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.
Net income or loss for this purpose is always determined under Business Interruption Coverages before consideration of income taxes.
Policy conditions, exclusions, limitations and endorsements may further limit or expand coverage or recovery under the policy.
The Underwriter's Exposure
The exposure the underwriter assumes when writing a business income insurance policy is the net income or loss plus all operating expenses, during a period of indemnity. The amount of operating expenses that actually continue will normally be dependent upon the extent of damage to covered property and the length of the necessary suspension. When property is partially damaged and the necessary suspension period is short, most or all operating expenses will normally continue. When damage is extensive or complete, many operating expenses will not continue, i.e., non-essential payroll, building rents, utilities, etc.
The Coinsurance Condition
The coinsurance condition is common in business income coverage. Thus, it is beneficial to consider the requirements of the coinsurance condition when attempting to understand business income loss measurement.
Most loss occurrences result in only partial damage or destruction of property. Without the coinsurance condition an insured could recover the limits of the business income policy over short periods despite the fact that it may be substantially underinsured for losses of longer duration.
The coinsurance condition in the policy is designed to encourage insureds to adequately insure business income values. In the event that the insured does not maintain the minimum amount of insurance required by the coinsurance condition (net income or loss plus all operating expenses multiplied by the stated coinsurance percentage), the insured will become a co-insurer of any loss sustained under the policy along with the insurer.
The amount of loss the underwriter will pay, expressed as a percentage, is the amount of insurance carried, as specified in the policy declarations, divided by the minimum amount of insurance required. The minimum amount of insurance required is the actual and projected net income and all operating expenses times the coinsurance percentage specified in the declarations, from the policy inception date (or last renewal) twelve months forward.
The coinsurance formula is expressed as follows:
Coinsurance Formula
Percentage of Loss Collectible is the
Insurance Carried
Divided by:
Insurance Required
Insurance Required is the
Net Income and All Operating Expense
Times:
Coinsurance Rate
For the purpose of illustration, consider the following projected income statement for a mercantile operation from January 1, 2000 (policy inception date) through December 31, 2000.
If an 80 percent coinsurance requirement is assumed in the above example, the minimum insurance required in order for the insured to be fully indemnified in the event of covered loss would be $199,600, which is the sum of net income and all operating expenses times 80 percent. Thus, if at least $199,600 of business income insurance were carried by the insured at the time of loss, the insurer would fully pay the insured to the extent that losses were determined under the policy.
If the insured had carried only $100,000 of insurance in the above example, the insurer would pay only 50 percent of a calculated loss [$100,000 (policy limit) divided by $249,500 (net income and all operating expenses) times 80 percent]. The insured would be responsible for the remaining portion of any loss, which in this case would be 50 percent.
How Income Statement Projections for Business Income Loss Measurement
may differ from the Income Statement prepared in Financial Accountings
Calculations of business income loss and the minimum insurance required by the coinsurance condition are normally rooted in an entity’s historical operating results (income statements), taking recent operating trends and other relevant factors into consideration.
The likely net income or loss that the business would have earned or incurred is determined based upon projected sales, direct costs and operating expenses during the period of indemnity. The loss evaluator must then determine to what extent operating expenses have continued during that period.
When undertaking projections for business income loss measurement, it is useful to recast the projected income statement including sales, cost of sales, and operating expenses in a manner that differs from financial accounting. This is necessary because the measurement objectives of the business income indemnity contract differ from those of financial accounting.
The presentation of the projected income statement for business income loss measurement will differ in two ways:
Selling Expenses
Certain selling expenses normally classified as operating expenses in financial accounting are deducted from gross sales (revenues) in income projections. These selling expenses may include sales discounts, freight-out expense on sales, bad debt expense and collection expense. Returns and allowances would also be a deduction from gross sales in income projections although they are normally reflected as such in financial accounting.
Direct Costs
Cost of Sales in business income projections should include only:
· Cost of goods purchased for resale and related freight costs
· Cost of raw materials, supplies and related freight costs used
(consumed) in production
· Cost of purchased services from outside sources that do not continue under contract
All other costs and expenses should be classified as operating expenses in projected income statements.
