How Insurers Calculate the Premium for Shorter Indemnity Periods Under a Business Interruption Policy
Two of the many mistakes made when taking out Business Interruption insurance, is that business owners think that a) taking a shorter Indemnity Period will save significant premium and b) if I select a shorter Indemnity Period I only have to declare the amount of insurable Gross Profit for that period. That is, for an Indemnity Period of 6 months you only need to set a sum insured equal to 50% of the annual figure.
Starting with the premium. Statistically, most disruptions to businesses are short term. On my estimation, 75% of all Business Interruption claims have a period of disruption of less than 3 months. Hold that thought.
Insurers base their premium based on the frequency of claims and the average size of claims. It, therefore, makes sense when you think about it that an insurer would not allow the business owner to set a sum insured of 25% of the annual figure for a 3 month Indemnity Period, but still pick up 75% of all the claims.
What insurers require under an Industrial Special Risks (“ISR”) policy or most business pack policies is to declare 12 months insurable Gross Profit and then they apply a discount to the premium rate where a shorter Indemnity Period is chosen. What that discount is depends in the size of the sum insured and the occupation of the business. A typical reduction is 10% when 6 months is chosen rather than 12 months.
When you consider you are losing a full 6 months protection for such a small saving in premium, I do not feel it is worth the risk.
If the business owner where to only declare 6 months gross profit by dividing the annual figure, two things can occur. First if the business is seasonal they may find that 50% of the annual insurable Gross Profit is not enough.
Secondly, and more importantly they will find they are penalised by average/co-insurance. That means they will have any claim greatly reduced. It could be as low as only 50% of their otherwise valid claim paid.
Secondly, under most Business Interruption policies you need to insure for 12 months loss of insurable gross profit whether you insure for 3, 6, 9, or 12 months.
In summary, the take away points are:
Under the vast majority of policies it is necessary to declare or set the sum insured based on 12 months insurable Gross Profit where an Indemnity Period of up to and including 12 months is chosen. I will look at longer Indemnity Periods in Thursday’s post.
Secondly, the saving in premium where you take an Indemnity Period is, for most businesses, simply not worth the loss of protection.