meeting the increasing need on the part of industry for comprehensive tailor-made insurance protection from the consequences of business interruptions. Experienced engineers must carefully assess the plants to be insured and calculate the premiums, duly taking into account all the factors influencing the risk conditions in the most various countries. In this way it is possible for insurers to obtain satisfactory results and further expansion in this particularly hazardous class of business.

Modern slab line controlled by a process computer. Even small damage may lead to complete standstill.

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Sources of illustrations: Allianz (6); Aluminium-Zentrale (7); Archives (6); Bird & Ass. (14, 15); KWU (15); Kymmene Oy (10); Loos (11); Lurgi (2); MAN (4, 11); Mannesmann (12); Munich Re (5, 8, 13); Philips (9); Polysius (14); Siemens (4); Verein deutscher Eisenhüttenleute (16); Voith (10).