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How to Assess Costs of Business Interruption

As a professional loss accountant with more than 20 years of experience with business interruption (BI) valuation, I can understand why policyholders struggle with finding a repeatable, efficient system that produces an accurate measurement of their BI exposure. Over the years, some of my clients recognized the issues with the traditional BI values approach, and decided to make a change. Unfortunately, too many companies continue doing what they have always done, even when there is a better way available.

BI

Consider for a moment, just how important BI information is to your underwriter. The numbers you report give the underwriter the basis for writing coverage and calculating premium. Each renewal provides policyholders the opportunity to present their unique BI exposure. Unfortunately, this opportunity is often squandered because of a misunderstanding of business interruption values and the exposures they represent. The point of this article is to share a proven, alternative approach.

Understanding BI Values

First, there’s the ratable value. It is the “big number” that is calculated for the business as a whole, assuming a 12-month, total shutdown of all revenue-generating operations. This worst-case and often unrealistic scenario is the information requested by the insurance company, usually in the form of a one-page worksheet. Without additional information, the underwriter will use this information to set limits and charge premium.

The ratable value calculated is somewhat meaningless, except that it establishes the base assumption that is used as the BI value in all other scenarios, such as unincurred cost categories. The ratable value is seldom a reflection of your exposures. Better ways to assess your exposures are to examine your maximum foreseeable loss (MFL) and probable maximum loss (PML) scenarios.

What Is Maximum Foreseeable Loss?

The MFL, as the name indicates, is the worst-case scenario. This is not as extreme as the ratable value scenario, but pretty close. The assumptions used here include a complete breakdown of protection and loss mitigating factors while you are hit where it hurts at the worst possible time. An example would be the loss of a unique distribution center to a retailer during the holiday shopping season — say the distribution center that handles online orders goes up in smoke on Cyber Monday.

The factors used to measure the ratable value would be used in this scenario to determine the business interruption value. Certain assumptions may change depending on the duration of the loss scenario. For example, labor expense may be considered completely saved in the ratable value scenario because of the assumption that there is nothing left, but only partly saved in an MFL scenario.

What About the Probable Maximum Loss?

The PML is the same as the MFL, except that loss mitigation efforts and protections work properly. The PML also takes into account pure extra expenses used to retain customers. The PML can help with decision making on purchasing extra expense coverage.

What Happens in Underwriting?

Although I’m not an underwriter, I’ve typically seen insurance companies take an engineer’s approach to MFL and PML scenarios that vary only in duration. This singular perspective does not account for the rest of the pieces of the puzzle. The other pieces are the finer details that actually occur during a claim. In a real claim, topics like seasonality, make-up and outsourcing would surely come up, but you won’t see them on any BI worksheet.

The MFL and PML should be based on realistic loss scenarios and measured as if they were a claim. Simply applying the ratable value to loss-period assumptions produces misleading and inflated numbers. This is precisely why it is in your best interest to develop your own valuation method based on real scenarios.

Why Create Exposure Scenarios?

If BI values are based on assumptions, and you are using the worksheet, then the assumption is a 12-month loss scenario. Can you imagine a scenario in which your operations would only be affected for six months? The worksheet makes a blanket assumption of 12 months whether realistic or not. Coming up with various loss scenarios by location would flesh out a more realistic representation of the impact of each particular loss. The scenarios would also highlight high-risk locations along your supply chain, which could improve your business continuity planning.

An exposure analysis project is not only an accounting project; it’s an integrated business exercise offering multiple benefits to an organization. The goal is to identify and examine loss scenarios and the resulting ripple effects.

It isn’t necessary, nor is it practical, to anticipate every possible loss scenario. It’s better to prioritize by perceived risk and probability. Then, develop a good sampling of loss scenarios from which you can determine the impact to operations and the mitigating actions that would be taken. Depending on the exposure, involve the appropriate internal personnel, e.g., operations, sales, business continuity, IT and accounting. The external experts you may involve are your broker, legal counsel and, of course, a forensic accounting firm that specializes in insurance work. Additionally, your company’s business continuity plan (BCP) and incident response plan should be factored in. However your scenarios play out, the loss accountants can calculate the business interruption as though it were an actual claim.

As you can see, this approach would produce a more accurate BI value by location and overall. It’s the right way to look at business interruption, so make it a part of your approach with underwriters.

