From Business Income Losses…The Insurance Policy: Common Interpretations And Measurement Illustrations by: Steven J. Meils, CPA
The business income form provides coverage for the net income or loss that would have been earned or incurred and for continuing normal operating expenses incurred, including payroll.
How Continuing Normal Operating Expenses are Determined
Basic Considerations
The Continuing Expense must be an Expense
In some instances, mortgage and other loan payments or dividends and other capital distributions (purported to be in the nature of owner’s compensation) are claimed by insureds as continuing expenses. Mortgage and other loan payments typically include provisions for both principal and interest. Only the interest portions of such payments are properly included in a claim for continuing expenses.
The principal portion of loan payments and dividend and other capital distributions are not expenses in the determination of income nor are they properly included in a claim for continuing expenses. Those transactions would impact the balance sheet only.
The Continuing Expense must be a Normal Expense
Only expenses that were considered in the calculation of net income or loss that would have been earned should be included as continuing normal operating expenses in business income loss calculations. If operating expenses are incurred during the period of indemnity that were not anticipated when normal operating expenses were projected, or the operating expense continues at a greater rate than was projected, the loss evaluator should modify income projections to reflect such expenses or greater rates of expense.
When an increased cost, over that which would normally have been incurred, is the result of the loss occurrence, however, and the increased cost is incurred to avoid or minimize the suspension of business and continue operations or to minimize the suspension of business in the event operations cannot be continued, then the costs may be claimed as extra expense or expense to reduce the loss, depending upon the applicable coverage, and subject to the appropriate limitations. The increased cost should be removed from continuing expense calculations, however, in order to avoid claim duplication.
The Continuing Expense must be Incurred during the Period of Indemnity.
If an operating expense was incurred prior to the date of loss and was payable at the time of loss, it should not be included in business income loss calculations as a continuing expense, despite the fact that it is paid during the period of indemnity. Conversely, the collection of accounts receivable owed at the date of loss would in no way mitigate losses actually sustained by an insured during a period of indemnity. An economic loss cannot reasonably be determined on the basis of cash receipts or expenditures.
When is an Operating Expense Incurred?
Operating expenses are incurred in the periods during which underlying services or products are actually utilized or consumed in operations, or in the case of rents or interest expense are incurred through the passage of time.
When Continuing Normal Operating Expenses are Determined by Estimates
Although the calculation of the net income or loss that would have been earned or incurred may be a somewhat subjective process, the calculation of continuing normal operating expenses is not. The amount of expense that actually continues is always determinable at the conclusion of the period of restoration or indemnity and may be verified through the review and analysis of books and records such as invoices, accounting journals, and ledgers.
In some cases, however, the parties to the indemnity contract may wish to settle the business income loss in advance of property restoration and before continuing expenses are actually incurred.
Normally, advance settlement is considered under the following circumstances:
· There are no opportunities for loss mitigation under the circumstances, and the expenses that will continue may be reasonably determined by estimate.
· There are opportunities for loss mitigation, but sufficient time has passed to determine the extent of actual profits and expenses that have been earned or incurred since the date of loss, and those results provide a reasonable basis to estimate the likely profits and expenses that would be earned or incurred throughout the remaining period of indemnity.
There are no provisions in the business income policy that would require or preclude the advance settlement of business income loss claims. The inherent risk in advance settlement is that the underlying measurement objective of the indemnity contract may not be achieved. An amount greater or less than the actual loss sustained may be paid, resulting in financial betterment or detriment to an insured.
When the period of restoration is longer than anticipated or operating expenses continue at rates greater than anticipated in settlement estimates, a financial loss can result to an insured for which it is not properly indemnified. On the other hand, the insured that steadfastly maintains that ordinary payroll expenses must continue out of business necessity prior to advance claim settlement may experience a change of heart when faced with the choice of actually continuing payroll expenses or personally profiting from insurance proceeds. Although more than one representative of an insured has advised the author that such matters should not be of concern, those who have said so completely miss the point. If an insured’s normal operating expenses do not continue, the insured has sustained no economic loss for those expenses. This very simple premise was also overlooked by the court in National Union Fire Ins. v. Scandia of Hialeah, Inc., 414 So.2d 533 (Fla. 1982).
