Business Income Insurance

“Difference basis” “profits form” – (From former AXA U.K. site)
U.K.
NEED FOR COVERAGE

Most businesses have capital assets – BUILDINGS, MACHINERY and STOCK – used to generate income. This income pays for salaries and wages, covers the running costs of the business and, once all expenses have been met, provides a net profit.

The physical assets should be protected by a material damage insurance, which pays for the rebuilding of damaged premises, the repair of machinery and the replacement of damaged stock. It is equally important, however, that the earning capacity of the business is protected by insurance, in order that it may continue after the loss.

BUSINESS INCOME INSURANCE will provide protection against contingencies, which might interfere with the smooth running of the business. With this, money can be made available to pay for costs, which the business will still incur despite the fact that it is not operating at full production of even if it stops altogether for a time. In addition, there may be extra costs as a direct result of the loss and these also need to be covered.

The types of costs fall into two categories, called FIXED COSTS, sometimes known as “Standing Charges” (it is important to remember that the “Fixed Costs” are those which do not automatically reduce in direct proportion to any reduction in Revenue), and ADDITIONAL COSTS.

FIXED COSTS can include –
  • Rent
  • Property Taxes
  • Heating
  • Lighting
  • Payroll
ADDITIONAL COSTS can include –
  • Rent of temporary accommodation
  • Use of sub-contractors
  • Hiring in temporary machinery
  • Overtime payments

In manufacturing, wholesaling or retaining businesses the income is described as “Revenue” and Business Interruption policies for these types of risk use Business Income as the basis of cover.

The best method of calculating the sum insured is the DIFFERENCE BASIS, where Business Income is defined as “The amount by which –

  • The sum of the amount of the Revenue and the amounts of the closing stock and work in progress
  • Shall exceed
  • The sum of the amount of the opening stock and work in progress and the amount of the “Variable Operating Expenses.”

It is known as the “Difference Basis” because the sum insured is, essentially, the difference between sales and purchases.

“Variable Operating Expenses”, mentioned above, are those business charges, which vary in direct proportion to the Revenue – in other words, if damage occurs which affects production, these charges reduce at the same rate as the reduction in Revenue. As you will not have to pay these charges if production ceases, they can be excluded from the cover.

These charges will differ from business to business – for example, freight and packing may vary in direct proportion to the Revenue for some businesses but not for others. If charges are reduced when production falls, but not in direct proportion to the drop in Revenue, they should not be excluded from the insurance, as you will still have to pay a proportion of these costs if there is a loss. (Bad debts and purchases are always shown as Variable Operating Expenses). The Extended Business Income (Broad Form IBC 4102B) defines these Variable Operating Expenses as follows:

  • All purchases (less discounts received);
  • Packing materials;
  • Delivery and freight (other than by own vehicles);
  • “Ordinary Payroll.”

On a “Difference Basis” wording the cover is split into two parts: –

Reduction in Business Income – this pays for the fixed costs and the net profit.

Increase in Cost of Working – this pays for the additional costs which may have to be incurred to keep production going as much as possible despite the damage.

It should be remembered that under (2) above, a limit is imposed which restricts the amount payable in respect of these additional costs to the amount of reduction in Business Income which was avoided by incurring these costs. This is sometimes known as the ECONOMIC LIMIT.

The “Difference Basis” wording described is used for most manufacturing, wholesaling and retail risks but some businesses derive their income in other ways and there are more appropriate forms of specification available. They are all based on the same principle – that the Client uses the Revenue (whether this is described as income, gross rentals, fees or revenue) and deducts from it any charges, which vary in direct proportion to the level of Revenue. Having done that, provided the sum insured is adequate; it will have full cover to pay for its fixed costs, its additional costs and its net profit.

THE SUM INSURED

Having identified the need for Business Interruption insurance and the range of perils to be insured, it is necessary to calculate an adequate sum insured. If this is correct, the resulting underinsurance will mean that you might, depending on the wording of the policy, receive only partial payment in the event of a loss. The staring point in calculating the sum insured is –
YOUR ACCOUNTS. Accounts follow a reasonably standardized format and there are three main types:

1. The Balance Sheet records the assets and liabilities of the business, generally at the end of the financial year. This account may be used to establish solvency and certain other aspects for business performance but has little bearing on Business Interruption insurance.