Checklist to Prepare for Business Interruption

Business interruption (BI) losses are among the most confusing types of claims in the insurance industry. As claim specialists, we are often asked for a “checklist” filled with action items for when a loss occurs. A “checklist” isn’t practical because there are too many variables and “if/then” scenarios to map out. When you have a significant property damage and business interruption claim, only experience can guide the way to a fair recovery.

However, there are actions that can be taken ahead of a loss to ensure you are prepared. The following seven items represent such a “checklist.” It will not only help with your next loss but can have an immediate benefit to your risk management program.

1. Prepare accurate ratable business interruption values

The annual ritual of preparing the business interruption worksheet is often treated as an administrative nuisance.  It should be looked at as an opportunity to accurately account for the insurable risk for which you pay your premium and to accumulate annual values for future trending.

The worksheet provided by the insurance company is woefully inadequate to explain the nuances of most businesses. Go beyond the worksheet and explain your business more completely to underwriters. For an effective BI values methodology, solicit help from the specialists, such as an experienced forensic accountant. The results will be appreciated by underwriters and should translate into more appropriate coverage and possibly a more favorable rate. Once a system is in place, accuracy, consistency and efficiency should be improved.

2.    Analyze exposure scenarios and calculate MFL and PML

Once the ratable BI values are calculated, policyholders should explore realistic loss scenarios. The BI value is an annual number that does not factor in real-life responses that would generally mitigate a claim. To get to the actual exposure to risk, companies should determine the maximum foreseeable loss (MFL) and probable maximum loss (PML) measurements. The MFL measures a “worst case scenario” in which all of the loss-control protections fail. The PML is the more realistic loss scenario, in which mitigation systems work and contingency plans are executed properly. In both cases, the property damage and business interruption effects would be calculated as if they had occurred.

Loss scenarios should be postulated in detail, e.g. by location and by occurrence, considering all factors. These numbers should not be measured by simply applying a daily “BI rate” to an engineered loss period. It is more realistic to prepare as if presenting a claim, exploring all “what if” possibilities. Insurers may offer some assistance in this process, but remember, their version will be from their perspective. As with any claim, you should always prepare your own scenarios and your own calculations according to your understanding of your operations. An independent forensic accountant will have prepared claims just like your scenarios and would be able to accurately value the losses.

3.   Analyze contingent risks

Concurrent with the MFL and PML analysis, you should work to understand contingent risks to your business. Knowing what your suppliers’ and customers’ exposures are is important. Policyholders should involve leaders in operations, procurement and sales to help identify contingent exposures. If you have a sole supplier, your contingent exposure may be greater than anticipated and should be examined.

It is important to understand how your current policy language would respond to the contingent loss scenarios you’ve identified. For example, if suppliers in your policy are referred to as direct supplier,” make sure you understand how this would be interpreted in a claim. If “direct” means only those suppliers with whom you have a direct contract, and an indirect supplier, i.e. a second-tier supplier, has a loss that affects you, would you be covered? These scenarios should be discussed with your broker and underwriter to ensure your policy will respond as expected.

Once the values and scenarios are updated, you will be better able to make informed decisions about your insurance coverage, limits and terms.

4.    Business interruption vs. extra expense

Another common discovery from performing an exposure analysis is which type of time element coverage is the best risk transfer solution. Considering each location, if the risk is a lost of sales, BI would cover the lost earnings. If sales are not the risk or they can be sustained at an extra expense, extra expense coverage would be more appropriate. If sales are at risk but can be mitigated to the degree contingency measures are enacted at an additional expense, it’s a combination loss exposure.

It’s of value to risk managers to know what the exposure truly is because, if an exposure can be covered by extra expense coverage, it may eliminate or reduce the need for BI insurance. For example, if you are a distributor with multiple warehouses whose inventory is insured at selling price, what’s at risk? If you have alternative space or can quickly secure temporary space, the likelihood of experiencing a sales loss that exceeds the sales value of your lost inventory is remote. How much BI coverage should you buy vs. extra expense? Exploring your loss scenarios and subsequent contingency plans would allow you to better quantify your risks and select the option best suited to your needs. Extra expense is a more “tangible” risk than BI, making it easier for underwriters to rate, and it generally will cost less.

5.   Gross earnings, gross profit and business income

The names are different, but the intent is the same – to protect earnings lost because of damage or loss of use of insured property. The history of each of these forms would take a separate paper to detail, but, in a nutshell, gross earnings is a form commonly used in the U.S. with a basis in manufacturing risks, while gross profit is used throughout the world and has its basis in mercantile operations. Business income is the term used for the current ISO forms. Today, all forms have been modified to accommodate almost any business — however, there are some situations where one form may be preferable. The terminology and the mechanics of calculating business interruption loss varies among the forms, but the answer should be the same, regardless.

