LOSS OF PROFITS INSURANCE

CONCEPTS

Hari Radhakrishnan
Regional Director
First Policy Insurance Brokers Pvt Ltd
www.firstpolicy.com
 PREFACE

Loss of Profit (LOP) Insurance is considered as a tough subject by many students and
prac oners of insurance.

I believe it is more conceptual than it is tough. Since concepts are not understood, o en by
experienced professionals, LOP becomes hard to grasp.

I think a be er way to learn anything that is conceptual like LOP is through Socra c method
of probing, ques oning and challenging.

I have tried to demys fy LOP with some explana ons and challenges of the concepts in this
booklet.

HARI RADHAKRISHNAN

Page | 2
 INDEX

1 MATERIAL DAMAGE PROVISO 4

2 THE SPECIFICATION 6
3 LOSS CALCULATION 8
4 THE INDEMNITY PERIOD 9
5 THE STANDARD GROSS PROFIT 11
6 ADJUSTMENTS 13
7 INCREASE IN COST OF WORKING 15
8 THE PREMISES 17
9 DEDUCTIBLES 18
10 SUM INSURED & UNDERINSURANCE 20
11 INDEX OF BUSINESS ACTIVITY 22
12 EXCLUSIONS 24
13 DEPARTMENTAL CLAUSE 26
14 CONTINGENT BUSINESS INTERRUPTION 28
15 ACCUMULATED STOCKS 30
16 ADDITIONAL INCREASED COST OF WORKING 32
17 INDEMNITY PERIOD DEFERMENT 34
18 SUM INSURED ADJUSTMENT 36
19 LEEWAY CLAUSE 38
20 CONTRACTUAL DAMAGES 39

Page | 3
 PART 1
MATERIAL DAMAGE PROVISO

The loss of profit policies would have the following provision in the insuring
agreement:

“At the me of the happening of the Damage there shall be in force a Fire Policy
covering the interest of the insured in the property at the premises against such
Damage and that payment shall have been made or liability admi ed thereunder.
However, the Proviso shall not apply where payment is not made under Fire Policy,
solely due to opera on of a proviso in fire policy excluding liability for losses below
a specified amount.”

Q. Why should an LOP policy be linked to a fire policy? Why can’t it be a free
standing policy in its own right?

The objec ve of the policy is to pay for loss of profit (as defined in the policy
specifica on) to a material damage loss, not ed to any non-damage event, such
as, unavailability of raw material or power. The linkage between the two policies
helps establish cause of loss.

Q. But the insuring clause can list down all covered perils so if someone wants a
standalone LOP policy, he could get that without necessarily taking a fire
policy?

The linkage eliminates the need for the loss of profit underwriter into causa on
of loss. This makes administra on of LOP policy simpler and free of disputes, as
causa on test is already passed by admission of the material damage claim.

Q. But can’t the insured be considered as his own insurer for fire damage and
adjudica on of liability done? Can’t he retain the risk himself?

Theore cally yes, but there is an issue that comes up with that approach. At the
me of loss, the insured being self-insured and lacking cash flow from his
business that is already interrupted, may not have sufficient opera ng surplus to
undertake prompt repairs, which can prolong the period of interrup on.
Availability of material damage policy from an insurer helps prevent that
situa on by providing access to funds for restora on.

Page | 4
Q. But the clause also says that loss of profit claim would sll be paid if the material
damage loss falls within deduc ble? How will funds be available then? Isn’t that
contrary to the previous asser on?

Not necessarily. There can be situa ons where the material damage event can
be minor but interrup on period can be long. This happens when smaller value
cri cal items with longer lead mes for procurement are damaged. It would be
unfair to deny such cases for the simple reason that the material damage loss fell
within the deduc ble. Fund availability from fire policy is not cri cal to
undertake repairs since loss itself is small. Such situa ons are taken care of by
this proviso.

To summarize, the material damage proviso helps in the following:

👉Establish causa on
👉Efficient LOP policy administra on
👉Ensures funds flow to the insured to undertake repairs and reduce down me.

Page | 5
 PART 2
THE SPECIFICATION

A loss of profits policy usually has the following parts:

👉 The policy jacket or wrapper, which details the insuring agreement, general exclusions
and condi ons.

👉 The Specifica on which details how the claim calcula on would be done.

👉 The Schedule which gives details of risk insured.

👉 Endorsements which extend coverage or provide clarifica ons.

Q. What is the need for a specifica on in the LOP policy?

The policy is meant to provide indemnity towards loss of business income. Let’s say a
business made 1000 units at Rs. 100 per unit and following the loss, it made only 500
units. So the loss is simply 500 X Rs.100 = Rs.50,000. Quite simple. Why get into gross
profit, rate of gross profit, standing charges, standard gross profit, standard turnover
and such other things? Why make it complicated?

The problem with the above approach is that sales or turnover includes variable costs.
These are input costs such as cost of raw material, fuel, power etc. They are incurred
only to the extent the business produces. If the claim is assessed as the cost of drop in
sales, then the insurer would be paying for input costs more than the insured did
actually spend.

The Insured cannot be paid what he hasn’t lost or has saved. Otherwise, the insured
would profit from insurance and the principle of indemnity would be violated.

Q. So does this mean that this methodology is applicable to every type of business? What
if a business does not have variable expenses and all expenses are fixed?

If the business has no variable cost, then LOP specifica on is not required. For instance,
property owners who lease out their assets can insure loss of rent as an extension to
their material damage policy.

Page | 6
Q. If that be so, why is there a gross rental specifica on?

