Ask yourself this: In the Event of a Major Loss, how will your Business Insurance respond in respect of Loss of Revenue?
Business Interruption Insurance is one of the most misunderstood areas of insurance with over 70% of businesses being underinsured. The majority of businesses that we speak to on a day to day basis do not properly understand this important area of Business Insurance.
The key reason for this misunderstanding is that most business managers believe that Accounting Gross Profit and Insurance Gross Profit are the same calculation. This is a very dangerous assumption and can lead to significant under insurance. Most importantly, the insurance policy you have purchased will not respond in the way you have intended.
We help our clients understand the fundamentals of Business Interruption Insurance and the key differences between Accounting Gross Profit and Insurable Gross Profit.
Overview
The basis of any insurance including Business Interruption insurance is to put you back in the position you enjoyed prior to the loss occurring. In respect of Business Interruption insurance there is no lump sum payout in the event of a loss. It is protection for your business against a reduction in turnover over the insured indemnity period following an insured loss under the Material Damage section of your Property policy.
In order to fully benefit from the insurance protection you are buying it is essential you understand how the cover will respond in the event of a loss so you can correctly calculate your Insurable Gross Profit. In addition it is important to set the required indemnity period to ensure cover is provided up until your business does return to the position it enjoyed prior to a loss.
The Business Interruption section of your policy provides cover Loss of Gross Profit due to a Reduction in Turnover following an insured event. Therefore a business must determine those expenses which will reduce directly in proportion to turnover in the event of an insured loss. This must be considered against each trading entity/division with a business and Insurable Gross Profit calculation applied to each one.
The Basis of Settlement is determined by applying the Rate of Gross Profit to the amount by which the Turnover during the indemnity period, shall in consequence of the damage, fall short of the Standard Turnover.
Therefore it is extremely important that you invest the time to understand what your Insurable Gross Profit should be as this will be assessed against your standard turnover to determine your Rate of Gross Profit. This then forms the basis of your claims settlement and will be subject to underinsurance.
Under Insurance
This is a key issue when assessing your Sum Insured for your Business Interruption Coverage. Even in the event of a partial loss you risk having to bear a substantial part of the loss yourself in the event you under insure. Most Property & Business Interruption policies will be subject to co-insurance which in effect is a penalty for being underinsured.
To ensure you don’t leave yourself underinsured we strongly recommend you closely review the following:
- Insurable Gross Profit Calculation
- Insuring Payroll Correctly
- Indemnity Period required to re-establish the business
Review of Gross Profit Calculation.
It is important to understand the difference between Accounting Gross Profit and Insurable Gross Profit. When it comes to an Insurance Gross Profit under an Interruption Policy, it is only those expenses that vary in direct proportion to sales that ought to be deducted from turnover to arrive at Insurable Gross Profit.
The definition of Gross Profit under a market standard ISR Policy is as follows:
Gross Profit – The amount by which:
- the sum of the Turnover and the amount 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 Uninsured Working Expenses as set out in the Schedule.
To arrive at the “Insurable Gross Profit” you should only deduct those expenses which vary in direct proportion to services sold from turnover to arrive at your “Insurable Gross Profit”. This is what is meant by Uninsured Working Expenses.
It is imperative that at least every 12 months a review of the calculation of “Insurable Gross Profit” for each entity using the Insurable Gross Profit calculation method is conducted.
- Insuring Your Payroll
To ensure you are not underinsured it is important that you declare you Payroll in accordance with the definition stated in the ISR Policy:
Payroll: the remuneration (including but not limited to pay-roll tax, fringe benefits tax, bonuses, overtime, commission, holiday pay, sick pay, long service leave, workers’ compensation insurance premiums and/or accident compensation levies, superannuation and pension fund contributions and the like) paid to all employees.
We strongly recommend a review your declared values to ensure your payroll has been declared in accordance with the above definition.
Many businesses elect to insured Payroll separately from your Gross Profit. This is common place however it is an area which requires further thought depending on the specific requirements of your business. In order to do this it is necessary to consider the implications a major loss would have on your staff.
It is important to understand the specific contribution of all of your staff when assessing the basis on which your wages should be insured. If there is a high percentage of unskilled / casual labour then this supports a Dual Wage Basis method.
However if your staff are more weighted towards skilled employees or staff who possess an in-house knowledge of your systems and industry which would be hard to replicate then the current weighting is worthy of close review. The more that wages are protected the longer you will be able to retain staff to assist in reducing the period of disruption and eliminate time spent in re-recruiting and training.
If you are proposing to insure and a Dual Wage Basis then it is important to consider any severance payments in the event you will be require to lay staff off as a result of a major loss.
Setting the correct Indemnity Period
A formal Disaster Recovery Plan is useful in determining the immediate actions required in the aftermath of a major loss event. We strongly recommend businesses give further thought to this as it does provide the required methodology to enable an accurate indemnity period for your Business Interruption coverage.
Setting the correct indemnity period is vitally important. It needs to take into account the entire time that your business could be effected by a major event. This includes the time it would take to replace / regain clients that were lost due to your inability to supply services following a major loss event.
The most common indemnity period selected is 12 months however each business must make their own informed assessment as to the time required to re-establish their business to the trading position they enjoyed prior to the loss occurring.
There are a number of factors which must be considered when assessing the correct Indemnity Period, these include:
- Acceptance of the Property Claim
- Management of the Claims
- Identifying Alternative Premises
- Connection of Services
- Removal of Debris
- Complying with Local Authority Requirements
- Environmental Issues
- Tender Phase for rebuilding works
- Lead Time on Replacement Equipment
- Fit out, Testing & Commissioning
- Winning Back Customers
- Catastrophe Situations i.e. demand / supply issues
The premium implications of reducing your indemnity period from 12 months is minimal and we would not recommend this course of action. However, if you choose to extend your Business Interruption indemnity period it does have a corresponding impact on you premium payable, i.e. if you extend your indemnity period to 18 months it will be an additional 50% loading to the premium payable for your Business Interruption coverage.
Crucial Insurance are experts in assisting business with understanding how to protect their business against future loss of revenues as a result of a major loss event.
If you would like to speak with one of our team please call us on 1300 400 700 or email us at info@crucialinsurance.com.au