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Following on from our first article on Business Interruption (BI) insurance entitled 5 reasons why purchasing Business Interruption Insurance has become a top consideration for corporations in Asia-Pacific in our second article in the series, we wanted to clarify and explain the differences between the two dominant derivatives of business interruption cover that have developed since the first attempts by 'Minerva Universal' were made in 1797.

I am of course talking about the UK form of cover and the US form of cover. These two forms of business interruption insurance have some stark differences, which risk professionals need to appreciate when placing cover and to help prevent any potential surprises during a loss.

Business interruption insurance covers just two elements regardless of which form of cover is selected by a client; loss of sales multiplied by the Rate of Gross Profit (RGP) and the increase in cost of working. However, depending on which of the two forms is selected will change the make-up of the cover as highlighted in the table below: 

Coverage range

In consequence of...

Directly caused by...

Characteristic

Gross Profit - Additions or Difference basis

Gross earnings or Business Income

Method

Formula - "the amount payable as indemnity shall be"

No formula - "Actual Loss sustained" - net income + continuing normal operating exps - but not exceeding GE less non continuing exps

Period of cover

Max. Indemnity Period selection

Interruption period - time to repair or replace

Increase costs

ICOW

Extra Expense

Finished goods inventory

Finished goods loss included

Finished goods loss excluded

Table to show the difference between the UK and US forms of Business Interruption cover

Under the basic US form, cover is intended to apply only for direct losses suffered during the period of restoration of the property damage. Any loss incurred after the property has been repaired or reinstated would not be covered. In contrast to this, the basic UK form provides cover for the time it takes for a business to put itself back into the financial position it would have been in had the damage not occurred in the first place, limited by the Maximum Indemnity Period selected by a client. This form of business interruption insurance therefore automatically covers not only the period of repair and restoration of the property but also the time necessary to restore the business in consequence of the damage.

In consequence of or directly caused by
The UK form states it will pay for losses 'in consequence of' the insured damage to property, whereas the US form says it will pay for the loss of business 'directly caused by' insured damage to property. The term 'directly caused by' really means 'proximately caused by' which means an unbroken chain of events that are directly linked to the original cause of damage.  There is a very big difference between the two phrases – “in consequence of” and “directly caused by”.

For example, suppose you have a factory that is damaged by fire. You bring in builders to repair the damaged property. However, during the rebuild phase there is a dispute and the builders strike for two weeks. As a result of which your business recovery is delayed and is two weeks late. Now, can you claim for that delay?

Well, if you didn't have the fire, you wouldn't need the builders. And, if you didn't need the builders, you wouldn't have been affected by the strike. In fact you wouldn't have been affected at all. So, under the UK form the business interruption loss caused by the strike would be covered as it would be very difficult to argue that it was not caused “in consequence of” the fire at the factory. However, under the US form the loss from the same strike would not be covered because it was not “directly caused by” the fire. In effect, it is a separate incident or cause.

This limitation in cover is arguably the biggest advantage of opting for the UK form as it offers much wider cover to a client.

Gross profit versus Gross Earnings
Looking at the UK first. The UK form talks about 'Gross Profit', which is sometimes confused with 'net profit' and is also often misinterpreted by the accounting world. It's important to understand and establish the Gross Profit insured by the policy when you structure your business interruption insurance cover.

In UK forms, business interruption cover works to a formula by applying a Rate of Gross Profit to the loss of sales. So for example, if you buy something for $10 and sell it for $50, the gross profit would be $40. The Rate of Gross Profit is then calculated by dividing the gross profit by the sales amount, represented as a percentage. In our example, the gross profit is $40 and the sale price is $50. Therefore the rate of gross profit is 80%. In other words for every dollar of lost sales, in the case of a business interruption claim, your insurer would pay you no more than 80 cents.

Sometimes confusion tends to set in when you introduce the cost of overheads to run the business, such as salaries and wages, transport, utilities, rent and administration costs for example.  So in our example imagine that the total overhead costs are $30. You know you make a gross profit of $40, but you have to pay overheads of $30 leaving you with a net profit of $10, which is 20% of your sales price. So if you made the mistake of calculating your business interruption insurance cover on the basis of the net profit amount, then in this example your recovery under the policy would be no more than 20 cents on each dollar of sales lost and so you'd have a significant protection gap if a loss was to occur. Remember that your overheads often continue while your business has stopped.

As an aside, businesses can and do make a net loss, especially if they are going through hard times. However, regardless of whether or not you make a net profit or net loss, you can still buy business interruption cover based on your gross profit amount – so in our example you're still making a gross profit of $40, but your overheads could be $45, resulting in a net loss of $5 (but still a gross profit of $40).

Where the coverage can get a little bit complicated is that under the UK form there are two ways of telling your insurer what type of Gross Profit cover you want:

  • The Additions Basis,
  • Or, the Difference Basis.

The Difference Basis is simply the difference between sales and the cost of buying in the items for sale. So, keeping with our example the difference would be $40.

