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.”
The net income and operating expense that would be earned under normal operations, or that is actually earned under continuing operations is always the result of anticipated or actual sales, less direct product costs. It is out of sales, net of direct product costs, that funds necessary to cover operating expenses and net income are derived.
For this reason, if an interruption or suspension of operations does not result in the loss of sales, then no monetary business income loss is sustained by an insured. No monetary loss will result from business interruption then, when sales/revenues are not actually lost due to an inability to produce, provide service or provide the utility of property, and in the case of:
A manufacturing concern
· The insured has or could have made up production losses during the period of indemnity or subsequent to that period through the use of damaged facilities, equipment, or the use of other facilities with available production capacities.
· The insured has or could have purchased products normally produced from outside sources.
· The insured has or could have drawn upon existing inventories at the loss location or elsewhere in order to avoid sales losses.
A service business
If the insured’s customers, clients or patients have or could have been rescheduled during or subsequent to the period of restoration.
Temporary locations are utilized to provide services normally provided at the loss facility.
An apartment complex
· If an insured has or could have transferred tenants from damaged apartment units to previously unoccupied units.
Although in the above circumstances a monetary loss will not have resulted from a loss of sales, a monetary loss will have resulted if the insured incurred costs in excess of those that normally would have been incurred in efforts to continue operations or mitigate losses. The manner in which the policy responds to those increased expenses will depend on the coverage form selected, i.e., CP 00 30 or CP 00 32.
What is the Likelihood that Sales will be Lost?
The likelihood sales will be lost and to what extent will be largely dependent upon the loss mitigation opportunities available to an insured, as described in the preceding paragraphs. The normal length of time between sales order placement and delivery of goods or services necessary to consummate sales is an important consideration in judging whether sales losses will begin immediately after a loss occurrence.
Because there is no time lag between order placement and the delivery of goods in operations such as restaurants, grocery stores, or other operations dependent upon facilities to do business, in those operations, sales losses will usually begin immediately after a loss and will continue throughout the period of suspension. In cases where sales are not necessarily facility dependent and order lead times are long enough to afford an insured the opportunity to respond to the circumstances of its loss, sales may or may not be lost depending on the mitigation opportunities available to the insured. A wholesaler of goods capable of quickly relocating operations and procuring replacement inventories within a reasonably long window of sales opportunity, for example, may sustain no loss of sales at all, notwithstanding the destruction of its permanent warehouse facility. It would, however, likely incur extra expenses or expenses to reduce the loss in its efforts to continue operations.
Are the Measurement Objectives of the Business Income Indemnity Contract Better Served by Providing the Business Income Value of Lost Production, Services or Utility of Property?
Insureds, their advocates, and others have long maintained the position that it is a loss of production and not necessarily a monetary loss that should provide the measure of loss under the indemnity contract. Although the author does not agree with this position, because such views are common in practice, the merits of the arguments in support of the position are worthy of consideration.
In an article entitled “Going Off-Line,” appearing in the November 1992 issue of Claims magazine, the article's author, Joseph Segal, a CPA and public adjuster, expresses the view that the sales value of production should be the measure of business interruption loss for a manufacturing concern.
In this article, Segal defines business income coverage as follows:
“In a mercantile operation, the retailers operating expenses and profit are derived from the markup of goods purchased for resale. That difference is what is insured.”
“In a service business, with little or no sale of merchandise, the earnings are reflected in the value of services rendered, and that is what is insured.”
“In a manufacturing operation, the manufacturer generates its income from the value added to raw materials which it converts into a product. The difference between the value added plus the raw material cost and the sales value of the product is what is insured.”
Segal further states,
“ISO never intended for a manufacturer to measure the lost revenue by any other means than sales value of production, as has been traditional for a manufacturer.”
As proof of ISO’s intent in this regard, Segal refers to the “Business Income Report/Worksheet,” Form CP 15 15, which he notes measures the revenue based upon sales value of production in determining insurable interest. He then concludes that ISO recognizes that a manufacturer is insuring the ability to produce. It is further suggested in the article that insurance companies and their representatives, by clinging to lost sales as a measure of loss, ignore the insured’s lack of ability to produce and that they attempt to alleviate the problem by resorting to a makeup clause that does not exist in the policy.