This specifica on is suitable for wet leasing (as opposed to dry leasing), where there are
input costs such as fuel and power. There can also be rent abatement following loss, so
gross rental specifica on becomes more appropriate, to get the true picture of
indemnity.

To conclude, the basic premise of the specifica on is to eliminate variable costs that the
insured saved from the loss of sale and arrive at the true loss. Of course, this is not the only
purpose and there are others which will be covered in subsequent parts.

Page | 7
 PART 3
LOSS CALCULATION

As discussed in the last part, the insured can’t be paid for loss of sales, but the value of lost
sales, a er adjus ng for variable costs or working expenses, which is called gross profit (GP).

The objec ve of the policy is to find out what insured would have earned in GP, had it not
been for the loss of produc on, following the insured loss event.

Q. So why can’t there be a fixed GP formula based on historical produc on numbers? A er

all, the historical numbers factor the business trends. This would make the calcula on
simple.

For instance, the GP formula is fixed at 65% of sales based on historical figures. If 500
units is lost, Rs.100 is unit price, GP payable is:

65% X 500 X Rs. 100 = Rs. 32,500/-

Why can’t this be done?

Loss of profits calcula on is a counterfactual. A counterfactual is something that deals

with the ques on “what would have been” if something had or had not happened.

It’s always a projec on, not an exact thing. In property damage claims, it is exact, as bills
and invoices are there. In LOP there is no such thing.

A “norma ve” or fixed formula-based assessment will introduce “basis risk”, which
means loss paid will be either higher or lesser than the actual indemnity payable to the
insured. This can work for or against the par es.

Q. But historical figures will ensure that the norma ve rate is accurate, shouldn’t it?

The historical figures will adjust only for past performance, not necessarily future
performance. We can’t always predict the future performance with past data. The 65%
GP rate in the example may or may not be achieved with a reasonable confidence level.

Q. But the LOP loss adjustment itself is counterfactual so basis risk is ingrained in it, right?
Yes. But the objec ve of the LOP loss calcula on is to keep the basis risk to the
minimum. It endeavors to achieve a result “as nearly as may be reasonably prac cable”
to the true indemnity payable under the policy.

To conclude, we can’t have a fixed formula for finding out the loss of GP. We need reference
points to measure the loss which will be dealt in the next part.

Page | 8
 PART 4
THE INDEMNITY PERIOD

So far in this series on LOP, the following aspects have been covered:

👉 There has to be a proven causa on under a concurrent material damage policy for LOP
claim to trigger.

👉 Value of lost sales or turnover cannot be paid if the business has variable costs, which
needs to be deducted from sales to arrive at Gross Profit (GP).

👉 The GP cannot be arrived at by using a fixed formula and would need situa onal
adjustments.

Given the above, we need reference points to calculate the GP the insured would have made
if it weren’t for the loss.

The first reference point is the indemnity period (IP) which is defined as under:

“The period beginning with the occurrence of the damage and ending not later than
…..months therea er during which the results of the business shall be affected in
consequence of the damage.”

Q. Does the IP correspond to the period required for repairing/reinsta ng the damaged
assets back into produc on?

No. The IP corresponds to the period required for the business to come back to its
previous levels of produc on prior to the loss. So IP includes the period of restora on
plus period of recoupment necessary to reach levels of produc on prior to loss.

Q. Does this mean the insured gets a free pass to take as much me as he wishes to get
back to the pre-loss produc on levels?

No. The IP has an outer limit of 12 months, 18 months or 24 months etc., to be chosen
by the insured. If the IP chosen is 12 months and the period of restora on plus period of
recoupment exceeds 12 months, the liability is restricted to 12 months only.

Page | 9
Q. What if there is a market downturn and the insured has no incen ve to restart the
produc on at the earliest? Can’t he deliberately slow down restora on to collect the
insurance claim?

As per the policy condi ons, insured is expected to do due diligence and act as a prudent
uninsured and minimize the loss. If the insured has taken too much me to repair, the
insurer can choose to restrict IP to a reasonable period under the circumstances.
Further, any market downturn will be factored into the loss calcula ons for arriving at
the loss of gross profit.

To conclude, IP is dynamic and depends on various factors some of which are within the
control of the insured while others are not. Close co-opera on between the insured and the
insurer is necessary to get the best outcomes for both.

Page | 10
 PART 5
THE STANDARD GROSS PROFIT (SGP)

In the previous part, the discussion was on indemnity period (IP) as a reference point.

The second reference point or measurement unit or ruler, to calculate the claim under an
LOP policy is the SGP. This is the likely value of the GP, the business would have generated
during the IP, had it not been for the loss event.

Loss = Standard Gross Profit - Actual Gross Profit earned during the IP.

Assuming IP of 12 months, if the business produced 1000 units @ Rs.100 in the 12 months
prior to the loss, with a rate of GP of 65%,

SGP = 65% X 1000 X Rs.100 = Rs. 65,000

The rate of GP is considered by dividing the GP for the full financial year immediately before
the loss by the turnover for that financial year.

Following the loss, the business only produced 500 units in the same 12 months period (IP),
with rate of GP of 65%,

Actual GP = 65% X 500 X Rs.100 = Rs. 32,500

So adjusted loss = Rs. 65,000 - Rs.32,500 = Rs.32,500

Q. Why is SGP taken with reference to the period immediately preceding the loss?
This period is most likely to mirror the performance of the business. If you take too far
backwards, it may not truly reflect the performance.

Q. Why is the rate of GP for the financial year immediately before the loss? Why can’t it be
the financial year following the loss?

