Expenses to Reduce Loss and Extra Expenses

From Business Income Losses…The Insurance Policy: Common Interpretations And Measurement Illustrations by: Steven J. Meils, CPA

Expenses to reduce loss - coverage

It is a condition of the business income policy that if an insured can resume operations in whole or in part by using damaged or undamaged property at the described premises or elsewhere, it must do so. The earnings that result from the resumption or continuation of operations must be deducted from the business income loss that results from the application of the coverage definition during the period of indemnity.

The Business Income Coverage Form (without Extra Expense), CP 00 32, provides additional coverage for necessary expenses over those which would normally have been incurred to resume or continue operations. The expense incurred under this coverage, however, cannot exceed the amount of loss that otherwise would have been payable under the business income coverage without such expenditures. Similar coverage is provided in all actual loss sustained coverage forms.

What are expenses to reduce loss?

Expenses to reduce loss generally fall within two categories of expense as follows:

1. Expenses that allow the insured to continue operations
(sales or production); and

2. Expenses that would shorten the period of suspension.

Expenses that allow the insured to continue operations

If all or a portion of the insured’s operations can be resumed at the loss location or at a temporary location, the costs incurred over those that normally would have been incurred and those necessary to equip a temporary location, may be claimed as expenses to reduce loss.

If, in a manufacturing operation, an insured can make up production lost at the loss location or at another location, the production costs incurred over those that normally would have been incurred, such as payroll premiums, may be claimed as expenses to reduce loss.

If an insured can draw upon inventories at the loss location or at other locations in order to avoid sales losses, the additional costs incurred, such as freight costs, may be claimed as expenses to reduce loss.

If an insured can purchase products that it normally manufactures from outside sources in order to avoid sales losses, then the purchase costs in excess of normal variable production costs for the products purchased, may be claimed as expenses to reduce loss.

Expenses that would shorten the period of suspension

If an insured can accelerate the restoration of property and thereby reduce the period of restoration through payment of labor or other premiums to building contractors or equipment suppliers, then such costs may be claimed as expenses to reduce loss.

If items of equipment are purchased and claimed as expenses to reduce loss, and the equipment has value when operations are restored, then the salvage value of the equipment must be deducted from the total of expenses to reduce loss.

Extra Expenses

The coverage for expenses to reduce loss described in the preceding paragraphs and available in the Business Income Coverage Form (without Extra Expense), CP 00 32, is similar to that provided in the gross earnings coverage forms previously offered as standard coverage (and most other actual loss sustained coverage forms).

The extra expense coverage provided by the Business Income Coverage Form (and Extra Expense), CP 00 30, is intended to go beyond the expenses to reduce loss coverage provided in form CP 00 32. The inclusion of extra expense as part of the basic coverage was a significant change from the prior standard coverage forms. (Although extra expense coverage could be added to the gross earnings forms by policy endorsement, it was not a part of the standard coverage.)

It is unfortunate that now, over a decade after the introduction of the business income form, many insurers interpret defined coverage for extra expenses in a manner which effectively denies an insured the benefit of intended coverage. This is due in large part to the policy language discussed in the following section.
Do extra expenses differ from expenses to reduce loss?

Extra expenses are normally the same expenses and are incurred for the same purposes as expenses that would be claimed as expense to reduce loss under other policies. There is, however, one important difference. Extra expenses are not limited in the same manner as expenses to reduce loss. It is not necessary that an extra expense reduce the amount of loss although it often does. In fact, such a requirement would defeat the purpose of intended coverage.

In order to fall within the extra expense coverage definition the expense must serve to:

· Avoid or minimize the suspension of operations, when operations can be continued; or

· Minimize the suspension of operations if operations cannot be continued.

A third item of defined extra expense coverage would pay the extra expense to repair or replace any property or research and to replace or restore lost information on damaged valuable papers and records. The extra expenses related to this item of coverage, however, cannot exceed the amount of loss that otherwise would have been payable without the expenditures.