Although in previous versions of the Business Income Form CP 00 30, operating expenses were not defined, in the revision of the form, 06 95, it is stated that operating expenses include all categories of costs and expenses, less the items comprising the two general categories described above.
The Business Income Form CP 00 30 is intended for use in both mercantile and manufacturing concerns. In order to illustrate how the historical financial statement for mercantile and manufacturing operations should be recast for business income loss projections, the following examples are provided:
As can be seen in the above illustrations, operating expenses in the business income projection do not vary significantly from those reflected in the financial statement for the mercantile business. This is the case because mercantile businesses normally include in cost of sales only goods purchased for resale and related freight costs. These costs would normally not continue in the event of business suspension, nor would they be part of the loss exposure accepted by the underwriter.
Similarly, certain direct selling costs will not continue when sales are prevented. These costs, including bad debts, freight-out costs, etc., should not be reflected as operating expenses in business income projections for mercantile or manufacturing insureds.
Operating expenses in income projections for the manufacturing insured will usually vary substantially from those reflected in financial accounting, as previously illustrated. In financial accounting, all manufacturing costs, both direct and indirect, attach to the product manufactured. The costs are then allocated to periods in which the products are actually sold and are classified as cost of product sales. (The matching of product manufacturing costs, both direct and indirect, with related product sales in the period in which sales are earned is a basic accounting principle.) Many of these allocated costs of sale, however, including direct labor and other manufacturing overheads such as facility rents, utilities, indirect labor, etc. may, and often do, continue in the event of a business suspension. If these costs were not recast as operating expenses in business income projections, the insured would not be fully indemnified for its losses when the coverage definition is applied, nor would the minimum insurance required for coinsurance calculations be properly measured.
For business income loss measurement, operating expenses are all expenses that may, and actually do, continue (are incurred). In coinsurance calculations, operating expenses are any expenses that may continue. Whether the operating expenses actually do continue, or to what extent, is not relevant in the coinsurance calculation.
The Disparity between the Recoverable Loss and the Required Insurance for Coinsurance Calculations
For the reasons stated in the preceding paragraphs, the insurance required under the coinsurance calculation will normally exceed the amount of loss recoverable under the policy.
In many cases, an insured would be required to insure a greater business income value than would actually be recoverable in order to be fully indemnified for its losses.
Note: Although the coinsurance calculation is based on a twelve-month period, the period of restoration under the policy is not limited to one year. Thus, the limits of the policy would be recoverable provided that the period of restoration was long enough. Restoration periods in excess of one year, however, are not common.
In short-term losses, the disparity between the recoverable loss and the required insurance is usually not significant. In losses of longer duration, differences may be substantial.
Using the details in Illustration 1, the potential disparity between the recoverable losses and the minimum insurance required for assumed losses of one month and of twelve months is shown below.
The above differences are graphically illustrated as follows:
As can be seen in the preceding example, much of the disparity in the twelve-month loss calculation is caused by payroll. Payroll costs are a significant operating expense for most businesses. When the continuation of ordinary payroll is considered unnecessary in the event of partial or complete suspension of operations, an insured may elect to exclude all or a portion of ordinary payroll from coverage by policy endorsement (CP 15 10). Ordinary payroll is all payroll except that of officers, executives, department managers, employees under contract, and scheduled designated job classifications or employees. Ordinary payroll would also include the payroll-related costs of employee benefits, FICA expenses, and worker’s compensation premiums.
When ordinary payroll is excluded by policy endorsement, the amounts so excluded reduce the total operating expenses in coinsurance calculations. Thus, some of the disparity between the recoverable loss and the required insurance may be eliminated as shown in the following illustrations:
Similarly, an endorsement for exclusion of power, heat, and refrigeration expenses is available that would exclude those items from both coverage and coinsurance calculations.
Actual Loss Sustained
Coverage under the business income policy is defined as the net income (or loss) that would have been earned or incurred and continuing normal operating expenses incurred. The policy further provides, however, that this calculation is to be reduced to the extent that operations have or could have been resumed in whole or in part through the use of damaged or undamaged property at the described premises or elsewhere.
