September 30, 2008 by
Business interruption losses are less tangible than direct physical losses. In the last issue of Claims Canada, Education Forum featured 10 steps for examining and settling business interruption claims. This article follows up with a more detailed look at Step 8: Calculate the loss.
Framework for calculations
Let’s review the basic framework for calculating losses under the standard Profits and Gross Earnings wordings.
1. Calculate the insurable values (defined gross profit or gross earnings) using the profit and loss statement for the most recent financial year, adjusted to reflect the results that would have been obtained without the insured incident.
Gross profit = net income before taxes plus insured standing charges
Gross earnings = net sales and other earnings derived from operations less the cost of merchandise sold including packaging materials, materials and supplies consumed directly in supplying the service(s) of the insured, and services purchased from outsiders (not employees of the insured) for resale which do not continue under contract
2. Calculate the rate of contribution (rate of gross profit or rate of gross earnings) based on the insurable values as a percentage of sales.
Rate of gross profit = defined gross profit / net sales (turnover)
Rate of gross earnings = defined gross earnings / net sales
3. Calculate the rate of recovery by comparing the insurance in force with the minimum coverage required (determined by applying the specified coinsurance percentage to the insurable values).
Profits coinsurance percentage contained in Measure of Recovery clause: 100 per cent
Gross earnings coinsurance percentage stated in declarations: 50 per cent or 80 per cent
4. Calculate the sales loss that occurred during the indemnity period as a direct result of the damage. The sales loss is the difference between the projected sales and the actual sales.
Profits indemnity period: the period in which operations are affected as a result of the damage (maximum of 12 months)
Gross earnings indemnity period: the length of time required to rebuild, repair, or replace damaged property
5. Calculate the lost contribution by applying the rate of contribution to the sales loss.
Profits lost contribution:
Projected turnover (absent the damage) less actual turnover = reduction in turnover
Reduction in turnover x rate of gross profit = loss of gross profit due to loss of turnover
Gross earnings lost contribution:
Projected net sales (absent the damage) less actual net sales = reduction in net sales
Reduction in net sales x rate of gross earnings = loss of gross earnings
6. Calculate the increased cost of working (Profits form) or the additional expenses necessarily incurred to mitigate the sales loss (Gross Earnings form). Compare these expenses to the avoided loss by applying the rate of contribution to the avoided sales loss (economic test*).
7. Deduct the savings in insured standing charges or non-continuing expenses.
8. Calculate the loss related to ordinary payroll if separate coverage applies.
9. Apply the rate of recovery to losses where a coinsurance clause applies.
10. Determine the amount recoverable subject to the policy limits and not in excess of the actual loss sustained. Consider any waiting periods and deductibles that may apply.
Sample facts and figures
For an example of how these calculations might work in practice, assume the following hypothetical circumstances:
XYZ Corp. produces cookies for distribution across Canada and the United States.
The company’s financial statements for the year ended Dec. 31, 2007, are shown in the sidebar. Annual sales are approximately $12 million and are earned evenly throughout the year ($1 million per month). Sales were steady in 2006 and 2007, and 2008 sales were expected to be similar. Variable costs (costs that vary in proportion to revenues) include materials, direct labour, variable selling costs, and 50 per cent of utilities.
On January 1, 2008, there was a serious fire at the company’s plant. Repairs to the plant took four months.
Sales during the repair period were nil in the first month, then 50 per cent of normal in the remaining three months because a third-party alternate site with excess capacity was engaged. The third-party site cost XYZ $250,000. Materials and labour for production at the third-party site were provided by XYZ.
Following start-up on May 1, 2008, sales averaged 80 per cent of normal for four months and returned to normal on Sept. 1, 2008.
In addition to the reduction in variable costs (proportionate to the reduction in sales), office expenses of $50,000 were saved during the four-month shutdown.
The company’s business interruption coverage is provided under the Profits form with a limit of $5,000,000. There is no separate payroll coverage.
Calculating the loss (Profits form)
In this fact situation, here’s how the calculation could look.
Bear in mind that this calculation assumes business interruption coverage under the Profits form. Calculation under the Gross Earnings form would be different and would yield a recoverable loss of $1,040 instead -try it and see!
This article is based on excerpts from the study material in the Claims Professional Series of applied courses -a core of the CIP Program that helps adjusters learn the functional knowledge and skills required of their profession.