Weighing Up Depreciation in a Business Interruption Claim

Determining whether depreciation can be factored into a business interruption claim depends on the definition of “depreciation”. From an insurance perspective, this refers to the depreciation of “fixed assets” such as buildings, plant, machinery, furniture, fittings and everything other than stock following cessation or reduction in sales/production after a fire or other insured catastrophe. The depreciation of stock is a trading loss and is therefore not an insurable item.

Fixed assets are usually recorded in the accounts of a business at the original cost price less “bookkeeping” depreciation which has been accumulated over the period that the asset has been in use. The theory is that the net figure should represent the remaining value. This figure may vary considerably from the current “real value”. That is because factors such as location, physical depreciation, and obsolescence due to advances in technology or fashion might not be reflected in the “bookkeeping” formula. This, however, brings two important considerations into play – the “standing charge”, and the “savings clause”. How do these work?

STANDING CHARGE

In determining the insured value of deprecation, it is worthy to note from “Riley on Business Interruption Insurance” (8th edition) the following: that in order for the policy to work it is necessary “to bear in mind the fundamental principle that in order to protect the net profit of a business it is essential to insure net profit plus those charges which will not fall proportionately with a drop in turnover. From this a working definition can be drawn, namely that an insurable standing charge is one that does not diminish proportionately with a reduction in turnover if there is an interruption of or interference with the business by any of the contingencies insured against. To which an important addition must be made – or any variable charge which it would be desirable to continue in the interest of the business. Those in the latter category are referred to as optional charges.”

In this respect, depreciation would certainly fit in the category of an “optional charge” and the inference is that optional charges are insured. It is therefore clear that the sum insured should be sufficient to provide for the net profit plus all of the standing charges of a business, including optional charges.

In addition, the definition of “net profit” in a profits policy with the sum insured calculated on the “addition method” specifically states that due provision must be made for “all standing and other charges including depreciation”. It does not say that depreciation is insured, but only that provision must be made for it. When the sum insured is calculated on the “difference basis” (as in business income or gross earnings policies), depreciation is automatically included in the sum insured since it is not deducted as an un-insured working expense.

SAVINGS CLAUSE

The purpose of the “saving clause” is to prevent the insured from making a profit in the event of a claim. For example, in the event that some buildings were destroyed in a fire, then some of the operating expenses involved such as heating, lighting or cooling would cease. The insured would not have to pay them. If they were not deducted from the claim the net profit would be increased. As such, it is only equitable that they be deducted.

The saving clause reads: “…less any sum during the indemnity period in respect of such of the insured standing charges as may cease or be reduced in consequence of the damage”. As a result, the clause should not be regarded as a reduction of the claim, but as an adjustment to more accurately reflect the true loss.

In Honour and Hickmott’s “Principles and Practice of Interruption Insurance” (4th edition), the definition of “normal depreciation” is determined as follows: “A charge against income of that portion of the cost of fixed assets deemed to have been consumed during the period under review.” The rate of depreciation should include:

Wear and tear;

Gradual deterioration;

The passage of time; and

The cost of obsolescence.

Although there is no “fixed rate” applied to determining the depreciation value within the above parameters, the most commonly used valuation is that allowed by the government for income tax purposes.

OTHER FACTORS

Depreciation must be charged against income before the net profit is determined. As mentioned, there is an argument that depreciation should be deducted under the savings clause. However, in doing so, there are several considerations that need to be taken into account.

Firstly, it is possible that substantial business interruption claims can be caused by relatively little property damage. Secondly, even when there has been substantial damage and repairs and/or replacement has been effected, depreciation will be taking place even before production is up to pre-damage levels. Thirdly, in the case of “contingent business interruption”, there may be no damage at the main location because the loss arose out of damage at a supplier’s or customer’s premises.

Another consideration is that the indemnity being paid is not in respect of past production which is measured by past performance, but for future production that would have taken place but for the damage. It is therefore only equitable that future production should contribute to depreciation.

Furthermore, Riley (as referred to above) brings up another interesting point: Because the sum insured is stated in one amount, i.e. there is no division between “net profit” and “standing charges” – in cases where there are exceptional charges in one year that might not be repeated in subsequent years, provided the sum insured is adequate, these exceptional charges are insured since any fluctuations in them will be reflected in the net profit figures and not in the gross profit (or the rate of gross profit). Therefore, in cases where an insured might have a very good year and decide to make an increased provision for depreciation and a loss is suffered the following year, no deduction should be made in respect of the reduced amount of depreciation because it would not have been caused by the damage.

SIZING UP

From the foregoing we can draw the following conclusions:

That depreciation should be insured and the calculation of the sum insured must reflect this fact;

That depreciation is properly payable under a claim and should not be deducted under the savings clause except in cases where the property has been totally destroyed and it is not proposed to effect repairs or replacement. And, where buildings have been destroyed that require considerable time to rebuild, depreciation is not normally charged until the reconstruction is complete. Furthermore, where depreciation would be saved is when you have a piece of equipment that is rated to produce “x million widgets” (e.g. a metal stamping machine), which is not damaged in a fire, but was not used for the next three months while the premises were being rebuilt.

These situations should be carefully analyzed to ensure equitable treatment of the insured in arriving at the correct amounts to be deducted.