Irrespective of the industry in which an Insured operates, the basic intent of business interruption (“BI”) coverage is to place the Insured back into the same position they would have been in had the insured peril not occurred.
Those of us who are already familiar with hotel industry losses will already know that all of the basic BI calculation mechanisms apply when calculating hotel losses. However, let us examine some of the ways in which basic BI concepts apply specifically to the hotel industry.
It is arguable that the projection of Standard Turnover is more of an art than a science: in the absence of a crystal ball, a significant degree of professional judgement and knowledge of the industry is required. A forensic accountant may rely on a number of sources and techniques when projecting Standard Turnover, such as:
- Historical revenues – occupancy and rates;
- Budgets adjusted for normal variations to budgets;
- Reservations and contracts; or
- Market analysis using industry statistics.
Regardless of the technique employed, there are important considerations to keep in mind which frequently arise in the quantification of hotel losses:
Hotel revenues are typically seasonal, where occupancy levels and room rates will be highest during the peak season and can be significantly lower during the off-peak season. Further, occupancy and room rates are generally high during holiday periods such as Christmas and Chinese New Year.
It thus follows that the timing of a loss event can have a major impact on Standard Turnover. For example, a loss period which primarily consists of peak season months is likely to lead a forensic accountant to project higher Standard Turnover than a loss period spanning non-peak months.
The hotel industry is also highly competitive, where occupancy is influenced by reputation garnered through repeat business, online booking portals and online reviews on platforms such as TripAdvisor, Booking.com and Expedia.
Projecting occupancy should be the first step in any calculation of Standard Turnover. Historical occupancy achieved during peak and off-peak periods are a good place to start. However, a forensic accountant should also consider trending – Are occupancy levels generally increasing or declining? How is this hotel performing as compared to comparable competitors?
Occupancy is also a driver of a hotel’s other revenue streams which tend to vary with the number of room nights sold, such as food and beverage sales and activities sales. However, F&B revenues may not be wholly driven by occupancy – locals who do not stay at the hotel may frequent the restaurants. Local traffic would have a greater impact on F&B revenues in urban or non-remote locations while inaccessible locations are less likely to be influenced by local clientele.
If some revenues are earned during a loss period, actual rates received during the loss period may be applied to projected occupancy. However, a forensic accountant should be careful that rates are not materially skewed by low occupancy levels caused by a loss incident. In a full closure situation where no revenues are earned during a loss period, a forensic accountant is required to project rates. Whilst historical rates may be used, a forensic accountant may consider potential rate increases, as many hotels increase rates at least annually.
Susceptibility to Wide Area Damage
Consider a hotel operating in an area recently hit by a typhoon that caused widespread destruction, where the hotel itself only sustained minor physical damage. The surrounding devastation is likely to have caused a loss of attraction, perhaps even restricting the availability of key requirements to operate such as power, transport infrastructure and labour.
It is thus probable that the hotel would experience lower occupancy and lower revenues. However, the decline in revenues is unlikely to be caused by the minor physical damage sustained during the typhoon (the policy trigger) and is more likely to be due to the declining volume of visitors to the area. As such, a forensic accountant should consider that hotel occupancy would have been low irrespective of the minor physical damage and factor this lower occupancy into Standard Turnover.
Therefore, it is crucial to keep in mind that losses caused by the insured peril need to be separated from losses potentially caused by other factors.
The COVID-19 pandemic had a crushing impact on the hotel industry worldwide – occupancy was low or non-existent and rates were substantially lowered in an effort to attract guests. How does COVID-19 impact an assessment of Standard Turnover? The 2021 UK supreme court judgment pertaining to the Financial Conduct Authority v Arch and Others raises interesting questions surrounding to the extent to which the wide area damage principle can be applied to Standard Turnover.
Consider a situation where a hotel sustains damage to only a small portion of its rooms during a period with low occupancy – has a loss really been sustained? In this case, as it is possible for guests to be placed in undamaged rooms which may not otherwise have been sold to other customers it could be argued that no revenue loss has occurred. If, for example, only basic rooms are damaged, a hotel may place guests in premium rooms whilst incurring a minimal or no increase in variable costs.
In contrast, damage caused to central features such as the pool or spa can have a larger impact. For example, a hotel whose main attraction is its spa may experience lower occupancy if the spa becomes unavailable to guests.
Rate of Gross Profit
Where different revenue streams are associated with different levels of variable costs, separate rates of gross profit should be assessed and applied. As such, separate rates are commonly calculated for each hotel department – rooms, F&B and activities.
Care should be taken to ensure that all variable costs are captured – where a hotel business prepares departmental profit and loss statements and incurs non-departmental variable costs which are not allocated to a specific revenue stream, an adjustment recognising non-departmental variable costs should be applied. Some examples may include credit card fees, complimentary services and travel agency commissions.
Typically, the proportion of total variable costs to total revenue in relation to rooms is low, resulting in a high rate of gross profit. In contrast, rates of gross profit earned in relation to F&B are usually lower due to a much larger cost of sales component.
Many hotels which are owned and operated by separate parties are commonly subject to management agreements which stipulate that certain fees are payable to the Operator based on either operating revenue or operating profit. Fees which are based on operating profit are frequently based on a tiered structure where higher operating profits as a percentage of operating revenue result in higher fees paid to the Operator. As such, fees based on operating profit are designed to incentivise the Operator to operate the hotel efficiently.
Management fees can raise some interesting issues when quantifying hotel claims, so a forensic accountant will need to understand the following:
- Are the Owner and Operator named Insureds in the Policy? Does a saving in fees payable by the Owner translate into a loss of revenue sustained by the Operator?
- Will any Management Fees be payable on any insurance proceeds?
The seasonality inherent in the hotel industry can have a material impact on projecting gross profits for calculating the adequacy of the sum insured if the maximum period of indemnity is in excess of 12 months.
Where a maximum period of indemnity is 18 months, different policy wordings may require adequacy to be assessed based the projected gross profits for either:
- The 18 months following the loss incident; or
- A proportionately increased multiple (i.e. 12 months x 1.5).
Consider a hotel where 12 months of normal operations for the Insured contains 4 peak months (November to February) and 8 off-peak months (March to October), and a loss incident occurs in March:
- What if the policy requires that 12 months of gross profit be projected and uplifted to 18 months? In multiplying the 12-month period containing 4 peak months and 8 off-peak months by 1.5, the calculation effectively considers 6 peak months and 12 off-peak months.
- What if the policy requires 18 months of gross profit to be projected? The 18-month period following a loss occurrence in March will only contain 4 peak months.
Therefore, in the first scenario where the 12 months are uplifted to 18 months, higher gross profits are likely to be projected which may result in an underinsurance penalty.
The quantification of losses sustained by hotel businesses requires a forensic accountant to be cognizant of a number of industry-specific considerations ranging from seasonality to whether the extent of damage gives rise to any loss at all. Further, it is imperative that a forensic accountant obtains a firm grasp of the business and the environment in which it operates along with an understanding of the causation of loss and the policy wordings at play from the Adjuster and Insurers. It is recommended that a forensic accountant be retained in the early stages of a claim so that all relevant potential quantification issues are identified early.