Advance Profits Business Interruption Insurance
This cover is available where a new business is contemplated or a major extension to an existing business is to be made by either their building work or the introduction of new equipment or machinery. Were either of the losses to happen, a financial a financial loss may occur through delay by:
- Damage to the work being undertaken.
- Delay in the finalization of the works as a result of a peril.
- Damage at the premises of a supplier of some key units of plant or equipment.
- Damage to such machinery or equipment while in transit.
The protection of the loss resulting from such interruption is called advance profits insurance. The indemnity period will start on the date when, but for the damage, the new business would have commenced operations in the new premises or with the new machinery or equipment. the contingencies involved may be fire and allied perils, accidental damage, to plant in transit, installation, testing and even marine risks. This type of cover is granted where there is reasonable certainty that the actual date upon which work should have commenced, had the damage not occurred, can be accurately determined. The contract date should allow for the possibility of delays or hold up in supplies not caused by the insured perils.
The following facts will be taken into account in underwriting this class of business.
- The degree of hazard posed by the perils which are the subject of insurance concerned.
- The exposure of insured business to interruption or interference by the spread of the premises, e.g. there may be three or four separate factories but they do operate independently.
- Dependence of the business on a particular part of the premises, e.g. the business may be a number of retail shops with a factory or warehouse. If fire occurs in the factory, this would seriously affect the business by interrupting supplies to the shops.
- Where the business is a seasonal one, for example, a fire at beach hotel in the coast at the beginning of peak season would have a serious effect upon the turnover than at any time.
- The length of indemnity period- the claim potential increases in proportion to the duration of the indemnity period.
- Specialized manufacture which may aggravate the delay in resumption of normal production, because of special machinery, goods or raw material being difficult to replace or in short supply.
- The aspect of competition and the ability of business to recover lost customers after damage to its premises.
The underwriter will most likely call for an interruption report to supplement the fire surveyors report. This will inter alia show the details of the comparative profitability of different premises to be included in the cover and the extent to which each can operate independently or is independent wholly or partly on the activities at other premises.
The effect of certain features may call for different judgement from the material damage and business interruption loss aspects. Thus a building of light or non- standard construction, while presenting a higher fire hazard, may indicate speedy and easy replacement, so that only a short period of interruption is likely following damage, whereas a high standard of construction, while minimizing the fire hazard, may indicate that if damage occurs, the production will be held up for a long time while a similar building is erected.
The Basis of Rating
The rate charged for business interruption insurance depends on:
- The physical risk of the insured premises
- The indemnity period chosen
- The interruption risk
Business interruption rates have a starting point called the basis rate which is usually average rate applied to the material damage on contents. Contents are the ones concerned with operation and therefore have a greater impact on interruption risk. To the basic rate, a percentage loading is then applied which caters for the interruption risk. The percentage is taken from a well-recognized standard scale of loading to produce a profit rate linked to the length of maximum indemnity period.
Common examples of indemnity periods chosen and percentages applicable are as follows,
Policy Period Percentage of premium
3-month indemnity period 50 percent of annual premium
15 95 of the full period premium
In few special cases, it is considered that the average fire rate on a building will give a more accurate indication on the interruption risk than the average rate on contents and in such cases it is the sums insured on buildings which are taken into account in the calculation of the basic rate.
An abnormally high or low interruption risk might influence an underwriter in deciding to vary the percentages shown above. For example, when underwriting a general ware house, situated in a modern brick and steel building on the outskirts of a large town with a high unemployment and plenty of vacant warehouse space, one will have to take into account the following,
- Alternative building is readily available
- There is no specialized machinery required
- Labour is available in plenty
- Replacement of stock is likely to be freely available
Losses which are not Covered
Examples of consequential losses which are not covered include:
- Under- insurance against material damage
- Difference between the value of stock or plant at the time it suffered insured damage and its value at the time of its subsequent replacement.
- Deterioration of undamaged stock after damage has occurred to the premises by the fire or other insured peril. E.g. foodstuff may deteriorate in store and become unsalable, or goods may go out of fashion.
- Fines, damages and/or penalties under contracts arising from breach of contract in consequence of damage.
- Loss of goodwill
- Failure to recover debts owing to destruction of accounting and business records
- Claims from third parties
Measuring the Loss
While it is not difficult to calculate the gross profit it earns after the effects of the damage have ceased. There are also some difficulties in calculating the gross profit which would have been earned had damage not occurred. The policy specification lays down the formula under which the trading loss will be assessed.