The financial year partly or fully coinciding with the indemnity period will not truly
reflect the rate of GP since the produc on or turnover achieved is less than a normal
year due to the loss event. It is be er to have a full year with uninterrupted produc on
which will reflect the rate of GP more accurately.

Q. What if the business is a start up in the first year of opera ons?

The New Business Clause can be inserted which provides for calcula on of SGP using
the turnover achieved from date of start of opera ons to date of loss.

Page | 11
Q. What if the plant was under closure for a substan al me during the immediate pre-loss
period?

One can go a year or two backwards if that’s the case. It’s not cast in stone that the
immediate past period only can be considered. Whatever suits best can be taken with
sufficient logic.

To conclude, the above loss calcula ons are projec ons based on historical values of
turnover and financial performance, which may need further refinements or adjustments. In
the next part, these adjustments would be discussed.

Page | 12
 PART 6
ADJUSTMENTS

In the last part, the discussion was on Standard Gross Profit (SGP) and how it can be used as
a benchmark to determine the LOP claim.

The SGP based on immediate past financial performance is formulaic. It is a projec on.
However, in prac ce the formula may not hold good and one needs to make some
adjustments to reflect the real situa on of loss.

There are broadly two adjustments:

👉 Adjustment for business trends:

This involves adjus ng for special situa ons, such as increased produc on capacity in the
accident year compared to previous year, seasonality of business, fluctua ons in market
demand or any such other factor that can influence the turnover or GP numbers.

👉 Adjustment for savings in fixed expenses:

The policy says “Less any sum saved during the indemnity Period in respect of such of the
charges and expenses of the business payable out of Gross Profit as may cease or be
reduced in consequence of loss, destruc on or damage.”

Q. Why is this adjustment needed?

The loss working, which is SGP less achieved GP, is predicated on fixed costs staying fixed
before and a er the loss. If the fixed costs reduce or get saved, then insured would be
paid more than he has actually lost. This will violate the principle of indemnity. Hence
the above adjustment takes out any savings in fixed costs from the equa on.

Q. Won’t these adjustments make the whole process subjec ve?

Yes, there will always be some element of subjec vity in any LOP loss adjustment. The
subjec vity can be minimized by proper reasoning, but not completely eliminated.

Page | 13
Q. Doesn’t the adjustment of LOP claim leave a lot in the hands of the loss adjuster? How
does one ensure contract certainty and ensure that the insured is paid what he is owed?

The trend adjustment requires thorough analysis of insured business and financial
statements for several financial years, produc on capaci es and u liza on, economic
condi ons, market demand and forecasts. Therefore, the loss adjuster has to be
competent and he should exercise sound judgment.

To conclude, LOP adjustment is as much science as it is an art. In the next part, we will
discuss increased cost of working (ICOW).

Page | 14
 PART 7
INCREASE IN COST OF WORKING (ICOW)

The insuring agreement of the LOP policy says that the insurer would pay for loss of Gross
Profit due to:

(a) Reduc on in Turnover

and

(b) increase in Cost of Working

The loss of GP due to (a) above had been discussed in the previous parts.

Q. Now coming to (b), why should the policy pay for ICoW? What’s the logic?
For any prudent insured, the first priority in a loss situa on is to avoid reduc on in
turnover. While the insurer may reimburse the insured for loss of GP, there are other
aspects like loss of reputa on or goodwill that the LOP policy would not cover, if the
insured fails to meet his supply obliga ons to the market.

So, he may like to incur addi onal costs to maintain turnover as much as possible, to
avoid consequences of turnover reduc on.

Q. Is there a limit to the ICoW that the policy would pay?

The insured cannot spend more in ICoW, than the loss of gross profit that he would
avoid and hope to be reimbursed in full.

Assume the insured is producing 1000 units per annum @ Rs. 100 per unit and the rate
of GP is 65%. There is a poten al loss of turnover by 500 units. The monetary limit upto
which the insured can spend to avoid this reduc on in turnover is :

500 X Rs.100 X 65% = Rs.32,500

So the maximum budget available to the insured towards the ICoW spend is Rs.32,500.

If the insured spends more than that, let’s say Rs.35,000, then he has to bear Rs.2,500
excess expenditure himself.

Q. Does this mean that the insurer would only pay either loss of GP or ICoW?
No. Let’s say insured can par ally reduce the reduc on in turnover by 200 units.

Page | 15
 Loss payable would be:

(a) Towards loss of GP: 300 X Rs.100 X 65% = Rs.19,500

(b) Towards ICoW : 200 X Rs.100 X 65% = Rs.13,000 (maximum payable)

Total adjusted loss : Rs.19,500 + Rs. 13,000 = Rs.32,500

Q. Is the ICoW a loss minimisa on expense?

Not necessarily. Some mes the ICoW does not result in any overall reduc on in loss
otherwise payable.

In the above prac cal example, the liability of the insurer is the same, with and without
incurring ICoW, which is Rs.32,500.

But there can also be situa ons where a expenditure of a smaller ICoW would result in
complete avoidance or dras c reduc on in turnover.

For instance, in the above example, let’s say instead of Rs.32,500, an expense of
Rs.10,000 would avoid the reduc on in turnover of 500 units. In this situa on, the
insurer is benefi ed as there is loss minimisa on due to ICoW (which will be Rs.32,500-
Rs.10,000 = Rs.22,500).

In the next part, another important concept of LOP, which is the premises concept would be
covered.

Page | 16
 PART 8
THE PREMISES

The business premises is an important considera on in LOP policy. The policy schedule
men ons the premise or premises where the insured conducts his business. If an insured
event happens at the insured premises and the business is interrupted, the policy pays out.