Others, prior to the introduction of the business income form, maintained the position that the coverage definition provided in the standard manufacturers’ gross earnings form implied that the measure of loss should be the sales value of production lost and not necessarily lost sales. In the form, coverage was defined as “the reduction in gross earnings less charges and expenses, which do not necessarily continue.” Gross earnings were defined as the “total net sales value of production,” less other direct product costs.
It has also been suggested when manufacturers or service businesses are interrupted that there is no way to turn back the clock to recover the production or services lost and that to suggest an insured must somehow makeup production or services after the suspension period ends is unreasonable, in light of the fact that losses after the suspension period ends are generally not covered by the policy.
The author would respond to these arguments as follows:
Although Segal, in advancing his positions, redefines coverage for us and distinguishes between mercantile, service, and manufacturing insureds, no such distinction is made in the Business Income Form CP 00 30 (the subject of his article). In fact, only one coverage definition is provided in the business income form and it is generally understood that the form is available to all insureds. In the form, coverage is defined in terms of net income or loss, which, as previously discussed, is a function of anticipated or actual sales, less direct product costs and operating expenses. Net income or loss is rarely recognized on the basis of production of goods alone in financial or insurance indemnity accountings.
Although Segal concludes that ISO recognizes a manufacturer is insuring the ability to produce and that this should always be the basis for recovery, he can do so only by ignoring the following loss condition in the policy which he effectively states does not exist.
Loss Condition D.4.c. Resumption of Operations
“We will reduce the amount of your:
(1) Business income loss, other than extra expense, to the extent you can resume your ‘operations’ in whole or in part, by using damaged or undamaged property (including merchandise or stock) at the described premises or elsewhere.”
Those who advanced the same position on the basis of defined coverage under the prior standard manufacturers’ gross earnings form also had to ignore a similar resumption of operations clause in that policy.
If one is to believe that it was ISO’s intent under either coverage form to insure the sales value of production without proper consideration of the actual monetary loss, then one must further believe that the resumption of operations clauses found in both policies are without meaning or purpose. Such an assumption would not be reasonable. In fact, the resumption of operations clauses found in both policies serve a very definite purpose. If an insured has the ability to mitigate its economic loss in any reasonable way, it must do so.
Segal relies upon the Business Income Report / Worksheet (Form CP 15 15) to support his position concerning ISO’s intent. When one understands the purpose of the worksheet, however, the argument quickly falls flat. The worksheet establishes a value to be used in calculations required by the coverage option agreed value. Agreed value is one of three coverage options that may be elected by an insured in lieu of the coinsurance condition in the policy. If the amount of insurance carried by an insured is inadequate based on the minimum insurance requirements of the coinsurance condition or under the calculations required by an optional coverage such as agreed value, then recovery of the actual loss sustained may be limited in the manner described in those policy provisions.
It is true, as Segal suggests that the net sales value of production is calculated on the worksheet. The author agrees that this is the amount that should be insured. It does not necessarily follow, however, that the net sales value of production will always provide the basis for recovery. As previously noted, the actual loss sustained can only be determined through the application of the coverage definition with appropriate consideration given the resumption of operations condition in the policy. The net sales amount of production, during the period of suspension, is always an important consideration in the determination of the actual loss sustained and must always be measured when a manufacturing loss occurs. It will serve as the appropriate measure of loss, however, only when an insured can demonstrate an equivalent and corresponding loss of sales, and the net sales value of production is appropriately reduced for non-continuing operating expenses during the period of restoration. If an insured recovers the sales value of production and an equivalent amount of sales are not actually lost, the insured has enhanced its financial condition over that which would have resulted had there been no interruption of production. This is inconsistent with the measurement objective of the business income indemnity contract.
