Coverage for business interruption losses and related extra expenses are often included in property and casualty insurance policies. The insurance policy defines the terms of coverage.
Overview of coverage provisions
Insurance coverage for loss of business income and extra expenses is typically provided when the loss is due to suspension of operations and direct physical loss of property, unless excluded. Exclusions typically include “water” with elaboration that this means “flood, surface water, tides, tidal waves, overflow of any body of water, all whether driven by wind or not.” Other exclusions include earth movement, nuclear hazards, war and military actions, and power failure. A civil authority provision included in policies provides for payment of loss of business income and extra expenses caused by action of civil authority that prohibits access to premises due to direct physical loss to property, other than at the described premises. The “period of restoration” is the time period for loss measurement and the “water” exclusion has limited many hurricane claims to the civil authority provision. Policyholders with flood damage and no civil authority that prohibited access to premises may have no coverage for loss of business income and extra expenses. The “period of restoration” may also be referred to as the loss period.
Some policies include time limits to the period of restoration; the civil authority provision may be limited to a specified number of weeks and loss of business income may be limited to a specified number of months. Policies may also include time limits for coverage of certain expenses, such as ordinary payroll during suspension of business operations. Many policies limit coverage for ordinary payroll during suspension of business operations to a specified time period such as 60 days. The period of restoration when there is direct physical loss to property generally begins immediately after the time of direct physical property loss and ends on the earlier of the date when the property should be repaired or restored or the date when business is resumed at a new permanent location. The period of restoration is extended in some policies until “normal” business operations are resumed.
Calculation of loss of business income
Loss of business income coverage replaces the net profit that would have been earned if no physical loss occurred. Revenues are projected over the period of restoration and are reduced by revenues actually earned during the period of restoration. An insured has the obligation to “mitigate” or minimize losses and an additional reduction may be applied if revenues could have been earned during the period of restoration, but the insured did not adequately do so. The difference between projected revenues and actual revenues (or revenues that should have been earned with proper mitigation) equals lost revenues. Lost revenues are reduced by expenses that would have been incurred to produce lost revenues to arrive at net lost business income. These expenses are referred to as “non-continuing expenses” or “saved expenses.”
Example: Joan’s Clothing sustained damage to its building when a tree crashed through the roof. Joan’s Clothing was closed from August 29 through October 31 for necessary repairs. Projected lost revenues total $15,000 per month. Cost of goods sold represents a non-continuing or saved expense and this amount is projected to total 55 percent of lost revenues. Analysis of historical business financial data reflects the following additional non-continuing or saved expenses: credit card fees, payroll, utilities, and rent.
Loss of business income coverage may also include continuing normal operating expenses incurred, including ordinary payroll.
Example: Joan’s Clothing continues to pay its employees during the period of restoration and has coverage for ordinary payroll up to 60 days. The amount paid to employees for 60 days will be added to net lost business income.
Coverage is generally also provided for extra expenses the business incurs due to the loss and for temporary operations. These amounts should be separated from loss of business income and non-continuing expenses.
Example: Joan’s Clothing rents a temporary facility for one month beginning October 1 to mitigate its losses. Clothing is shipped overnight, resulting in higher shipping costs than usual. Employees are paid overtime for working nights and weekends to re-open the business. Furniture and fixtures are rented for one month. The temporary rent, additional shipping, employee overtime and furniture rental are all examples of extra expenses incurred by the business to minimize lost business income and may be reimbursed by insurance.
Analysis of historical operations and industry data
Extra expenses are based upon the amount actually paid or incurred and the insurance company generally requests the invoice, proof of payment and brief explanation why the extra expense was incurred. Projection of lost net business income should be based upon the best information available. Review of historical operations and interviews with the insured may be sufficient, but new businesses or businesses without detailed records may require analysis of industry data or information from other sources to determine projected revenues and non-continuing expenses. The coverage is designed to put the insured in the position they would have been in had the loss event not occurred and is not intended to be a windfall to the insured. The certified public accountant has the training and experience to calculate loss of business income and extra expenses in business interruption matters.