Essen ally, the policy covers the DEPENDENCE that the business has on the premises for
turnover of goods or services.

Q. What if there is no dependence? If the business is on cloud-based technology and can

be remotely operated from anywhere?

If there is no dependence, there is no LOP to be insured. Businesses that are not

premises-dependent have no u lity for LOP policy. The policy requires physical loss or
damage at the premises which causes LOP. If there is no physical damage, there is no
LOP.

Q. But s ll there can be some addi onal expenses such as the cost of hiring alterna ve
premises to maintain turnover?

These one-off expenses can be covered under the material damage policy itself. This will
be more economical than buying an FLOP policy.

Q. If there are mul ple premises where business is carried out and all of them are covered
under the policy, does the policy cover them separately?

No. They are considered together, whether insured or uninsured, as per the memo
below a ached to the policy.

“If during the Indemnity Period goods shall be sold or services shall be rendered
elsewhere than at the premises for the benefit of the business either by the Insured or
by others on his behalf the money paid or payable in respect of such sales or services
shall be brought into account in arriving at the Turnover rduring the Indemnity Period.”

So if the insured is able to partly make up for lost produc on at the premise affected by
insured loss by ramping up produc on at an unaffected loca on, only the net impact
would be considered, not the loss of turnover at the affected premises in isola on.

In the next part, the applica on of deduc ble under LOP would be discussed.

Page | 17
 PART 9
DEDUCTIBLES

Like in other insurance policies LOP policies have a deduc ble. Usual prac ce is to have a
me deduc ble in certain number of days, eg., 7 days, 14 days, 21 days, 28 days etc.

Q. Why have a me deduc ble instead of a flat monetary deduc ble? A deduc ble
involving a fixed monetary amount is easier to apply and gives certainty to both the
insurer and insured.

The deduc ble on the basis of the number of days gives be er correla on with how the
LOP loss is adjusted. The loss is based on the number of days the plant remains affected
and deduc ble is set as a number of days out of the total number of days (IP) out of that
which the insured has to bear.

Q. How is the number of days translated into a monetary value for applying in the loss
adjustment?

There are various ways in which it is done:

1) Wai ng period basis

2) Average daily value basis
3) Standard GP basis

The following example would illustrate the difference between these:

A plant produces 1000 units @ Rs.100 per unit in the 12 months prior to the loss. The
rate of GP is 65%. Following the loss, it produced 500 units during the IP of 12 months .
The policy had a me deduc ble of 14 days.

Wai ng period basis

Let’s say during the first 14 days following the loss, the actual produc on was 5 units.
Had there been no loss, the standard turnover for 14 days would have been achieved.
Let’s take this as 38 units.

Time Deduc ble = (38 - 5) X 100 X 65% = Rs. 2,145

Average daily value basis

Adjusted loss = 500 X 100 X 65% = Rs.32,500

Average daily value of loss = Rs.32,500/365 = Rs.89
Value of loss for 14 days = Rs.89 X 14 = Rs.1246

Time deduc ble = Rs.1246

Page | 18
 Standard GP basis

Standard GP = 1000 X 100 X 65% = Rs.65,000

Standard GP per day = Rs.65,000/365 = Rs.178
Standard GP for 14 days = Rs.178 X 14 = Rs.2493

Time deduc ble = Rs. 2493

To summarize, as one can see, the average daily value basis is the most favourable of the
three from the insured’s point of view. However, in the Indian market, the standard GP basis
is followed which is the least favourable to the insured.

However, the difference between methods won’t be there if the business is totally shut
down and actual turnover achieved is zero during the IP.

The next part of this series will be about sum insured fixa on and underinsurance under LOP
policies.

Page | 19
 PART 10
SUM INSURED & UNDERINSURANCE

Sum insured under LOP policy is the Gross Profit that is expected to be achieved by the
insured in the policy period adjusted for the IP chosen.

The insured has to take the previous year’s Gross Profit and adjust the same for business
trends (upwards or downwards) to arrive at the projected sum insured for the policy period.

There are two ways of arriving at SI:

👉Addi on method
👉Difference method

In the addi on method, the standing charges (or fixed expenses that do not reduce with
turnover reduc on) are added to the net profit. The standing charges (SC) need to be listed
in the policy.

In the difference method, the working expenses are reduced from the turnover (including
change in stock value) to arrive at the GP. The standing charges need not be listed.

Q. Is there any advantage for one method over the other?

Addi on method is more precise as it iden fies all SC. However, the insured can miss
out insuring any par cular SC, if he fails to properly iden fy it as an SC instead of a
variable expense.

Difference method is a bit imprecise, as it assumes all expenses other than specified
working expenses as SC. It need not be so, in which case, there can be over insurance.

Q. When SI is only an es mate, how is it jus fied to have an underinsurance provision,

when the insured can honestly underes mate the SI?

The policy has a return of premium clause which provides for refund of premium if
there is over insurance based on audited annual reports following the policy period. So
the policy encourages or incen vises the insured to err on the side of cau on while
fixing the SI.

Page | 20
Q. How does underinsurance apply?
For both addi on and difference methods, the following provision applies:

“….if the Sum Insured by this Item be less than the sum produced by applying the Rate
of Gross Profit to the Annual Turnover, the amount payable shall be propor onately
reduced.”

So the SI should not be less than the standard gross profit (SGP).

For addi on basis, the following Memo 2 also applies:

“If any Standing Charges of the business be not insured by this policy then in
compu ng the amount recoverable hereunder as increase in Cost of Working that
propor on only of the addi onal expenditure shall be brought into account which the
sum of the Net Profit and the Insured Standing Charges bears to the sum of the Net
Profit and all the Standing Charges.”

