As recent natural and man-made disasters have made clear, CPAs are frequently required to prepare a business interruption insurance claim for their clients. In addition, CPAs, certified management accountants, and other professionals and specialists are often hired by insurance adjusters, other claims professionals, or attorneys to review such claims for reasonableness and accuracy and to assist in claim settlement, negotiation, and litigation. The larger and more complex the claim, the more likely that one or both sides will believe that a CPA’s services are required, and larger claims are becoming the norm. Thus, a working knowledge of business interruption insurance is becoming increasingly important to CPAs.
Catastrophic losses due to hurricanes, tornadoes, floods, fires, and terrorist attacks rank among the most common fears of small business owners. The September 11, 2001, terrorist attacks impacted an estimated 24,000 businesses in lower Manhattan, most of them small businesses. Preliminary estimates of insurable losses related to September 11 were between $25 and $30 billion; estimates have since risen to more than $100 billion. The full extent of business interruption losses remains uncertain, but business interruption losses frequently reach 25% or more of total losses. Insured losses suffered by businesses in the path of Hurricane Katrina are estimated to eventually top $70 billion, approximately onequarter of which will be attributable to business interruption losses.
Insurance analysts warn that even larger catastrophes may occur in the future. For example, an earthquake comparable to the 1906 San Francisco earthquake could produce upward of $100 billion in property damage and income losses for U.S. businesses. Although the property damages from such an earthquake could be restricted to the San Francisco Bay Area, due to wide-scale integration of information and communications technology, tight linkages within transportation and logistics networks, and the overall control exercised by private and government entities, businesses across the United States and worldwide would suffer business interruption losses as a result of such a disaster. After both September 11 and Hurricane Katrina, thousands of businesses, many of them thousands of miles away, suffered the loss of major customers, suppliers, or distributors in the affected areas.
Although weather-related catastrophes are the most common source of business interruption insurance claims, a wide array of more mundane circumstances can also trigger such claims. Power outages, telecommunications failures, computer hardware breakdowns, and simple human error can shut down businesses for extended periods of time and create large and unanticipated revenue shortfalls. Despite the huge losses that business interruption events can impose, however, a recent study found that less than half of all U.S. small businesses have insurance coverage to protect them from such losses.
Various forms of business interruption insurance have been available in the United States since at least the 18th century. Although the term “business interruption insurance” has been in use since the early 20th century, beginning in the 1980s most insurance companies selling this product began referring to it as business income (BI) insurance.
Insurance industry experts agree that BI insurance is the most complex and controversial type of business insurance coverage, primarily for two reasons. First, unlike other types of insurance coverage, BI insurance is designed to reimburse insured parties for something that never took place—that is, it reimburses the insured for the profit that a business failed to earn during the time its operations were disrupted. This feature of BI insurance can produce heated arguments between an insured and the insurance company regarding the method used, and the specific factors or circumstances considered, in calculating that profit.
In addition, most BI insurance policies are rather ambiguous. The authors of Business Interruption: Coverage, Claims, and Recovery, 2nd Edition, suggest that this ambiguity is responsible for the “thousands and thousands” of BI insurance–related lawsuits that have been filed in state and federal courts by business owners in recent years (D. L. Torpey, D. G. Lentz, and A. Melton, National Underwriter Company, 2011, p. 226).
Defining Business Interruption Loss
Similar to other types of insurance, BI policies include standard clauses and definitions of key terms that are used throughout the industry. Most policies currently in effect use one of two definitions of a BI loss, the more common of which is the “net-plus” definition: “Net income (net profit or loss before income taxes) that would have been earned or incurred, and continuing normal operating expenses.” Accountants might quarrel with the parenthetical interpretation of the phrase “net income,” which is of course an after-tax figure. Nevertheless, the insurance industry has chosen to include this awkward, if not misleading, definition of net income in BI insurance policies.
Although BI policies may indicate that insured parties will be compensated for a loss of net income, the actual BI loss computed under the net-plus definition, for practical purposes, is equivalent to the “operating income” that an insured sacrifices as a result of a loss event. Notice that the “plus” in the net-plus policy language refers to any continuing or unavoidable expenses that the insured incurs during the period its business operations are suspended. Such “restoration period” is defined by the policy as the period of time required for the affected business to resume normal operations, usually limited to a maximum of 12 months.