In the specific terms of the policy, the amount to be paid will be:
The sum produced by applying a rate of gross profit to the reduction in turnover; adding any increase in cost of working spend to minimize the loss of gross profit.
There will be additional expenses which may be found in items such as overtime to staff, rent and rent of temporary premises, advertising etc. the insurers liability is based upon the additional expenditure, not exceeding the amount produced by applying the rate of gross profit to the amount of the reduction that has been avoided by the expenditure. This restriction is inserted in the policy to prevent the insurers being called upon to pay unreasonable costs. In other words, insurers will not spend more than a shilling to save a shilling. The above results will be adjusted for:
- The trend of the business.
- Any saving such as rent, or rates which cease to be payable during the indemnity period
- Adjustment for under-insurance (where average is applicable)
For there to be a valid claim in a Business Interruption Policy, the following conditions must be met. There must be damage;
- Damage caused by an insured peril
- To the property used by insured
- At the premises where cover has been extended to other premises, for the purpose of the business. Resulting in interruption of the business.
Once the conditions are satisfied, the formula set out in the specifications is used to calculate the loss. the following are the steps set out in the formula to arrive at the amount paid.
- Establish the duration of the indemnity period
- Calculate the rate of gross period (or revenue, gross fee etc.)
- Calculate the reduction in turnover;
- Establish loss of profit (i.e. the reduction in turn over multiplied by the rate of gross profit)
- Calculate the increase in cost of working
- Identify any saving in expenses
- Check the adequacy of the sum insured
The following illustration shows how these steps are used to calculate a loss based on the gross profit type of cover.
Step 1. Establish the indemnity period
Let’s assume the indemnity period was 5 March 2010 to 23 April 2010, i.e. Seven Weeks
Step 2. Calculate the rate of gross profit
This is worked out by getting the gross profit earned in the last financial year divided by the turnover (sales) for the same period and expressed as a percentage. we shall assume that the Gross Profit in the last financial year was KES 55,000,000 and the turnover was KES 100,000,000. Therefore, the rate of gross profit is KES 55,000,000 divided by KES 100,000,000 X 100% = 55%
Step 3. Calculate the reduction in turnover
The reduction in turnover is:
The standard turnover, i.e. the turnover during the preceding the period in the preceding twelve months which corresponds with the indemnity period (05/03/2009 – 23/04/2009.
- Let us assume this was KES 10,000,000 while the actual turnover during the period of disruption was KES 8,000,000
- It follows a reduction in turnover was KES 2,000,000
Step 4. Establish loss of gross profit.
Reduction in turnover (KES 2,000,000) x rate of gross profit (55%) = Loss of gross profit.
Hence loss of gross profit was KES 2,000,000 multiplied by 55% is KES 1,100,000.
Step 5. Identify the increase in cost of working
These are the extra costs such as overtime payments and rent of temporary premises, incurred to try and reduce the impact of the interruption on the business. The amounts have to be within the economic limits. In simple terms, this mean the insurer will not be prepared to pay more than one shilling to save a shilling. example, we assume that the insured has spent KES 400,000 on increased cost of working. If the insured had not spend this amount, the reduction in turnover would have been KES 3,000,000 instead of KES 2,000,000
To check whether this makes sense, we apply the rate of gross profit to the reduction in turnover avoided. i.e. 55% x KES 1,000,000 = to Ksh 550,000
So, by spending an amount of KES 400,000 to prevent a loss of KES 550,000 in gross in gross profits, makes sound economic sense.
Step 6. Identify any Savings in the Business Expenses;
Savings may arise from any number of charges e.g. heating, lighting, packing, etc. which reduced during the indemnity period.
Let us assume a saving of KES 300,000
Loss of gross digit KES 1,100,000
Increase in cost of working KES 400,000
TOTAL KES 1,500,000
Less savings KES 300,000
Total loss KES 1,200,000
Test for adequacy of the sum insured.
The factors needed to establish what the sum insured should have been are:
Rate of gross profit (55%) applied to;
The turnover for the twelve months immediately prior to the loss. (i.e., before 05/03/09) which was KES 11,000,000
The condition of average states that in the event of underinsurance, the policy pays that proportion of the claim amount which the sum insured (KES 550,000) bears to the amount which should have been insured (KES 605,000)