Q. Why does the above Memo 2 apply only to the addi on method and not to the
difference method? Why are there two under insurance provisions? Won’t the first one
be enough?

In the difference method , the en re standing charges are intended to be covered as

working expenses are deducted from Turnover to work out the sum Insured.

Under addi on method, you are allowed to select the standing charges and so few of
the standing charges could have been le out inten onally. Therefore memo 2 applies
only to addi on method.

In the absence of Memo 2, if there is an ICoW claim with SC selec vely insured, the
ICoW claim would be paid in full provided the GP with selected SC are adequately
declared.

This will put an insured who has insured all SC and another insured who has selec vely
insured SC, on the same pedestal for adjustment of loss. This would be inequitable.
Hence the Memo 2 on the policy for addi on method.

Page | 21
 PART 11
INDEX OF BUSINESS ACTIVITY

As has been discussed in the previous parts, the specifica on of the LOP is its heart. This
shows how the loss would be adjusted.

An important element of the specifica on is the index of business ac vity.

Q. What are the indices available for deno ng business ac vity and what do they
represent?

TURNOVER – The money paid or payable to the Insured for goods sold and delivered
and for services rendered in course of the business at the premises. This is useful for
manufacturing companies.

OUTPUT - The quan ty of commodity produced by the insured at the premises

measured in kilograms/litres/metric tonnes as applicable. Useful for commodity
manufacturing measurable in quan es.

GROSS REVENUE – The money paid or payable to the insured for work done and/or
service rendered in course of the business at the premises. Useful for non-
manufacturing companies that offer services.

GROSS FEES – The money paid or payable to the insured for services rendered in course
of the business at the premises. Useful for professional services companies who charge
fees.

Q. Why do we need these separate indices? Why can’t we have one common index
applicable to all businesses?

Different businesses have different revenue flows, so we need to have separate indices
so that the loss gets manifested while applying the specifica on.

For eg., if we take turnover as the standard index for all types of businesses, some mes
there could be no reduc on in turnover, but s ll there can be a possible reduc on in
gross profit. This happens when op mal product mix is not achieved.

A refinery may make several products such as petrol, diesel, avia on fuel, lubrica ng oil,
paraffin, bitumen etc. If due to loss in one of the plants, the refinery could not make the
targeted produc on of avia on fuel and instead made more of bitumen, which is a lower
value product. While turnover was unaffected compared to previous year, more gross
profit could have been achieved had the avia on fuel facility not been affected by the
loss.

Page | 22
Q. What if choose one index and then it turns out that the loss is not ge ng manifested
using that index? Can I switch to another one?

Yes. The objec ve of the LOP loss adjustment is to achieve indemnity for the insured so
this should be allowed by the insurer.

There is also an enabling provision called alterna ve basis clause which can be opted
that says as under:

“It is agreed and declared that, whenever found necessary, the term Output may be
subs tuted for the term Turnover and for the purpose of this policy Output shall mean
the sale value of goods manufactured by the Insured in the course of the business at
the premises, Provided that only one such meaning shall be opera ve in connec on
with any one occurrence involving damage (as within defined).’

In the next part, the various exclusions of the LOP policy would be covered.

Page | 23
 PART 12
EXCLUSIONS

Since the LOP policy is a ached in conjunc on with a material damage insurance policy, the
exclusions applicable to MD policy such as war and allied perils, nuclear risks, pollu on and
contamina on, wilful acts etc., are equallly applicable to the LOP policy also.

A aching the LOP policy to the MD policy results in significant savings in wordings.

Q. So are there any specific excep ons to LOP policy?

There are some excep ons to an LOP policy, which may be wri en or implied as under:

-restric ons on reconstruc on or opera on imposed by any public authority

-the lack of sufficient capital with the insured for mely restora on or replacement of
property lost destroyed or damaged

-suspension, lapse or cancella on of a lease, license or order etc., without which the
insured cannot do business.

Q. What is the ra onale for excluding license suspensions or restric ons imposed by a
public authority? What if the restric ons or suspension have been imposed as a
consequence of the loss?

The insuring agreement of the policy says:

“……if any building or other property or any part thereof used by the Insured at the
premises for the purpose of the Business, be destroyed or damaged by the perils
covered under the fire policy, (Destruc on of damage so caused being herea er
termed Damage), and the Business carried on by the Insured at the Premises be in
consequence thereof interrupted or interfered with, then the company will pay to the
insured…..”

The objec ve of the policy is to cover interrup on a ributable to the physical loss or
damage, not other factors that may have a causal linkage. The exclusion is therefore
consistent with that objec ve.

Another aspect is that restric ons or license suspensions are not controllable factors for
the insured as it depends on a counterparty, ie., the government authority concerned.
The nature of risk assumed therefore can transform into a financial risk.

Page | 24
Q. How does one know if the interference or interrup on is due to the loss or due to
restric ons or license suspension, if both act together?

The periods need to be segregated between the two so that the one that arises out of
the loss alone gets counted in the indemnity period for loss adjustment.

The insurer’s liability would be limited to the me the business would have taken to get
back to normal opera ons subject to max IP and policy terms if no suspension or
restric ons operated.

Q. Why insured’s lack of funds be excluded? Won’t insured have access to on account
payment from the material damage claim?

O en the loss is a mix of insured and uninsured events. On account payment is a

preroga ve of the MD insurer. Therefore, the insured cannot be solely dependent on
payouts from the MD claim for undertaking repairs.

