Evaluating business interruption claims in a post-COVID-19 world
As insurers evaluate the costs associated with business interruption claims, the insured’s documentation will play a vital role.
Around the world, the COVID-19 pandemic has caused unthinkable disruptions. As businesses shut their doors due to government mandates, many are expecting their insurance policies to cover some, if not all, of their business losses due to the COVID-19 disruption.
Most insureds are evaluating their coverage under some variation of business interruption, including communicable disease, business income, contingent business interruption, interruption due to civil or military authority, ingress/egress and event cancellation. There has been much debate concerning whether or not insurance will cover disruptions caused by COVID-19, but a form of coverage may be triggered under some policies.
Whether there is coverage or not under differing policy types, exclusions or other limitations related to COVID-19 will be significantly contested issues that may be litigated in the post-COVID-19 environment. The focus here will be on the financial, accounting and economic issues typically present in the calculation of loss estimates related to submitted claims.
Assuming that coverage is triggered, the insured and insurer will benefit from working together to determine an accurate and supportable claimed loss. Business interruption coverage is generally part of the insured’s property insurance policy, and the types of reimbursable losses and expenses most typically include:
- Extra expenses; and
- Loss of income the business suffered due to the interruption.
Insurers will need to recognize, analyze and evaluate the merits, strengths and weaknesses of submitted claims through a comprehensive and detailed analysis of supporting documentation. The high-level financial and accounting issues that may be present in submitted claims are discussed here.
Extra expenses
Insurers should expect to see the documentation of an insured’s actual spending on expenses directly incurred as a result of the COVID-19 interruption. This may include orders, invoices, shipping records and related payment support documentation.
The focus is on a “but-for” type analysis, including an evaluation of the insured’s unforeseen expenses due to COVID-19. Insurers will assess the reasonableness of these expenses based on the documentation provided.
Documentation detailing the expense purpose and the resulting mitigation helps, especially when compiled contemporaneously with the spending. This assists insureds and insurers in segregating costs related to the COVID-19 pandemic from normal costs and minimizes questions or uncertainty when the claim is submitted.
For example, an extra expense incurred to expedite shipping to obtain a delayed product from suppliers might be recorded in the general ledger account with other regular shipping expenses. It is easier to identify and document this extra expense when incurred during the interruption period as opposed to sometime afterward. Further, insurers should also understand the nature of fixed versus variable costs that may be apportioned to a claim. Understanding the differing cost types may be relevant to the proper assessment of the loss estimate in a submitted claim.
Loss of income
Insurers should assess whether the loss calculations of the claims are supported, sensible and reasonable. The strengths or weaknesses of a claim will often be rooted not only in the quality but also the comprehensive nature of historical financial reporting.
Historical financial statements
Insurers should ordinarily expect to analyze at least three years of annual financial statements before the date of interruption and should consider whether they have been audited, reviewed or compiled by an independent accounting firm. Audited financial statements provide a measure of scrutiny so insurers can be more comfortable with the accuracy of the reported results.
If the financial statements have not been audited or reviewed, or if carriers are uncertain of the insured’s financial acumen, they should consider performing enhanced diligence around the financial statements. This could be accomplished by the insurer performing its own testing and analytical procedures or engaging an outside consultant to perform certain testing and analytical procedures deemed appropriate for the circumstances.
Budgets, forecasts or projections
Insurers should also look at budgets, forecasts or projections prepared before the interruption. These reports are beneficial in assessing the credibility and reasonableness of a claim as they provide estimates of financial activity “but-for” the interruption.
Monthly reports are likely to capture any seasonality in revenues and expenses. Additionally, who the budgets, forecasts or projections were prepared for should be considered, such as potential investors, since the numbers could be overstated.
Forecasts, projections or budgets prepared as part of an internal process to be used by management to evaluate on-going results may yield the insured’s most reliable and reasonable estimate, although this is not always the case. Budgets often contain estimates that do not reflect achievable results or realistic expense containment.
Ancillary accounting and management reports
Ancillary accounting and management reports might also be relevant to a claim’s documentation. For example, specific revenue and costs reports by product line, geography or customer can often be useful.
These reports do not have to be generated from the insured’s general ledger or accounting system but may reside in off-system spreadsheets or management and operational systems — mimicking a more typical management discussion and analysis one might find in public company reporting. Like the historical financial statements discussed earlier, at least three years of historical management reports can help analyze trends and establish a reasonable basis for estimating future income and expense activity during the interruption period.
Non-COVID-19 related income/expense effects
Insurers should be cautious and not overlook items unrelated to COVID-19 that might affect the insured’s losses and consider whether they are present in an insured’s loss estimate or historical financial statements. Here are some examples of the types of items to consider:
- Are there changes in the application of generally accepted accounting principles (GAAP) that might impact, distort or amplify estimated losses when compared to historical financial reporting?
- Are there new GAAP standards being applied that were different in prior reporting periods, and whose effects on financial statement comparability need to be considered?
- Are there non-recurring items that may be present in historical financial reporting that should be adjusted to remove their potential effects on an insured’s loss estimates?
- Did the insured improperly include expenses in the claim submitting process that should have been dealt with in prior periods and are unrelated to COVID-19?
- Are there customer or revenue stream losses unrelated to the COVID-19 claim that were previously known or should have been anticipated by the insured in the normal course of business?
In the coming months, insurers will be faced with a myriad of questions about the support for and the calculation of business interruption loss estimates as the world ventures into the post-COVID-19 reality. The breadth, detail and level of documentation provided will be critical to the insurers’ assessment of the validity of claimed losses.
Whether the interruption losses can be appropriately measured and supported will ultimately depend on the credibility of the submitted documentation.
Todd Bailey, CPA, MBA, CFF (tbailey@resecon.com) is a director, and Clara Park, CPA, CFE (cpark@resecon.com) is a manager in the Los Angeles office of Resolution Economics LLC, an economics, statistics, forensic accounting and economic damages consulting firm. This content is for general information purposes only and should not be used as a substitute for legal advice or consultation with professional advisors. Reprinted with permission from Resolution Economics LLC.
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