2. The Trading Account monitors the trading activities of the business and will show sales, purchases of materials or stock, production expenses and the Business Income earned during the financial year. This Business Income figure, however, is one, which is carried to the Profit and Loss Account and is not the same as the “Business Income” to be insured under a Business Interruption policy.

3. The Profit and Loss Account records the overall progress of the business throughout the financial year by setting the Business Income earned in that year against the general expenses paid in the same period. These expenses will include wages, salaries and all other overheads, leaving the balance as either net profit or net loss.

The accounts, which must be considered when arranging a Business Interruption policy, are the Trading and Profit and Loss accounts. Together, they provide the figures used as a basis for calculating the Business Income as defined in the policy.

Detailed below are Trading and Profit and Loss accounts for a manufacturing company, showing a calculation of sum insured. An example based on these accounts shows how to calculate the basic Business Income sum insured using the “Business Income” definition under a Difference Basis specification. In the example shown, the Uninsured Working Expenses are:

  • Freight
  • Packing Materials
  • Bad Debts
  • Purchases

Remember that expenses (other than bad debts and purchases) should only be excluded if they vary in direct proportion to the Revenue – these will differ from business to business. Each expense should be examined very carefully before being excluded.

PAYROLL

All salaries will automatically be included in the Business Income sum insured unless they are specifically excluded. Ordinary payroll can be included by endorsement. While you always have the option not to include Ordinary Payroll or to insure them on a partial basis, it is often recommended that it be insured in full for the following reasons:

  • Time is needed for you to assess the situation and formulate plans for recovery, during which employees will have to be paid.
  • You may be obliged by legislation to make payment to employees if they are laid off or made redundant from any cause. The amount paid varies depending upon the length of employment of each individual employee. In addition to this, there may be separate trade union agreements, which could extend the payments even further.
  • In many businesses there are key, skilled employees which the you would not wish to release in the event of a loss, as they could be instrumental in ensuring that the business returns to full production as quickly as possible. If they do leave, they may be difficult to replace.
ADJUSTMENTS FOR FUTURE EARNINGS

The basic sum insured, as calculated from the books of account, will have to be adjusted so that the actual amount shown in the policy provides adequate protection, not only for the immediate period of insurance, but also for the length of time the business could be affected as a result of the loss.

The factors to be considered when adjusting the basic figures are:

  • When the accounts were prepared. The date on which the accounts were prepared is important because, by definition, the audited accounts will be an historical rather than a current record.
  • Any trend in the business. It is necessary to take into account any trend in the business, including both real growth and growth due to inflation, expected during both
  • The Period of Insurance and
  • The length of the maximum Indemnity Period

Damage may occur at any time after the inception of the cover, possibly in the last month of the period of insurance. The indemnity period will then begin and could continue up to the Maximum Indemnity Period selected. The Business Income sum insured calculated by the Client must therefore be the Business Income anticipated at the end of the Maximum Indemnity Period.

For example, if the period of Insurance is twelve months and the Maximum Indemnity Period is twelve months the basic Business Income figure taken from the accounts at inception must make allowances for inflation and real growth two years ahead. For Maximum Indemnity Periods greater than twelve months the Business Income figure must be increased even further.

PREMIUM ADJUSTMENT CLAUSE

The PREMIUM ADJUSTMENT CLAUSE allows for a return of up to 50% of the initial premium.

The premium paid at the beginning of the period of insurance is based on the final sum insured. This will be adjusted annually at the end of the period of insurance when a declaration form from either you or your accountants is submitted. This will contain the actual Business Income (as defined in the policy) earned during the financial year, which corresponds most closely with the period of insurance that has just expired.

This encourages some over-estimation when the sum insured is being calculated, a wise precaution in view of the fact that an inadequate sum insured will result in only a partial settlement if a loss occurs.