Suppose a business experiences a loss that forces it to suspend operations for 12 months, during which time it incurs $20,000 of “continuing” expenses. If the business would have earned an operating income of $100,000 during that 12-month period, its total BI loss would be $120,000.
Alternatively, assume that a business resumed operations after six months but was unable to return to a normal level of operations for an additional six months. Assume that during the first six-month period, it incurred $10,000 of continuing expenses; for the second six months, assume that the company earned an operating income of $30,000. Under this scenario, and again assuming a “would have” operating loss of $100,000, the total BI loss would be $80,000 ($100,000 + $10,000 − $30,000). This is because the amount of a BI loss must be reduced by any operating income that the insured earned during the restoration period.
The second definition of a BI loss, called “gross-less,” is incorporated in many BI insurance policies in effect since 2002 or earlier. It defines a BI loss as the gross earnings—that is, gross profit—sacrificed by the insured as a result of the loss event during the restoration period, less any “saved expenses.” This term refers to costs that the insured party avoided as a result of the loss event. An example of a saved expense would be discretionary advertising expenses that were deemed unnecessary during the restoration period.
Under either version of a BI insurance policy, the insured can purchase an “extra expenses” rider. Examples of common extra expenses would be the cost of providing security to protect a business from theft when it has incurred major structural damage to buildings or other property, rent for operation at an alternative location, a friendly competitor’s performance of services normally provided by the insured, and the additional cost of expediting the delivery of material for the resumption of business. Extra expenses typically account for only a nominal percentage of a BI insurance claim.
Businesses that file BI loss claims should be prepared for contentious and protracted negotiations with their insurance company. Not being prepared for such negotiations could result in settling the claim at a substantial “discount.” The first step in preparing to file a significant BI loss claim is to hire a public adjustor skilled in handling such claims. Such an adjustor will need to rely on an experienced management accountant who is knowledgeable about the business’s operations and familiar with the nature of such claims.
An Example of BI Loss Calculation
On January 1, 2014, a fire heavily damaged the principal production facility of Emma’s Interiors (EI), a small company that manufactures window treatments and related items for residential homes. The company resumed operations on April 1, 2014, but its normal level of operations was not achieved until May 1, 2015, 16 months after the date of loss. Because EI’s insurance policy provides for a maximum 12-month restoration period, the BI loss estimate would be calculated for the 12 months ended December 31, 2014.
The first step in computing the BI loss estimate is to estimate the total revenues that EI would have generated during 2014. The Exhibit presents the monthly revenues for the two years immediately prior to the fire. This data can be used to arrive at various estimates of revenues for the 12-month restoration period. For example, the insurance company might assume that the company would have generated the same amount of revenues in 2014 as it did in 2013. The company’s CPAs might counter that such an assumption ignores the fact that EI’s revenues were trending upward over the two-year period before the fire. In the absence of evidence to the contrary, it seems reasonable that the company’s revenues would have continued to increase.
Emma’s Interiors 2013 and 2012 Monthly Revenues
A more reasonable method of projecting EI’s 2014 revenues would be to use the overall percentage increase in revenues realized by the company in 2013, compared to 2012, as the basis for that estimate. EI’s 2013 revenues were 115% of the company’s 2012 revenues ($3,105,000 vs. $2,700,000). If revenues increased by the same percentage the following year, the company’s projected revenues for the 12-month restoration period would be $3,570,075 ($3,105,000 × 115%).
Although more defensible than the original revenue estimate for the restoration period, this latter estimate ignores the fact that EI’s revenues increased much more rapidly in the final few months of 2013. Total revenues for that period were $1,850,000, compared to $1,415,000 for the comparable period in 2012, an increase of 130.7%. If that trend had persisted throughout 2014, the company’s 2014 revenues would have been approximately $4,058,235 ($3,105,000 × 130.7%).
