It is often said that the purpose of business interruption coverage is to do for the insured’s company what the business would have continued to do had no loss occurred. But Mike Hoffman, assistant vice president at Aon Risk Services Central Inc., says it is equally important to understand what the coverage is not intended to do.
“A business interruption contract is not a cure-all for an ailing business or industry,” says Hoffman.
Smart Business spoke with Hoffman about how business interruption coverage can help your business navigate a crisis.
How can a company navigate a business interruption loss?
There are four areas in a business interruption situation that must be addressed to effectively evaluate the exposure on any given loss. These are: 1) determination of the period of suspension; 2) the concept, definition and understanding of the term ‘actual loss sustained’; 3) the determination of the company’s projected business for the period of suspension; and 4) the establishment of those expenses that do not necessarily continue during a total or partial suspension of operations.
The human element should not be overlooked amid the more technical aspects of the determination of a business interruption loss. A major contributing factor to an improper and unsatisfactory loss adjustment is the failure by the parties involved to communicate effectively. It is important to open the lines of communication immediately following a loss to provide a quick and reasonable understanding of what is needed by all parties.
What is due diligence and dispatch?
The first issue to overcome in the loss analysis is the proper determination of the period of interruption. Involved parties should agree upon what is needed to complete repairs to damaged or destroyed buildings and equipment, and then arrange for the timely replacement of necessary raw materials, work in process, or other supplies essential to the resumption of operations.
Often, a business will want to make improvements during the repair process. The effects of replacing with dissimilar materials or type of construction or the intent to rebuild on a grander scale should be addressed as soon as possible after the plans are known. When plans are known early in the settlement process, an agreement can be reached between the business and insurance company as to what the time element loss would be without these changes, so future disputes over delays arising from the changes can be avoided.
How is the actual loss sustained determined?
While the term ‘actual cash value’ may be among the most misunderstood of insurance contract phrases, the term ‘actual loss sustained’ is equally misunderstood by parties involved in business interruption claims. Actual loss sustained may range from ‘no loss at all’ to ‘record’ production or sales and margins of profit on these sales. Somewhere in between is the perception of what is fair and reasonable to the parties evaluating the loss.
Many insurance companies interpret actual loss sustained to mean that, regardless of whether a company has sustained a loss in production, it must demonstrate, beyond any reasonable doubt, that the loss in production resulted in a loss of sales. Factors to consider when trying to determine whether a business has sustained a loss of sales include the length of the suspension period, the amount of inventory available to meet sales commitments, the mix of the inventory on hand, the timing of the sale and the ability to deliver all of an order on time.
In the end, it is incumbent upon the insurance company to restore the business to the same condition that existed at the time of loss.
How can a business demonstrate its loss?
Among the more common ways are the uses of production records, sales records, inventory data, order backlog reports and customer order documents. One of the most troublesome business interruption calculations is the necessity of demonstrating what the business would have done had no loss occurred.
This is a subjective judgment and extremes must be avoided; what a business could do is not necessarily what it would have done.
What constitutes necessary continuing expenses?
When discussing those expenses that do not necessarily continue during the interruption of the business, it is important to recognize the degree of disallowance depends very closely upon the question of whether the impacted operation is down completely, or whether it is maintaining partial production through the use of other equipment or a substitute facility. Even in the case of a substitute facility, it is necessary to make the distinction as to which of those expenses can be truly avoided and which are necessary to the ongoing operation of the business.
In the case where ordinary payroll is excluded from the insurance contract, it may still be appropriate for the insurance company to indemnify the impacted business for payroll costs associated with making up lost production. In some cases, it is not a payment of the ordinary payroll itself but rather a recognition of an expense incurred to reduce the loss.
The simplest way to measure continuing and noncontinuing expenses is to study the history of the business prior to the loss. One should determine the degree of variability of the expenses and attempt to recognize which of those would or should discontinue under the circumstances surrounding the loss.
The timing and location of the loss, as well as related contractual agreements, all have considerable bearing on whether expenses can be avoided following the occurrence. In short, the determination of continuing versus noncontinuing expenses is a matter of practicality and judgment among all involved parties.
The situation following a loss may be safely navigated by keeping in mind that open and ongoing communication is essential to effective business interruption claims negotiations. Everything else is secondary.
Mike Hoffman is assistant vice president at Aon Risk Services Central Inc. Reach him at (314) 854-0726 or firstname.lastname@example.org.