The exception to this has to do with the period of indemnity — the gross profit form is usually limited to a specific time, while gross earnings will continue until repairs are (or should be) completed with “due diligence and dispatch”; there is the ability to add an extended period to recover sales. It is important to make sure the form you have would cover your potential loss period. For example, if you have a manufacturing company with specialized production equipment that have long lead times to replace — longer than the period that a gross profit form would cover — you should probably have a gross earnings form. If you do not see a scenario that would exceed the gross profit period and you cannot accurately predict an extended period required to add to gross earnings, the gross profit might be a better option. If there isn’t any scenario that would create a loss that exceeds the gross profit period of indemnity and you are comfortable that you can cover that time to recover sales, than either form would work. There are new options that allow you to pick which form you would like to use up until the closure of a claim — these forms eliminate the need to determine which form is right for your business. Just make sure you have a form that will cover your worst-case scenario.

6.   Professional fees coverage

Most policies now include professional fees coverage. Insurers recognize the need for dedicated claim preparation experts and are willing to pay for it as part of the claim. Often, this coverage is subject to limits that can be negotiated. If you are not familiar with this coverage or do not have it, you should discuss with underwriters. For the most part, this coverage can be included at some level just by asking. The benefits of having specialized claim preparation experts available as a resource for a claim can make the difference between a successful claim and a headache.

7.  Organize your claim team

In addition to forensic accountants, a claim may include forensic engineers, attorneys and others. It is a good idea to know those you want to use before needing their services. Meet with the various providers beforehand and select those that fit best for your organization. Typically, paperwork associated with hiring someone can be completed before needing their assistance (i.e. non-disclosure, purchasing, W-9, etc.) so that if something happens they can begin work immediately. Additionally, there may be an opportunity for the provider to help with reporting issues on business interruption values.

While no business wants to suffer a loss of earnings, the more prepared you are the better the results will be. The steps shown above may take years to fully develop and should be evaluated annually to account for changes to your business.

If these recommendations are incorporated into your insurance program, there’s no need for a claim checklist. Your risk management team will be prepared for any worst-case situations with the best-case solutions.

A Nuisance Form Can Be Your Friend

If you are like most companies, the annual ritual of filling out the business interruption worksheet is a nuisance administrative task. The worksheet is generally required by the insurance company to track changes in the business and may be used as the basis to price your program.  Along with general industry knowledge, this worksheet may be the most important item that underwriters have at their disposal to price your risk. However, the worksheet is woefully inadequate to explain the intricacies of most businesses and is biased to err on the high side – which usually means a higher premium for you. For a routine that is regularly glossed over, the results can have some pretty substantial consequences.

The worksheet is meant to estimate the business interruption exposure for the policy period by estimating a value for the coming year. The business interruption value (BI value) is revenue minus certain specific direct variable costs, possibly adjusted to account for the payroll of for skilled wage employees who may be retained even if operations cease for a period. The result is an annual ratable BI value that assumes a complete outage for 12 months with no mitigation.

Only by coincidence can this BI value number come close to a realistic exposure to business interruption loss.

What does the ratable BI value tell the underwriter? In theory, the premiums required to cover the risk. How can this be when the number used is so unrealistic?

The underwriter would like to know more about your business. His problem is that he needs some mechanism to measure your risk against others in your industry. The BI values worksheet is an attempt to do this.

But, if the worksheet is so far off, what else can you do to tell your story?

You need to supplement the ratable BI value with information to differentiate your business from the pack. Developing realistic, worst-case loss scenarios, known as maximum foreseeable loss (MFL) and probable maximum loss (PML), and measuring them using a methodology that would actually be used in a claim is a better way to present your exposure. Measuring MFL and PML exposures will allow you to highlight your ability to mitigate losses through business continuity planning (BCM).

Just as improved physical safeguards generate lower premiums, adequate business continuity planning should also result in premium savings. This step is completely missed when providing the worksheet alone.

The effort to identify and measure exposures can be challenging — after all, it is impossible to predict everything that might happen. History of actual claims and current industry experience can be very helpful. In most cases, it is best to tackle this project in manageable pieces and try not to do it all at once. For example, start with the largest or most troublesome businesses or locations and work down from there.

This may end up being a multi-year project that will require some dedicated effort from you and third parties. But chances are the cost of a project like this will be justified by allowing you to make more precise decisions on coverage and possibly reducing premiums.