Blog Reader Question: Business Interruption Gross Profit Calculation

I received the following question from a reader and reproduce it and my answer below for you all:

Dear Mr Manning,
There is something I may be missing in the calculation of Gross Profit under the BI policy.

The policy states:
GROSS PROFIT
the amount by which:
(a)      the sum of the Turnover and the amount of the Closing Stock and Work in Progress shall exceed
(b)      the sum of the amount of the Opening Stock and Wo

rk in Progress and the amount of the Uninsured Working Expenses as set out in the Schedule.
Why does it start with the opening stock?
Closing stock less production plus opening stock will give as a result production available for sale. If the Gross Profit I need to know refers to products sold then I calculate, for example, the cost of raw materials used in the product sold as: Opening stock of raw materials plus raw materials purchased less Closing stocks opening stock.  The resulting amount less turnover will comprise all costs and expenses from which I deduct not insurable cost and expenses. I shall be obliged if can explain me the policy definition and if I am wrong or missing something.

Thank you very much for the attention you may give to this query-
Carlos [last name and email withheld]

 

I replied to Carlos as follows:

We add closing stock to the turnover to the business to get one figure.

From this new combined figure you deduct the sum on opening stock and the expenses, such as purchases you do not need to insure.

If I am reading your question right you are asking about opening and closing stock.

What the formula is doing is looking to include the difference in the opening and closing stock as this is another form of profit.

For example if a business was to increase its stock level from say $50,000 at purchase price at the start of the accounting period to $100,000 at the end. The value of the business if everything else stayed the same would be $50,000 more. ($100,000 closing stock -$50,000 opening stock)

This is profit to the company. One way to  look at it, is, that the business chose to invest in more stock so they could provide a better service (faster or offer wider range than before). Whatever the reason this increase in stock is profit in the form of stock instead of cash but it is still valuable acne still profit reinvested in the form of stock.

I hope this helps.

Allan

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Alarming Trends – Part 1: Indemnity Periods

Over the past month or so, I have been inundated with questions regarding moving from reinstatement and replacement conditions to indemnity, in reducing Sums Insured and reducing indemnity periods. Over the next couple of days, I will address each of these and I will start today with Indemnity Periods.

Back when I first wrote my blue book on Business Interruption insurance in 2001, I was often confronted with indemnity periods of 3 or 6 months and my aim with the book and training sessions, was to move to 12 months being the minimum. Since that time, it has become more and more apparent that 12 months is not sufficient even for many risks, particularly property owners and manufacturing risks. When I say property, this includes infrastructure such as airports and tourism resorts.

If you add to this the complexity of a natural disaster, where the resources of the insurance industry, along with builders, engineers, right down to town building and planning departments, this only exasperates an already crucial problem.

As such, over the last 5 – 10 years, I have really been pushing for indemnity periods, particularly on larger risks which are insured under an ISR, to have a minimum of 24 months or at least 18 month indemnity periods. Speaking to underwriters and brokers, it has been pleasing to see that this advice has been accepted by many insureds.

What is alarming me, is that with the rate increases which are filtering through of late, many clients and/or brokers are reducing the indemnity periods back to 12 months. Yes, there is a premium saving, however, at what risk?

Going beneath 12 months, I believe, is complete folly for the rating of business interruption insurance is not simply a pro rate based on the length of time set for the indemnity period.

Statistically, my research shows that about 75% of business interruption losses have a period of disruption of 3 months or less. As such, if a client was to insure for a 3 month indemnity period, no insurer in their right mind would charge 1/4 of the premium that 12 months cover would cost, for they are going to pick up 75% of the claims, and even with claims which extend beyond the 3 months, they are likely to pick up the biggest burden during that first 3 month period.

Typically, the difference in premium for a 6 month indemnity period and 12 month is less than 10% of the fire rate applied to the full 12 months Insurable Gross Profit figure.

When considering the indemnity period, I have set out under the heading “How long should I insure for?” in the BIExplained section of the LMI Business Interruption Calculator all the things that should be considered when setting an indemnity period. You will note, the cost of insurance is not one of the criteria.

