The term “Extra Expense” is often misused in the context of aCommercial Property claim.

More importantly, Extra Expense is often improperly estimatedand accounted for when placing coverage. A complete understandingof Extra Expense may eliminate unnecessary premiums. Conversely, athorough understanding of Extra Expense coverage may allow coveragegaps to be filled that you didn’t realize existed.

Extra Expense is synonymously mistaken for “expense to reduce”coverage. These terms are not the same. In fact, “expenseto reduce” is not really a separate coverage.

Extra Expense, however, is an additional coverage that is addedto enhance Business Interruption (BI) insurance. All basic BIcoverage includes “expense to reduce.” It is rare to find a policythat spells out “expense to reduce” or has a separate “expense toreduce” clause.

Before we continue, let’s first refresh our understanding of BIcoverage: It provides coverage for a company’s change in revenueand expenses after suffering a covered loss. Said another way, BIcoverage will step in and replace the revenue lost during theperiod of interruption (note that changes in expenses, higher orlower, are also part of BI).

Extra Expense and “expense to reduce” enter the loss recoverypicture after an insured suffers a covered loss and then has anopportunity to minimize its potential BI losses. As previouslymentioned, all BI coverage inherently includes “expense to reduce”coverage. This is true whether separately stated or not. “Expensesto reduce” are simply costs incurred by a policyholder after a lossincident that reduce the potential BI losses.

Let me demonstrate how “expense to reduce” is inherently part ofall BI coverage. Say a policyholder has a potential $100 BI loss.For $20 they can perform an action that will make the $100 BI lossgo away. The $20 expense is considered an “expense toreduce.” I am not aware of any insurance carrier that would telltheir insured to lose the $100 instead of spending the $20 … itwould defy all common logic.

One important note to highlight is that all property policiesrequire an insured to mitigate its loss. Thus, if there is anopportunity to minimize BI losses, even partially, the policyrequires the insured to take action.

Continue reading ...

As an example, a small law firm has a fire that completelydestroys its office. It does not own the building, but the landlordintends on rebuilding. The estimate to rebuild and to have the newspace ready and available is 12 months. Fortunately, the firm hasan online backup for all of its systems and does not lose any data.Naturally, the firm replaces all of its laptops immediately andfinds temporary office space for the next year. Within two weeks,the entire firm is fully functional. It was also able to maintainand service all of its clients through the disruption.

The temporary short-term space is quite expensive and costs$15,000 per month. Based on its lease agreement, the firm is nolonger responsible for paying its normal $5,000 per month rent; sothe net incremental monthly rent amount is $10,000. This $10,000monthly amount is an “expense to reduce” the Business Interruptionloss.

I’m sure you are asking, why is the monthly $10,000 amountconsidered an “expense to reduce” versus an ExtraExpense?

The key difference between Extra Expense and “expense to reduce”is that “expense to reduce” must equate to an amount lower than BIlosses that would have been incurred absent the mitigationefforts.

In the example above, the law firm generates about $5 million inrevenue on an annual basis. If it would not have found temporaryoffice space and done nothing to mitigate its loss, it likely wouldhave lost all of its clients and would have had a BI loss far morethan the $120,000 “expense to reduce” amount. Therefore, the“expense to reduce” value is lower than the potential BI exposure.It would be common for people to mistake the $120,000 as an ExtraExpense.

Where Extra Expense comes in

What happens when loss mitigation efforts exceed the potentialBI losses? This is where we bring in the concept of ExtraExpense.

Extra Expense coverage is always separated in a policy; usuallyas an additional coverage. The important difference from “expenseto reduce” is that Extra Expense does not have to reduce BI lossesotherwise payable under the policy. This does not mean ExtraExpense is a free-for-all. Almost every policy’s language requiresthe Extra Expense to be reasonable, necessary and spent to continueoperations.

While most businesses seem to find a way to mitigate BI lossesafter suffering from a covered peril, the reality is that ExtraExpenses are rare. Most mitigation efforts taken by a business fitthe “expense to reduce” definition.

Now that we have defined and illustrated the difference betweenExtra Expense and “expense to reduce,” let’s explore how thepolicy limits apply. Because “expense to reduce” is part of thebasic BI coverage, your “expense to reduce” amount is only limitedby the BI limit of the policy. In many cases, the BI coverage maybe part of an even broader property blanket limit depending on thestructure of the policy. This would be one limit for Building,Business Personal Property and Business Interruption combined.Note, it is possible and common to incur both BI and “expense toreduce” losses at the same time. Extra Expense almost always has aseparate sublimit, which you will find on the Declarations page ofthe policy.

Why is this all important? During the placement process,the confusion over how mitigation efforts impact an insured’sfinancials can cause the efforts to be incorrectly considered ExtraExpenses. Therefore, unnecessary Extra Expense coverage ispurchased when the policy already provides recovery for mitigationefforts under existing BI coverage.

My intention is not to minimize the value of Extra Expense, butrather to clarify the purpose and practical application of thecoverage. It is impossible to prepare for every loss scenario, soyou never know when Extra Expense may prove valuable. The mostcommon use I have seen in practice is when a loss mitigationopportunity is extremely expensive. Normally spending a significantamount of unprofitable money to continue operations would goagainst all common business logic. However, with Extra Expensecoverage available, the expense may make sense. I have also seenExtra Expense dollars effectively used on aggressive marketingcampaigns.

The best-case scenario for a policyholder after suffering a lossis to maintain revenue and customers, even if it means incurringadditional expenses. A careful review of a policyholder’s disasterrecovery plan and/or mitigation opportunities can help quantify theactual Extra Expense exposure.

Kevin M. Grudzien is director of Chicago-based insuranceclaims consulting firm QuantumGlobal Advisors LLC. E-mail him at [email protected].

Related: Survey: Cyber incidents, competition aremajor Business Interruption threats