This article explores the areas of overlap between insurance coverage for inventory loss and business interruption.
In the event of physical damage to inventory, different policies provide different valuations, including: replacement cost, actual cash value, historical cost or selling price. In the event that a company has insured its inventory at selling price, in a sense the insurer becomes the insured’s customer and will be required to “buy” the damaged inventory from the insured for the same price as a regular customer would have paid.
Business interruption coverage will compensate an insured for the loss of income or profits that they experience as a result of not operating for a period of time. The coverage is intended to put a company in the financial position they would have been in had a loss not occurred, and will often (though not always) include wording specifying that coverage is limited to the “actual loss sustained”.
Inventory Losses and Business Interruption Claims: The Issue
Consider ABC Inc., a manufacturer of widgets with annual sales of $8M, and a profits rate (i.e. margin) of 50%. ABC always carries finished goods with a retail value of $4M (Cost of $2M). ABC suffers a loss due to a fire at their facility and all finished goods are destroyed. ABC will not operate for 24 months; however, their policy provides a maximum indemnity period of 12 months. ABC insured their finished goods at selling price and is therefore paid $4M for these goods by their insurer.
For commercial property policies that do address the overlap and provide for the deduction of insurance proceeds received for finished goods, this leaves little to the imagination and one would simply deduct the profit earned on the settlement of the inventory loss from the business interruption loss.
More often than not, however, business interruption wordings do not address this issue. In such cases there are several arguments that may be put forth.
An insured might argue that they have purchased two separate contracts from their insurer (or insurers) and that these contracts stand on their own. As the insured has been paying two separate premiums for these contracts, it may take the position that it is entitled to the results of both contracts if a loss were to occur, regardless of any economic overlap between the two coverages. ABC may present a calculation similar to that set out in Table 1:
Table 1: No Deduction for Inventory Proceeds
From an economic damage quantification perspective, however, one could argue that when an insurer purchases damaged finished goods from an insured at its selling price, it is the equivalent to the insured selling the goods to customers in the marketplace. As such, valuing an insured’s damaged inventory at its retail value and also considering the lost sales for that same inventory under the business interruption claim results in the insured being paid twice for the damaged inventory, or being put in a better financial position than they would have been in had the loss not occurred. Policies often refer to the “actual loss sustained”, or similar wording, and one could argue that not considering the inventory proceeds in the business interruption claim is not consistent with paying the insured their loss of business income or actual business loss.
Table 2: Deduction for Inventory Proceeds
There are potential issues with this argument in the context of ABC Inc., however. Deducting the inventory proceeds from the business interruption claim has made the insured whole on the sales they would have generated had the loss not occurred. However, when companies insure their inventory, it is often with the intention to replenish their inventory should it become unsaleable due to physical damage. Although ABC is now able to replenish their inventory, they have not been left in the same financial position overall, as they may suffer a loss of profit due to lack of inventory in the period beyond the 12-month indemnity period.
The above issues present challenges from both a policy construction perspective and an economic damage measurement standpoint. The above example illustrates how different areas of loss often impact each other and that it is often beneficial if the policy speaks to how it responds to these situations in avoiding disputes. To our knowledge, these issues have not been addressed by Canadian courts; but considering the often significant financial considerations involved, we hope that the above discussion has added some clarity to the topic.
By Cameron McQuaid. Published in Insurance People – November 2014 issue.