Speaking to underwriters about the situation, one of the reasons they have had to increase the premium rate, is that they are not getting the growth in premiums that they require. This is because we are not increasing Sums Insured as we should each year. If we are going to reduce cover, this is only going to create more problems moving forward as insurers are forced to increase rates again to make up for the lost revenue of people reducing their coverage. I know in the property insurance for LMI Group, there is two things about the program, the first is that we tend to over insure for we see first hand what happens to businesses when they under insure and we would rather pay a little extra premium rather than risk not being fully indemnified in the event of a loss. Secondly, we review our insurances every year, this being the case, we have found our rate has been retained.

Next post, I will go into a bit of detail about the risk of moving from reinstatement and replacement to indemnity conditions.

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NSW Government continue to bend the facts to hide their ineptitude.

Like all rate payers in New South Wales, I received this (image) flyer from the New South Wales Government on the emergency services levy.

I cannot accept that deferring the levy is going to help those that are currently bearing the cost of funding the fire and emergency services.

Fact 1: everyone in New South Wales benefits from having an efficient, well funded, well trained and equipped fire and emergency services.

Fact 2: the men and women that do this work deserve our full support for doing some of the most dangerous and stressful work in our society to protect all of us and our property.

Fact 3: it is completely unfair that only a percentage of the community bear the bulk of the cost and not everyone.

Fact 4: by deferring the changes, it means that those that insure go back to bearing the brunt of funding the fire and emergency services.

Fact 5: this, in turn, means that to avoid paying the levy people do not insure or do not insure fully. Putting an even greater burden on the prudent and risk averse who insure fully.

Fact 6: Currently, the Fire and Emergency Services means that many insurance policies are 40% higher in New South Wales than say Victoria. If you add the triple taxation of Goods and Services Tax being imposed on the Fire and Emergency Services and then the State Government Stamp Duty on insurance premiums, Fire and Emergency Services Fees, and the GST component any fool can see the inequity of having the levy on any product or service.

Fact 7: Every single study on Fire and Emergency Services shows that the fairest way for the community to fund the service is to have as broad a tax base as possible. This is property rates where everyone pays, whether you are a tenant or an owner occupier.

Fact 8: In 2012, the New South Wales Government issued a White Paper and called for input from the community on moving the levy away from insurance, rightly pointing out that it was inequitable in the current form. This means the NSW government have had 5 years to get this right as well as the benefit of consulting with all the other mainland states who successfully made the transition from insurance to property rates.

Armed with these facts, I am sure that you will agree with me that this is a monumental and inexcusable balls up by the New South Wales government.

I am pleased to see the issue is getting some time in the Sydney Morning Herald  which sheds more facts on the waste involved here and how the new levy was so wrongly calculated. For a home owner who fully insures it should logically have gone down with the broader tax base.

We cannot put the toothpaste back in the tube but what we need is some honesty on the part of the Government that they and only they got it wrong and secondly an honest time line as to when the reforms will be implemented.

My guess is that it is in the too hard basket for this government, that is, it is beyond their ability and that we may be stuck with it for another generation.

Of course, this is not the only issue this government has failed us on. The water issue from the Murray Darling is a complete story of failure in itself.

We all deserve better!

 

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Business Interruption Issues Series – Part 5 – Time Excesses – Part D – Possible Solutions

After addressing 3 common problems in time excesses last week, I return to the topic with some possible solutions.

What is the Answer?

I would suggest there are several answers to the problems of time deductibles, and would like to explore three with you.

The first is to replace the excess/deductible with a franchise. If the insured business is disrupted due to an event for a period less than the franchise of say 1, 2 or 3 days, then the loss will be at the full expense of the Insured. If it extends beyond the period of the franchise, then the entire amount would be met by the insurer. This would mean that the Insured would carry the risk for minor periods of disruption, but beyond that they would have the comfort of having full insurance subject to adequacy of insurance etc.

I appreciate the insurance industry need not be there to protect short term, what we call working losses. The cost of doing so in just calculating such losses often proving they are not real losses in any event but just delayed sales would increase the cost of business interruption insurance prohibitively. However, the cost of working out a time excess can be significant and cause the Insured to feel cheated. I know that is how I feel every time I put in a health insurance claim when I consider the premium I pay each year.

I would rather see the client get the amount rather than it go to loss adjusters and claims prepares trying to agree an equitable allowance.

Some underwriters are worried that an insured can manipulate the stop time and so get a claim paid. I think in disruption such as in failure of public utilities, or closure by public authority, the Insured has no chance to influence when the issue is resolved. As such, I do not see this as an issue. It has certainly not come up in the claims I have handled under business packs where time franchises are more common under high quality wordings.

