Business Income and Extra Expense Coverage….What Business Owners Often Overlook

Business Income and Extra Expense Coverage….What Business Owners Often Overlook

 

I have yet to meet someone who talked about how much they love filling out a Business Interruption (BI) Worksheet.  Over the years, I have found two major issues with BI Worksheets, as I will discuss further below.  

Despite their general dislike, these forms are a necessary part of the commercial property insurance program.  Errors or mistakes completing these worksheets can be costly. The Business Income Worksheet can play a significant role in the placement/renewal process, but it is crucial to understand the form’s purpose and limitations.  A better understanding of this form can help ensure that BI coverage is accurate and appropriate.

A BI Worksheet is a form almost every carrier requires their insureds to complete in the property insurance placement/renewal process.  The goal of the BI Worksheet is to summarize a company’s financial information that allows a carrier to assess an insured’s business interruption exposure.  Carriers use the information in many aspects of the underwriting process, including the calculation of premiums.

Although every BI Worksheet attempts to arrive at the same conclusion, each carrier may use a slightly different version of the form.  Regardless, they are always to be completed by the policyholder.

Accounting is scary to most people, but you do not need to be an accountant to understand the basic financial information used to complete a BI Worksheet.  Very simply, a BI Worksheet captures a company’s specific revenue and expenses for a given period.  That’s it!  The specific revenue and expenses follow the BI coverage.  The confusion ensues when someone tries to figure out which expenses to include or exclude on the form.  At this point, the standardized form usually fails.

One of the most important things to understand about a BI Worksheet is that it quantifies the BI exposure of a company for a 12-month period.  Equally important, it assumes a total shutdown of operations for the same 12-month duration.  Essentially, it’s a prediction of the impact a total loss has on a company’s income statement if it did nothing for an entire year.

As mentioned above, I have found two significant issues with BI Worksheets.  First, many insured’s mistake the calculated amount on the BI Worksheet as their company’s BI needs.  Second, almost every version of the BI Worksheet in the industry is too simplified to accurately calculate a company’s BI exposure.  I have elaborated on these two major issues below.

Issue #1:

The 12-month, total shutdown scenario a BI Worksheet calculates does not represent an insured’s BI needs!  Here is why.  When an insured suffers a total loss, the actual “Period of Restoration” will unlikely equate to exactly 12 months. Loosely speaking, the “Period of Restoration” is the time it takes an insured to rebuild/restore their property damaged or destroyed by a covered loss.  There are endless scenarios where the “actual” Period of Restoration could be more or less than 12 months.  Any difference from 12 months would make the value on the BI Worksheet incorrect.  Remember, the purpose of the form is not to estimate the value of a claim, but rather give an insurance company the information to assess the BI exposure.

The other reason a BI Worksheet does not represent an insured’s BI needs is because an insured may never realistically suffer a “total loss”.  This is true if the policyholder has loss mitigation opportunities available.  You should be aware that loss mitigation opportunities come in many forms and are quite common.

A past engagement where we assessed the BI exposure for a well-known RV manufacturer provides a perfect example.  The manufacturer had three locations (Colorado, Indiana, and North Carolina.)  Each location was almost identical from a capacity and operations perspective.  Because of the location similarities, we focused our analysis on only one of the facilities, as the values at each location would be similar.

At the time of the analysis, gas prices were very high, so industry sales were down significantly.   All of their facilities were operating around 50% of capacity.   Through our process, we came to understand that if the manufacturer had a total loss at any of their facilities, their other two locations would be able to handle all of the incoming sales orders.  This effort would fully mitigate their sales losses.  However, mitigation would come at a significant expense.

We quantified the hypothetical BI value at the Indiana location as required by the BI Worksheet.  Again, this value assumes a 12-month total loss, where no loss mitigation occurs.  The value calculated totaled $13.7 million.  However, this was an unrealistic scenario that would never happen in a single location loss scenario.   This is because the insured would immediately transfer orders to their other facilities and fully mitigate their sales loss.  Based on this information, we calculated a second BI value.  The second value calculated the “real world” expense to reduce BI value.  This amount totaled only $2.8 million for the same 12 months.  The second value considers incremental freight and employee costs to produce at the other locations.  The depressed RV industry partially accounts for the gap in BI values, which is a good reminder why BI values should be reviewed on an annual basis.

This $2.8 million represents the insured’s actual BI exposure and is obviously, far less than the $13.7 million the BI Worksheet calculates.  These calculated values assume a total loss at only one of their locations.  Losses at more than one location would significantly change the scenario.  Given the geographic location of their facilities, this was a risk the policyholder was willing to accept.  This analysis proved to be invaluable information for the insured and broker during the renewal.

Issue #2:

The other major issue with BI Worksheets is that they are too generic to accurately calculate BI exposure.  How can a standard one-page form of financial information accurately measure every different company’s unique BI exposure?  It can’t (at least not very accurately).  There is no doubt the information a BI Worksheet provides can be helpful, and it’s certainly better than nothing.  However, the generic format can lead to miscalculations and errors.

As previously stated, some carriers have expanded the basic one page BI Worksheet by adding sub-calculations and customizing forms for specific industries.  While the more detailed versions can be better at quantifying the exposure, they are much more convoluted and still cannot consider the nuances of each policyholder.  At least not in a way that provides relevant data to both parties.

BI Worksheets are usually confusing for the policyholder to complete, even if the individual completing the form is an accountant.  As previously mentioned, a BI Worksheet requires an insured to fill in fields of financial information.  As an example, a BI Worksheet may ask for a company’s “Cost of Goods Sold.”  Well, every company’s accounting of “Cost of Goods Sold” may be slightly different.  Unless someone has the expertise to bridge the gap between a company’s accounting and BI coverage, there is a risk the BI Worksheet will be incorrect.

Conclusion:

Awareness of these two issues is the first step in overcoming the BI Worksheets limitations.  Most do not realize the importance of this form or know if it is accurate.  A thorough understanding of a policyholder’s operations and potential response to a loss can help bridge the gap between the BI Worksheet and a company’s true BI exposure.  Having the correct expertise involved in the process will guarantee the information is accurate and used appropriately.

By: Kevin Grudzien

Forensic Accountant | Property Insurance Expert | Claim Preparation Consultant | Speaker | Author