Adjusting business income claims and calculating the amount payable is typically considered complex and difficult to understand.
When claims professionals look for how-to information, they discover that it is hard to find.
Several books have been written on coverage, theories and principles, but most fail to provide step-by-step information on the process. As a result, many insurers routinely refer business income claims to CPAs and forensic accountants, and the result is that insurers incur substantial adjustment expense.
With a little training, most small-business claims can be processed by in-house claims personnel. This article provides an introduction of the basics of the business interruption/income claims process.
The ISO BP 00 03 and the Insurance Services Office Inc. (ISO) CP 00 30 and CP 00 32 business income (with and without extra expense) coverage forms define business income as: “a. Net income (net profit or loss before income taxes), that would have been earned or incurred if no physical loss or damage had occurred ... and b. Continuing normal operating expenses, including payroll.”
This is frequently called the “bottom-up plus continuing expenses method.” The word “baseline” is used by accountants and knowledgeable adjusters to describe this policy provision. But don't expect to find “baseline” defined in the ISO business policy (BP) or commercial policy (CP) business income policy forms.
The baseline is used to evaluate or measure the amount payable for business income under various claims scenarios. It is also used to calculate the business income loss payable, as well as the amounts payable under other coverages, depending on an insured's actions following a covered loss.
Net income plus continuing expenses is called the bottom-up method, but the most commonly used method is the top-down method, also known as gross earnings less discontinued expenses. The two methods refer to the position of the gross revenue at the top of a typical income statement (profit and loss statement) or a tax return, and the bottom-up refers to the net profit located at the bottom of an income statement or tax return.
The adjuster should confirm:
- That the cause of a loss is covered.
- That business operations were interrupted or “suspended.”
- That the suspension resulted in the loss of business income.
If there are coverage questions, the field adjuster should use a non-waiver agreement or reservation of rights letter and proceed to handle the business income loss and investigate further to resolve the coverage issue.
Differing types of losses will need different types of records for the claims adjuster to examine. (Photo: iStock)
Sales, billing and tax records
The adjuster or examiner should request that the insured, his or her bookkeeper, or accountant provide cash flow information confirming daily sales or billing. This is done by taking a retrospective look back at the business’ sales or billing performance preceding the date of loss. The following records may be needed depending on the severity of the loss:
- Daily sales or billing records.
- Income statements, if any.
- Expense ledger or ledgers.
- Federal tax returns.
- Sales tax records.
- Real property and BPP lease/loan documents.
- Business personal property leases.
- Floor plan financing records.
- Bank records.
If the loss has a limited period of restoration (or suspension) such as a small water loss, only a few weeks of sales or billing records may be needed. If the covered cause of loss is more serious, additional records will be needed.
For example, lease/rental/mortgage documents are usually not necessary to handle minor losses. If the damage or loss is catastrophic, more documents will be required, such as two or more years of business and tax records.
If the loss involves seasonality, prior year's books, records and income statements corresponding to the projected period of suspension are crucial to quantifying the business income loss.
Gross revenue less discontinued (or abated) expenses
The adjuster needs to determine which expenses have been discontinued and which will continue during the period of restoration.
Expenses may discontinue following a covered loss for a number of reasons and the primary one is that they are not incurred. If an expense is not incurred, it cannot be reimbursed to the insured business.
If employees are laid off and not paid, payroll is not incurred and discontinues.
For commercial property (CP) policies, ordinary payroll (hourly worker payroll) may be excluded unless a CP 15 10 06 07 endorsement is selected by the insured. The businessowners policy includes 60 days of ordinary payroll coverage, but only if it is incurred. If the period of restoration exceeds 60 days, ordinary payroll will be considered a discontinued expense after 60 days. If the business premises is leased and sustains heavy damage, the lease's “abatement clause” may apply so that lease payments discontinue during the period of restoration.
Secured business personal property that is leased or may be collateral for loans such as dealer flooring financing usually has a loss payable endorsement attached to the policy and is recorded with the secretary of state and/or the county recorder's office.
Retailers also obtain loans and use their inventory as collateral. Business Personal Property (BPP) coverage insures several categories of movable property which can include unscheduled and scheduled BPP. Business property that is leased such as vehicles or equipment used in the business may be insured by other insurers, but lease payments are typically paid by the business.
The same situation applies to loan payments where business property is used as collateral. In the event of a total loss, the other insurer pays the loss and the lease or loan payments will discontinue or abate. Real and business personal property is usually destroyed as the result of serious or catastrophic losses. Although lease and loan payments may abate, there will be an increase in loss payments under structure and BPP coverages.
When operations are suspended in a retail/mercantile business, the cost of goods sold abates because the goods are not sold and not expensed off the business’ balance sheet. Many other types of variable expenses can abate, depending on the severity of the loss and may include utilities, business personal property and real property taxes, advertising, shipping costs, depreciation on destroyed business property, payroll and more.