The second solution is to apply a monetary deductible, which both the Insured and insurer know and understand in advance. I would suspect that this would be easier for the underwriter to underwrite and the Insured would be in a much clearer position as to the effect of the deductible in the event of a claim. It would also reduce the stress and claims handling costs following a loss.

The third alternative is simply a combination of the first two. The monetary deductible would apply after the franchise period had lapsed or it could be the “greater of”.

1.2                 Summary of Chapter

Space limitations have only allowed three case studies to be provided. Underwriters, claims staff and Insureds who lodged a claim following any business interruption claim with a time deductible can provide similar examples of complications arising from their experiences of the interpretation of time deductibles.

At the very least, time deductibles need to be reviewed to incorporate clear details in the policy as to how they should operate. Alternatively, they should be replaced with a franchise, a set monetary deductible, or a combination of both. Food for thought to improve what, in the main, is a very good product.

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Business Interruption Issues Series – Part 4 – Time Excesses – Part C

 

Insurance should not be a game of Russian Roulette

This is the third post in this series on time excesses and the fourth on common business interruption issues that started on Monday 10th April 2017.

 

I continue the examination of time excesses using another case study.

Case Study 3: The Policy will not Cover Losses within the First 48 Hours

The third case involves a wording that states the policy will not cover losses within the first 48 hours. In many cases of smaller commercial and industrial premises, the Insured was not advised to shut down their gas until after 5.00pm on Friday, 25 September 1998. 

If they had no planned production within the next 48 hours, they suffered no losses and, as such, the time deductible did not apply. Had the shutdown occurred at the same time on Sunday, Monday, Tuesday, Wednesday or Thursday, then the same time deductible would have applied, but this time with a financial penalty being borne by the insured business.

On the other hand, taking restaurants for an example, Friday and Saturday evenings are often their busiest nights. They, therefore, were penalised by pure chance due to the fact that the disruption caused by the Longford Gas Explosion occurred on a Friday. For them, if it had occurred on a Sunday or Monday, the reduction in the claim due to the application of the deductible would have been much less.

Rather than know their respective positions when a loss occurs, it could be said that the insurers and operators of businesses that do not operate 7 days per week are both playing Russian Roulette with a revolver holding 5 bullets in a 7-chamber gun. That is, 5 working days in a 7-day week.


Tomorrow is Good Friday and as it is a religious holiday for many, coupled with the fact that many in the industry have been working their tails off with the cyclone claims, I, while not wishing to follow the approach of a TV soap opera, will hold off till next Tuesday to provide some alternative solutions.

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Business Interruption Issues Series – Part 3 – Time Excesses – Part B

Today, we continue our discussion on time deductibles. As I did yesterday, I draw on a case study to explain an issue.

Case Study 2: 24 Hours after Cessation of Supply

This case study involves another large manufacturer. In this case, the wordings for the time deductible is contained within the Public Utility clause provided that cover does not commence until “24 hours after cessation of supply”.

To avoid major damage to the insured plant at a large production facility, the gas supplier allowed the Insured to implement a staged shutdown of the gas supply over the site, which took 11 hours. In other words, it took 11 hours from when gas supply was cut to the first machine, until it was cut to the last machine. Does this mean that the Insured in fact suffers a 35-hour time deductible? That is, 24 hours from the cessation of supply, plus the 11 hours of disruption they suffered during the phased shutdown. The wording of the deductible did not match the intention of either the insurer or the Insured.

In this case, using the Departmental Clause, it was possible to identify the loss by machine, and the claim was settled by applying the 24-hour time deductible on a machine-by-machine basis. A much more difficult adjustment and negotiation would have been required to achieve the agreed intention of the time deductible had the method of claim calculation used not been possible.

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Business Interruption Issues Series – Part 2 – Time Excesses – Part A

Following on from yesterday’s article on part insuring a standing charge, I move to time excesses for the rest of this week.

When I wrote the first edition of my book on Business Interruption, time excesses were relatively new, except for particularly large risks, especially in the mining industry.

The large number of business interruption claims that arose from the gas crisis in Victoria, Australia in September 1998 highlighted the inherent problems associated with time deductibles. Many of the issues have again been seen following the Western Australian gas crisis 10 years later, in June 2008 as well as natural catastrophe claims and the 2014 Sydney Hostage Crisis.

