Many companies have crumbled under the weight of their own infrastructure when their revenue stream slows to a trickle.
But just because your business comes to a halt doesn’t mean your expenses vanish, as well. If your business is interrupted, are you prepared so that interruption doesn’t lead to the demise of your company?
“Business interruption can lead to catastrophic losses,” says Philip Reardon, director of Aon Risk Accounting Management and Administration. “Unless you have adequate insurance that has transferred the risk to insurers, it can leave a heavy impact on the balance sheet and ultimately lead to the failure of an organization.”
Smart Business spoke with Reardon about how business interruption coverage can protect your company in times of crisis.
How does business interruption coverage work?
It’s essential to understand that BI coverage is a component of a property policy, which covers the physical assets of an organization and the business interruption element that goes with it.
In order to have a business interruption claim, your property policy must be triggered by physical damage to an asset. Damage triggers the policy, and as a result of that damage and its impact upon the business, BI coverage comes into play.
There are two components of BI coverage; the first is a loss of gross profits, and the second is an extra expense component. The loss of profits component covers the revenue of the organization, less any variable expenses that may cease during a period of interruption. Its purpose is to protect the bottom line. Gross profits coverage is designed to cover all the fixed costs that continue on in the event of a loss, plus the net profits of an organization. Rather than generate revenue from the sale of products, for example, the insurance company will pay the gross profit element and those costs will be covered.
In addition to that, there is an extra expense element to the policy that covers the additional costs associated with trying to mitigate that loss of revenue.
What are some expenses that occur as a result of business interruption?
There are several fairly common expenses. If your organization recently had a major fire and leased temporary premises, the extra leasing cost is covered under the policy. Also, if an organization has more than one manufacturing site and loses one, there may be the opportunity to increase the production coming out of the remaining sites. You can work around the clock at those remaining sites and ideally maintain the same level of production. Obviously, there is additional cost and labor associated with the increased production, and those costs are covered under the extra expense component.
Some organizations may be faced with the opportunity to contract with a competitor. If competing companies have a fairly amicable relationship, they may have an agreement that if one has a business interruption, the other will help out. This gives a client the opportunity to continue to manufacture its product and maintain its customer base. But certainly the competitor will make hay while the sun shines and charge you a premium to use its facilities and equipment. If it does that, the additional cost of going to a competitor is covered under the extra expense component.
What are some things companies can do to cover extra expenses?
Clients are obliged to mitigate their losses to the best of their ability under the terms of the policy. So more often than not, an organization will have some level of mitigation it can employ in the event of a major interruption.
Insurers actually prefer to spend money on mitigation than to hand out money on a loss of profits claim, because a loss of profits claim will invariably go on a lot longer than an extra expenses claim. Insurers prefer to have that extra expense coverage implied and utilized by the client.
There are two elements of extra expense. The first is expense to reduce loss, which basically means you can spend a dollar in order to avoid losing a dollar. Of that potential lost gross profits, you can spend that amount in order to prevent losing it.
The second element is a separate extra expense clause best defined as a separate sublimit — it’s a separate bucket of cash. If there is anything that falls outside the realm of the expense for reduced loss, then it falls into that extra expense category. It’s a safety net for additional spending that a client may incur trying to mitigate its losses.
Also, a client may potentially elect to insure extra expense only. An organization may be comfortable with its own mitigation options that it elects not to have coverage for gross profits and will only cover extra expenses.
In doing that, an organization must be comfortable with its mitigation options because any loss of revenue is subsequently not covered.
How can companies determine what their plan should be?
It is essential for organizations to regularly review their business interruption coverage because there are changes every day in business, and if you don’t change, you’re going to fall by the wayside.
Many organizations have diversified or made acquisitions, and they must make sure these changes are reflected in the business interruption values provided to insurers. In the current economic climate, if an organization simply provides the same values to the insurer it did the prior year, it may well be missing out on a premium reduction. If revenue and profits have gone down, the values you provide to insurers should go down. All other things being equal, the premium associated with that should also go down.