Common Pitfalls in Business Interruption Insurance
COMMON PITFALLS IN BUSINESS INTERRUPTION INSURANCE Tips on what to look for to ensure complete--not partial--recovery from a disaster. Economic ruin from a business interruption may be averted through adequate insurance coverage. However, how to calculate such coverage is often misunderstood. A prospective insurance buyer should not attempt to make this determination; it should be left to CPAs and others with expertise in the field. Business interruption insurance insures a business for earnings that would have been generated had no interruption occurred. This article discusses the common fallacies that arise in dealing with business interruption insurance. These may stem from the form of the policy--gross earnings or net income. They also may arise because insurance agents themselves are unfamiliar with how to calculate coverage properly or because the insured is inexperienced at filing a claim. Moreover, recoverability may be impaired when the due diligence and dispatch clause of the policy is not met. THE GROSS EARNINGS FORM Although insurance and accounting terms may sound similar, CPAs should be aware that definitions differ. For example, practitioners should not confuse "gross earnings" with "gross profit." Gross earnings is a technical insurance term with only limited similarity to the accounting concept of gross profit. It refers to a subtotal in the formula below: Gross sales minus Sales deductions equals Net sales minus Gross earnings deductions equals Gross earnings minus Noncontinuing expenses equals Business interruption loss times Co-insurance percentage equals Collectible business interruption loss plus Extra expenses equals Total collectible business interruption loss The formula begins with "gross sales"--a term that's defined similarly by accountants and insurance companies. "Sales deductions," however, consist of discounts, commissions, bad debt and other items directly related to sales. "Gross earnings deductions" include only raw materials and consumable supplies. This insurance concept is not the same as the accounting concept of cost of goods manufactured, because gross earnings deductions don't include any other inventoriable manufacturing expenses--for example, direct labor and overhead. These expenses are considered elsewhere. Therefore, gross earnings is quite different from gross profit. "Noncontinuing expenses" (also referred to as "discontinued expenses") represent the difference between projected normal expenses and the actual expenses that would have occurred during the loss period. By treating noncontinuing expenses as a reduction of gross earnings, the insurance company, in essence, takes a credit against the gross earings--which they insure--for expenses that have ceased. For example, if employees were laid off following a catastrophe, the difference between the anticipated normal labor expense and the actual expense incurred represents a noncontinuing expense. Similarly, if a production facility is partially or totally destroyed, less gas and electricity, for example, would be needed. Depending on the extent of the damage, utility consumption could cease altogether. Here again, the insurance company would take credit for the reduction in expense. Noncontinuing expenses should not be confused with the accountant's "variable expenses" and continuing expenses should not be confused with "fixed expenses." Some variable expenses--such as direct labor--may continue during a period of business interruption if partial production continues. Conversely, some fixed expenses--such as rent--may not continue if production comes to a complete halt. Each operating expense needs to be analyzed to determine whether it's noncontinuing--not whether it's variable or fixed. After all operating expenses have been analyzed, the total noncontinuing expenses are deducted from gross earnings. …