Alternatively, you could go to your insurance company and say you only wanted to insure your salaries and your net profit. So, if your salary costs were $12 and your net profit was $10 then the gross profit amount used to calculate your insurance cover would be only $22. This is the Additions Basis. If you said to your insurer you wanted to insure all your overhead costs and net profit, the resultant figure would be the same as the Difference Basis, i.e. $30 fixed costs of operating and $10 net profit. You can select any of the fixed costs that you want to insure, be that salaries, rent, wages, utilities or any other operational costs you want.

The US form talks about Gross Earnings or Business Income within the policy, but this is essentially Gross Profit and a different way of expressing the same thing.

Formula versus no formula
The UK form of business interruption insurance provides cover by use of a formula. It says that if property is damaged and the business suffers, “the amount payable as indemnity shall be” calculated based on a formula.

(a) Reduction in Turnover: The sum produced 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.
(b) Increase in Cost of Working: The additional expenditure necessarily and reasonably incurred for the sole purpose of avoiding or diminishing the reduction in Turnover, which, but for that expenditure, would have taken place during the Indemnity period in consequence of the Damage, but not exceeding the sum produced by applying the Rate of Gross Profit to the amount of the reduction thereby avoided.


The US or American form says it will pay you the 'actual loss sustained' which means an indemnity, albeit subject to limitations and without a simple formula. So the UK form is generally easier to read and apply.

Period of cover: Maximum Indemnity Period versus Interruption Period
The UK form requires that you pick the Maximum Indemnity Period or MIP. The MIP period begins with the date of the accident and ends at the expiry of the number of months selected in the policy. Many organisations select 12 months as the period of indemnity, but in the case of a severe loss this can be too little. However, the period typically ranges from anywhere between six to 36 months and expressed in six month increments, i.e. 12, 18, 24, and 36 months. It is possible to arrange cover or 48 months in some cases.

The US form, in contrast, does not require that you select a MIP and the business interruption cover will start at the date of the incident and it will end when the repairs should have been completed with reasonable speed.

The term 'reasonable speed' can open up a bit of a debate. For example if the reinstatement or repair is slow, why is it slow? The other part of this is that you might have reinstated your business, rebuilt the assets, but you've lost all your business, your customers have gone away. In other words, the business hasn't got back to where it was before the loss occurred. Obtaining cover for that proportion of the business interruption loss under a US form would require you to buy it and usually in blocks of 30 days. You could therefore extend the cover for 30,60 or 90 days and so on.

Increase in Cost of Working (ICOW)
Typically, when you have damage to property from fire, storm or an incident, you will need to spend money to move things along quickly to restore the operations. This is called increased costs of working. Under a US form they are called Extra Expense (EE). Ultimately they are the same and will cover the additional expenditure necessarily and reasonably incurred for the sole purpose of avoiding or diminishing the reduction in sales in consequence of the physical loss.

As a point of interest – the rule here is that the insurer is willing to pay 99 cents to save a dollar, but not more than that.

In our Business Interruption Masterclass sessions we have looked at a number of scenarios and one of the questions states:

  • 'The manufacturer confirms that the damaged machine can't be repaired and must be replaced. There is a machine available, however typical sea freight will take one and a half months.  This can be expedited via air freight, however given the size and weight, it can only be transported by the Antanov 225 (a specially designed cargo aircraft) at an estimated cost of USD 500,000. How would your insurance policy respond to these different options?'

This question is based on a real event and in that case we paid the increased expenses for the aircraft as it proved to be the most economical outcome when compared with the loss that would otherwise have been payable.

It is possible under the UK form to extend cover to include 'Additional Increased Costs of Working (AICOW). This extension will typically top-up the economic limit (99 cents to save a dollar) stipulated in the ICOW cover.

Finished goods loss
As a last point, if you have a fire or incident in a finished goods warehouse under a UK form you would turn to your property damage policy to reimburse for the cost of remanufacturing those goods and the business interruption policy to pay you for any Gross Profit on the loss of sales that resulted.

The US form excludes business interruption losses caused by the loss of finished goods, but the good news is that the attendant property damage cover will usually pay the full selling value of the finished goods less any unincurred expenses.

Which form of business interruption cover do you have?
A simple way to tell if you are under the UK or US form is to look at your policy and see if it contains this block of text. If it does it’s most probably a UK form:



However, as a caution, we always advocate for reading the policy carefully and gaining an understanding with your insurer and broker as to what is covered and how the policy operates in the event of a loss. Over recent years attempts have been made to “improve” the standard wording of the two BI forms and in many instances this has done just the opposite!

In summary, in this article our aim was to explain the two different forms of cover under a business interruption insurance policy and to examine the differences between the two. In my view the UK form provides wider cover, however, the type of cover that is right for your business will need to be discussed with your insurer and broker to ensure that there aren't any potential gaps in coverage that could cause issues when and if a business interruption loss occurs.

Download the lessons learnt publication on business interruption.

Peter Newall
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