Do you know the difference between Extra Expense coverage and 'expense to reduce'?

Business Interruption insurance includes
Business Interruption insurance includes "expense to reduce." But it is not the same thing as Extra Expense coverage. (Photo: iStock)

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

More importantly, Extra Expense is often improperly estimated and accounted for when placing coverage. A complete understanding of Extra Expense may eliminate unnecessary premiums. Conversely, a thorough understanding of Extra Expense coverage may allow coverage gaps 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, “expense to reduce” is not really a separate coverage. 

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

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

Extra Expense and “expense to reduce” enter the loss recovery picture after an insured suffers a covered loss and then has an opportunity to minimize its potential BI losses. As previously mentioned, all BI coverage inherently includes “expense to reduce” coverage. This is true whether separately stated or not. “Expenses to reduce” are simply costs incurred by a policyholder after a loss incident that reduce the potential BI losses. 

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

One important note to highlight is that all property policies require an insured to mitigate its loss. Thus, if there is an opportunity to minimize BI losses, even partially, the policy requires the insured to take action. 

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Extra expense chart

As an example, a small law firm has a fire that completely destroys its office. It does not own the building, but the landlord intends on rebuilding. The estimate to rebuild and to have the new space ready and available is 12 months. Fortunately, the firm has an online backup for all of its systems and does not lose any data. Naturally, the firm replaces all of its laptops immediately and finds temporary office space for the next year. Within two weeks, the entire firm is fully functional. It was also able to maintain and 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 no longer responsible for paying its normal $5,000 per month rent; so the net incremental monthly rent amount is $10,000. This $10,000 monthly amount is an “expense to reduce” the Business Interruption loss.

I’m sure you are asking, why is the monthly $10,000 amount considered an “expense to reduce” versus an Extra Expense? 

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

In the example above, the law firm generates about $5 million in revenue on an annual basis. If it would not have found temporary office space and done nothing to mitigate its loss, it likely would have lost all of its clients and would have had a BI loss far more than 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 Extra Expense.

Where Extra Expense comes in

What happens when loss mitigation efforts exceed the potential BI losses?  This is where we bring in the concept of Extra Expense. 

Extra Expense coverage is always separated in a policy; usually as an additional coverage. The important difference from “expense to reduce” is that Extra Expense does not have to reduce BI losses otherwise payable under the policy. This does not mean Extra Expense is a free-for-all. Almost every policy’s language requires the Extra Expense to be reasonable, necessary and spent to continue operations. 

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

Now that we have defined and illustrated the difference between Extra Expense and “expense to reduce,”  let’s explore how the policy limits apply. Because “expense to reduce” is part of the basic BI coverage, your “expense to reduce” amount is only limited by the BI limit of the policy. In many cases, the BI coverage may be part of an even broader property blanket limit depending on the structure 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 to reduce” losses at the same time. Extra Expense almost always has a separate sublimit, which you will find on the Declarations page of the policy.

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

My intention is not to minimize the value of Extra Expense, but rather to clarify the purpose and practical application of the coverage. It is impossible to prepare for every loss scenario, so you never know when Extra Expense may prove valuable. The most common use I have seen in practice is when a loss mitigation opportunity is extremely expensive. Normally spending a significant amount of unprofitable money to continue operations would go against all common business logic. However, with Extra Expense coverage available, the expense may make sense. I have also seen Extra Expense dollars effectively used on aggressive marketing campaigns.

The best-case scenario for a policyholder after suffering a loss is to maintain revenue and customers, even if it means incurring additional expenses. A careful review of a policyholder’s disaster recovery plan and/or mitigation opportunities can help quantify the actual Extra Expense exposure. 

Kevin M. Grudzien is director of Chicago-based insurance claims consulting firm Quantum Global Advisors LLC. E-mail him at kgrudzien@quantumglobaladvisors.com.

Related: Survey: Cyber incidents, competition are major Business Interruption threats

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