Exploring Business Interruption Insurance in the Wake of Disaster
- Published on July 11, 2011
Companies with operations, customers and suppliers in Japan are working to address the immediate challenges faced by their employees, colleagues and vendors; many others are participating in grassroots relief efforts. In addition to these fundamental initiatives, companies around the world can best address their employees, customers and stakeholders’ concerns by focusing on their own preparedness – including a detailed policy audit of their business interruption coverage, available extensions of coverage, exclusions and business interruption values.
Most business owners and senior risk executives have an understanding of their property and liability insurance needs and dollar limits and are comfortable purchasing coverage that protects their companies from a loss due to an insured peril. However, it has been my experience their comfort level drops dramatically when it comes to business interruption coverage and limits. The uncertainty surrounding business interruption coverage, extensions of coverage, and respective limits of coverage consistently results in many middle-market organizations finding themselves underinsured and short of cash when faced with a major loss.
Even the fortunate business owners who have not experienced a major loss may eventually discover they have been significantly overinsured for business interruption losses and paying unnecessarily higher premiums for their coverage. Of course, the more devastating situation is finding out after a shutdown of operations from a loss that company management has not mitigated the company’s risk of lost profits and now has insufficient coverage to protect profits and cash flow during a potentially long period of restoration.
A detailed policy audit responds directly to many of the concerns of the people at the heart of every business. Conducting a policy audit now enables companies to reassure employees, clients and other stakeholders that business interruption coverage will be available and sufficient to replace lost profits, reimburse extra expenses incurred and provide the cash flow required to fund the entity’s survival in the event of a disaster – thus making the difference between rebuilding and coming back to work versus shutting down. Specifically, the Tohoku earthquake highlights the importance of considering several factors during a policy audit even for companies with no current operations in Japan:
- Developing scenarios that might have been overlooked or minimized during a theoretical “drill” over possible disaster outcomes by comparing those prior plans to the range of actual outcomes which have played out in real time for many companies.
- Focusing on the importance of supply chain disruption and the benefits of naming specific attractions and dependent properties as part of contingent claims coverage.
- Identifying additional types of extensions of coverage to consider with the company’s insurance broker, such as contingent business interruption, extended period of interruption, claim preparation fee coverage, service interruption/power outage (including off-premises service and overhead transmission lines), extra expense, expediting expense, finished goods inventory selling price, walked guest expense and loss of attraction (primarily for the hospitality industry), ingress/egress, sue and labor, and civil authority. See below for more details on some specific extensions of coverage.
- Moving quickly to modify business interruption policies due to a need for increased or enhanced coverage and possible changes in the business before that coverage becomes more expensive or difficult to obtain (including for reasons beyond the control of any one insured entity, such as a revision of computerized models used by carriers to predict the impact of disasters).
Below I have outlined a few additional keys steps for business owners, financial executives, or risk managers to take in order to avoid that day of reckoning when their companies cannot afford the economic consequences of an underinsured loss:
1. Understand what kind of catastrophic events could cause a major loss
It must be recognized that a shutdown of operations can be caused by many events other than a natural disaster. Additionally, even if companies do not suffer physical damage, they can experience a business loss. A few examples would be:
- A company’s major component supplier has a fire and it is not able to procure the component from an alternate source
- A majority of a hotel’s bookings are derived from a nearby convention center that is shut down as a result of roof collapse from heavy snow
- A manufacturer shuts down due to an explosion, causing its suppliers to lose half their sales until the customer repairs or replaces its facility
2. Set a meeting with an insurance broker to review the company’s policy
Focus on the company’s reported or insured values for its business interruption coverage, as well as the numerous extensions of coverage that are available based on the organization’s specific operations and needs. Calculating the appropriate business interruption values, whether through reevaluation or assessment for the first time, is fundamental to selecting the proper coverage and respective limits and will enable executives to better manage and minimize financial risk.
3. Prepare a Maximum Loss Scenario (MLS) analysis
An MLS analysis is the process of simulating an occurrence in which an organization experiences a catastrophic loss event. The financial impact of this simulated loss event is quantified and addressed in a report to underwriters that provides a more comprehensive analysis and understanding of the risk that they are evaluating and underwriting. Senior management benefits from the MLS analysis because it may identify critical path weaknesses and interdependencies in an organization which may then be used to update their strategic and disaster recovery plans. The MLS analysis should also include an assessment of potential extra expenses that could be incurred as a result of the simulated risk, in addition to the business interruption losses.
4. Navigate the numerous extensions of coverage that are available to mitigate risk
While this step is a daunting part of the process, it’s important that business owners and senior management understand these additional extensions, especially as many of the time-element coverages may be critical to safeguarding potential lost profits from a catastrophic event, and therefore must be individually analyzed and addressed with a broker. Below are details about some additional coverages to consider:
- Contingent business interruption
This provides additional coverage as a result of a covered loss to suppliers and receivers of goods and services. Without this coverage extension, companies that have critical suppliers, customers, or feeder-type properties may find themselves at the mercy of a supplier’s or customer’s rebuilding schedule. In the worst-case scenario, companies may have to shut down due to a supplier’s or customer’s physical loss.
- Ordinary payroll coverage
Managerial and salaried employees are normally covered as a continued expense. However, any hourly non-managerial employees may not be covered. If a company has hourly skilled labor or is located in a tight labor market and cannot afford to lose trained workers from lack of payment during a business interruption, it can purchase an extension of coverage that will allow it to pay these workers for a specified period of time while the company is shut down. Generally, the coverage is purchased for a specific number of days (e.g., 30, 60, 90, and up to 365 days). To determine how many days of coverage a company may need to purchase, management must determine the skill level of its workforce and evaluate the risk that they will not return to work after a closure.
- Extended period of indemnity
Business interruption coverage indemnifies a company through the period of interruption, which is also referred to as the period of indemnity or restoration. This period is often defined as the time it takes to rebuild or restore the damaged property to its pre-loss condition using due diligence and dispatch. An extension of coverage allows for continued indemnification from a company’s insurance coverage for the time necessary to ramp up its business to pre-loss levels following the physical restoration. This is an important coverage for businesses in a highly competitive environment, such as the hospitality industry.
Business owners, financial executives, and risk managers should meet with their brokers to closely examine their business interruption values, limits and available extensions of coverage in their current policies. The critical takeaway is that properly calibrated business interruption coverage can be one of the most valuable assets for providing the critical working capital needed to survive a catastrophic event.
As I have seen firsthand during the aftermaths of the recent earthquakes in Chile as well as after Hurricane Katrina, other natural disasters and industrial incidents, people want to get back to work. When insurance coverage is not adequate for the scale of a disaster or has not been purchased for specific types of business interruption, entities do not recover as quickly or at all. At a time when the human suffering and financial losses in Japan are in our minds, employees and management at insured entities throughout the world welcome the opportunity to feel as though they are doing something concrete now that may help preserve jobs and enable their companies to get back to work more quickly in the event of a disaster.
Bob Glasser is a managing director at BDO Consulting, a division of BDO USA, LLP, in the New York office focusing on business interruption and insurance claims services. Glasser is a certified public accountant, a certified fraud examiner, certified in financial forensics, and a certified insolvency and reorganization accountant, with more than 30 years of diverse financial management and accounting experience at public and private companies.