LMI Director, Steven Manning shares some important information when placing your client’s business interruption insurance.
When setting the Sum Insured or Declared Value for your client’s Business Interruption program you are required to not only declare the Insurable Gross Profit, but you must also list the expenses you have deducted to arrive at this figure. These expenses are called ‘Uninsured Working Expenses’.
Using the Industrial Special Risk ‘ISR’ policy for convenience, the policy contract sets out how the Rate of Gross Profit is to be calculated.
This reads as follows:
“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.”
So, why is it necessary to list these Uninsured Working Expenses? In simple terms it creates contract certainty. With any contract, having contract certainty ensures the operation of the contract is much clearer when it needs to be relied upon. Contract certainty is something that is of benefit to both the Insured and Insurer and of course, makes it so much easier for the claims officer, loss adjuster and claims preparer.
Going back to our above definition and looking at it as a formula, the way to calculate the Insured Gross Profit would be:
Rate of Gross Profit = (Turnover + Closing Stock) – (Opening Stock + Purchases + LISTED Uninsured working expenses)
So, what can happen if the Uninsured Working Expenses are inadvertently not listed?
To show this I have set out a very simple Sum Insured / Declared Value calculation which only covers off the area that I wish to discuss today. For the example, I am ignoring business trend, indemnity periods etc. To calculate this properly I strongly recommend using www.BIcalculator.com.
Sitting alongside the Declared Value calculation I have completed the same calculation as would be done by the insurer at claim time to assess the Value at Risk. This has, and would be done, in strict accordance with the policy definition with only one exception. In the experience of our expert team here at LMI, we have seen that most claims officers will allow a deduction for Purchases (even if not listed) for a business that has a reasonable amount of purchases. Strictly speaking, there is no reason that they need to do this, but it has become market practice over time. However, there is no obligation for an insurer to make any other deductions.
Having said this, it is my strong recommendation to avoid any confusion, save time and have that contract certainty that all Uninsured Working Expenses should be listed on the Schedule.
Back to the two calculations:
By failing to list the Uninsured Working Expenses it has resulted in significantly different figures at the time of the claim compared to the original Declared Value calculation. This becomes concerning when the test for adequacy is brought into operation at the time a claim under the policy is made.
While the base ISR policy has 100% co-insurance on Section 2 – Consequential Loss, I have allowed 80% co-insurance as many ISR’s have been endorsed to this effect.
(Declared Value / 80% of the Value at Risk) X 100 = Percentage of Claim Paid.
Using the figures in our earlier example this would calculate out to be (420,000 ÷ 80% of 705,000) x 100 = 74.46%
As a result, in the event our client suffers an interruption, any claim would be reduced proportionately. The result – only 74.33% of any claim will be paid by the Insurer, with the remaining 25.67% to be carried by the Insured.
The sad truth of the matter is that the oversite or decision to not include the Uninsured Working Expenses on the Policy Schedule as is required by the Definition for the insured Rate of Gross Profit can leave a client significantly short changed and create substantial cash flow issues for them at the worst possible time, often leading to the Insured business failing and or leading to a professional indemnity claim for the advisor.
Note: Not all wordings are the same with some only allowing for the purchases to be deducted and others listing expenses for you, common expenses being Freight, Bad Debts, Packaging Materials. Extra care needs to be taken when moving covers to ensure it fits in line with the policy definition. For more information please refer to LMI PolicyComparison.com and BI Explained under LMI BIcalculator.com