Welcome to our first edition of Forensic Insight. In this issue we will provide a brief overview of how to calculate losses under business interruption coverage.
Broadly speaking, business interruption (“BI”) insurance coverage is meant to indemnify the insured for the loss of profit it suffers as a result of an insured peril.
There are typically three main steps in a BI calculation.
- First, we calculate the amount of revenue the insured lost as a result of the insured incident. We do this by comparing the revenue the insured would have received but for the incident with the revenue the insured did receive. There are many ways in which one might project the insured’s revenue but for the incident, and we’ll discuss some of these in a future article.
Different policies will define the period over which the loss of revenue is to be measured differently. Some policies will compensate the insured so long as the business is affected by the insured event; other policies will only provide coverage until the insured completes physical repairs, and do not cover any lingering impact.
- Second, we need to consider the insured’s savings in variable costs. Most businesses will have certain costs that vary in direct proportion with revenue. For example, for every dollar of sales a restaurant earns, it will typically incur $0.30 to $0.40 in food and beverage costs; a 10% increase in revenue will result in a 10% increase in food and beverage costs. When that restaurant suffers a revenue loss, this loss is offset somewhat by a savings in these variable costs.
We calculate the savings in the insured’s variable costs by applying a “rate” to the revenue loss.Different policies will define and describe these rates slightly differently (e.g. “gross earnings”, “gross profit”, “business income”), but the basic idea is that we are taking our revenue loss and figuring out what level of variable costs were saved as a result of that revenue loss.
- Finally, we need to consider whether the insured has experienced a change in its fixed costs. Fixed costs are those that tend not to change in direct proportion to revenue; an example will be rent. A 10% increase in revenue for a restaurant will not result in any increase in rent. But if the restaurant burns down, its lease may contain a clause that relieves it of the obligation to pay rent. This savings needs to be taken into account in calculating the restaurant’s lost profit.
Conversely, the restaurant may find a temporary location out of which to operate, but may incur an increase in its normal rent in order to do so. The policy may cover this incremental cost, although there are often limitations as to how much of an increase the policy will cover.
At MDD, our accountants have worked on numerous losses involving business interruption claims around the globe.
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