Common Business Interruption Policy Provisions

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

In this Weblog the we provide an analysis of the contract provisions and illustrate the measurements that are often required in the Business Income (and Extra Expense) Form CP 00 30. Although the form and close variations thereof represent a significant portion of the business interruption coverage provided in the United States today, there are many other coverage forms offered. Forms are often tailored to specific industries or are unique to the insurance companies providing the coverage, or both. Most customized forms, however, borrow heavily from the language of the basic (ISO) coverage analyzed in this Weblog.

Although an in-depth analysis of each and every form available is not practical, through study of the language contained in the business income form, useful insight can be gained to better understand and interpret the other policies.

The Business Interruption Insurance Contract

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

The business interruption insurance contract has been long in development and has undergone many changes since its introduction almost a century ago. For almost as long, the contract with its unique insurance and accounting concepts has been a source of confusion for professionals responsible for its practical application.

The Insurance Services Office, Inc. (ISO) Business Income Coverage Form (CP 00 30) is the last major revision of the business interruption insurance contract and now serves as the standard business interruption coverage form in the industry. The ISO is a trade association of stock and mutual property and casualty insurance companies. The business income forms analyzed in this web log are prepared on an advisory basis by ISO for its members.

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:

Continuing Expenses

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 Actual Loss you Sustain

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

How Is the Actual Loss Sustained Determined?

It is the measurement objective of the business income indemnity contract to find the amount that would restore an insured to the financial condition that likely would have been achieved without the suspension of business.

When operations are completely suspended, the measurement objective is achieved through the application of the coverage definition (business income means the net income or loss that would have been earned or incurred and the continuing normal operating expenses incurred, including payroll).

The actual loss sustained is not properly measured under the coverage definition, however, if a projected loss is not subtracted from continuing expenses incurred, or if continuing operating expenses are not actually incurred.

When an insured has or could have continued operations through the use of damaged or undamaged facilities, equipment, or stock at the insured premises or elsewhere, the business income loss that would result from the application of the coverage definition must be reduced to reflect the impact of continuing operations, as provided by policy loss condition D.4.c., “Resumption of Operations.”

Business Income Loss Measurement

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

What is Covered

The business entity normally consists of both tangible and intangible property (assets), economic obligations (liabilities) and a residual interest (equity). In pursuit of profit, the business endeavors to sell its products or services. In that process, it will normally incur product costs and other operating expenses. If sales (revenues) less product or service costs exceed operating expenses, net income will be earned. If operating expenses exceed sales less product costs, a net loss will be incurred. Purchases, sales and other business transactions naturally impact the financial condition (assets, liabilities and equities) of the business and ultimately determine to what extent funds are available for distribution to the business owner and for other purposes.

When property is damaged or destroyed, in whole or in part, such that anticipated sales are prevented, the normal net income and resulting funds will no longer be available to the business. In addition, to the extent that operating expenses continue without sales, net of related direct product costs, further out-of-pocket losses will be incurred.

It is the intent of the business income indemnity contract to restore to an insured during a period of indemnity, the net income or loss that would have been earned or incurred and all operating expenses that continue, but only when the loss:

· results from the necessary suspension of operations;
· is caused by direct physical loss or damage to property at the insured premises; and
· results from a covered cause of loss.

Are Generally Accepted Accounting Principles Always Relevant when Measuring Financial Damages under the Insurance Contract?

From an article appearing in the CPA Litigation Counselor, entitled,
"Determining Damages Under Insurance Indemnity Contracts-Appropriate Measures,"
Steven J. Meils, CPA, October 1999

Many years ago those drafting the first insurance indemnity contracts recognized the inherent differences in the measurement objectives of the indemnity contract compared to those of financial accounting and reporting. In the world of financial accounting, the accountant concerns him-or herself with the presentation of financial information in a fair, complete and objective manner. However, it is the measurement objective of indemnity accounting to find an amount that would restore an insured to the financial condition that likely would have resulted or been achieved without damage or destruction of property or a resulting suspension of operations. The amount of measured damages recoverable will normally depend on the provisions of the insurance policy.

Over time basic accounting concepts, assumptions, principles, and modifying conventions have emerged and have been adopted by the accounting profession. The body of theory comprising those principles provides the foundation for what is commonly referred to as Generally Accepted Accounting Principles (GAAP).

In many cases the principles relevant in financial accounting will be equally relevant in insurance indemnity accounting. For example, when one uses the historical trends in monthly sales to project likely sales during a period of indemnity, it is important that the historical sales used for projections be reported in the periods actually earned. If this is not the case a sales projection may result that is not indicative of the sales that likely would have occurred during the period of indemnity.

Similarly, historical operating expenses must be reported in the periods in which they were incurred if they are to be relied upon for expense projections and to determine the appropriate values in loss calculations. Thus the revenue realization principle, a basic principle in financial accounting, is equally important in insurance indemnity accounting.