Projections – Likely Net Income

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 continuing normal operating expenses incurred, including payroll.

How is the net income or loss determined?

The projection of sales, direct costs, and operating expenses during the period of indemnity is necessary to determine the net income or loss that would have been earned or incurred. Although one could speculate endlessly about what might have occurred had a peril not interrupted an insured’s operations, business income projections must be approached in a practical way.

The business income policy provides general guidance concerning what information should be considered in determining the business income loss. The loss determination conditions provided in the policy are as follows:


The amount of net income of the business before the direct physical loss or damage occurred;

The likely net income of the business had no loss or damage occurred, but not including any likely increase in net income attributable to an increase in the volume of business as a result of favorable business conditions caused by the impact of the covered cause of loss on customers or on other businesses;

The operating expenses, including payroll, necessary to resume operations with the same quality of service that existed just before the direct physical loss or damage; and

Other relevant sources of information, including:
· your financial records and accounting procedures
· bills, invoices and other vouchers; and
· deeds, liens or contracts.

The historical operating results of an entity are intended to be an important consideration in the determination of the loss, as indicated in the first loss condition above. What an entity would do is sometimes best indicated by what it has done in the past. In practice, the historical operating results of an entity are often used as a basis for normal income projections.

Sales trends developed from two or more historical pre-loss periods, for example, are applied to the actual sales of months in the prior year corresponding with the period of indemnity in order to project normal sales.

Direct costs and operating expenses are often projected based upon the historical relationship of costs and expenses to sales.

Although the amount of net income of the business before the direct physical loss is an important consideration in the loss determination, it is not necessarily the only consideration.

Should business income projections be based upon and limited to a business' historical operating results?

There are some loss evaluators who have argued that projections based upon assumptions other than those rooted in the historical results of operations are purely speculative and therefore should be ignored. In fact, limited support for this position may be found in the law.

In the author’s opinion, however, a reasonable reading of the business income loss determination conditions would not preclude the considerations of other factors notwithstanding the prominence of loss condition #1, i.e., net income before the loss.

Loss determination condition #2 states that the loss is to be determined based upon the likely net income of the business had no loss or damage occurred. Thus, when historical operations have been significantly impacted by circumstances or events that would likely not occur during the period of indemnity, historical data must be modified, or alternative sources of information must be considered, in order to project normal operations.

For example, if the historical results of a business were impacted by road construction in a business dependent on traffic, and construction was or would have been completed during the period of indemnity, it is unlikely that the use of historical results in order to project operations would provide the likely net income of the business had no loss or damage occurred.

Other examples might include:

· extremes of weather for prolonged periods

· internal strikes or strikes impacting customers or vendors

Should recent changes in operations or other post loss external events or circumstances be considered in income projections?

The policy does not preclude the consideration of other relevant sources of information, as stated in loss determination condition #4, in the determination of the likely net income of a business. Consequently, changes in operations or post-loss external events or circumstances may reasonably be considered.

Such circumstances may include

· the loss of a historically significant customer;
· a newly acquired customer of significance;
· new products or substantial changes in pricing strategies;
· newly acquired production efficiencies resulting from capital investments or management changes;
· new competitors or the failure of existing competitors; and
· significant changes in the local or national economy.

When reliance is placed upon such circumstances in income projections, however, the loss evaluator must concern himself not with mere possibilities, but probabilities that those events or circumstances would have occurred and the extent of their impact on operations. When income projections differ substantially from the actual income earned before the loss, the evidence in support of income projections must be compelling. The commentary of the court in Prudential LMI Chemical Insurance Co. v. Colleton Enterprises, Inc., 976 F.2d 727 (S.C. 1992) would likely reflect the mainstream industry view. The court noted, “Where an insured attempts to rely on post-interruption profit expectancies, rather than pre-interruption realities, courts have required proof of probabilities rather than mere possibilities, and on practical rather than theoretical assessments of the probabilities.”

Should business income projections include income that may have been realized from a peril-generated source?

Natural disasters such as Hurricanes Hugo and Andrew in the past several years have brought to the forefront questions concerning whether the likely net income of a business should include the potential profit windfall that likely would have occurred had the same physical damage not occurred to the insured’s own property.

Should businesses that would benefit in the aftermath of such disasters, such as building supply companies, hotels, and others be given the benefit of the potential increased volume of business when projecting likely net income?

The revision of the loss determination conditions (06 96, Loss Determination Condition #2) now clarifies that such windfalls are not intended by the policy.

Methods of Business Income Projection

The methods used to project sales, direct costs, operating expenses, and net income or loss vary in practice and are often dependent upon the nature of the business, records available, the duration of business suspension, and a rational consideration of the business circumstances before and after the date of loss. Common projection methods are described in the following paragraphs.
Sales Projection Methods

Historical Sales Trends

When using this approach, the actual sales for periods preceding the loss corresponding with the period of indemnity are multiplied by recent sales trends. The recent sales trend is established by comparing a period prior to the loss, e.g., three months, six months, etc., with the same period of a preceding year. The projection of sales based upon historical sales trends is useful when the pattern of historical sales show seasonal variations.