INDEMNITY PERIOD

One final point to remember when establishing the sums insured under either the Conventional Basis or a Declaration Linked basis is that the annual Business Income used as the basis of the calculation. If the maximum indemnity period exceeds 12 months, a corresponding multiple of the annual Business Income should be used, e.g.

18 months: 1 1/2% x the annual Business Income 24 months: 2 x the annual Business Income 36 months: 3 x the annual Business Income If the maximum indemnity period is less than 12 months, the full annual Business Income is still used, in order to allow for seasonable fluctuations.

It often takes much longer to recover fully from a loss than the Client appreciates and the maximum indemnity period selected should be based on an assumption of the worst possible set of circumstances, so that the possibility of inadequate cover is minimized.

It is advisable to fill out a worksheet to arrive at the correct amount of insurance.

There are various extension to normal coverage coverage for example:

  • Ordinary payroll can be included to whatever extent is desired.
  • Suppliers and Customers premises and Suppliers of Suppliers and customers of Customers can be included.
  • Penalties for breaking leases or contracts can be included.
  • Stored Property on other premises.
  • Public Utilities.
  • Accountants fees to prepare loss information.
  • Transit coverage.
EXAMPLE OF TRADING
PROFIT AND LOSS ACCOUNTS FOR A MANUFACTURING COMPANY
Trading Account Year Ending 31.12.20…
DR. CR.
Stock in hand - Jan 1st 121,846 Sales 1,387,632
Work in Progress - Jan 1st 27,055 Stock in Hand - Dec 31st 149,001
Stock Purchased 338,009 Work in Progress - Dec 31st 37,229
Production Wages 527,991
National Insurance Contributions 67,550
Power Charges 21,498
Gross Profit (carried to Profit and Loss Account) 469,913
1,573,862 15,738,623
Profit and Loss Account Year Ending 31.12.20…
DR. CR.
Salaries 86,098 Gross Profit (from Trading a/c) 469,913
Pension Fund Contributions 65,258
Rates 16,191
Carriage 77,942
Packing Materials 18,081
Travelling Expenses 27,441
Advertising Costs 15,000
Postage & Telephone Costs 11,122
Lighting and Heating 10,481
Bank Charges 9,027
Depreciation 25,000
Bad Debts 4,870
Sundries 981
Net Profit 102,421
469,913 469,913
Turnover 1,387,632
Plus Closing Stock 149,001
Plus Closing Work in Progress 37,229
= 1,573,862
Less Opening Stock 121,846
Plus Opening Work in Progress 27,055
Plus Uninsured Working Expenses 438,902
587,803
Insurable Amount 986,059
*Uninsured Working Expenses in this example are:
Carriage 77,942
Packing Materials 18,081
Bad Debts 4,870
Purchases 338,009
If we assume that:
a) the accounts were prepared some 6 months prior to the insurance being arranged
b) the period of insurance is 12 months
c) the Maximum Indemnity Period is also 12 months
d) a steady growth inflation factor of 10% per annum applies
the figures would be adjusted as follows:
+ 5% for the accounts being out of date 986,059 +49,302 =1,035,361
+10% for growth during the period of insurance +103,536 =1,138,897
+10% for growth during the Maximum Indemnity Period =113,890
POLICY SUM INSURED  1,252,797
THE PERILS

Fire causes the majority of serious Business Interruption losses, but other perils can have an equally devastating effect on a business and the Client should carefully select the range of perils required. However, whatever is selected, there must be a material damage policy in force covering the same peril at the premises and a claim for loss to property by that peril must have been accepted under the material damage insurance before a claim can be paid under the Business Interruption policy. This stipulation is known as the MATERIAL DAMAGE PROVISO. The Client should not select a range of perils under the Business Interruption policy which is wider than under the material damage cover.

The perils covered under a basic Business Interruption policy are Fire, Lightning and a limited form of Explosion – similar cover to that provided under the basic fire policy, although the explosion protection is somewhat wide in that it applies to all boilers and economisers on the premises. To comply with the material damage proviso, boilers should be covered under an engineering policy.

