The Economic Crisis

While the signs have been there for some time now, the significant fallout that has occurred in the worldwide economic market became a reality to everyone this past September. In particular, and close to many of us who work in the insurance industry, the sudden fall of the AIG stock sent a signal that no particular industry is safe in these difficult economic times. However, life indeed does go on and in the insurance world, policies continue to be written, losses continue to occur and claims continue to be made.

From a standpoint of measuring the business interruption losses associated with the claims occurring in a time of economic turmoil, one must ask “how does the current situation affect the measurement of business interruption losses?” At first glance it may seem the answer would be a simple one: revenues can be expected to be down and the impacts are far reaching and affect businesses in many different ways. During both our internal training seminars and external client seminars, we always stress the need to fully understand the “affected business” and the economic climate it operates in before attempting to measure the loss. Never has this been more important.

In the process of measuring a business interruption loss, the first step is most often to project what revenues the business would have achieved, if not for the loss. In stable, predictable times this is an involved and at times, cumbersome task. Add in the instability of the market as a whole, the ability of companies to get financing, the bleak future outlook and the task of predicting what would have occurred becomes one that takes careful analysis. In order to predict what a business would have done, the following approaches are often used to develop projected sales levels:

• Comparison to prior year and adjusted for revenue growth

• Experience just prior to the loss

• Comparison with budgets and forecasts

• Comparison with industry trends

In each of the above methods, the change in the market conditions that hit hardest in September 2008 could significantly impact the potential revenue levels that would have been expected in the last quarter of 2008. For instance a comparison of the revenue levels in the two years prior to an August 2008 loss may show significant gains. However, depending on the business, applying this growth to the loss period (which runs August to December 2008), could drastically overestimate the revenues that would have been earned.

Typically, a company prepares an annual budget in advance of its fiscal year end. Therefore, for calendar 2008 many companies would have projected sales in December 2007. The automakers and their suppliers would be prime examples of companies that would have projected good to moderate sales levels throughout 2008. However, when the current crisis hit, and even prior to, automakers were in a state of declining orders and eventually into plant shutdowns as 2008 progressed. Therefore, you may have an auto parts supplier that expected steady revenue throughout 2008 and even continued to produce under those assumptions through the first half of 2008. However, assuming a loss in August 2008, those projections from late 2007 or early 2008 were unlikely to come to fruition.

Generally, utilizing industry trends and analyzing them before and after the loss should allow for a relatively good basis for projecting the expected revenue levels of a business. But, the continued decline of many commodity prices throughout the fall of 2008 indicates that in these current conditions, it cannot be assumed that there is a “reasonable floor” to base calculations on. As an example, throughout the first half of 2008, steel prices soared and increased by nearly 100 per cent between January and July. Assuming a loss in August, one might expect that a similarly aggressive decline in prices would be unlikely to occur in the period from August to December 2008 and project losses based on July 2008 prices. However, the current crisis did hit the steel industry and may now lead to assumptions that a loss, while impacting production, would result in no revenue loss whatsoever.

The effects of these impacts can be far reaching and cascading throughout many different industries. The domino effect certainly can take place in recessionary type conditions that we are currently in In Canada, we experienced a “white Christmas” all across the country for the first time since the early 1970’s. The snow continued to fall well into April, which tends to lead weary Canadians with sore backs to purchase snow blowers. Because of two consecutive snowy winters, snow blower sales have been quite high. If you were to assume a loss at one of these locations, you might expect to continue to project increasing revenue figures for the sale of snow blowers. However, consider the following headline which was recently in The Globe and Mail, “Shutdown of U. S. motor-maker leaves many retailers across the GTA sold out of or very low on inventory.” While many consumers were still looking and searching for a snow blower, the economic recession had resulted in the inability to manufacture something that was in high demand.

There is a need to be cautious in the current economic situation when placing reliance on past or historical results. It should be noted, the current situation can also result in instances where prior year’s results and budgets may in fact understate the potential revenue loss a business may suffer.

Walmart Canada saw its sales increase in September and October, largely driven by higher sales of food products as individuals chose to stay home and cook rather than dining out. Kraft Foods and Campbell’s have also experienced significant gains following the market crash, again due to the consumer purchasing more staple foods and backing away from discretionary spending. While in many cases the current economic situation would result in decreases in projected revenues, there are others that will benefit from the same economic turmoil.

It is expected that eventually the economy will recover and revenues will return to prior levels at many businesses, impacting projections of revenue levels for several years to come as well. If we were to assume the economy slowly recovers in 2009 and in 2010, the 2008 and 2009 periods would represent your base period in losses occurring in 2010. On first glance, an analysis would show significant growth occurring. However, this would in fact be largely due to the low revenues experienced as a result of the economic crisis and not represent a trend to be carried on into the future.

While policies continue to be written and claims continue to be made, for the foreseeable future business interruption losses will need to be analyzed carefully to properly consider how the current economic crisis is impacting the business world.

Gerry Bouwman, CMA is a partner and vice president with Matson Driscoll & Damico Ltd. in the Toronto office. Bouwman specializes in economic damage quantification and has handled losses throughout Canada and across the world.