In the next part of this series on LOP, various clauses and addi onal covers under LOP policy
would be discussed, star ng with the departmental clause.

Page | 25
 PART 13
DEPARTMENTAL CLAUSE

This clause is a key element of LOP policies. The wording is as below:

“If the business be conducted in departments, the independent trading results of which are
ascertainable, the provision of REDUCTION IN TURNOVER and INCREASE IN COST OF
WORKING shall apply separately to each department affected by the damage except that
if the Sum Insured by the said item (GROSS PROFIT) be less than the aggregate of the sum
produced by applying the rate of gross profit for each department of the business
(whether affected by the damage or not) to the rela ve Annual Turnover thereof, the
amount payable shall be propor onately reduced.”

Q. Why is this provision there in an LOP policy?

In many industries there will be mul ple units making different products. These work as
different profit centres. If loss adjustment is done on a consolidated basis for all units it
can result in subop mal outcome where one unit can cross subsidise the other and the
loss adjusted would be lesser than if assessed individually for each department.

Q. What does a departmental clause do?

It splits the policy (logically, not physically) into the number of such departments, so
each department has a separate policy of its own. So the loss adjustment would also
happen department wise.

Q. Does this mean the insured has to have separate balance sheets published for each
department?

The clause says ascertainability of independent trading results should be there, which
means the insured should be able to produce a P&L for each department independent
of another. It is not necessary that the annual report should show department wise
financial results.

Q. What if the departments have some common u li es? Do they then lose their
independence and become ineligible for departmental clause applica on?

No. The independence between units is not physical independence, but financial. Units
can be inter-dependent or have common u li es.

Page | 26
Q. How would the deduc ble apply? Would it be on the overall SGP or the affected unit?

Since the policy gets split by the departmental clause, deduc ble also gets logically split
departmentally.

Q. How does the underinsurance work? Would it be applied department-wise or on a

consolidated basis or both?

The underinsurance provision works collec vely. The affected unit may be adequately
insured but on an overall basis, there is underinsurance that would apppy on the claim
applicable to the affected unit. The SGP of each department will be ascertained and
added up to arrive at overall SGP which should not be less than the SI.

In the next part, the con ngent business interrup on covers would be discussed.

Page | 27
 PART 14
CONTINGENT BUSINESS INTERRUPTION (CBI)

I would always say that more than a policy covering business income, the LOP policy is a
policy covering DEPENDENCE. In part 8 of this series, I have already men oned this.

It is the dependence of the insured on his premises to generate income that is covered
under the policy.

If there is no such dependence, there will be no interrup on or interference of business;

there will be no reduc on in turnover and no reduc on in GP or ICOW to be insured.

However, the dependence need not only be on the insured’s own premises, but other types
of dependence also, such as on:

- Suppliers or U li es such as gas, power, water etc., who are unable to provide inputs as
their own premises are affected by physical loss or damage.

- Customers who are unable to accept finished products from the insured for further
processing as their own premises are affected by physical loss or damage.

- Denial of access/egress. While the insured facility may be opera onal, access to it is
affected by the opera on of insured peril and hence the normal opera on cannot be
carried out

Q. How does a CBI cover a ach to an LOP policy?

The clauses say that the physical loss or damage at the supplier/customer premises due
to specified perils shall be considered as having happened at the insured premises itself.
So the material damage proviso is sa sfied by the occurrence of loss at such other third
party premises also.

Q. How does one know whether the interrup on has happened due to opera on of an
insured peril? What if it is due to some other reason?

The insured has to demonstrate that loss due to the specified peril has happened at the
supplier/customer/u lity supplier premises due to which the supply chain has been
affected. But it is not necessary that the supplier/customer has to have a material
damage policy and claim admi ed under that policy.

Page | 28
Q. How can insured exercise control over his supplier or customer who is a third party?
Does this not mean the interrup on period would be uncontrolled?

The insured would have only limited control on CBI. Hence coverage will be limited to
direct, first er suppliers on a named basis. Covers are usually sub-limited to 10% or 20%
of BI sum insured, so that irrespec ve of the indemnity period taken, the payout will be
restricted.

To summarise, CBI is a con ngent or indirect exposure and not a direct one. It covers the
exposure emana ng from the ecosystem of the insured rather than his own premises.

Page | 29
 PART 15
ACCUMULATED STOCKS

In many businesses, there could be buffer stock of finished products. There will be reduc on
in turnover following loss or damage, but that may be made up during the indemnity period
by u lizing some or all of this stockpile.

However, the insured will be le without the buffer stock once the plant is recommissioned
following the loss and the indemnity period is over.

To adjust for the above situa on, the following clause is inserted in the policy:

“In adjus ng any loss, account shall be taken and an equitable allowance made if any
shortage in turnover due to the damage is postponed by reason of the Turnover being
temporarily maintained from accumulated stocks of finished goods in the Insured’s
warehouses.”

Q. The clause seems unjus fied as the insured can always build up the buffer stocks in
future as he had built it up in the past prior to the loss? So why should the insurer
adjust for the buffer stock usage?

Buffer stocks are maintained by the insureds as a risk management measure to de over
any supply disrup on. Interrup on of business happens due to uninsured causes such
as strikes or lockouts. Insured is en tled to its benefit and the insurer cannot take a
stand that nothing has been really lost.

Q. What is meant by “equitable allowance”? This looks like a vague and subjec ve
provision?

The applica on of the clause is subject to the principle of equity, which means neither
the insured nor the insurer, should derive any unfair advantage over the other.