Although Segal, in his article, would seem to suggest that his view is the traditional view in the industry, the works of noted authors such as Withers and Glendening on the topic of business interruption would clearly contradict this.
Should a Monetary Loss that Would Result from Lost Production during the Suspension of Operations be Limited to the Period of Restoration?
Some have suggested that a strict reading of the language provided in the coverage definition of the business income form would preclude recovery for losses not incurred during the period of restoration. They would further suggest that coverage language for extra expenses would similarly restrict recovery for those expenses to the same period.
The policy states with regard to business income:
“We will pay for the actual loss of business income you sustain due to the necessary suspension of your ‘operations’ during the ‘period of restoration.’”
The policy states with regard to additional coverage for extra expense:
“Extra expense means necessary expenses you incur during the ‘period of restoration’ that you would not have incurred if there had been no direct physical loss or damage to property caused by or resulting from a covered cause of loss.”
It is clear that if those definitions are narrowly construed to mean that a monetary loss (loss of sales or extra expense) must be incurred during the period of restoration, that in many cases a measurement result would be obtained that does not fully indemnify an insured for the economic impact of its production losses. A manufacturer whose products are seasonally demanded, for example, may lose no sales if a production interruption occurs in months prior to months of peak sales demand and if sufficient levels of inventory are on hand in order to avoid sales losses. It would, however, likely lose sales as a result of the production interruption if it did not have sufficient production capacity to restore normal inventory levels prior to the months of peak sales.
If a monetary loss must be incurred during the period of restoration as some would suggest, then under the previously-described circumstances nothing would be recovered under the policy, notwithstanding the fact that the insured may eventually sustain a monetary loss from the interruption of production. On the one hand, the policy would require the insured to draw upon inventories in order to avoid sales losses; on the other, the extra expense necessary to restore inventory drawn upon would likely fall outside the period of restoration and not be covered. Conversely, a windfall profit may result to the insured based upon this interpretation if sales could not be made during the period of restoration but intended sales during that period are actually made up after the restoration of property.
In the author’s opinion, the business income coverage form intends neither of the two results described above. It is ultimately the net sales amount of production that is insured under the business income coverage form for a manufacturer. Although it has long been the position of many in the insurance industry and held by the courts that production losses incurred must also result in monetary losses, it does not necessarily follow that the monetary loss must fall within the period of restoration, nor, in the author’s opinion, should a reasonable reading of the policy coverage language lead one to this conclusion. When a loss of production has or will result in sales losses whether within the period of restoration or not, the business income loss calculation must reflect the impact of those sales losses. No other interpretation would be reasonable or achieve the measurement objective of the contract (the actual loss you sustain).
With regard to the limitation of extra expenses during the period of restoration, although at first reading the limitation described in defined coverage would seem difficult to overcome, in fact it can be overcome when one closely examines the loss determination conditions related to extra expense coverage (Loss Condition D.4.b. - Loss Determination).
The extra expense loss determination conditions provide:
“The amount of extra expense will be determined based on:
(1) All expenses that exceed the normal operating expenses that would have been incurred by ‘operations’ during the ‘period of restoration’ if no direct physical loss or damage occurred. We will deduct from the total such expenses:
(a) The salvage value that remains of any property bought for temporary use during the ‘period of restoration’ once ‘operations’ are resumed; and
(b) Any extra expense that is paid by other insurance except for insurance that is written subject to the same plan, terms conditions and provisions as this insurance; and
(2) All necessary expenses that reduce the business income loss that otherwise would have been incurred.”
It is clear that items of extra expense that result from item (2) above are to be added to item (1). It is also clear that the only requirement of item (2) is that the necessary expense must serve to reduce the loss that otherwise would have been incurred. The period of restoration limitation is not stated for item (2).
It can reasonably be concluded then, based upon the policy language, that an expense incurred may be recovered outside the period of restoration if the expense served to reduce the loss that otherwise would have been incurred. Unlike the extra expenses incurred during the period of restoration, however, the insured must demonstrate that the expenses incurred outside the period of restoration do not exceed the amount of loss savings resulting from those expenditures.
