Business interruption cover: what it is, why it matters

July 5, 2023

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In a typical day, a variety of situations may unfold that could stop a business’s operations in its tracks. Consider for example, a warehouse of consumer goods is heavily damaged by a tornado. It partially rips off the roof and destroys a considerable fraction of the inventory. Business doesn’t pause when a disaster hits — there are bills to pay, client and supplier relationships to maintain. Aside from physical damage to the structure itself and its contents — including anything that needs to be repaired or replaced — the organization will suffer a loss of income and profit during the recovery period. There will be additional costs to keep the business running, such as hiring a contractor to fix the damage, renting a temporary storage facility or replacing lost inventory. This is, in essence, the importance of business interruption (BI) coverage: it can protect against losses sustained during periods of suspended business operations — mitigating economic harm and minimizing financial loss.

Not all BI covers are created equal, and it’s imperative to be mindful of the expectation gap — there is a tendency to overestimate or assume coverage, when in fact there is a limit.

BI policy types: their purpose and differences

There are three main types of business interruption cover, and a business’s unique activities and requirements help dictate which is suitable. All policy types share a common foundation: when an incident occurs, it is designed to respond to changes in a business’s costs and revenue. But it’s how costs and revenue change post-event that matters. In other words, what would happen to a business in the event of a loss — which costs would cease, which would continue, and how would revenue be impacted? Each cover operates differently and might be suited to certain circumstances based on a particular business’s needs.

First, a loss of Gross Profit cover — the most common choice of business interruption cover in the UK — covers the loss of Gross Profit following a reduction in turnover and any increased cost of working. A key feature of this type of cover is that policyholders can specify certain uninsured working expenses to deduct to reach their final Gross Profit sum insured.

Second, a loss of Gross Revenue cover pays back the reduction in turnover following a loss, in addition to any increased costs of working. This cover avoids the need to calculate the sum of a business’s Gross Profit to be insured —calculating revenue is exceedingly easier than calculating profit, and leaves less room for underinsuring.

Finally, there’s the increased cost of working (ICW) cover, which can exist in one of two ways — either included as part of the Gross Profit and gross revenue covers, or taken out as a standalone policy. At a bare bones level, in either scenario, ICW provides policyholders with cash to cover reasonable expenses that will help a business recover following a loss. If an incident’s primary impact is causing revenue to go down, look to loss of Gross Revenue/Gross Profit. But if an incident’s primary impact is causing some costs to go up to reduce a revenue reduction, look to ICW.

Defining ICW, word by word

The increased cost of working cover insures any additional expenditure that is solely, necessarily, and reasonably incurred, to avoid a reduction in turnover (within the maximum indemnity period). In the context of this policy, because the word ‘solely’ denotes the benefit of one single thing, it can be quite limiting. Instead, we can think of solely as predominantly — an increased cost is an expenditure that’s incurred for the predominant purpose of avoiding or diminishing a reduction in turnover. The policyholder is the only person who can best determine and propose what is necessary or reasonable since they know their business best. If an expenditure proposed as an increased cost is clearly obscene and objectively unreasonable, common sense can be applied. Otherwise, it’s guided by policyholder discretion.

Ideally, agreeing proposed increased cost expenditure would take place during a collaborative, early and open dialogue between the policyholder and insurer. The discussion would not only entail crafting a mitigation strategy and establishing which increased costs of working fit into the cover presented, mindful that UK BI cover has a hard stop in time. The maximum indemnity period (MIP) is the period (selected at inception by the policyholder) for which insurers will indemnify or compensate the policyholder for financial losses arising from an insured event. What must fall within the MIP is the revenue reduction avoided. Increased costs incurred after that time might still be covered (ie if a minimum term lease on an alternative building was say five years, and a policyholder was stuck with that even though they re-occupied the repaired building within the MIP). The timing of the revenue reduction avoided is key, rather than the timing of the expenditure to avoid that. Additionally, ICW covers are subject to the economic limit, meaning that proposed costs cannot be of higher value than the Gross Profit would be if the expenditure was not incurred. Further, it must constitute an actual increase in cash spent, and not just increase as a ratio to (reduced) turnover.

Which costs are considered increased costs?

Examples of traditional expenditures incurred include costs that accelerate property damage repairs, such as costs to hire a project manager to drive a mitigation plan, or a contribution to building costs to avoid further delay. Other costs might be associated with overtime working, subcontracting or a simple additional cash expenditure necessary for sustaining business practices. Notably, these are all costs a business owner would choose to incur to help their business recover after an incident (within the maximum indemnity period).

However, not all costs caused by a peril will be covered as increased costs of working — such as those related to property damage underinsurance, increased cost: revenue ratios or contractual penalties, to name a few. Further, any costs that are themselves a consequence of a reduction in turnover are not considered ICW, whether or not they arose as a consequence of the insured event. The costs had to have been incurred to avoid a reduction in turnover in the first place, not as a consequence of the reduction.

A good rule of thumb is as follows: if the insured can choose to incur a cost, it may be an increased cost — if they can’t choose to incur the cost, it may simply be a consequence of the incident (and not all consequences are covered).

The bottom line

Whether it be increased cost of working only or Gross Profit, business interruption covers ultimately all revolve around increased costs and mitigation. Deciding on a BI policy, and crafting a beneficial cover (with an MIP of at least 2 or 3 years, and as short a list of costs that are not insured as possible) means working with brokers to assess all realistic business-specific scenarios, even beyond external factors.

Then when there is a claim, there must be frank discussions on proposed costs early on. The most important factor in this process is the insurer’s ability to utilize a collaborative approach throughout, and successfully build trust. A policyholder needs to trust if they spend the money to protect their business, insurers will do their part to reimburse them. And with trust, comes the confidence on behalf of the policyholder to incur increased costs — which in the end, if done correctly, will benefit all parties.