For instance, if the insured is able to make up for the depleted accumulated stocks by
working over me for 6 months following reinstatement, then what he has lost is the
ICoW for the over me incurred. So the insured cannot be en tled to the full loss of GP
claim that was avoided by using the accumulated stocks. That would defeat the principle
of equity.

Q. Does this mean loss adjustment involving accumulated stocks clause would take me?

Yes, it can.

Page | 30
Q. The clause talks of accumulated stocks of finished goods only? What if the reduc on in
turnover is avoided by using buffer stocks of semi-finished goods?

The clause in its tradi onal form talks only of finished goods. The wording would have
to be modified to other types of stocks if necessary.

To conclude, Accumulated Stocks Clause is suitable for produc on or manufacturing units

which has a physical goods that can be kept in inventory. There is a school of thought that
even without the clause the insurer/loss adjuster should give allowance to the insured. But it
is be er to be with the clause in the policy than without, from a customer perspec ve.

Page | 31
 PART 16
ADDITIONAL INCREASED COST OF WORKING (AICoW)

AICoW is an adjunct cover to the standard ICoW cover under a LOP policy. This is not inbuilt
into a standard policy, but offered as a rider in most markets.

Q. What is the difference between ICoW and AICoW?

ICoW is subject to some condi ons men oned in the clause which defines ICoW as
under:

“addi onal expenditure necessarily and reasonably incurred for the sole
purpose of avoiding or diminishing the reduc on in Turnover which but for that
expenditure would have taken place during the Indemnity period in consequence of
the Damage but not exceeding the sum produced by applying the Rate of Gross Profit
to the amount of the reduc on thereby avoided.”

Therefore the insured has to sa sfy two condi ons for qualify for ICoW:

- there has to be a reduc on in turnover avoided or minimized by the ICoW spend

and

- the amount reimbursable by the insurer towards ICoW, cannot exceed the loss of gross
profit that would have happened, had the ICoW not been spent by the insured.

In respect of AICoW, the above economic jus fica on is not applicable. The insured
does not have to demonstrate that the expense led to avoidance of reduc on of gross
profit.

Q. What is the jusfica on for AICoW? Will it not violate principle if indemnity by
sanc oning wanton expenses by the insured in the guise of loss avoidance?

All expenses are not amenable to the economic test. For instance, there is a loss and the
property is reinstated within the indemnity period but there is a huge backlog of orders
to be cleared. Insured runs over me and hires extra hands to clear the backlog.

This ac on of the insured does not result in any avoidance of reduc on of gross profit
during the indemnity period. Without addi onal hands, the pre-loss produc on levels
were reached, thereby termina ng the indemnity period and leaving the costs beyond
the scope of the policy.

Page | 32
 However, if the insured had not cleared the backlog on me, he might have lost some
valuable customers. The expense was therefore jus fied.

Hence AICoW coverage is jus fied in defraying such costs to the insured that do not fall
otherwise under the scope of the policy.

To conclude, AICoW is a legi mate and useful cover to have to fully protect the insured in
respect of an LOP claim situa on. Usually this is sublimited and always subject to the test of
reasonableness.

Page | 33
 PART 17
INDEMNITY PERIOD DEFERMENT (IPD)

IPD is a useful coverage provision which is found in LOP policies in some markets, though it is
not common in India. The u lity of this clause is not well understood.

The clause reads as under:

“If there is delay in the results of the Business being affected, the Insured may request the
Insurer to delay the commencement of the Indemnity Period to a later date, but not
exceeding twelve (12) months from the date when the Damage occurred.

Any such request for delay in the commencement of the Indemnity Period must be made in
wri ng to the Insurer by the Insured within ninety (90) days of the date of the Damage and
the Insurer agrees not to unreasonably withhold consent to such varia on.

Upon the agreement to any such varia on, all references to Indemnity Period and cover in
Sec on 2 of the Policy will be interpreted and applied in accordance with the changes
agreed.”

Q. What does this clause do?

It allows the insured to start the IP from a date of his choice following the loss.
Otherwise, the IP will start from the date of loss as per standard defini on of IP.

The insured must make the elec on to defer IP within 90 days of loss occurrence and
maximum period of deferment is 12 months.

Q. What is the benefit of an IPD? When does it come into play?

Let’s say there is damage to a machine which requires its main sha to be replaced. The
sha being imported will take 9 months to procure and another 6 months to repair and
restart the opera ons. The maximum indemnity period under the policy is 12 months.

The sha can be temporarily repaired in a few days and the machine can be run for 6
months before shu ng it down for permanent repairs.

In the above example, insured can opt for an IPD of 6 months. The total interrup on
period of 15 months (9 months lead me plus 6 months repair me) would then be
covered under the policy.

In the absence of IPD of 6 months, the insured’s effec vely available IP would be only 6
months, coun ng IP from the date of loss, eventhough the machine ran for 6 months
following the loss.

Page | 34
To conclude, IPD is suitable for situa ons where turnover can be temporarily maintained
following loss and restora on of property is postponed to a later date.

Page | 35
 PART 18
SUM INSURED ADJUSTMENT

The LOP policy has a provision for sum insured on an adjustable basis, with provision for
return of premium in case of over-insurance as under:

“If the insured declares at the latest twelve months a er the expiry of any period of
Insurance, that the Gross Profits earned (or a propor onately increased mul ple thereof
where the maximum Indemnity Period exceeds 12 months) during the accoun ng period
of 12 months most nearly concurrent with any period of insurance, as cer fied by the
Insured’s Auditors, was less than the Sum Insured thereon, a pro-rata return of premium
not exceeding 50% of the premium paid on such Sum Insured for such period of insurance
shall be made in respect of the difference. Where however the declara on is not received
by the Company within twelve months a er the expiry of the period of insurance no
refund shall be admissible.