Historical Sales Averages

When historical sales are relatively flat and the historical pattern of sales does not reflect seasonal variation, sales may be projected during the period of indemnity based upon historical weekly or monthly averages of sales.

Operating Budgets

Many businesses utilize operating budgets as a means of profit planning or for managerial control and evaluation.

The process of establishing an annual operating budget often involves a consideration of the same facts and circumstances that the business income loss evaluator must consider in the determination of the likely net income or loss during a period of indemnity, e.g., historical performance, the effect of anticipated market plans, new products, etc. Thus, the operating budget can be an important source of information concerning a business’ plans during the period of indemnity.

When there is sufficient actual sales history prior to a loss, and that history closely approximates the anticipated sales reflected in operating budgets, the sales reflected in operating budgets subsequent to the loss may be used to project normal sales during a period of indemnity.

An evaluator may further consider the variances between budgeted and actual sales when projecting sales.

Sales Orders

When sales orders are received well in advance of required shipping dates and the period of suspension is short, sales may be projected based on outstanding sales orders during the period of indemnity.

Sales at Other Locations or Sales from Partial Operations during the Period of Indemnity

When an insured maintains multiple locations and operations at the other locations are similar to those of the loss location, trends at the similar locations may be applied to actual sales of the loss location for the prior year corresponding with the period of indemnity in order to project sales.

In addition, when a loss does not result in the complete suspension of operations and sales of products not impacted by the loss continue during the period of indemnity, the sales of products not impacted by the occurrence may provide a basis for sales projections for impacted products. The method of projection would be the same as that described in the preceding paragraph. This approach may be useful when historical sales of one product have generally followed the sales of the other and the loss evaluator is satisfied that publicity concerning the loss has not adversely affected the sales of all products.

Regression Analysis

Statistical approaches such as regression analysis are sometimes used to project sales when there is sufficient sales history in order to utilize those methods.

Sales Amount of Production

When measuring the business income loss of a manufacturing concern, it is necessary to project normal production in addition to normal sales during the period of restoration.

This is necessary because the measure of business income loss for the manufacturing concern is the business income value of either the sales amount of production lost, or lost sales, whichever is less.

For further discussion see Section 16, “The Actual Loss You Sustain.”

Projections of normal production are typically provided in units. Much like sales projections, production projections should be based upon patterns of actual production prior to the loss and the likely production thereafter. Many of the considerations and methods discussed above for sales projections are also applicable in production projections.

When normal production is projected in units, unit totals are then multiplied by historical unit sales values, or likely values during the period of restoration for impacted products, in order to determine the sales amount of production lost.


Deductions from Sales, Direct Costs and Operating Expense - Projection Methods

Loss determination condition #3 provides that the loss is to be determined based on operating expenses, including payroll expenses necessary to resume operations with the same quality of service that existed just before the direct physical loss or damage.

Thus, another important reference to pre-loss operations is provided in connection with the projection of operating expenses in the loss determination conditions.

Historical Cost Relationships

As discussed in this section, a common approach to the projection of deductions from sales, direct costs, and operating expenses is to establish the historical relationship of deductions, costs, and expenses to sales. That relationship, expressed as a percentage, is then multiplied by projected sales to project costs and expenses. Because some operating expenses will vary with the level of sales or production (often referred to as variable expenses) and others will not, further refinement of the above approach is sometimes necessary.

When substantial increases in sales are projected during the period of indemnity over those experienced prior to the loss, for example, it would not be reasonable to assume that operating expenses which normally remain constant should increase proportionately based upon their pre-loss relationship with sales. Such an assumption would understate the likely net income. Operating expenses that normally remain constant (often referred to as fixed expenses) may be more reasonably projected through use of monthly averages of annual pre-loss expense, multiplied by the number of months included in the period of indemnity.

Review of Contracts and Other Commitments

When the loss evaluator can better estimate specific costs or expenses based upon leases or contracts (union, purchase, or other) in force at the date of loss, those estimates should be used in cost and expense projections in lieu of estimates based on historical relationships.

Review of Continuing Expenses

In some cases, judgments concerning normal costs and expenses may be made based on insights gained through review of expenses that actually continue during the period of indemnity. When a normal operating expense continues at a greater rate than would be projected based on historical cost relationships and the evaluator determines that the increases are not caused by the loss occurrence, the continuing expense may reasonably be used as a basis for expense projection.

The methods of projection used by the loss evaluator should be those that as a matter of judgment provide the most likely net income or loss that would have been earned or incurred.