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Business interruption insurance

This article was last updated by the author in October 2016.

A brief introduction to business interruption insurance.

Contents

Overview

Business interruption insurance (BI) is also known as time loss, consequential loss and loss of profits insurance. It provides cover for the financial losses due to an interruption to a business caused by material damage to property.  

Consider, for example, a factory which is destroyed or damaged by fire. Apart from physical damage, the insured may also suffer a loss of business income from which to pay the expenses of the business and make a profit. They may also incur extra costs, such as renting alternative premises, to maintain the turnover of the business. All these losses are covered by business interruption insurance.

It can be issued as a separate stand-alone policy, although business interruption insurance may also be incorporated into a package or commercial combined policy.

Typical cover provided

There are two key elements to a business interruption policy, which are defined in the policy:

  • the time period for which the interruption will affect the business (known as the indemnity period)
  • the maximum amount that needs to be insured (called the Gross Profit).

The indemnity period

This is defined as 'the period beginning with the occurrence and ending not later than the maximum indemnity period thereafter, during which time the business is affected by the interruption occasioned by the damage'. The period for which insurers will pay for any losses is limited to the maximum indemnity period selected by the insured. In deciding the maximum indemnity period the insured will need to take into account the type of business, the time taken to replace specialist machinery, the types of customer and other factors that may have an impact upon the speed of a firm's recovery to its anticipated trading position.

Gross Profit

A business interruption policy is not designed to replace all the turnover (the total income generated by the activities of a business) which may be lost as a result of damage to the premises. The turnover of the business is used to pay the costs of running the business and to generate a net profit. The costs can in turn be divided between:

  • variable costs: those that reduce in direct proportion to the reduction in turnover, such as raw materials, and
  • fixed costs: those that must still be paid even if the business is not operating, such as rent.

Not all of these costs will result in a loss to the insured, as the variable charges will reduce in direct proportion to the reduction in turnover. If the turnover reduces, the insured will not suffer a loss under this heading. A business interruption policy, therefore, only needs to cover the insured's net profit and fixed expenses (which are often called 'standing charges'). The term that insurers use for the addition of net profit and standing charges is 'gross profit'. Rather than the insured having to list all the standing charges (and possibly omitting to include something), insurers instead arrange cover on a difference basis. The gross profit is calculated by deducting variable expenses (which are also known as uninsured working expenses) from the turnover. The figures are adjusted for differences between opening and closing stock.

Most policies are written on a 'Declaration linked' basis. This type of cover requires the policyholder to estimate the gross profit for the forthcoming year. Insurers then apply a one-third uplift automatically to take account of any future growth in turnover.

Increased cost of working

The other element of cover under a business interruption policy is increased cost of working. Certain expenses may be incurred following loss or damage to try to maintain business activity, such as renting alternative premises, hiring additional staff and additional advertising. A business interruption policy provides cover for such risks, so long as there is an equivalent saving in the loss of gross profit claim that would otherwise be paid.

Accountants' fees

Cover includes the cost of accountants' or auditors' fees incurred in preparing a claim. There is no separate sum insured for this item. This is the only class of business that allows for the preparation of the insured's claim to form part of the claim itself.

Material damage warranty

This states that there must be a property damage policy in place which covers the physical damage to the premises and its contents, for the business interruption policy to be effective. Therefore, the perils under the business interruption policy must always have an equivalent peril under the material damage cover, for a claim to be payable.

There are several types of business interruption policies, the most common being:

  • fire and special perils
  • all risks
  • engineering

Fire and special perils

The minimum cover provided is for loss of gross profit following damage to the insured's property caused by fire, lightning and explosion of gas used for domestic purposes and all boilers.

Additional perils, known as special perils or specified contingencies, can be added to this basic cover. These are explosion, aircraft, riot and civil commotion, malicious damage, earthquake, subterranean fire, spontaneous fermentation or heating, storm, flood, escape of water, impact, sprinkler leakage and subsidence.

All risks

Cover is provided for loss of gross profit following accidental loss or destruction of, or damage to, the property insured. All types of loss or destruction of or damage to the property insured are covered, provided the cause is not specifically excluded from the policy.

Engineering

The perils covered usually fall under one of two headings:

  • failure of the public utilities supply of gas, electricity, water or telecommunications at the supply undertaking's feed to the premises
  • sudden and unforeseen damage from any accidental cause not specifically excluded.