If any damage has occurred giving rise to claim under this Policy, such return shall be made
in respect only of said difference as is not due to such damage.”

Q. If the SI under LOP policy is adjustable, why is there an underinsurance provision in the
policy?

The standard LOP policy is not fully adjustable. Only downward adjustment is possible.
Not upward adjustment, so if the sum insured ought to have been higher, the insured is
not required to pay addi onal premium. Only fully adjustable policies that provide for
both upward and downward adjustment at policy expiry are usually exempt from
underinsurance (examples WC and Money policies).

Q. What if there is a loss, would the insured be denied the return of premium? How much
refund would be made?

Happening of loss doesn’t disen tle the insured to premium return. However, due to
interrup on following the loss, the GP achieved will anyway be lower than SGP.

Giving return on premium on the whole difference will result in undue benefit to the
insured.

Hence adjustment is done as below:

Sum Insured (Annual GP) = Rs.1,000,000

Achieved GP : Rs.500,000 (following the loss, basis the financial year of the loss)

SGP : Rs. 750,000

Page | 36
 So return of premium would be allowed on:
(Rs.1,000,000 – Rs.500,000) - (Rs.750,000 – Rs.500,000) = Rs. 250,000

The return of premium on Rs.250,000 would be 25% which is within the monetary limit
of 50% permissible as per the clause.

Q. If the policy period falls almost equally in two financial years, which financial year would
be considered for return of premium?

The clause provides for the most representa ve accoun ng period to be considered for
adjustment of sum insured. The choice can be appropriately made by the insured with
jus fica on of the business trend.

In the next part, I will discuss the leeway provisions under LOP policy.

Page | 37
 PART 19
LEEWAY CLAUSE

The LOP policy is subject to underinsurance provision, as has been discussed earlier. If the
SGP is more than SI, underinsurance applies.

In some markets, the policy comes with a leeway provision whereby the average condi on
applies only if the SGP exceeds SI by a certain percentage:

“If the es mated value of Gross Profit declared at the commencement of the Period of
Insurance is less than eighty five per cent (85%) of the sum produced by applying the Rate
of Gross Profit to the Annual Turnover (appropriately increased if the Indemnity Period
exceeds twelve (12) months) which would have been achieved if the Damage had occurred
on the day the Period of Insurance commences, the amount payable hereunder shall be
propor onately reduced.”

Q. Why such leeway provisions? Why dilute underinsurance provisions and undermine the
mo va on of the insured to insure correctly?

Insured is expected to make a fair es mate of the turnover he is likely to achieve in the
future while arriving at the SI. But there can be situa ons like sudden increase in
demand, which may render the sum insured inadequate at the me of loss.

Q. Can the leeway be increased to 50%?

The provision helps the client to avoid accidental underinsurance. However, the leeway
provided is usually limited (15% to 20%) and does not absolve the insured of his
obliga on to properly es mate the sum insured and declare the same to the insurer for
insurance.

Page | 38
 PART 20
CONTRACTUAL DAMAGES

This is a conten ous topic in LOP. Some tradi onal underwriters hold the view that these are
of financial nature and are be er addressed outside of the ambit of an LOP policy. These
losses are not direct consequen al losses but indirect and separate by a degree from the
primary material damage loss.

But there is an opposite view that these are casually linked to the material damage loss and
by applying the “but for” principle, there is a strong enough ground to consider them under
LOP.

Q. Is there any specific exclusion in LOP policy for contractual damages such as fines and
penal es? In the absence of any specific excep on, can it be concluded that it is
covered?

Fines and penal es are con ngent on an event happening (breach of contract) so these
are not specifically included in the sum insured as a standing charge. So the insurers
may deny coverage.

Q. If coverage for fines and penal es is desired, how can it be achieved?

There has to be an affirma ve provision in the policy for fines and penal es. The
following is one such provision:

“Contractual Damages: The insurance under this item is limited to fines and/or
damages for breach of contract and the amount payable as indemnity hereunder
shall be such sum or sums as the Insured shall be legally liable to pay in discharge of
fines and/ or damages incurred in consequence of the Damage for non-comple on or
late comple on of orders, inability to meet contract specifica ons, or cancella on of
orders.”

Q. Why can’t contractual damages such as minimum fuel o ake charges be included as
standing charges and part of the GP insured?

These being con ngent expenses are not part of the normal P&L of a firm and can’t be
included in the GP. This can poten ally lead to disputes at the me of loss adjustment.

To conclude, contractual damages unless specifically agreed may not be covered under an
LOP policy. Affirma ve coverage must be nego ated if they are intended to be covered.
Inclusion of such charges in the sum insured without prior agreement with underwriters
must not be resorted to.

Page | 39
DISCLAIMER

Insurance is a subject ma er of solicita on. The informa on provided in this booklet cannot
subs tute for the advice of a licensed professional. The informa on and data provided on
this booklet is of a general nature and strictly for informa onal purposes. For more details
on risk factors, terms and condi ons, please read the product brochure and policy wording
of the insurer carefully before concluding a sale.

The author accepts no responsibility or liability for decisions based whatsoever with regard
to the informa on on this booklet.

This informa on provided here is of a general nature only and is not intended to address the
specific circumstances of any par cular individual or en ty and not necessarily
comprehensive, complete, accurate or up to date; not professional or legal advice (if you
need specific advice, you should always consult a suitably qualified professional).

Page | 40