The purpose of the post today and the next few days is to highlight through case studies, some of the many problems that can arise with the interpretation of a time deductible. And second, equally important, the purpose is to offer suggestions for alternative forms of deductible that may assist each party to the insurance contract in understanding their respective position in the event of a loss.

Case Study 1: 3-Business Day Time Deductible

The first case example is in respect of a large manufacturer that has a Section 2 Deductible of “3 business days”.

The loss of 7 days’ production caused by the gas outage was made up by the Insured through working weekends and public holidays between the date when the gas supplies resumed and the end of the Indemnity Period. The loss was confined to the Increase in Costs of Working associated with making up the lost production.

The position that should be adopted with such a disruption being considered under a policy with a time deductible is that regardless of when the costs are incurred, they should be matched to the benefit that the increased costs have generated. For example, if within the first 3 days the Insured had incurred significant costs, say several million dollars, to convert their production facilities to run on LPG rather than natural gas, but the benefit of this expenditure was not realised until after the first 3 days and was therefore to the entire benefit of the insurer, then the insurer should, in equity, meet the entire cost of the Increase in Costs of Working. This is logical even though it was incurred during the first 3 days.

Conversely, any costs associated with making up lost production suffered during the first 3 days, for instance by way of overtime etc, should be at the expense of the Insured; the first 3 days being the period of time deductible.

This is in line with not only the generally accepted accounting principle of matching revenue with expenses, but also with the spirit of the underlying principle of indemnity which, as we have discussed elsewhere in the text, is to “put the Insured back, as near as money will allow, to the same position that they would have enjoyed but for the loss” [1].

In this case, an accountant acting for the Insured as a claims preparer, argued that there were no lost sales during the first 3 days and, as such, there was no loss suffered by the Insured. They went further to argue that as the Insured ‘stood down’ employees during this period, there were savings made. However, as these were made during the 3-day deductible, these costs should not be taken into consideration in adjustment of the claim. If this was to be accepted (and it was not), it would have converted the deductible into a positive benefit to the Insured. This is because the insurer was being asked to meet all the additional costs to make up the lost production, but was not being granted any benefit of the savings made during the period.

This is a nonsense argument that goes against the underlying principle of business interruption insurance as explained above. What this case study does, however, is highlight the problems that can arise in adjustment of a claim involving a time deductible.

The lesson to be learnt from this case is that the policy must clearly state how the deductible is to be applied.

To learn more please refer to Business Interruption & Claims, Chapter 18.

[1]     Castellain v Preston (1883) 11 QBD 380.

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LMI Mining attending claims due to Cyclone Debbie

There has been a good deal of news regarding the effect of Cyclone Debbie on the supply of coal to the world. We at LMI have been keeping a close eye on this and assisting many mining clients to calculate their business interruption losses as a result of the damage.

What many readers do not know, is that LMI have a specialist mining division that specialises in mining claims, risk assessment, policy and endorsement drafting and review.

Headed by Murray Rowley, with 50 years experience in mining losses, and backed by a team of on staff qualified mining engineers and accountants, the team are handling several losses arising from the closure of the rail lines in Queensland due to damage that occurred during Cyclone Debbie.

I myself, am proud to be part of this team, having handled mining losses since the mid 1980’s including some of the world’s largest claims. My MBA Thesis was on the Closure of the Bougainville Mine. My experience, however, is far outweighed by Murray’s.

Mining, perhaps more than any 0ther industry, requires a great deal of knowledge and experience. There is often a great deal of money at stake and it is certainly not an area for the generalist or amateur. While Murray and his team are based in Queensland, he and his team have and continue to handle losses all around the world due to their extensive expertise in this industry.

LMI Mining is just one of the specialist divisions we have at LMI that provide expertise for specific industries such as tourism, packaging, manufacturing, energy risks, motor trade, crop, retail, and property management.

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Business Interruption Issues Series – Part 1 – Insuring a Business Expense/Standard Charge

Last week LMI’s Max Salveson and I had the rare privileage of meeting a some of the best underwriters and technicians in Australia when it comes to the Industrial Special Risks (“ISR”) Policy.