Cover is only in respect of specified items of machinery and plant.

Engineering business interruption policies usually exclude:

  • perils covered by the fire and special perils policy
  • general market exclusions (war etc.)
  • any scheme which rations supplies by a supply authority
  • deliberate acts of a supply authority.

Other bases of cover

Although the majority of business interruption insurance is written on a gross profit basis, there are other forms of cover which are tailored to particular circumstances or to the needs of certain types of business. These include:

  • Increased cost of working only. This more restricted form of cover may be chosen by some businesses, whose income would not be reduced in the event of physical damage to the insured's property. Typically these are office type risks who only need a temporary office from which to conduct their business.
  • Additional increased cost of working. This form of cover is offered as an extension to a standard business interruption policy and removes the economic limit which would otherwise apply to the increased cost of working cover. It may be needed by businesses which operate in an extremely competitive environment, whose customers are extremely difficult to regain once lost.
  • Gross revenue/fees/rentals cover. This type of cover is suitable for businesses that have few or no expenses which vary with turnover, such as solicitors and other professionals and property owners.
  • Advanced profits. This type of policy provides protection for the future earnings of a new business or an extension to an existing business. It differs from a standard business interruption policy in that the indemnity period only starts to run from the date on which income would have started to be earned from the new enterprise, rather than the date of the physical damage.

Optional extensions

A standard business interruption policy only covers losses which are a result of insured damage at the insured's own premises. However, the insured's business may also be affected by damage at third party premises for which a number of extensions to cover are available. Such extensions are subject to an additional premium but not to the material damage warranty.

The most common extensions include:

  • losses resulting from damage at the premises of suppliers
  • losses resulting from damage at the premises of named customers. Limits apply based on the estimate of maximum turnover which is dependent on each named customer
  • losses resulting from damage to the property of the insured whilst in transit
  • losses resulting from access to an insured's premises being prevented due to damage to nearby premises. Cover may be extended to include prevention of access due to a bomb threat
  • losses resulting from damage at the premises of a public utility
  • losses due to the occurrence of a notifiable disease, vermin, defective sanitary arrangements, murder and suicide

An inner policy limit applies to the cover provided by each of these extensions.

Key exclusions

Each of the special perils is subject to specific exclusions. In addition, a number of standard market exclusions also apply to cover as a whole:

  • riot or civil commotion (although this exclusion may be removed on payment of an additional premium)
  • war risks
  • radioactive contamination/explosive nuclear assemblies
  • Northern Ireland excluded perils
  • Terrorism (although this exclusion may be removed on payment of an additional premium)
  • pollution or contamination
  • property insured under a marine policy
  • property more specifically insured.

A business interruption all risks policy also contains a large number of additional exclusions, relating to risks that insurers are unwilling to cover or which are more appropriately insured under a separate, more specialist policy. They fall under one of four headings:

  • Absolute exclusions, including war, nuclear assemblies, terrorism, Northern Ireland risks, pollution or contamination, marine risks, specific insurance, consequential loss and certain 'trade' risks (such as faulty workmanship)
  • Exclusions which relate to an aspect of cover which can sometimes be included in the policy, but only with careful underwriting, such as corrosion, rust, change in temperature, wind or rain damage to moveable property in the open and malicious damage cover in respect of empty buildings
  • Exclusions which relate to an aspect of cover which can be written into the policy, including money, jewellery, glass, computers, goods in transit, theft, subsidence, ground heave and landslip
  • Exclusions which relate to property or risks which are more appropriate to another class of business, including motor vehicles, watercraft, aircraft, livestock and buildings in the course of erection.

Rating factors

The premium is calculated by applying a rate to the Gross profit sums insured. The rate applied will be based on the property damage rate and so will reflect a variety of factors including the trade, the special perils insured, construction of the premises and heating, housekeeping and the presence of fire extinguishing appliances. This rate is then adjusted to reflect business interruption specific factors, including the maximum indemnity period.

Product providers

Most composite insurers, as well as a number of specialist insurers and Lloyd's syndicates, offer business interruption cover.

Cover is often arranged through an insurance intermediary, although small businesses can purchase cover by telephone or on line as part of a commercial package policy. 

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