The art and science of getting business interruption cover right

July 8, 2024

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By Aruna Chandrapalan, Partner, Head of Forensic Accounting Services, Asia; Gerald Cheang, Senior Manager, Forensic Accounting Services, Asia

According to a January 2024 report, business interruption (BI) is the second-biggest risk (behind cyber incidents) facing companies today — both globally and in Asia in particular. In fact, BI often accounts for more than 50% of incurred losses in commercial property claims. Large-scale supply chain disruptions and natural disasters in recent years have shined a light on the need for businesses to have proper insurance cover for their ability to generate revenue. But determining the right level of cover, to ensure proper coverage without overpaying on premiums, can be challenging — especially since what’s being insured is intangible. In this blog, we’ll explore some of the factors that businesses need to consider when evaluating their cover for business interruption.

Types of BI cover

When it comes to BI, one size does not fit all. There are various types of cover that work differently to meet the financial needs of a wide range of businesses. Here are some of the most common ones:

  • Gross profit: In this model, only those expenses that directly vary in proportion to sales are deducted from turnover in calculating the insurable profit. While most policies come with a standard definition of gross profit, the advantage of this cover is that businesses can specify which costs to deduct to arrive at the sum insured. This means they don’t have to insure costs that will cease in the event of a loss. Gross profit is well suited to businesses in the manufacturing, retail and restaurant sectors that have many variable and direct costs (such as raw materials and distribution). 
  • Gross revenue: Unlike with gross profit, no costs are deducted from total turnover under gross revenue cover. This approach has fewer pitfalls and greatly reduces the risk of being underinsured. Gross revenue cover is a good fit for service providers, like accounting and law firms, that have few variable and direct costs.
  • Increased cost of working: With this kind of cover, there is no economic limit. This type is best suited for large multinational organizations with solid business continuity plans (BCP) and that may be relatively unaffected by a loss at a single operating location. They are more likely than small businesses to successfully move operations to another location or have people work remotely in order to keep things running.
  • Standing charges: This type of cover provides protection for specified operating expenses (such as rent and salaries) that companies must pay, regardless of revenue loss. Because they generally have substantial fixed costs, manufacturing and retail businesses are most likely to take advantage of this option.

Calculating sums insured and indemnity periods

These coverage options have ramifications for a business’s sum insured (SI). Unlike in property insurance, where the intent is to restore or replace something tangible that’s been damaged or lost, in BI what’s covered is intangible: the revenue-generating capacity of a business. But just as with any kind of insurance, BI insurers accept a degree of risk in exchange for premiums paid. To ensure risk is transferred appropriately, SI must be accurate at the inception of the policy. If the SI is too low, the insured may be inadequately indemnified for losses and absorb too much risk. If the SI is too high, the business may overpay for premiums for years.

When determining appropriate SI, always begin with a thorough understanding of the business. Keep in mind that although two companies’ profiles may look similar, their risks can be quite different. Consider, for example, two restaurants in different parts of town that serve different cuisine at different price points to different types of clientele; their SI calculations will vary greatly. Another thing to remember is that past performance may not be indicative of future revenue, given changes in local conditions and other market factors. This is especially true for relatively new businesses that are on the rise. Third, many neglect to account for the fact that a partial loss can actually exceed a total loss— and nearly 90% of BI claims are partial losses. The business may continue to incur fixed costs while operating at reduced capacity, which can have a significant impact on profit margins for a longer period of time.

Another critical variable companies must consider is the indemnity period. This is how long it will take the business to get up and running again following a loss. It can be affected by the time needed for rebuilding and reinstatement, planning and approvals, new and replacement equipment, hiring efforts, regaining market share and more. Businesses are, of course, always looking to compress these timelines to minimize disruption to their operations and revenue. Setting an appropriate indemnity period requires realistically projecting into the future. Because a loss can happen at any time during a 12-month policy period, businesses are wise to look ahead. Say a loss takes place on the last day of the policy period spanning the full maximum indemnity period; if the indemnity period is 24 months, they should be projecting revenue about three years from the start of their BI policy.     

Reserves

Following an insured event, accurate reserving helps insurers manage their financial stability. Knowing how much funding to put aside to cover future claim payments enables them to fulfill their commitments to policyholders. 

Setting accurate reserves starts with a thorough and careful evaluation of various aspects of the business. These include revenue streams, supply chains, dependencies, business continuity plans and related mitigation strategies, historical data and external market factors. A deep dive into the wording and definitions in the BI policy is also critical. Typical reserve calculations are based on the assumed time needed to repair the damaged property and for the business to recover, while accounting for both increased costs and possible savings. Reserves should be continuously reviewed for appropriateness, knowing that circumstances change and new information may come to light after the initial setting.

In summary

Determining the right type of BI cover and calculating the sum insured with correct indemnity periods to appropriately protect the business and their insurer requires an in-depth understanding of the complexities involved. It’s important that businesses accurately assess their risk exposures and financial vulnerabilities related to unexpected interruptions. 

When a BI loss occurs, it’s critical to engage an experienced adjuster with the right kind of specialized expertise as soon as possible. If our team of forensic accounting and business interruption experts can be of service to you or your organization, please contact us at [email protected] or [email protected].

The authors presented some of the content above earlier this year in a webinar hosted by the Sedgwick forensic accounting services team in Asia. Follow Sedgwick on LinkedIn to be notified about future webinars in their series on business interruption.

Learn more — explore our business interruption and forensic accounting services in Asia

Tags: Asia, BI, Business interruption, business interruption (BI) insurance, Coverage, Forensic, forensic accounting services, Insurance, insurance coverage, Property