In order to determine the actual loss sustained, the calculated net income or loss and continuing operating expenses must be reduced to reflect the impact of continuing operations. The impact of continuing operations on the business income loss calculation is illustrated as follows:
Comparison of the Business Income Coverage Form and the Gross Earnings Form
Although the expression of coverage in the business income and gross earnings forms differ, the loss calculations under either approach will always provide the same result, illustrated as follows:
The Selection of Policy Limits and Coverage Options
Business income coverage is provided in addition to coverage for property and is integrally related to property coverage. It is the income producing utility (use or occupancy) of damaged or destroyed property for which coverage is intended.
The selection of an amount of insurance and a coverage option requires an evaluation of the time necessary to restore property in the event of a complete loss. All real property, personal property and a tenant's interest in improvements and betterments used in operations should be considered in this evaluation.
The length of the period of restoration is always of critical importance when determining the loss exposures of the insured or underwriter. The importance of the property insured in order to do business is also a consideration. Could the business use temporary locations or property in order to continue its operations? How much would those efforts cost?
After establishing the time necessary to restore property and the opportunities to continue business, the likely business income and extra expense losses that would occur in the event of the complete destruction must be estimated. The amount of those losses that are collectible will depend, in large part, on the amount of insurance carried and the selected coverage option. The coverage options available include agreed value, maximum period of indemnity, and the monthly limit of indemnity.
The Coinsurance Condition
Where no coverage option is selected, the coinsurance condition of the policy will be in force. Thus, if the amount of insurance selected is less than the amount required by the coinsurance condition, then unindemnified business income losses may result when operations are suspended.
The amount of insurance required is the underwriter's estimate of the maximum exposure it assumes when writing business income protection. When a coinsurance rate of 50 percent is used in the policy, there is an assumption by the underwriter that the period of restoration will be six months (50 percent of twelve months). The required insurance is then calculated using the net income and all operating expenses for twelve months from the policy inception or the last renewal, times the specified coinsurance rate, as previously discussed in this section.
If the business maintains the amount of insurance required it will fully recover its business income losses in the event of a loss. Extra expenses are not subject to the coinsurance condition.
In most cases, when a complete loss occurs, the calculated business income losses incurred will be less than the calculated business income loss exposure computed in the coinsurance condition. This is because many operating expenses will not continue.
If the anticipated extra expenses incurred in efforts to continue operations exceed the amount of estimated non-continuing expenses in business income loss calculations, and the business seeks to avoid unindemnified losses, amounts should be added to the coverage limits to cover those expenses.
Agreed Value
When the agreed value coverage option is selected, the insured reports its business income values to the insurer. The considerations with regard to the amount of coverage purchased (policy limit) are identical to those involved when the coinsurance condition is in effect. If an amount of insurance (policy limit) is selected that is less than the agreed value (net income and all operating expenses for twelve months times the specified coinsurance rate), then in the event of a loss, the insured can only collect the ratio of the insurance carried to the agreed value, times its actual losses.
Maximum Period of Indemnity
In the event of complete destruction, if business income losses would not exceed 120 days, use of this coverage option would allow an insured to underinsure its business income values without penalty. However, if the insured seeks to avoid unindemnified losses it must select an amount of coverage no less than anticipated losses and extra expenses for its maximum period of business suspension. Any losses incurred after 120 days would not be recoverable when this coverage option is selected.
Monthly Limit
The monthly limit coverage option limits the amount of recovery under the policy for each 30-day interval from the date of loss. The amount of business income losses collectible in any 30-day period cannot exceed the policy limit times the fraction e.g., one-third, one-fourth, etc., shown in the policy declarations.
Thus, if a business seeks to avoid unindemnified losses under this coverage option, it must maintain a coverage limit that, when multiplied by the fraction specified in the declarations, produces a monthly limit that would exceed the maximum amount of loss it may incur for any 30-day period.
For this reason, highly seasonal businesses may want to select other coverage options.
