Insurance of Cash Flow: Basic Theory

The Business Income forms differ from the other older forms in use before 1995 in that they are complete policies having their own Declarations, Insuring Agreements, Exclusions, Perils, and Conditions. This is applicable to the older forms, which were designed as riders to Property policies and took the above-mentioned details from the Property policy.

All forms, with the exception of the Extra Expense forms, provide reimbursement for:

a) Lost profits and continuing expenses, and

b) Increased costs incurred in maintaining pre-loss business activity levels, provided that these would not be more than what would have been payable under a), above, had the expense not been incurred.

The most important difference between all of these forms is the length of the indemnity period, which is the period following damage to property during which the policy will reimburse the Insured for the consequent loss of income. The Profits form and the Extended Business Income forms promise to pay until the income reaches the point where it would have been had no loss occurred.

Here are some of the considerations one has to take into account when fixing the indemnity period under a policy: (see chart).

The Gross Earnings forms, including the Business Income Limited form, promise to pay only until the damaged property is repaired so that the business can resume. Any time lag between the restarting of the business and the income reaching its pre-loss level is not insured.

An important limitation on all of the policies is the media limitation of the indemnity period in respect of loss or damage to electronic data, etc., to 30 days or the length of time required to rebuild or replace the other property damaged. In the U.S., the initial period is 60 days and some authorities advise that this clause may be removed on request of the Insured. The clause does not appear in policies in the United Kingdom.

Another important difference between the Profits type and the Gross Income type of form is the Due Diligence clause. In the Profits forms the Insured is required to do everything possible to minimize the loss, but in the Gross Income forms this duty is not limited to the Insured but involves all parties such as contractors, suppliers, etc.

The indemnity provided by all of the forms is limited both by time, that is the indemnity period, and by amount, that is the sum insured purchased.

Most of the forms have a co-insurance requirement. This, is set out for the benefit of others. It provides that if an insufficient sum insured is purchased, any claim will be reduced by the same proportion that the sum insured bears to the actual amount at risk.

It may be possible to avoid the effects of the co-insurance clause by use of a Stated Amount clause. This provides that where the Insured has filed a worksheet that has been agreed to by the Insurer and the limit of the policy is in accord with the figure produced on the worksheet the co-insurance clause will not apply for the agreed-upon period (usually until the renewal date of the policy).

The Profits, Gross Earning and Business Income forms will pay, as an alternative to lost income, additional expenses incurred to maintain pre-loss income levels. However, any such payment is limited to the loss of income avoided.

The Extra Expense form is based on the premise that certain types of business, such as hospitals or other service organizations, cannot or should not close, so it is necessary for them to make alternative arrangements – even if at an un-economic cost – in order to keep going. It provides for the payment of an arbitrary amount to enable the business to continue. It is not based on loss of income or revenue, as are the other forms. It is not subject to a co-insurance requirement, although it is common to find limitations on the amount payable in any one month. It is also commonly used to supplement the “Additional Expenditure” part of other forms, in cases where the expense to reduce loss might exceed the amount saved in respect of lost profits and continuing expenses.

Actual Loss Sustained forms are very interesting. They appeared relatively recently, and are an attempt to simplify Business Interruption Insurance for small mercantile businesses. The forms have to be read carefully, because some of them are like Profits policies: they promise to pay past the period of physical restoration, until the business gets back to where it would have been had no loss occurred, subject to a maximum indemnity period of 12 months from the date of the damage. Others are like the Gross Earnings Policies in that they will only pay for business lost during the time that it takes to repair the damaged property. It is not usual for them to be subject to Co-Insurance. It must be remembered that the term “Actual Loss Sustained” is a loss limit, not an entitlement. Its purpose is to make these policies of indemnity rather than valued policies. The use of these forms does not avoid the necessity of the claims calculations that are a feature of the other forms.

These forms are often used in “Package Policies” for small businesses in place of Earnings–No Co. forms.

Each of these forms will be dealt with in greater detail in the following chapters.

The Insurance Act of Ontario, and presumably the relevant Acts of the other provinces, specifically excludes Business Interruption insurance from the application of Part IV. This is the Section that imposes the Statutory Conditions; it appears on all Fire Insurance policies. However Insurers avoid this problem by attaching the same conditions to the Business Interruption covers, not as Statutory Conditions but as Policy Conditions.

Among these Conditions is the one dealing with Proscription. This condition states that all actions against the insurer must be commenced within one year of the date of the loss or damage.

It was held in the case of 718340 Alberta Ltd vs. C.G.U. that the limitation period for bringing an action under an extended business income broad form policy did not begin to run until the end of the indemnity period.

This obviously makes sense, because the loss under a Business Interruption Policy only starts at the time of the damage to the property, and continues until the end of the indemnity period. In addition, it takes some time for the claim to be calculated and submitted.

IN THE REAL WORLD

We expect that in life everything will work smoothly. We believe our children will have straight teeth; in the real world they won’t and we will have to pay orthodontists a lot of money.

As insurance brokers we believe our clients know exactly what they are buying when they take out a policy; in the real world they just want all their claims paid promptly and for their premiums to be the cheapest in the market.

HOW CAN WE FULFILL THESE EXPECTATIONS?

We have already seen that the most important components of Business Interruption policies are: the indemnity period, the Due Diligence clause, and the sum insured.

Is there a way to keep these under constant review and ensure that in the event of a claim things will run smoothly? Is there a magic bullet that will solve most if not all of our problems?

There is such a way, and it lies in the Premium Adjustment clause. This clause appears in every Business Interruption policy, except for the Actual Loss Sustained and the Earning No-Co., for a very good reason: These policies either do not have a sum insured (actual loss sustained) or, as in the Earnings No-Co., there is a Loss Limit rather than a sum insured.

Because the sum insured on all other policies is of necessity estimated and is subject to the co-insurance clause, it is the insurer’s intention that the sum insured should be an over-estimate so that the co-insurance penalty will not apply. It is only equitable that at the end of each policy year, when the actual results are known, the insurer will refund any excess premium on the amount of over-insurance up to a limit of 50% of the sum insured. Therefore over-insurance of up to 100 % will not be penalized.

Why is this clause not taken advantage of?

Some of the advantages to utilizing this clause are:

* A more accurate determination of the sum insured,

* Regular premium refunds,

* A better grasp of the standing charges to be insured and of the “Variable Operating Expenses” not to be insured.

In the event of a claim, reference can be made to the previous Premium Adjustment Reports that have been filed to resolve some of the contentions that might arise in a claim settlement. Furthermore, since the reports have to be certified by the client’s auditors, this will ensure that they have become familiar with the Policy details.

Both you and the Client will gain a better understanding of the Insured’s need for the coverage, and how the policy works.

There are no disadvantages to complying with the provisions of this clause. Plus, from the Brokers point of view, this affords the best Errors and Omissions protection around.

The method of complying with the clause is very simple. All that is required is to take the Insured’s profit and loss account for the last financial year and extract the necessary figures in compliance with the policy definitions of Gross Profits, Business Income, or Gross Earnings, as may be appropriate. This may be done by anyone, but in the real world, the broker will have to at least initiate the process.

After the figures have been extracted they will have to be submitted to the auditors for certification. At the end of this chapter is a suggested Premium Adjustment form but some insurers will have their own certificate forms to be completed by the auditors.

In cases where clients might object to providing their Income and Expense Accounts on the grounds of confidentiality, it should be necessary only to point out that in the event of a claim the first thing that the adjusters will require is the same Income and Expense Accounts, usually for the past three years. Policy conditions also require full disclosure of all financial information and records. No disclosure–no claims.