Although it is clear in the form that this limitation is imposed only on item (3), extra expense; in practice some insurers maintain that the limitation is applicable to all of the items of coverage. With such an interpretation the coverage ceases to be extra expense coverage and would provide nothing more in the way of coverage than Business Income Form (without Extra Expense) CP 00 32. This is not the intent of the contract.

In the author’s opinion, coverage item (3) serves only a limited purpose and in its present form causes confusion about the intended coverage.

If, for example, an expense served to reduce the amount of loss that otherwise would have been payable (a requirement for coverage), it would likely do so because it allowed the insured to avoid or minimize the suspension of operations ( to continue sales or production); or it minimized the suspension of operations if operations could not be continued. If an expense served either purpose, it presumably would be fully indemnified under coverage items (1) and (2), subject only to the policy limits. The limitation provided in coverage item (3) would not be applicable.

Note: Although the extra expenses incurred during the period of restoration would not be limited in the manner described above, expenses incurred after the period of restoration would be limited in the same manner as expenses to reduce loss and items contemplated under extra expense coverage item (3).


What is the purpose of extra expense coverage?

The commercial insured’s loss exposure, in the event of a business suspension, is often dependent upon the nature of the business, the importance of property to do business and the customer base upon which the insured must rely.

In businesses providing services, the business is sometimes more dependent upon personnel than on property. Consequently, revenue losses, if any, will normally occur only briefly until operations can be relocated. The greater exposure for some service businesses would be the increased costs of doing business, including those expenses necessary to temporarily relocate business operations. Other service businesses such as bowling alleys, motion picture theatres, etc., highly dependent on property to do business, would sustain sales losses immediately.

In retail operations, very much dependent upon property to do business, there is normally little that can be done to continue operations when a peril occurs. The primary loss exposure is the loss of business income while property is being restored. Usually in those operations sales will resume at normal levels after the resumption of operations.

In some businesses, however, even a short term suspension of operations may result in a permanent loss of customers. Although the business income policy would provide indemnification for losses during the period of restoration, it would not respond to the long-term financial damage caused by the permanent loss of customers outside the period of restoration.

When the exposure for permanent customer losses is great, the insured must often continue operations at any cost. It is in recognition of this fact that extra expense coverage is offered.

It is not necessary that the extra expenses incurred result in loss savings; it is only necessary that the expense allow the insured to continue operations (sales or production) or minimize the period of suspension. This is the purpose of the coverage. It is now part of the basic coverage provided by Form CP 00 30.

Are expenses to reduce loss and extra expenses limited by the coinsurance condition or other coverage options?

Expenses to Reduce Loss

With the recent revisions in Form CP 00 32 coverage Section A.3.a., it is now stated that, “The coinsurance condition does not apply specifically to such expenses to reduce loss.”

The revised additional coverage for expenses to reduce loss further states, “The total of our payment for business income loss and expenses to reduce loss will not be more than the business income loss that would have been payable under this coverage form (after application of any coinsurance penalty) if the expense to reduce loss had not been incurred.”

Thus, in order to determine the amount of expenses to reduce loss that may be recoverable, a coinsurance calculation is required, which would determine an amount of recovery, based on the amount of loss that would have resulted without the expenses to reduce loss. The hypothetical coinsurance calculation and amount collectible would establish an upper limit for loss recovery.

The expenses to reduce loss when added to the collectible business income loss could not exceed the upper limit established in this calculation.

When the form changes were proposed, ISO indicated that the changes were to provide clarification of intent only, and that it did not represent a change in coverage. (See "Coverage Changes,” 10-4.)

Extra Expenses

The policy additional condition E. - Coinsurance, states, "the coinsurance condition does not apply to extra expense coverage."

Note: It is generally understood that loss limitations imposed by other selected coverage options would not limit extra expenses. The extra expenses incurred are limited only if when they are combined with the amount of business income loss collectible under the selected coverage option, the limits of the policy are exceeded.