The extra perils normally available are the same as those available under a material damage insurance, namely

  • STORM
  • FLOOD
  • BURST PIPES
  • RIOT AND CIVIL COMMOTION
  • MALICIOUS DAMAGE
  • EXPLOSION
  • AIRCRAFT
  • EARTHQUAKE
  • IMPACT
  • SPRINKLER LEAKAGE

It may also be possible to arrange for additional perils, such as theft (automatically included on AXA Insurance’s Unity Policies), accidental damage and subsidence. Once again, material damage insurance will need to be in force for any additional cover to be available.

POLICY EXTENSIONS

So far, only a loss at the Client’s own premises has been considered, but, of course, the business could be affected by disasters elsewhere. The Business Interruption policy is capable of being tailor-made to protect the business from insurable losses wherever they may occur, by the correct use of policy extensions.

The most common way in which a business may be affected by a loss occurring elsewhere than at the Client’s premises is when neighbouring premises are damaged by fire. Access to the Client’s premises may be restricted because of the damage and the Client’s business may suffer as a result. This is particularly important in narrow shopping streets, shopping centres or even industrial estates. Cover is available under the PREVENTION OF ACCESS EXTENSION, which AXA Insurance provides automatically under all Business Interruption policies – FREE OF CHARGE.

The SUPPLIERS EXTENSION is one of the most frequently used. This provided cover if the Client’s business is adversely affected by fire or other insured peril at the premises of the Client’s supplier. This supplier may be in the U.K. or overseas and more than one supplier may be insured. Indeed it is possible to insure unnamed suppliers for a limited amount. It should be remembered that under the definition of suppliers it is not only a supplier of goods that can be included but also a supplier of services.

The CUSTOMERS EXTENSION operates in a similar manner; in this case the policy pays if the Client’s business is affected by a loss occurring in the customer’s premises.

Under both Suppliers and Customers extensions the Client selects a percentage limit which will apply and can extend the policy to include as many suppliers and customers as he chooses.

The PROPERTY STORED EXTENSION should be selected by a Client who stores either raw materials or finished goods at another firm’s premises. A fire at these premises could seriously affect the Client’s business in terms of production or sales. Engineering firms often use specialists to produce patterns or moulds to their own design and these parts may be crucial to the firm’s production. Destruction of this property at the specialist’s premises could seriously interrupt production and the PATTERNS EXTENSION is designed to protect against this potential loss.

Most manufacturers need to transport their finished goods to their customers and the TRANSIT EXTENSION will provide cover in the event of a loss by an insured peril to the goods being carried. Cover is available for transit by road, rail or inland waterway.

If the Client uses specialised or custom built vehicles then the MOTOR VEHICLE OPERATORS EXTENSION should be selected. The basic policy would normally provide cover for interruption as a result of damage caused to the vehicles by an insured peril at the premises but this extension applies whilst the vehicles are away from the premises. It may take some considerable time to obtain replacements.

Please note cover for the peril of impact is not available in respect of either the transit or motor vehicle operators extension.

A business can suffer severe disruption if the electricity, gas, water or telephone supplies are cut off. The PUBLIC UTILITIES EXTENSION can provide protection, in the event of loss or damage caused by an insured peril at the

  • electricity generating station or substation
  • land based premises of the public gas supply undertaking
  • waterworks or pumping station
  • land based premises of the public communications undertaking,
  • from which Clients obtain their supply or services.

Many businesses e.g. joiners, electrical contractors, heating engineers, etc. operate away from their own premises. They may earn a large proportion of their income from work on contract sites and if that work is interrupted by fire or other insured peril the business may be severely affected. The CONTRACT SITES EXTENSION protects against this. For builders and similar trades particularly low levels of rating apply to this extension, which makes this an attractive form of cover.

The Client must consider the extent to which the business is dependent on the factors covered by the selected extensions and advise a percentage limit of the gross profit to apply to each extension selected (although 100% protection is automatically provided under the Prevention of Access and Public Utilities extensions and builders and similar trades receive the same protection under the Contract Sites extension).

