Can interest on a loan be claimed under a business interruption policy?

One issue keeps coming up more regularly internally here at LMI than any other and that is loss adjusters refusing outright to consider additional interest being claimed as an Increase or Additional Increase in Cost of Working.

I cannot understand why this is an issue as I know of hundreds if not thousands of cases where it has been paid. Yet what is happening is that there is a blanket rejection without any opportunity to discuss the issue.

The only thing I can think of is that the adjuster is perhaps trying to hide the fact that the client has been starved of cash and as a result to keep their business afloat has had to go out and find alternative finance rather than rely on the insurance product they paid premium on.

Let us look at the issue under three areas of the policy.

For the sake of completeness, I start with under Item I (a) Loss of Gross Profit as a result on an reduction in turnover. [As policies use different terms not only in Australia but around the world I have chosen the Australian Industrial Special Risks Policy (“ISR”) Mark IV Modified and Consolidated versions to base my analysis on.

The basis of settlement reads:

“The insurance under this item is limited to actual loss of Gross Profit due to: (a) Reduction in Turnover and (b) Increase in Cost of Working and the amount payable as indemnity thereunder shall be:”

“(a)        In respect of Reduction in Turnover:       

“the sum produced by applying the Rate of Gross Profit to the amount by which the Turnover during the Indemnity Period shall, in consequence of the Damage, fall short of the Standard Turnover.

The next step then is to look at the definition of what constitutes Gross Profit and this reads:

“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 Work in Progress and the amount of the Uninsured Working Expenses as set out in the Schedule.

Note: The amounts of the Opening and Closing Stocks and Work in Progress shall be arrived at in accordance with the Insured’s normal accountancy methods; due provision being made for depreciation.”

As song as interest is not shown on the schedule as an Uninsured Working Expense and I cannot think of any reason it would ever be under the “Difference Method” of Interruption Insurance, then the settlement would by definition include a contribution towards the interest already being funded by the insured organisation. I stress that this only applies to existing interest payments and not additional interest that has been incurred to fund the recovery of the business after a insured event that triggers a business interruption claim.

The next step is to look at Item 1 (b) Increase in Cost of Working.

The cover here reads under the Mark IV ISR Policy both in the Modified and Consolidated versions as:

“(b)        In respect of Increase in Cost of Working:                                                                                                              

the additional expenditure necessarily and reasonably incurred .for the sole purpose of avoiding or diminishing the reduction in Turnover which, but for that expenditure, would have taken place during the Indemnity Period in consequence of the Damage, but not exceeding the sum produced by applying the Rate of Gross Profit to the amount of the reduction thereby avoided.”

If we go back to our underlying principle of indemnity “putting the Insured in the same position that they would have enjoyed, as near as money will allow, but for the loss”[1], it is easy to appreciate that the Insured should be reimbursed for any additional costs that they would not normally have had to pay but which have been incurred as a result of the interruption. For items to fall into this category, they need to pass five tests.

Test 1: The expenditure has to be actually incurred.

Test 2: The expenditure must be additional to normal expenditure.

Test 3:  The expenditure needs to be necessarily and reasonably incurred. The test as to whether something was necessarily incurred is really addressed in Test 4. Similarly, Test 5 will assist in determining if the expense was reasonable to a degree. Notwithstanding Tests 4 and 5, the Insured needs to demonstrate that the costs were “necessarily and reasonably” incurred. A good self-test is for the Insured to ask him- or herself, “Would I have incurred this expense if I was not insured?”. If the answer was, “Yes”, then it probably meets this test.

Test 4:  The expenditure must pass what is known as the ‘sole purpose’ test. It must be incurred for the sole purpose of avoiding or diminishing the Reduction in Turnover, which would otherwise occur during the Indemnity Period.

As I explain in by books on the ISR and Business Interruption, the word ‘solely’ could be interpreted in two ways:

• No recovery of any expenditure or individual costs that do not solely operate to reduce the loss.

or

• Recovery of that portion of the expenditure of individual costs, that solely gives benefit by loss reduction, out of the total expenditure.While not every expenditure could be split up like this using commonsense, the principle of equity is nonetheless the same. If the Insurer receives a benefit for the outlay of an expenditure, albeit as a percentage of an overall cost, then they should contribute to that portion of the expenditure that achieved or diminished a “reduction in Turnover”. Hickmott (1990)[2]

  Needless to say, the way I have always considered such an issue when either adjusting or preparing a claim, has been based on the second alternative as I keep going back to the underlying Principle of Indemnity to guide me. Gordon Hickmott who I refer to above, a highly respected UK based practitioner in his day and author of several books on Interruption Insurance, with whom I have had the privilege to consult with, and I share this approach.

Test 5   The expenditure must fall within the Economic Limit. That is, the expenditure will only be covered to the extent that it avoids a loss of Gross Profit. In simplest terms, if the Insured spends $2 to save $1 of Gross Profit, the additional expenditure to be included will be limited to $1.

The Economic Limit of recovery relative to Increase in Cost of Working is applied so as to make it clear that uneconomic costs to maintain business operations, even if reasonable in other ways (ie. longer term protection of business interests), are not recoverable under the gross profit item[3].

