Understanding Business Interruption Insurance
Like other insurance products, BI coverage is governed by a policy limit and specific terms and conditions. It is a contract between the customer and the insurance company to pay for claims under certain circumstances. It is not a blanket promise to reimburse the customer regardless of the cause of the business interruption. Typical conditions include the interruption being the result of direct physical impact that would be covered by the property insurance policy and exclusions or restrictions for business interruptions caused by war, actions by civil/military authorities, utility interruption, inability to access their property and terrorism. Court rulings producing a broad interpretation of these conditions have resulted in many insurers becoming more detailed and specific in the language used in their policies.
Terminology and Concepts
Since business interruption concepts are intimidating to some involved in crisis management, a good place to start is with an understanding of some of the basics. Business interruption values are usually, but not always, annual operating earnings measured in accordance with policy coverage. These earnings are not net income or earnings before interest, taxes, depreciation, and amortization (EBITDA) but are instead gross operating profits as outlined in the insurance policy.
The values are actually calculated using a business interruption work sheet. Business interruption work sheets come in many shapes and sizes but all will have a few basic components. First, they require an estimation of revenue and any expenses that will not be incurred due to the loss event. These are often called "noncontinuing expenses." Some examples of possible noncontinuing expenses are direct feedstocks of raw materials, some utilities expenses, maintenance supplies, etc. for the damaged facility.
The estimation of BI values is developed using the work sheet, and is strictly a mathematical calculation of the earnings that would be lost if the business were to be interrupted for a year. Insurance company underwriters will consider this calculation as part of the underwriting process. Additionally, the BI values can then be used to determine a limit of liability by estimating the maximum period that an interruption will occur. In simplistic terms, if the maximum period is considered to be six months a limit equal to 50 percent of the BI value would be chosen, while for a 15 - month interruption, a limit of 125 percent would be used.
Estimating BI values does not typically involve hypothetical loss or disaster type scenarios, such as how the company would be affected by an earthquake in Los Angeles or an explosion at a manufacturing plant. Hypothetical loss event scenarios are instead typically found in probable maximum loss (PML) or maximum foreseeable loss (MFL) studies. A PML study will look at the scenario that has the highest probability of happening but might not be the worst-case scenario. On the other hand, a MFL study will explore the worst-case scenario.
PML/MFL studies look at what a potential business interruption claim would be based on that hypothetical loss event. BI values are one of the most critical data inputs into a PML/MFL study. However, a PML/MFL study will go further, taking into consideration potential hypothetical loss scenarios as well as other issues (e.g., the expected length of the loss, any asset interdependency, and mitigation plans the company might have) to determine what one single event could lead to the largest overall loss. PML/MFL studies are critical in helping the risk manager determine if the overall insurance limits in place are sufficient. They also help identify potential coverage issues that an actual loss might create. Because BI values are one of the most critical pieces of information used in the studies, inaccurate BI values will cause PML/MFL studies to also be wrong.
Business continuity and crisis management capabilities are critical to controlling BI losses and may affect the calculation of BI values. If a company has a formal program in business continuity and crisis management, it should be taken into account when performing the PML/MFL study and in choosing the insurance limits. The plans may also help identify noncontinuing expenses and other items for use in the creation of the BI work sheets. It is critical that those responsible for these plans work with insurance buyers to ensure an accurate representation of the organization's capabilities.
Changing Insurance Landscape
The world of business interruption insurance has changed a great deal in recent years. Not too long ago, commercial insurers competed vigorously with each other to write property damage and business interruption insurance. Although the market has softened somewhat in recent years, insurers no longer offer the broad policy language with low deductibles at low premiums that were seen during the 1990s. Today, higher deductibles and more restrictive policy language at higher premiums are the norm, and insurance carriers are more selective in the business that they choose to write.
Also gone are the days when the business interruption (BI) values reported with an insurance submission are taken at face value. Many companies will still carry a different amount of insurance than the stated business interruption values, however underwriters are more diligent to seek out reasons for the variance. Close inspection of the values are crucial for more than just underwriting purposes as well. Some policies now impose a limitation on overall claim payouts equal to the lesser of the actual loss sustained or the reported BI values by location (plus some error rate).
For these reasons, making an effort to estimate the most accurate and detailed business interruption values possible is very important. Doing so can avoid the embarrassment and ramifications of having to tell senior management that a large uninsured loss has to be written off because the BI business interruption values were incorrect. It also, of course, will avoid having to pay the unnecessary premiums that will arise if the estimated value is higher than needed. Today, a detailed review of the BI values and the BI work sheet is not just good business practice-it is a basic requirement for risk professionals.
This article reviews how BI values are established through the use custom business insurance work sheets. Other issues related to business interruption are examined and discussed as well.
How the Crisis Manager Can Assist
Work with the Risk Manager or insurance buyer to evaluate whether the assumptions in the reported BI values and chosen BI limits make sense. Your insight into how the organization will actually perform in a crisis is critical to accurate values.
If the organization does not carry BI insurance, evaluate whether coverage would facilitate a timelier or less devastating recovery. Access to funds following an event can ease the decision making process and provide comfort to senior management who want to do the "right thing" but may also have lingering fears about the financial consequences.
Compare your assumptions with those used in the BI calculations. Does the BI coverage include deductibles, sublimits or maximum recovery amounts that are inconsistent with how you believe a loss will play out?
Review the policy conditions and exclusions for the purpose of determining whether scenarios you believe possible are excluded from coverage. Consider how your approach to building a resilient enterprise may need to change given the conditions/exclusions.
Take an active role in determining BI values. Your experience in dealing with a broad array of the organization's management team provides a unique understanding of what expenses (including which employees warrant continued salaries during a shutdown) might continue during an interruption.
Work with Risk Management to evaluate the overall BI limit. It is possible that the organization could be buying more BI insurance than the company will reasonably need following an interruption. The more mature the business continuity and crisis management program, the more likely this is to be the case. Consider how savings in insurance premiums can be used to reinvest in a more resilient enterprise.
Brad Murlick is a managing director in the Chicago office of Navigant Consulting and leads Navigant's insurance claims consulting practice. He has assisted numerous clients in a variety of industries with the preparation, negotiation, and settlement of property, business interruption, fidelity/employee dishonesty, builders risk, political risk and product recall claims associated with both insured and uninsured (i.e., litigation) events. His work has also included the development of business interruption values analyses for corporate policyholders on numerous occasions. Murlick is a frequent speaker and published author on matters relating to insurance claims, and has also appeared on CNBC, Summit TV (South Africa), and National Public Radio to discuss catastrophic events.
Mark O'Rear is an Director in the Houston office of Navigant Consulting and leads Navigant's Houston office insurance claims consulting practice. He has managed and assisted clients in textile, construction, retail, manufacturing and almost all aspects of the energy and chemicals industries in the quantification, presentation and negotiation of claims. During these engagements he has developed property damage, theoretical repairs, business interruption, contingent business interruption, expediting and extra expense claims, among others. He is also a frequent speaker on business interruption topics.