Various methods are used to quantify revenue and expenses to arrive at the business income loss in dollars and cents. (Photo: iStock)
Top-down method (gross income less discontinued expenses)
Gross Loss of Revenue – Discontinued Expenses
+ Incurred Extra Expense (EE)
= the Loss Payable
In practice, the top-down method is used in most cases to quantify the loss of business income for the period of indemnity.
Doing the math — the methods
Whether the top-down or bottom-up method is used, the period of restoration or suspension must be projected.
The next step is to establish the loss of sales and billing revenue, and then quantify the discontinued and continuing expenses for the relevant period to establish the period of indemnity.
Various methods are used to quantify revenue and expenses to arrive at the business income loss in dollars and cents. All of the methods use a “retrospective” approach as they require looking back at the business’ historical records preceding the date of loss.
As to the loss of revenue, the business’ historical daily sales and billing can be examined and averaged to quantify daily, weekly and monthly loss of revenue.
For expenses, other methods can be used to calculate those that discontinue or continue. Expense ratios can be used to compute the variable expenses as a percentage of sales. Variable expense ratios can be derived from income statements such as: profit and loss statements, tax returns and forms. Prior sales tax records can also be helpful. Annual income statements usually show percentages for each expense during the period covered by the income statement.
With retail or mercantile businesses, the cost of goods sold (COGS) discontinues when business operations are interrupted during the restoration period.
Most federal tax returns include an IRS Form 1125-A — Cost of Goods Sold Form. Corporate IRS forms will include the cost of goods sold as a line item. The COGS as a percentage of the gross revenue can be quantified with an expense ratio using information in these tax documents.
Proration can be used to quantify fixed expenses such as rental or lease payments for any month or part of a month during the period of suspension.
The loss of net profit for each day of operation can also be ascertained using income statements for any period to establish a daily gross revenue and net income. This is done by dividing the gross revenue or net profit by the number of days of operation in the period covered by the statement. The results represent the average daily sales or daily net profit for the projected period of indemnity.
Because of the complexity of payroll coverage, the actual dollars and cents total of incurred or discontinued payroll should be used to evaluate the loss payable.
Extra expense (EE)
Extra expense coverage is used to avoid or minimize the suspension of operations or to resume partial operations at the insured location or elsewhere for the period of restoration. The third extra expense provision provides coverage to “repair or replace property and to replace or restore lost information or damaged records.” The “to the extent” provision applies to the third category of EE, which is used to measure the amount of coverage based on the amount of reduction of the business income loss. (See Chapter Five § 5.6 page 162 & § 5.7 page 163-164 in “Small Business Net Income Loss Fundamentals”)
Business Income insurance is designed “to prevent the insured from being placed in a better position than if no loss or interruption of business had occurred.” (Photo: iStock)
Loss determination and 'to the extent' provisions
Handling a business income loss is measured by the baseline and the process detailed in the BP or CP policy provisions. As to the BP 00 03, the business income cover is described on Pages 6 and 7 under f.(1) Business Income and Page 30 at paragraph 7. Resumption of Operations.
The “Loss Determination” and “Resumption of Operations” provisions of the CP 00 30 (with EE), on page 6, and CP 00 32 (without EE), on pages 5 and 6 of the business income forms will inform the adjuster of the process of quantifying the loss. The BP and CP provisions provide guidance in establishing the insurer's obligations as to payment. The following are comments and some supporting case law regarding the process:
Reduce business income loss to the extent the business can resume operations. The loss to the insured business is determined by comparing the actual income earned and expenses incurred during the projected period of restoration and the resumption of operations to the same period assuming there has been no physical loss or damage that occurred. (See W.S. Shanban & Co. v. Commerce & Industry Ins. Co., 475 F.2d 34 (9th Cir. 1973);
The business must use damaged and undamaged property (merchandise, stock) to reduce the business income loss specified in the BP and CP business income forms;
Deduction of salvage retained in the extra expense provisions regarding repair or replacement of any property.
Expenses are recouped when the business resumes operations at the loss location or elsewhere and the business makes a net profit. [See Legier & Co. v. Travelers Indem. Co. No. 09-6674 Slip op. at 7 (E.D. La. April 28, 2010 and Consolidated Companies, Inc. v. Lexington Insurance Co. (616 F.3 422 (US App Ct — Fifth Circuit — Aug. 17, 2010 (Westlaw — WL 211751).] The policyholder is not permitted to recover continuing expense if the business resumed operations and had a net profit. A provision regarding recouping expenses is not listed in the BP or CP policies, but it is proper in practice.
Deduct expenses paid by others or other insurance. Provisions of BP and CP include provisions regarding other insurance and others that pay the loss.
A basic principle of all insurance is to protect and indemnify the insured from loss and to make the insured whole again. Insurance is not intended to put the insured in a better position than before the date of loss. Business Income insurance is designed “to prevent the insured from being placed in a better position than if no loss or interruption of business had occurred.”
It's clear that business income and associated coverages provide excellent protection and benefits that allow the insured to resume normal operations.
With some training, front-line adjusters and examiners can acquire the skills to handle and adjust business interruption/income losses.
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