In practice, it is difficult to establish the longer-term benefit of increased expenditure, and the normal criterion adopted is to consider it against the benefits achieved by its outlay within the maximum Indemnity Period. It is dangerous to apply the Economic Limit in narrow terms, as it is likely that the interruption to the business would have continued after the damage, and the business’s recovery to the ‘would have been’ level, have all been in consequence of the Increase in Cost of Working to some extent.

Some less experienced loss adjusters take the approach that he/she will not make any commitment or decision on a loss minimisation strategy until the benefit can be quantified. They believe that it is in order for them to make the evaluation with perfect 20/20 hindsight. The line often used is that “the Insured should act is if they are uninsured”. If he does then why should he or she not be entitled to claim if the policy provides the coverage which I believe it clearly does for this expense.

On the other side of the coin, if due to the indecision of the loss adjuster or Insurer, it prompts a cash-strapped Insured not to incur the increased cost, then it would be unreasonable for the Insurer to argue that the Insured has not taken reasonable steps to mitigate the loss. One way to avoid this type of argument is for the Insured to have Additional Increased Cost of Working cover, and thereby any reasonable costs incurred by the Insured are covered without any economic limit test.

Besides any costs that fail Test 5, any costs which fail Test 4 may be considered under Item No. 4 (Additional) Increase in Cost of Working, subject to the Sub-Limit stated on the Policy Schedule.

It should also be remembered that if Wages are insured separately, then there is provision for the shortfall in Increased Costs of Working that are not covered due to the application of the Economic Limit test in this sub-clause, ie. to be considered under the separate Increase in Cost of Working Cover provided under Item No. 3 Payroll.

Assuming for some reason that interest is caught by any Tests 4 or 5 above or if the Insured has elected to take out Additional Increase in Cost of Working cover only then we need to move to Item 4 (Additional) Increase in Cost of Working. This reads:

“The insurance under this item is limited to increase in cost of working (not otherwise recoverable hereunder) necessarily and reasonably incurred during the Indemnity Period in consequence of the Damage for the purpose of avoiding or diminishing reduction in Turnover and/or resuming and/or maintaining normal business operations and/or services.”

The cover afforded here refers to the additional expenditure not otherwise recoverable under Item No. 1 or Item No. 3 – refer Sub-Clause 8.1.1(b) and Sub-Clause 8.3.1(b), respectively. The costs still need to reflect actual expenditure incurred, which is necessarily and reasonably incurred in consequence of the Damage.

Naturally the Policy limits the Additional Increased Costs of Working to expenses incurred to during the Indemnity Period. However, the Economic Limit tests imposed within Items No. 1 (Gross Profit) and No. 3 (Pay-Roll), are not imposed here. Furthermore, the ‘sole purpose’ test is expanded. It refers not only to “avoiding or diminishing reduction in Turnover”, but introduces the wider category of “resuming and maintaining normal operation of the Business”. Therefore, even if there is a dispute over whether interest is claimable under Item 1 (b) it would prima facie be covered under Item No. 4 (Additional Increased Cost of Working).

To some, this sub-clause has not been well written and is ambiguous. This surrounds increased costs excluded from other parts of Section 2 due to the application of Average. One school of thought is that such costs are ‘recoverable’, but are not recovered because of inadequate Declared Values. As such, any Increase in Cost of Working not paid solely due to the application of Average is not claimable under Item No. 4 (Additional Increased Cost of Working). This approach appears to arise from an objection on the part of the loss adjuster or Insurer to the thought of an Insured being compensated despite being under-insured and, as such, they work to justify their position by reading what they want to into the words.

The second school of thought argues that if the Increases in Cost of Working are not ‘recoverable’ for any reason, including the fact that they are not ‘recoverable’ if Average operates to preclude them, then the unrecoverable expenses are claimable under this item, Item No. 4. But this is a different debate for a different day.

Cover under this item, Item 4, is invaluable to the implementation of a recovery strategy for the business following an insured event. Insurance intermediaries and Insureds need to set a Sub-Limit based on the relative size of the business, a realistic assessment of the extent of possible foreseeable Material Damage, and the subsequent business interruption impacts that may include setting up in alternative premises, temporary fit-out, or having production done elsewhere not to mention of course, the interest component of additional financing that they may require to get things moving. Figures up to $50,000 are quite unrealistic for many businesses, and covers in excess of $250,000 are now common. Major organisations usually require Sub-limits in the millions.

For more commentary on Additional Increased Cost of Working, please refer to Chapters 2 and 5 in Business Interruption Insurance & Claims: A Practical Guide[4]. Similarly, if the reader would like to work through actual examples of Gross Profit and Dual Wages Claims, I would recommend Chapters 5 and 9 of the same text [4].

[1]     Marks F. and Morgan T., 1991, Guide to the 1990 ISR Advisory Policy Wording, Dunhill Madden Butler & Robins GAB, Sydney, p.55.

[2]     Osborn’s Concise Law Dictionary, 8^th Edition, edited by Rutherford L. and Bone S., 1993, Sweet & Maxwell, London, p.88.

[3]     Ibid.

[4]     Manning A., 2005, Business Interruption Insurance & Claims: A Practical Guide, 4^th Edition, Mannings of Melbourne, Camberwell, p.108.