As I continually say, we are all students of insurance and despite all I have read, and written on the policy not to mention the 1,000 plus claims I have calculated under this policy I still learned many things and changed my view on a couple. While many improvements to the policy that Max and I proposed were accepted, some of the changes that I asked to be included I did a complete 360 on. This is despite the fact they have already been rightly adopted in quality Business Packs. The reason is that business packs are designed to cover small to small/medium businesses where as the ISR is for larger often more complex risks.

In many ways the ISR remains a world class product offering great protection to business when it comes to property damage and business interruption. As with any general insurance product, it just needs to be set up correctly from the start.

The fact that the vast majority of the people who attended the meeting had a genuine desire to protect their clients and our communites was fanstastic and reminded me of the original commmitte that drafted the Mark IV way back in 1987.

It was also great that so many experienced experts from different insurers were willing to share their experience and knowledge for the common good and listen and like me walk away with a different view on some points.

With this background, I thought I would share with readers some of the issues that we discussed in the business interruption space that was discussed.

I start with the problem that can arise where an insured (or their broker) decides to insure only a percentage of an expense rather than the full amount.

For example, let us say an insured elects to insure 10% of electricity. This means that 90% of the expense is automatically deducted when it comes to determining the insured’s claim when you multiply the insured rate of Gross Profit by the shortfall in Turnover.

What can happen when an inexperienced adjuster or forensic accountant is involved is that they deduct all the savings from the claim not appreciating that 90% has already been excluded from the claim.

This in effect means that the insured is paid 10% of 10% of their claim for wages which of course is totally wrong.

Gordon Southern in his book “Consequential Loss and Risk Insurance” addressed the issue very well. I attach an extract of his book which addresses the issue in detail.

Uninsured Working Expenses part 1

Uninsured Working Expenses part 2

To overcome this inequity, I attach an endorsement that Max and I drafted that does not change the ISR wording but simply sets out the formula that should be used when calculating an insured loss where there is  a percentage of an Uninsured Working Expense is in fact insured. Endorsement

Tomorrow I will continue to the series moving to one of my pet hates, I appreciate that is a harsh word, Time Excesses.

 

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Recap of week one.

LMI activated its Emergency Response plan on Thursday 30 March starting first in Mackay, Proserpine, Bowen and surrounds and as we were able to gain access, extended this into the Whitsundays. Other teams looked after claims in South East Queensland, Murwillumbah and Lismore.

Within this first 10 days, we have arranged for progress payments for close to $40 millions to be made to assist business recovery. This of course, makes a huge difference to those businesses allowing them to engage trades, replace stock and recover that much quicker. But more it helps the suppliers, tradespeople etc asked to step in and do the rebuild etc. It helps the whole community.

I make this point in an effort to show the public that with the right correct adviser/broker arranging the correct coverage with a quality insurer, followed up when it really matters with good claims service, insurance is an invaluable service protecting you from financial loss.

We do not hear about the huge effort, insurers, their claims teams, loss adjusters, and claims preparers put in after every such event to help our customers and communities.

Of course, we see the horror stories in all the regions we are responding to, where at the time it was considered too high a premium and now having taken the risk of “it will never happen to me”, business owners are now faced with significant uninsured losses both in property damage and business interruption.

The reality is no matter how skilled and willing to help the LMI team are, we cannot put the toothpaste back in the tube. If the cover is not there, or is not adequate then we cannot wave a magic wand and fix it.

Even if your business was not affected by the event, please remember this at your next renewal. Make sure that your assets, business income and liabilities are insured adequately just in case it is your turn next time.

I end on a positive note. One of our clients we visited had felt overwhelmed by the whole event and was upset that no money was offered by the loss adjuster during his first visit. The Insured sent a text to her broker who in turn rang the Insured straight away. She rang me and Rian Jenkinson our State Manager in Queensland acting as a Claims Preparer got straight onto it and with the help of the claims team and the loss adjuster who certainly did not mean to cause any stress arranged a progress payment. The insurer sent out their senior property claims manager who assisted by arranging a second payment at the end of the week.

It does make such a difference to have a good insurer on board.

Insurance is not just about $, it is about people.

Despite his very hectic workload, Rian dropped in and picked up some flowers and a bottle of wine for the Insured and her husband from their broker, he and I to put a smile back on their face and let them know they were not alone at this time.

This small gesture had a really marked effect as we now focus and getting this business back up and running “double quick time”.

Thanks to all the insurers that helped us help your clients, to the brokers who have entrusted your client’s claims with us,  and a special well done to Rian for going the extra mile.

 

 

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