Finally, one could “trim” the company’s revenue data set for the benchmark period, eliminating the months during the final half of 2013 with the lowest and highest percentage revenue increases. As seen in the Exhibit, EI realized its lowest month-over-month increase in revenue for the final six months of 2013 in August and the highest such increase in December. Eliminating those two months from the data set results in total revenues of $1,185,000 and $930,000, respectively, for the four remaining months in 2013 and 2012. This trimming of revenue data produces a forecasted revenue increase of 127.4%; this yields estimated sales of $3,955,770 ($3,105,000 × 127.4%).
However the restoration period revenue estimate is reached, the next step in calculating a BI loss is to estimate the total operations-related expenses—cost of goods sold and operating expenses—the company would have incurred at that level of revenue. This requires identifying the company’s cost structure by analyzing the individual behavior patterns of its operations-related expenses to arrive at an overall cost–behavior model for those expenses.
In this example, EI relies heavily on fixed costs to finance its operations. During 2013, the contribution margin ratio (total contribution margin divided by sales) was approximately 70.4%, while its variable cost ratio (total variable costs divided by sales) was approximately 29.6%. Assuming that EI’s cost structure would not have changed in 2014, the 2013 cost structure can be used to predict the total operations-related expenses the company would have incurred during the 12-month restoration period under its BI insurance policy.
Applying an assumed revenue growth rate of 127.4% and the cost structure derived from EI’s 2013 operating results, the company’s projected operating income for 2014 in the absence of the fire would have been $1,054,862. To determine the BI loss, the actual operating income the company earned during that year must be subtracted from the projected operating income figure. If the company’s actual operating income for 2014 was $200,000, the BI loss estimate would be $854,862.
Disputes Between Insurer and Insured
After the relevant financial information has been collected, computing a BI loss estimate is a fairly simple task, as illustrated by the above example. In fact, a primary objective when computing a BI loss estimate should be to keep the computation as simple as possible for the benefit of the jury who may eventually be called upon resolve the matter.
The process of computing a BI loss estimate is replete with opportunities for disputes between the insured and its insurance company. Common disputes include disagreements over the time frame to use in determining a benchmark revenue trend, the classification of expenses as either fixed or variable costs, the “relevant range” over which the insured’s cost structure will remain stable, and the length of the restoration period. These conflicts often result in tense and protracted negotiations.
Small business owners are typically at a decided disadvantage when attempting to resolve a disputed BI insurance claim. They are often in dire need of cash to sustain their operations, which may force them to accept an unfair settlement offer from their insurance company. Similarly, pursuing a BI insurance claim in court can be extremely expensive and add months, if not years, to its resolution. In contrast, major insurance companies have ample resources available to them: for example, consulting firms on retainer who specialize in computing BI losses. Not surprisingly, these consulting firms typically use methodologies and assumptions that result in conservative estimates of BI losses.
When a BI insurance claim winds up in court, small business owners have two key factors in their favor. First, the primary responsibility for computing a BI loss estimate rests with the insured. As a general rule, if the insured uses both a “reasonable” method of computing the estimate and incorporates in that method the most “reliable” or “competent” evidence available, the courts consider the estimate credible. The insurance company then has an affirmative duty to establish that the insured’s BI loss estimate is not credible.
Secondly, as mentioned above, most BI insurance policies are notoriously ambiguous. An insurance policy is a “contract of adhesion,” meaning that the terms are drafted completely by one party, the insurance company. As a result, the courts generally interpret any ambiguity within the insurance policy in favor of the insured, who had no input into the drafting of the policy.
Resolving Claims Successfully
CPAs involved in developing a claim and negotiating a settlement under a BI policy should be aware of the unique terminology, risks, and practical realities of BI insurance and business interruption claims. CPAs that use an inquisitive and thorough approach, together with a strong technical and organizational background and risk management focus, will resolve BI insurance claims successfully.
After a significant business interruption loss, a company, its BI claim team, and its CPAs will have to work hard to ensure that company operations resume efficiently and effectively and to recover the insurance proceeds to which the company is entitled. Although the adversarial nature of the process is not to be underestimated, the rewards accruing to CPAs who adopt a proactive and disciplined approach to BI insurance claims can have a significant effect on a company’s bottom line.