Pandemic peril: How business interruption insurance can mitigate risk

The ongoing COVID-19 pandemic has brought the issue of business interruption into sharp focus, as has the recent UK Supreme Court decision to dismiss appeals by insurers in a test case brought by the Financial Conduct Authority on behalf of policyholders.

Business interruption relates to the loss of customers and the inability to trade due to a pandemic but can equally result from other reasons, such as fire or flood causing the loss of production facilities, suppliers, or specialist machinery.

So how do you protect yourself from the unforeseen? Perhaps the most obvious strategy is to maintain a flexible cost structure. This gives you the ability to adjust capacity and costs in line with the demand for your goods and services. Businesses, however, need investment to grow, requiring longer-term financial commitments to enable manufacturing facilities and warehouses to be built or leases to be paid. These financial commitments can leave a business vulnerable to significant interruption.

Managing a healthy cash flow for your business is also critical. This involves monitoring the credit given to each of your customers and ensuring, where possible, that your creditors fund your stock. Cash management strategies are discussed more fully in the 17 June 2020 FM article “Crisis Basics: Managing Cash”.

As well as taking steps to structure the business in a way that strikes a balance between flexibility and growth, many businesses over the past year have turned to their interruption insurance to help weather the storm of the pandemic. However, many are questioning the merits of their cover (as with cybersecurity cover). Too often the business interruption section of a policy is regarded as an “add on” to the main cover, and the extent of the benefits that it could provide are not fully understood or explained.

So what do businesses need to know when considering interruption insurance?

Perils

Business interruption clauses in a policy will often follow the list of “perils” that are covered in the material damage section of the policy, or they may make up a separate policy. In either case, the policy should indicate the perils it covers. Generally these start with fire, flood, etc.

The business interruption section or policy, however, may go on to provide an even bigger and better benefit beyond that relating to fire and flood damage. Business interruption clauses can often provide cover for loss or damage at the supplier or customer location — a fire at your main suppliers may be as injurious to your business as a fire at your own premises. It may cover closure due to infectious disease such as COVID-19 or the consequences arising from it, such as employee quarantine. It may also provide what is known as “key person insurance”. This will provide relief if a key employee is lost to the business.

Valuation and reimbursement

A buildings or contents/stock policy is relatively simple: You insure for the maximum value of the item that you hold, subject to adjustments for wear and tear if the policy requires that. For business interruption policies, however, there are different parameters: First, there is the sum insured; and second, the maximum length of time the policy will operate after the insured event or peril has arisen.

A normal business interruption policy provides cover on the basis of:

• A definition of gross profit. At its most basic level this is sales less cost of sales. It will indemnify or compensate the business for losses on this basis for a period from the start of the interruption, eg, the day of the fire, up until the date the business returns to normal, or for a maximum period stipulated within the policy. The definition of gross profit is found within the policy and can often be amended.
• Cover is always less than the equivalent loss in gross profit. In any situation where a reduction in sales or cessation of business occurs, there are savings over and above the cost of sales or specified working expenses, eg, wages, heating, lighting, and possibly business rates. These savings will be deducted from the loss in gross profit. If the business were to close permanently, the loss would be the net rather than gross profit.
• The “increased cost in working”. This is where reasonable expenditure to maintain turnover is considered. This may mean advertising prior to the reopening of the business or, if your production is reduced, purchasing a product at a higher price than normal from another supplier. The basic rule is that the expenditure should be economic; ie, the gross profit achieved is greater than the cost expended during the period of indemnity.

The “adequacy of the sum insured” should also be considered. Here the insurer will assess the total gross profit of the business over the period of maximum indemnity against the actual value insured. Where the value insured is less than gross profit in the period, any actual loss will be adjusted to reflect this shortfall.

Basic policies generally offer a maximum indemnity period of one year. It is, however, difficult to conceive that a business suffering a major loss such as a fire or flood would be able to resume normal operations within a 12-month period. The path to recovery may be considerably longer if the business also loses its customer base.

Business continuity plan

The point about mitigating risk is that you make sensible decisions anticipating future events. An over-dependence on business interruption insurance at the outset can lead to a false sense of security.

If you rely only on insurance, it’s still unlikely that you’ll be able to recover all losses. Many businesses fail however well insured they are. It’s advisable to have some form of operational contingency in place enabling you to continue trading, even in a limited capacity. Your customers, competitors, and the market may have moved on by the time you’re back up and running.

When the crisis, fire, flood, or disease hits, activate your plan to manage from day one. For example, reduce staff, buy in stock, and consult with your PR team as to what to say to customers and suppliers.

4 steps to protect your business

In summary, there are four ways to limit the damage caused by business interruption. They are:

• Maintain a diverse and flexible approach to your business to enable you to steer clear in a crisis.
• Check your insurance cover, the perils insured, the sum insured, and the maximum length of cover.
• Activate your business continuity plan.
• Do not be over-optimistic. Businesses frequently fail because they expect to be in the same position as before the event. Your market may have changed when you’re ready to operate again.

Sometimes the best decision is to accept the inevitable and close. Your insurers could pay on the basis of net profit loss, but you need to negotiate this with them in advance or they may suggest you have not adequately mitigated the loss.

Resources

CPD or CPE courses

CIMA members: Business Continuity Management

AICPA members: Business Continuity Management

— Mark Gault, ACMA, CGMA, is a UK-based business architect at Gault & Co. Ltd. Peter Satchel is director at Decani Risk and Claims Management Services Ltd. To comment on this article or to suggest an idea for another article, contact Oliver Rowe, an FM magazine senior editor, at Oliver.Rowe@aicpa-cima.com.