The Client’s business may be affected by many incidents occurring away from the premises. The extensions mentioned above show only some of the ways in which protection is available and we will be happy to discuss other ways of extending a policy to provide the protection required.

ADVANCE PROFITS & ADVANCE RENTALS

Under a Business Interruption policy, the indemnity period, that is, the period during which the business is affected as a result of a loss, starts with the date the damage occurs. Cover continues until the business is back in full production, subject to the limitation of the maximum indemnity period. This cover operates perfectly well for businesses already operational, but what happens when a business plans a new factory or extension? The firm will expect to start production by a particular date at the new premises. If damage occurs before this date, production will be delayed, with a resulting loss of gross profit. The loss of gross profit would happen only after the expected opening date rather than immediately the damage occurs.

Under an ADVANCE PROFITS policy, the period of insurance should start when work on the new premises begins and continue until the expected opening date. However the indemnity period begins at the date on which the business should commence and should be calculated to take into account the period of time necessary to rebuild and re-equip the premises.

This form of cover is also suitable for buildings undergoing conversion work before business can begin, such as hotels being modernised before re-opening.

Property developers usually insure their rental income from properties on a normal Business Interruption basis. However where a developer is building new properties which will be ready for occupation at some future date and where the future tenancy has been agreed ADVANCE RENTALS cover should meet the Client’s needs.

The potential for financial loss caused by a delay in starting a business is considerable and some form of “Advance” cover is to be recommended for all Clients who may be involved in such a heavy investment.

THE MAXIMUM INDEMNITY PERIOD

What is the Maximum Indemnity Period? This is the period of time selected by the Client as being the longest period during which the business could be affected as the result of a loss. There are many different factors which affect the assessment of the indemnity period and some of the more important points to consider are outlined below:

BUILDINGS

If the Client’s premises are severely damaged, architects will have to draw up replacement plans and these will need to be approved by the local authority.

The building will have to conform to the local authority bye-laws and to Health and Safety at Work requirements. This may mean that otherwise simple rebuilding plans could be delayed while the correct architectural features are planned and special materials obtained.

Listed buildings unless totally destroyed need to be rebuilt in a similar manner to the original, using similar, if not identical, materials and it will usually take longer to restore these than it would to rebuild a modern building of conventional style.

Once planning permission is given, it will be necessary to seek tenders for reconstruction. Delays may be experienced in rebuilding because of labour problems, the weather, or even shortages of materials (particularly relevant to stone-built properties).

Buildings on modern industrial estates may be comparatively easy to rebuild, but buildings in congested areas are likely to take place much longer.

MACHINERY

The Client must consider not only a possible delivery date for replacement machinery, but also, if there is a minor loss, the availability of spares. Specialised or custom-made machinery is a particular problem. It is often worthwhile approaching suppliers to obtain some idea of the length of time required for replacement.

STOCK

Replacing stock of some types of commodities can present problems, particularly if there are limited numbers of suppliers or if supplies have to be imported.

LOCATION

Some businesses depend upon being located in a particular place for transportation links. Others, e.g. shops, hotels and public houses, generally depend for their trade on their position. Temporary accommodation would not be practicable.

STAFF

In most cases, trained staff are very important and if the business suffers a severe interruption, they could move elsewhere and be difficult to replace.

SUMMARY

Estimating the correct Maximum Indemnity Period can be a complicated task. It is, of course, the Client’s responsibility to select the correct period, but insurance advisors are often consulted for their specialist knowledge. For larger cases, we will provide a free interruption survey service, which should help the Client to identify the interruption survey service, which should help the Client to identify the interruption hazards peculiar to the business; if this is used in conjunction with the Client’s own catastrophe plans, the correct maximum indemnity period will be easier to determine.

Please remember that protection under a Business Interruption policy ceases at the end of the Maximum Indemnity Period; if the length of time selected is inadequate, the Client may suffer serious financial loss or even go out of business. Many businesses can take more than twelve months to regain their pre-damage trading position after a serious loss and longer Maximum Indemnity Periods should always be considered.


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