At a glance
- Business Interruption (BI) is often a key area where opportunities exist to optimise risk and insurance programmes
- There are three main types of BI cover, each operating in different ways
- We examine the differences between them and which type is most suitable for a particular business's requirements
This article counts towards accumulating your annual CII CPD structured learning hours for Business Interruption and Underinsurance.
By reading this article, and correctly answering the three questions underneath, you will have achieved the following learning outcome: Identify one or more of the most common causes of underinsurance on business interruption policies and Identify the key factors that make up the gross profit calculation
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Following an insured property damage loss, it is crucial that the correct and most suitable BI cover is in place. There are three main types of business interruption cover: loss of gross profit, loss of gross revenue and increased cost of working.
Definition: Increased cost of working
Additional costs incurred in order to prevent a further reduction in turnover.
These might include:
- Staff overtime
- Hiring temporary staff
- Sourcing alternative premises including rental costs
- Installing new/temporary means of communication
- Removal and storage fees
- Advertising ‘business as usual’
- Costs of sensitive waste disposal – linked to documents or IT equipment containing sensitive data.
- Security and fire protection costs – involved with making the damaged location and any temporary location secure
However, where part of a Gross Profit of Gross Revenue cover, all costs must be within the ‘economic limit’. For example, if £1 is spent, then it needs to avoid at least a £1 reduction in turnover. Or, simply put, you cannot spend more than a pound to save a pound.
Each of these covers operates in a different way and there are several reasons why they might be best suited to a customer’s particular circumstances.
We explain the differences between these three types of cover and discuss how to choose the most appropriate cover for a particular business’s needs.
1. Loss of gross profit
A gross profit basis is the most common choice of business interruption cover in the UK. This covers the loss of net profit following a reduction in turnover, standing charges and also any increased cost of working (see definition in boxout).
Gross profit’s key distinguishing feature is that customers can specify certain costs to deduct in order to arrive at their final sum insured. These deductions are known as variable costs or ‘uninsured working expenses’ (UWEs), and comprise costs that vary in direct proportion to the reduction in turnover. So, if turnover is reduced by 30% that cost will also be reduced by 30%.
The intention of UWEs is to enable customers to not insure costs that will cease in the event of a loss. By insuring on a gross profit basis, any UWEs are excluded, reducing the exposure base to which a BI rate is applied, which means a customer’s premium is likely to be less.
However, incorrectly specifying UWEs is a common source of underinsurance, as many customers do not undertake the proper processes required to identify them.
Who is it suitable for?
The gross profit basis was initially developed for customers with many directly variable costs, such as those in the manufacturing and retail sectors. However, as business models have changed, it is no longer the case that these business types are always best suited to a gross profit basis of cover.
“Using generalisations about business types is not the correct approach to take,” says Ian Dunbar, Risk Engineer at Zurich. “Brokers and customers need to think carefully about what would happen in the event of a loss – which costs would cease and which would continue?”
2. Loss of gross revenue
If, having carefully considered loss scenarios there are few directly variable costs, then a different basis of cover, such as loss of gross revenue, may be more suitable. A gross revenue basis covers the reduction in turnover following a loss and also any increased cost of working. This could help customers avoid some of the inherent difficulties in calculating a gross profit sum insured and reduce the risk of underinsurance.
To calculate a gross revenue sum insured, customers simply need to know the total turnover of their business for the length of the indemnity period. This avoids many of the intrinsic pitfalls in the gross profit calculation and can help provide a more accurate sum insured for those customers where a gross profit basis would bring few or no additional benefits.
Who is it suitable for?
Traditionally, gross revenue has been considered most suitable for the service industry, including businesses such as accountants, solicitors and hotels.
This is because the majority of these businesses’ costs, such as staff and IT, will not reduce in direct proportion to turnover in the event of a loss. These businesses will therefore typically have very few UWEs, giving them less incentive to opt for a gross profit basis, which may leave them exposed if an inaccurate sum insured is calculated.
As mentioned previously however, generalising should be avoided, and each customer should be assessed according to how their particular business operates.
“When looking at business interruption, the key is to get under the skin of the business,” says Graham Herridge, Major Loss Team at Zurich. “Understand how it works and what would happen to its revenue and costs in the event of a loss.”
3. Increased cost of working
As detailed above, increased cost of working cover is included within both the gross profit and gross revenue bases, where it is subject to an ‘economic limit’ (see boxout for further details). However, it can also be arranged in isolation, in which case it will not be subject to an economic limit.
“Increased cost of working is essentially the bare bones BI cover,” says Mike Aspinall, Risk Engineer at Zurich. “It provides the customer with cash to cover reasonable additional expenses that will help the business recover following a loss.”
Who is it suitable for?
This basis is only suitable for customers whose business continuity planning and management is such that they will be very resilient to a loss; for example, businesses that are able to easily minimise the impact to their business and might simply require some additional cash to put an established recovery plan into action.
Large multinationals often choose an increased cost of working basis as they might be relatively unaffected by a loss at a single location, have large cash reserves to rely on and may be able to absorb lost capacity in other areas of the business.
How we can help
We have a range of information and tools that can help you calculate more accurate sums insured and get a better understanding of business interruption and underinsurance.
For more information please speak to your local Zurich contact.