Article, Claims Magazine – June 2008
Insurance / Property
Calculating business income loss claims can be tricky. To achieve an accurate outcome, claim professionals must understand what makes a business tick and be comfortable working with business records says Russ Matheson. An added complexity is the inherent difference between accounting terms and insurance policy language, especially as they relate to business income terminology.
Calculating business income loss claims can be tricky. To achieve an accurate outcome, claim professionals must understand what makes a business tick and be comfortable working with business records. An added complexity is the inherent difference between accounting terms and insurance policy language, especially as they relate to business income terminology.
From an accounting perspective, business income loss calculations are dependent upon a number of factors. Even though these factors can be complicated to resolve, claim professionals can become more confident and more proficient in adjusting this type of claim by familiarizing themselves with four key elements: the period of restoration; sales projection; mitigation; and expense projection. A clear understanding of these elements and how they impact business income loss calculations will go a long way towards the efficient resolution of these losses.
The period of restoration is important because it defines the start and the end dates of the damage measurement period. Typically, this begins on the date the property is physically damaged and ends on the date that the property should be repaired or replaced. A variety of factors can impact the period of restoration. Paying close attention to them will reduce misunderstandings with the insured about periods of time that may not qualify for business income loss recovery.
First and foremost, it is critical that every consultant involved in estimating the repair period — the contractor, the engineer, and the architect — has the same scope of work in mind following the loss event. It is far easier to compare estimates when the information on which they are based is the same. A clearly defined scope of repairs will help establish when the property should be repaired or replaced.
Additionally, the insured will often choose to make improvements or expand facilities while the business is closed for repairs. This can cause a delay in the resumption of operations and is typically excluded from the insured period of restoration. Before finalizing improvement plans, the insured should understand that the additional time to complete any expansion is excluded from the period of restoration. If the insured decides to move forward with improvements, then it is imperative that the adjuster frequently check with the contractor and ascertain whether the project is progressing as originally planned. Any variances in the original time estimates should be investigated and resolved as soon as possible. This will limit potential problems during the final settlement process. Next, careful planning not only can mitigate the insured’s business income loss but also minimize the suspension of operations. For example, certain situations may allow for replacement and installation of critical equipment well before the building is completely repaired or rebuilt. Even a partial resumption of operations can dramatically reduce the insured’s business income loss.Lastly, many standard commercial insurance policies include an extended period of indemnity beyond the period of restoration. Extended periods are typically limited to 30 days and begin immediately after the period of restoration ends. However, occasionally a gap may exist between the end of the period of restoration and the beginning of the extended period. For example, if an insured decides to make improvements that delay the commencement of operations, then the extended period of coverage would not begin until the date when the property was actually repaired or replaced and operations resumed. This means that the actual date could be weeks or even months after the period of restoration.
The sales projection is often an area of disagreement and spirited debate between policyholders and insurance companies. Two key considerations that impact the sales projection are seasonality and trend analysis. To support a projection, it is crucial to present a forecast that falls within a reasonable range. This forecast would reflect what the business would have done, as opposed to what the business could have done. The former has a basis in fact, while the latter is merely possible. It is also important to review the insured’s sales history. The amount of data needed to project sales is contingent upon the length of the loss period and other situational factors. One common method is to determine either the increase or the decrease in sales (expressed as a percentage) prior to the loss. This will be based on a comparison of the same months from the prior year. For example, consider the sales trend analysis shown in Figure 1 (see figure links provided at end of article). After a base period is established, the next step is to apply either the percentage increase or the decrease to the loss period. Continuing with our example and assuming a four-month loss period, the projected sales might look something like those listed in Figure 2. At first glance, this appears to be a straightforward calculation. However, a credible sales projection is one that can be explained in real terms, not just in terms of the math. It should also be consistent with the experience of the business and changes in market conditions. For instance, the applicability of the 10 percent sales growth explained to forecast sales in 2007 depends on what you might find during your investigation. The projected increase might not be appropriate if, at the end of 2006, the business lost its largest customer, new competition appeared, it closed or sold an unprofitable segment, or its employees went on strike. It is critical to exercise good judgment in formulating sales projections. In short, without common sense, sales projections are merely mathematical computations. Another method employed to project sales is a pre-loss monthly or daily average. When a business is stable — exhibiting no growth or declining trends — and is not seasonally dependent, a pre-loss monthly or daily average can be used to anticipate sales. An example of a business where this methodology would be appropriate is an established dental practice that is closed for one week. Note that this method tends to work best when the loss period is short. Budget numbers can be a useful source to project sales as long as the reliability of the budgeted sales has been confirmed. Compare pre-loss budgeted monthly sales for a period of time to the actual sales for the same period. If the ratio between actual and budgeted sales is consistent over a span of several months, then using the budget for the loss period may be a reliable approach. To project sales, you would apply the computed ratio to the budgeted sales for the suspension period.
Mitigation involves efforts on the part of the insured to reduce the business income loss. When considering mitigation, you must address several questions:
- What measures (if any) were taken to reduce the loss?
- Could anything have been done to mitigate the loss?
- What is the financial impact of the mitigation?
- Is it possible to make up the loss during the post-loss period either through normal or stepped-up operations?
As appeared in Claims Magazine, June 2008.