Terminologies in Business Interruption Insurance
This is the income from goods supplied or services rendered by the business. This is arrived at by multiplying the total sale by the price at which the goods or services were sold. From turn overall the costs of running the businesses must be paid before a net profit is produced. And such running costs, being charges on the business, are referred to either variable charges or standing charges. From this, it should be clear that turnover consists of three components, Net profit, fixed costs and variable charges.
Variable Charges/Uninsured Working Expenses.
Variable charges are charges which vary direct proportional to turnover or activity of the business, e.g. are purchase of raw materials, packing materials and transport expenses for carries of good. Where turnover is reduced due to damage, there will be a proportionate saving directly variable expenses and the proportion of expenses which goes to meet those expenses need not therefore insured.
Standing charges are also known as fixed expenses and are the charges which remain constant despite reduction in production or trading. Hence when the operation of peril slows down or stops, these expenses must continue to be met. They include, rent, ground rates payable to county authorities, interest on loans, bank overdraft charges, fixed cost of water and electricity bills
If a business is disrupted by the operation of a peril, net profits will be affected as it can only be made if turnover more than the combined variables and fixed costs. But since variable charges vary with the level of activity but their disruption cannot involve the insured in loss. it is therefore the net profit and standing charges which are known as gross profit.
Gross profit is arrived at using the following approaches;
Turnover = Net Profit + Standing Costs + Variable Cost
Gross profit = Net Profit +Standing costs
Gross profit = Turnover – variables
Calculations of Gross Profit
This is the amount by which the sum of turnover and the amounts of closing stock and work in progress shall exceed the sums of amounts of the opening stock and the work in progress and the amount of uninsured working expenses.
Working Out of Gross Profit
Gross profit for the period 1.1.2010 to 31.1.2010
Amount of turnover/sales
Opening stock and work in progress
Closing stock or work in progress
Purchases + W.I.P
Gross profit = turnover + closing stock and W.I.P – (Opening stock +Purchases+ W.I.P + Uninsured working expenses)
Gross profit is (KES 35 million minus 16 million) equal 19 million
The uninsured working expenses (in KES)
Insurance premium 350,000
Transport costs 450,000
Raw materials 300,000
Packing materials 200,000
TOTAL 14,300,000 KES 14.3 Million
Net profit is equal to KES 19 million minus KES 14.3 million and is equal to KES 4.7 million.
It can be seen from the above that the gross profit is the total of the insured working expenses plus the net profit, those are the figures covered by the business interruption policy.
The Sum Insured
The gross profit calculated above is KES 19 million. To work out the sum insured from this one has to consider the points below
The financial period
Our starting most current published accounts or business records. We shall assume the period to be January 2010 and 31st December 2010. The gross profit during this period is KES 19 million.
Period of Insurance
The policy is to run from 1st January 2010 to 31st December 2010. The KES 19 million gross profit is a historical figure and needs to be adjusted to cater for inflation and business trends and expansion.
Period of Recover
This should be taken into account the time that the loss has occurred. There is always a possibility that it can occur on the last day of insurance and the business may take some time to recover. The period begins when an insured event occurs to end when the level of business income and profit margin ceases to be affected by the same. we can assume the recovery period will take 12 months.
Increase of Gross Profit Over a 12 Month Period (in KES)
Period of insurance
Loss on 31st December 2010 which will take 12 months to recover
1.1.2009 to 31.1.2009
1st January 2010 to 31st December 2010
1st January 2011 to 31st December 2011
KES 19 million
19 million plus 10% which is 1.9 million =20.9 million
20.9 million plus 10% which is 22.99 million
The sum insured will therefore be KES 22,990,000
This the period beginning with the occurrence of the damage and ending not later than maximum indemnity period thereafter during which results of the business shall be affected because of the damage.
The maximum indemnity period
This is the number of months stated in the policy as the period of which the insurer will provide cover. It is the indemnity period which with a specified period. The period is stated in one month with the usual period being 12 months but periods of 18,24, and 36 months are also common. It is the duty of the insured to fix the indemnity period which they can deem suitable for their business. The longer the period, the higher the sum insured and hence the higher the premium will be.
When deciding the maximum indemnity period, the proposer needs to take into account the following,
- Nature of business – some businesses may be able to recover faster than others
- The time it would take to repair or replace specialized machinery
- The time it would take to recover the customer base
- How long it will take to recover the lost market share
Maximum Indemnity period for 12 months
Period of insurance
Loss on 31.12.2010 – 12 months cover
Sum insured/estimated gross profit
01/01/2010 to 31/01/2010
31.01.2011 to 31.12.2011
1st January 2011 to 31st December 2011
KES 20.9 million
KES 20.9 million 10%
For a 12-month indemnity period, the estimated gross profit or sum insured will be KES 22,990,000. If the indemnity period is longer, the figures will be worked in a similar manner
For example, for indemnity period of 24 months, we shall add 10% on KES 22,990,000 i.e. 10% of KES 22,990,000 equals 25,289,000. The sum insured for the month will be:
KES 22,990,000 plus KES 25,289,000 which equals to 48,279,000
Material Damage Warranty
A business interruption policy is essentially a fire policy. The perils, conditions and warranties incorporated in the policies are to a large extent the same. The business interruption policy contains a material damage provisio which indicates that, there must be fire be a fire material damage policy in place before arranging a BIP. further, in the event of a claim, the material damage policy must admit liability for a claim to be admissible in the BIP, the reasons for these provisions are:
- The existence of the material policy ensures that business interruption loss is not aggravated by lack of capital to replace, reinstate, or repair the property lost or damaged.
- It secures for business interruption policy for protection of all the conditions clauses and warranties which appear upon the material damage policy. This avoids inclusion of different wordings under the business interruption policy.
- Material damage insurers will have satisfied themselves that there is a valid claim under their policy and no further investigations need to be made into the cause thus saving effort and expenses