Editor’s Note: This article has been contributed by Bruce D. Smith, CPA, CFF, CFE, is a consultant and expert witness. Smith provides forensic and investigative accounting services to the insurance industry and has also assisted non-insurance clients in business disputes, including misappropriation of assets.

To fairly value a business income (BI) loss claim, a claims handler must have an understanding of how a policyholder captures economic transactions on its financial statements and other relevant operating reports and records. Sometimes the valuation is a relatively simple task, as the claims professional is familiar with similar businesses and their recordkeeping, the loss period is short, and revenue and expenses have been stable over a number of years. In other cases, however, it is the polar opposite, resulting in an extremely challenging task.

A “Simple” Scenario
A fire damaged a restaurant. The policyholder contacted his insurance company’s claims department to report the incident. The insurer deployed a claims adjuster to the loss location. The adjuster scoped the damage and reported to the insurer his determination of coverage, initial reserves, and an estimate of the time required to repair or replace the damaged property. The adjuster then engaged a forensic accountant to assist in the valuation of the policyholder’s BI loss claim, informing the accountant that the Period of Restoration1 was two months.

The forensic accountant requested various historical financial documents from the policyholder for the purpose of determining an appropriate base period from which to project the restaurant’s operating results during the period of restoration. Based on the results of his review of the records provided, the forensic accountant determined that the appropriate base period would be the two months preceding the date of loss, as historically operating results were similar to those that occurred during the months that encompassed the Period of Restoration. 

To value the BI loss, the forensic accountant compared the projected operating results to the period of restoration operating results. The difference was considered the BI loss. 

A “Complicated” Scenario
A forensic accountant may discover during his or her initial review of records and/or conversations with the policyholder that internal and/or external factors have affected business operations during the potential base period. Furthermore, these factors would have a direct impact on the policyholder’s BI loss. Examples would be: 

  • Limited availability of historical financial and production records.
  • Pre-loss events that skewed production/sales trends.
  • Changes in operating capability through the purchase, disposal, or modification of plant and equipment. 

The following scenario incorporates these complicating factors.

Facts and Background
Saw-Masters Company is a vertically integrated timber, lumber, and hardwood flooring operation. On May 1, 2012, a fire destroyed one of its two operating sawmills. 

Saw-Master Company purchases and then harvests standing timber from landowners. It then transports the timber back to its sawmills. At the sawmills, the bark is removed from the timber, processed and sold for landscaping mulch. The logs are then moved by a conveyor to a “head rig,” which consists of a large saw and carriage. The saw squares up the log by cutting a slab from each of its sides. The slabs are processed and sold to paper mills and certain metal processors. The sawdust generated by the sawmill is used as fuel on site and also sold to manufacturers and farmers for various purposes. The mulch, chips, and sawdust all generate a significant stream of revenue.

For the purpose of discussion, the two mills that were operating on May 1, 2012, will be called “Mill Y” and Mill “Z.” Mill Y was designed primarily for small, low-grade logs. It sawed logs for the purpose of: (a) producing lumber used by other companies/customers to assemble pallets, and (b) producing logs to be re-sawed into lumber at Mill Z. 

One should note that Mill Z was designed for larger, high-grade logs. It consisted of two head-rigs and a fast, efficient re-saw, which processed both the logs received from Mill Y and those received directly from the timber farms. 

From January 1, 2009 through May 31, 2011, the company had a third mill (“Mill X”), which had a circular saw. Thus, from January 1, 2009 through May 2011, the company had three operating sawmills. Mill X was destroyed by fire on May 31, 2011.  

Shortly after the Mill X fire, the company decided to modify/improve Mill Y by replacing the machine’s band saw with a circular saw. The purpose of the modification was to maintain the same production capacity that existed when all three mills—Mill X, Y and Z—were operating. Although the modification to Mill Y commenced shortly after the Mill X fire, Mill Y was not operating at or near its intended production capability until two weeks before its May 1, 2012 fire. 

An office fire occurred on November 30, 2011. All production records from January 2008 through November 30, 2011, were destroyed in the fire. No computerized or hard-copy backup existed of the documents. 

Why It Is Complicated
In the restaurant fire BI loss scenario, the projection of the restaurant’s financial operations during the period of restoration and resulting BI loss was relatively simple and straightforward. The BI loss analysis of the sawmill fire was far more complex. As noted in the “Facts and Background” section, many factors had to be considered before selecting the appropriate base period to project financial operations during the period of restoration. Listed below are those factors: 

  1. Modification of the company’s production facilities. From January 1, 2009 through May 31, 2011, the Company had an additional mill (“Mill X”), which had a circular saw. Thus, from January 1, 2009 through May 2011, the Company had three sawmills vs. the two operating sawmills at the date of loss.
  2. Shortly after the Mill X fire, the company decided to modify Mill Y by replacing its band saw with a circular saw.  The purpose of the modification was to maintain the same production capacity that existed when all three mills—X, Y and Z—were operating. Although the modification to Mill Y commenced shortly after the Mill X fire, because of mechanical difficulties resulting from the “saw swap-out,” Mill Y was not operating at or near its production capability until two weeks before the Mill Y fire. 
  3. An office fire occurred on November 30, 2011. All production records from January 2008 through November 30, 2011, were destroyed in the fire. No backup existed, which complicated the evaluation and selection of a base period.
  4. The price of lumber is affected by supply and demand. 

Final Calculations
In the “simple” restaurant BI loss scenario, a base period was selected after an analysis of historical financial information and inquiries of management, as to whether there were any significant changes to the company’s business operations. Projected operating results were then compared to actual operating results during the period of restoration, with the difference being considered the projected BI loss.

In the sawmill BI loss scenario, many internal and external factors affecting the BI loss calculation were evident. The noted factors included: pre-loss changes in operating capability of the destroyed sawmill (change of Mill Y from a band saw to a circular saw); previous fires (Mill X fire on May 31, 2011); loss in efficiency of Mill Z (it had to saw lumber for which it was not set up…that which was previously sawed at Mill Y); changes in the economy (market conditions/supply and demand); and destroyed and missing records (production records destroyed in the November 30, 2011 office fire).