Relevant Factors when Continuing Expenses are Determined by Estimate
· Nature of the Expense
Certain expenses under normal operations will vary with the level of sales or production and others will remain constant within a relevant range of operations. When continuing operating expenses are determined by estimate, the expenses that are identified as variable in expense projections may be considered non-continuing expenses when operations are completely suspended.
· Extent of Damage and Length of the Necessary Suspension
The fact that an operating expense remains constant during normal operations does not necessarily indicate that it will continue in the event of business suspension. The extent of damage and the length of the necessary suspension are important considerations when judging the likelihood that operating expenses will continue. When leased premises are substantially damaged as a result of fire or other peril, for example, building leases will often provide for the abatement of rents. When damage is minimal, however, rents will normally continue. Many expenses regarded as fixed during normal operations will not continue when the period of suspension is long, due to the extent of damage. The likelihood of expense continuation is also diminished when there is no reasonable means of continuing operations during the period of restoration. Thus, operating expenses such as supervisory salaries, advertising, and others may not, and often do not, continue when operations are suspended for long periods.
· Business Necessity or Legal Obligation
The business necessity and/or legal obligation to continue expenses are also important considerations when assessing the likelihood of expense continuation. An insured may consider the hourly labor expenses necessary, for example, if it has had recent difficulties filling positions due to labor shortages. Under such circumstances the loss evaluator may reasonably include labor expenses in loss estimates.
Note: In most cases, some time will have passed since the date of loss through the date that advance settlement is considered. The business necessity of those expenses may reasonably be questioned and excluded from loss estimates if an insured did not actually incur those costs in the weeks or months subsequent to the loss occurrence.
In some instances, operating expenses will continue as a result of legal obligation. Lease payments for property not damaged or destroyed in a loss occurrence, for example, will normally continue due to contractual commitments. In most cases expenses that continue due to legal obligations can be reasonably estimated and provided for in settlement estimates.
When Continuing Normal Operating Expenses are Determined by Estimates and Operations are Partially Resumed During the Period of Restoration
The loss evaluator must have the ability to reasonably estimate the extent of continuing sales and related material and product costs in addition to continuing normal operating expenses when settlement in advance is considered and the insured has the ability to partially or completely resume operations during the period of indemnity.
In many cases it is difficult to assess the insured’s ability to resume operations immediately following a loss occurrence. When the insured has the ability to continue operations, to what extent operations are continued and the amounts that will be earned will normally increase with the passage of time during the period of indemnity.
Uncertainties concerning the extent of continuing operations and overly optimistic or pessimistic views of the prospects for earnings on the part of loss evaluators in many cases will prevent settlement in advance.
When Continuing Expenses are Determined by Estimates and an Insured Elects not to Restore Operations
A decision by an insured not to restore operations is often made when operations have been unprofitable and prospects for future earnings are judged poor. Some insurers maintain the position, and some courts have held that the period of indemnity is a hypothetical one. Thus, if an insured elects not to restore property, it should be entitled to recover the projected net income or loss and the continuing operating expenses incurred during the hypothetical period of indemnity. (The period that would have been required to restore property.)
In most cases where property damage is complete under such circumstances, few normal operating expenses will actually continue. More importantly, because the continuing operating expenses are recoverable only to the extent that they would exceed a projected loss, in most cases when projected losses are substantial, nothing would be recoverable under the policy even when a hypothetical period of restoration is considered.
An insured’s recovery may be further limited if the insured elects not to restore property, if property damage was not complete, and if the insured could have resumed operations through the use of other facilities, equipment or stock.
If a business income loss is computed during a hypothetical period of indemnity, it must be reduced to reflect the extent of hypothetical operations during the period of indemnity, in accordance with policy loss condition D.4.c., “Resumption of Operations.”
