Business Interruption – avoiding the risk of underinsurance
Supply chain incidents…product liability issues…event cancellations…equipment malfunctions…fraud or theft…fire, flood, storm and cyclone…accidental/malicious damage…cyber incidents – these are just some of the perils that can derail a business and leave it unable to operate for a period of time.
Events that cause business interruption are a key concern for business owners, directors and officers. The 2023 Global Risk Management Survey found business interruption was the second highest ranked global risk (after cyberattacks/data breaches) and the third highest amongst Asia Pacific businesses.
The concern is warranted.
Statistics from the Insurance Council of Australia (ICA) showed business interruption claims accounted for 15% of total business insurance claims in 2022, with an average cost of $17,000 per claim.
According to a survey conducted by CGU Insurance, 81% of SMEs admitted that an unforeseen business interruption would have a severe impact on their business.
Despite this, many businesses don’t have business interruption (BI) insurance. Research commissioned by QBE Insurance revealed just 17% of small businesses hold a BI policy, while CGU found 27% of SMEs had a policy.
Research from the ICA has shown than 70% of uninsured or under-insured businesses that incur a major insurable loss fail within the following year. Professor Allan Manning of LMI Group notes that without BI insurance, a business has less than a one in 10 chance of survival following a major loss.
BI insurance is like income protection cover for your business.
BI insurance deals with the continuity of income after insured property is damaged or lost after an unexpected event.
After a major loss (stemming from an insured event), BI insurance typically covers loss of trading profit and other additional business expenses incurred to maintain business turnover, such as rent, mortgage repayments, repaying business loans, hire of vehicles and equipment, paying salaries, fixed electricity, gas and water charges, and other costs associated with minimising the effects of the closure or downturn. BI policies are designed to cover the financial impacts on the business for a period of time, to allow the business to continue running and recover.
A BI policy aims to ensure that the business is in a comparable financial position despite exposure to an insurable event. To do this, insurers create a picture of the business finances as if no loss has occurred and then find ways to mitigate the impact of the loss so the business can continue to trade normally. For example, policies may cover the cost of business consultants and specialists whose advice may reduce the impact of the recovery period. Or, at the end of the recovery period, the policy may cover the lost profit that is usually calculated based on the difference between the actual post-loss business turnover, and what was financially modelled for the on-going business.
According to QBE Insurance, the top three BI claims stem from fire damage, weather damage, and damage triggered by people (e.g. malicious damage from vandalism or theft, or accidental damage if the insured, an employee or a customer break something by mistake). The insurer also notes that more than 5% of businesses have recurring BI claims over a period of five years, with an average cost of $10,000 per claim.
Having BI insurance can help protect your business – but only if you get it right.
Businesses run the risk of underinsurance by underestimating the costs that will be incurred while recovering from the insured event. This extends beyond inadequate sums insured for property to inadequate cover for business interruption.
In fact, claims data from industry sources indicate that the most common business underinsurance pitfall relates to business interruption. Namely, not having an adequate indemnity period (the time for which the policy will pay for the shortfall in profit) and failing to accurately calculate the increased costs of working in the interim, such as renting alternative premises and equipment.
Work with your EBM Account Manager to assess the business interruption risks to your business and secure a policy to protect your finances. Key considerations your broker will discuss with you to ensure that the risk of BI underinsurance is minimised include:
- Reviewing/creating a business continuity plan.
Business continuity planning can help increase your business resilience through anticipating potential losses and planning how best to respond. It is also essential in choosing the correct BI cover. Considering potential loss scenarios is the best way of identifying a lot of the information needed to set suitable BI cover levels. For example, without fully understanding how your variable costs will change following a loss, it will not be possible to set an accurate gross profit sum insured. Equally, without contemplating potential worst-case scenarios, it will not be possible to choose a suitable maximum indemnity period. - Securing the right type of BI policy.
There is more than one way to insure against financial losses as a result of business interruption. For example, there are loss of gross profit policies, which are referred to as consequential loss of profits (Industrial Special Risks policy), gross profit, annual gross profit, annual income, or gross income. Loss of gross profit is the most common form of BI cover. There are also weekly income policies, additional increase in cost of working policies, and other options. Your broker can also look at optioning up base wording to suit your business needs. - Calculating annual gross profit.
Accountancy and insurance policy definitions of annual gross profit are different. You need to ensure your assessment of gross profit matches the one in your policy so that you don’t understate it (definitions can differ between insurers). It is also important to understand how the gross annual profit relates to the indemnity period. For example, if the indemnity period is 18 months, the required sum insured needs to be 1.5 times the annual gross profit amount. Even if the indemnity period is less than 12 months, the sum insured should still be the annual gross profit amount and not a percentage of it. The formula requires the amount to be based on the annual figure and the premium rating takes care of the shorter indemnity period – if the annual figure is reduced, only a portion of the loss will be covered. - Assessing costs.
To accurately calculate annual gross profit, you’ll need to work out the costs for which your business would still be liable (e.g. wages, mortgage repayments, rent) and those it would be likely to incur (e.g. hire of vehicles or machinery, advertising costs associated with announcing recommencement of business). Consider the full range of expenses (based on the continuity planning) and take care with “uninsured working expenses” and other calculations such as declaring payroll in accordance with the definition stated in the ISR policy. - Selecting an appropriate indemnity period.
The amount of cover you will need will depend on the amount of time you think it will take for your revenue or turnover to recover to the level immediately prior to the loss – this is the indemnity period and it is essential that you get it right. It is widely agreed that most businesses need at least 24 months to recover their trading positions and rebuild their customer base. At a minimum, a 12-month indemnity period is strongly recommended as many insured events, such as fires, involve a lengthy disruption. It is wise not to be overly-optimistic about your business recovery time and take into account how much control you’ll have in rebuilding operations. - Assessing various extensions to BI cover.
Extensions may include things such as denial of access, public utilities cover, suppliers’ and customers’ premises, and even murder and suicide. An important extension is additional increase in cost of working cover. This cover allows the business to claim the increased costs that maintain the business or service, but which do not necessarily reduce or avoid a loss of turnover during the indemnity period. Depending on the policy, there may be a need to consider additional insurance to cover claims-related costs such as instructing an expert or an accountant to help with the claim. You may also need to consider whether you insure your payroll separately. - Factoring in inflation.
- Considering emerging risks, such as cyberthreats.
- Understanding the consequences of underinsurance.
Like property sums insured policies, BI insurance will usually have a co-insurance clause (also known as an average or underinsurance clause). This means that if you underinsure your business, any payout can be proportionately reduced in line with the under declaration. In effect, you would be self-insuring the difference between what you nominated as the BI sum insured and the actual level of insurance needed. - Regularly reviewing the cover limits.
Business operations and performance change over time, and it is important for coverage amounts to be regularly reviewed to ensure the business is adequately protected. For example, sums insured should be adjusted in line with maximum indemnity periods. Cover should also account for future business trends and the impact on revenue and profitability.
By working with your EBM Account Manager you can secure the BI cover you need and also ensure that you set accurate sums insured and maximum indemnity periods – financially protecting your business and providing you with peace of mind. (According to QBE, that’s the reason 55% of SME owners take out the cover!)
